# Calculating CFO using Direct Method

Hi, this is a question i done in qbank and i think i’m confused with some of the concepts. Hope someone will guide me along. According to what i know, based in the kaplan notes at LOS 34.e under the professor note, there are a few points it stated: Throughout the discussion of direct and indirect methods, remember the following points, I decided to simplify it cos there are too much text 1) Increase in asset = use of cash (-) 2) Decrease in asset = source of cash (+) 3) Increase in liability = Source of cash (+) 4) Decrease in liability = use of cash (-) My 1st qns: Does the 4 statements above use in direct method? I have no problems with indirect calculation. However based on this question using the direct calculation, I"M CONFUSED if i use the points stated above Interest payable and Income tax payable are consider as liabilities. Based on the 4 points above, these are what i concluded while attempting the qns: 1) increase in interest payable 1,200,000 - \$800,000 (source of cash) 2) increase in deferred income taxes payable 1,000,000-800,000 = 200,000 (source of cash) 3) decrease in income taxes payable 800,000 - 1,000,000 = -200,000 (use of cash). However during the calcuation, it seems that whether to minus or add in direct method is different. Below are my 2nd to 4th qns: 2nd qns) why the increase in interest payable does not add to the interest expense? 3rd qns) why the increase in deferred income taxes payable does not add to the tax expense? 4th qns) why the decrease in taxes payable does not minus from the tax expense? The qbank qns as listed below. And thanks in advance for spending time to read my post and helping me. Greatly appreciated. The Red Company’s balance sheet as of December 31, 2004 was as follows: ************************************************************************ Cash Dec. 31, 2003: \$1,500,000 Dec. 31, 2003: \$1,900,000 Accounts Receivable Dec. 31, 2003: 3,000,000 Dec. 31, 2003: 3,400,000 Inventory Dec. 31, 2003: 2,300,000 Dec. 31, 2003: 2,500,000 Property, Plant & Equipment Dec. 31, 2003: 16,700,000 Dec. 31, 2003: 19,700,000 Less Accumulated Depreciation Dec. 31, 2003: (5,300,000) Dec. 31, 2003: (8,200,000) Total Assets Dec. 31, 2003: \$18,200,000 Dec. 31, 2003: \$19,300,000 Accounts Payable Dec. 31, 2003: \$2,100,000 Dec. 31, 2003: \$1,900,000 Interest Payable Dec. 31, 2003: 800,000 Dec. 31, 2003: 1,200,000 Income Taxes Payable Dec. 31, 2003: 1,000,000 Dec. 31, 2003: 800,000 Notes Payable Dec. 31, 2003: 2,700,000 Dec. 31, 2003: 2,900,000 Deferred Income Taxes Dec. 31, 2003: 2,600,000 Dec. 31, 2003: 2,900,000 Common Stock Dec. 31, 2003: 1,000,000 Dec. 31, 2003: 1,000,000 Retained Earnings Dec. 31, 2003: 8,000,000 Dec. 31, 2003: 8,600,000 Red’s interest expense was \$900,000 and income tax expense was \$1,000,000 in 2004. Red prepares its Statements of Cash Flows using the direct method. The other cash outflows section of Cash Flow from Operations (CFO) for 2004 would total: A) \$2,100,000. B) \$1,700,000. C) \$1,400,000. The answer was C. Below is the explanation from Qbank: Other cash outflows is the third step in calculating CFO using the direct method. It consists of Cash taxes paid + Cash interest paid. Cash interest paid = interest expense less increase in interest payable: (\$900,000 – (1,200,000 - \$800,000) =) \$500,000. Cash taxes paid = tax expense of \$1,000,000 (+) decrease in income taxes payable (1,000,000-800,000) = 200,000 (-) increase in deferred income taxes (2,600,000-2,900,000) = 300,000 which is equals to \$900,000. Other cash outflows = \$500,000 + 900,000 = \$1,400,000 =============================================================================================== Thanks:)

My 1st qns: Does the 4 statements above use in direct method? yes you would need to use the info on changes in assets/liabilities for computing cash flows using the direct method. 2nd qns) why the increase in interest payable does not add to the interest expense? 3rd qns) why the increase in deferred income taxes payable does not add to the tax expense? 4th qns) why the decrease in taxes payable does not minus from the tax expense? i think the reason for your confusion is the way the answer has been presented. the answer computes cash interest and taxes paid i.e outflows but those outflows have been presented as positive numbers perhaps an alternative presentation might help to clear your doubt: cash flow to interest = interest expense + increase in interest payable (increase in liability) = -\$900,000 + (\$1,200,000-\$800,000) = -\$500,000 = \$500,000 outflow (negative sign) note that here we add the increase in interest payable just as you expected, but its important that interest expense has a negative sign (expense = outflow!) similarly cash flow to taxes = -\$1,000,000 + (\$800,000-\$1,000,000) + (\$2,900,000-\$2,600,000) = -\$900,000 = \$900,000 outflow other cash outflows = \$500,000 + 900,000 = \$1,400,000 i suggest you stick with the correct signs to avoid confusion.

Whoo… thanks for the response. That really clear it up… 