Salary Expense

Question: The net cash inflow or outflow generated by operating activities is especially significant information to

any person looking at an organization’s financial health and future prospects. According to FASB, that information

can be presented within the statement of cash flows by either of two approaches: the direct method or the

indirect method. The numerical amount of the change in cash resulting from the company’s daily operations is

not impacted by this reporting choice. The increase or decrease in cash is a fact that will not vary based on

the manner of presentation. Both methods arrive at the same total. The informational value to decision makers,

though, is potentially affected by the approach selected.

FASB has indicated a preference for the direct method. In contrast, reporting companies (by an extremely wide

margin) have continued to use the more traditional indirect method. Thus, both will be demonstrated here. The

direct method seems a bit easier to explain and will be discussed first. How is information presented when the

direct method is selected to disclose a company’s cash flows from operating activities?

Answer: The direct method starts with the income statement for the period. Then, each of the separate figures is

converted into the amount of cash received or spent in carrying on operating activities. “Sales,” for example, is

turned into “cash collected from customers.” “Salary expense” and “rent expense” are recomputed as “cash paid

to employees” and “cash paid to rent facilities.”

For illustration purposes, assume that that Liberto Company prepared the following income statement for the year

ended December 31, Year One. This statement has been kept rather simple so that the conversion to cash flows

from operating activities is not unnecessarily complex. For example, income tax expense has been omitted.

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