Cash flow statement direct vs indirect method
Direct cash flow example
An illustration of a cash flow statement made using the direct method is provided below:
What is direct cash flow?
One of the two accounting techniques used to produce a detailed statement of cash flow that displays changes in cash over time is known as direct cash flow, and it refers to the direct method. The direct method cash flow statement tracks the flow of cash coming into and leaving a company over a specific time period. It is also referred to as the “income statement method.”
With the help of this technique, a company’s operational activities are also identified through changes in cash payments and receipts. It provides information about a company’s financial situation so that they can make decisions and make plans for the future.
Under the direct cash flow method, you subtract cash payments—e. g. , payments to suppliers, employees, operations—from cash receipts—e. g. , receipt from customers—during the accounting period. As a result, the net cash flow from operating expenses of the company is calculated. To calculate the net change in the company’s cash flow for that period, investing and financing activities must come after net cash flow from operations.
Indirect cash flow example
An illustration of a cash flow statement created using the indirect method is provided below:
What is indirect cash flow?
You can determine the company’s net income from its income statement to start the indirect cash flow method. Then, you add back depreciation. You then state the modifications to current liabilities, current assets, and other sources—e g. , non-operating losses/gains from non-current assets) on the balance sheet.
Remember that an income statement has limitations, so you must adjust for earnings before taxes and interest. To calculate the cash flow for the company’s operating expenses, you must also account for non-operating expenses like accounts payable, accounts receivable, inventory, depreciation, and accrued expenses.
Direct vs indirect cash flow
The cash flows from operating expenses are the primary distinction between the direct method and the indirect method of creating cash flow statements. Without starting with net income on an accrued basis, you present the cash flow from operating activities under the direct method as actual cash outflows and inflows on a cash basis. The cash flow statement’s financing and investing sections are created in the same manner for both direct and indirect methods.
Only the cash flow from operations section of a company’s three primary financial statements—the cash flow statement, the income statement, and the balance sheet—is impacted by the direct method, whereas the cash flow from investing and financing sections will be comparable whether an indirect or direct method is used.
Since it is simple to prepare the statement of cash flow using information from the balance sheet and income statement, many accounting professionals prefer to use the indirect method. Since the accrual method of accounting is used by the majority of businesses, the balance sheet and income statement reflect data that is accurate under this system. Instead of recognizing income when client payments are actually received, accrual accounting instead records income in the period in which it is received.
Having said that, the Financial Accounting Standards Board (FASB), a nonprofit organization that operates independently in the U S. that establishes guidelines for financial and accounting reporting prefers to employ the direct cash flow method because it gives a clear picture of how money comes in and goes out of a business. FASB nevertheless advises performing a statement of cash flow to balance sheet reconciliation if a company employs the direct method.
Advantages and disadvantages of direct cash flow
The advantages and disadvantages of the direct cash flow method are as follows:
Advantages
Although there are various ways to perform calculations, one method isn’t always superior to another. However, each company uses what works best for them. The advantages of employing the direct cash flow method are as follows:
Creditors and investors may find the direct sources of cash payments and receipts reported by the direct cash flow method to be useful.
The direct cash flow method divides a company’s transactions into two categories: negative, which includes cash outflows like employee salaries and rent payments; and positive, which includes cash flows like accounts receivable payments received and cash collected from customers. As a result, the direct cash flow method is the simplest to understand and read. The direct cash flow method and a bank statement are very similar in this regard.
A more reliable way to track cash flows is to prepare financial reports using real-time data.
Disadvantages
Despite the fact that some businesses opt to use the direct cash flow method, others discover that it doesn’t meet their bookkeeping requirements. The following are some disadvantages of applying the direct cash flow method:
The direct cash flow method mandates that you list every cash receipt and disbursement, which can be very time-consuming and labor-intensive.
A company using the direct cash flow method is required by generally accepted accounting principles (GAAP) to disclose to the FASB how it reconciles net income to cash flow from operating activities.
The reconciliation report verifies the accuracy of the operating activities. The report includes adjustments for non-cash transactions, changes to the balance sheet accounts, and net income. As a result of the additional work this task requires, accounting professionals are less likely to favor this approach.
Advantages and disadvantages of indirect cash flow
The advantages and disadvantages of the indirect cash flow method are as follows:
Advantages
Here are some reasons to consider using this method:
Because most businesses maintain their records on an accrual basis, the indirect cash flow method is simpler to prepare than the direct method.
The indirect cash flow method shows the discrepancy between the company’s cash holding position and its reported profitability by comparing the accrual-based accounting net cash flow with the actual cash flows from its operating activities.
The indirect cash flow method necessitates the creation of a direct connection between the income statement and balance sheet of the company, allowing you to view a company’s financial statements more methodically.
When using the indirect cash flow method, the non-cash transactions are disclosed to help you comprehend how they affect the company’s net income but are not sources of cash flows.
Disadvantage
One disadvantage is that this method lacks transparency. Rarely does this cash flow method adhere to certain standards or generally accepted accounting practices.
FAQ
What is the difference between direct and indirect cash flow method?
Changes in cash receipts and payments are tracked in the cash flow from operations section using the cash flow direct method. The implied cash flow is calculated using the indirect method by adding or subtracting changes in the asset and liability accounts from the net income generated during the period.
Is direct or indirect cash flow better?
Because it doesn’t rely on adjustments, the direct cash flow statement is generally accurate and requires less time to prepare than other types of cash flow statements. The indirect cashflow method, which takes into account adjustments and typically takes more time to prepare, cannot be regarded as accurate.
What is an indirect cash flow?
In order to show actual cash inflows and outflows during the period, the indirect method of the cash flow statement attempts to convert the record to the cash method. In this case, a $500 credit to sales revenue and a $500 debit to accounts receivable would have been recorded at the time of the sale.
Why indirect method of cash flow statement is better?
The indirect method of cash flows offers a reconciliation between net income and cash flows, which is one of its main benefits. The indirect method is also a straightforward way to create the statement of cash flows and aids users of financial statements in understanding the various connections between financial statements.
