Definition of Direct Method of Cash Flow Statement
Direct Method of Cash Flow Statement is one of how actual cash flow information is retrieved from the segments of a company’s operations and used instead of the accrual accounting values. The Cash Flow for Operations statement will vary in direct and indirect methods. In contrast, the other two forms of cash flows, Cash Flow from Investing and Cash Flow from Financing, will remain the same for direct and indirect methods.
Explanation Of Direct Method
As we know, any company’s financial statement has three important components: the balance sheet, income statement, and cash flow statement. The cash flow statement has three parts which are cash flow from operations (CFO), cash flow from investing activities (CFI), and cash flow from financing (CFF). This cash flow statement can be prepared by two methods, either direct or indirect.
Under the direct method of cash flow statement, the cash flows from receipts and payments made during the financial period are listed. Then the cash outflows are subtracted from the cash inflows to calculate the net cash flow from operations of a company. In the indirect method, net income is the starting point which is then adjusted for changes in different assets and liabilities either by adding or subtracting from the net income to arrive at the net cash flow from operations.
Example of Direct Method of Cash Flow Statement
Under the direct method, examples of cash outflows and inflows are Cash salaries paid to employees of the firm; Cash paid to vendors and suppliers, interest income, dividend received, cash collected from customers, income tax paid, interest paid, etc.
Cash flow from operations in the direct method is presented in the following format:
Cash Flow from Operations
- Cash collected from customers – $10000
- Salaries and Wages paid – ($2500)
- Cash paid to vendors – ($1500)
- Interest Income – $700
- Total cash flow before taxes – $6700
- Interest paid – ($1000)
- Taxes paid – ($700)
- Net Cash Flow from Operations – $5000
Differences between Direct and Indirect Method of Cash Flow Statement
- In the direct method, the cash flow statement from operations is calculated using only cash transactions such as cash spent and cash received. On the other hand, in the indirect method, cash flow from operations calculation is done using net income as the base. Then non-cash expenses like depreciation are added back, and non-cash income like profits garnered on scrap sales are deducted. Also, there is a net adjustment done between current assets and current liabilities to reach the final cash flow from operations.
- Another difference between the direct method and the indirect method is reconciliation. In the direct method, reconciliation is used to separate various cash flows from others, while in the indirect method, the conversion of net income is done in cash flow.
- Non-cash expenses like depreciation and amortization are ignored in the direct method while they are taken into consideration in the indirect method.
- No preparations are required for the direct method, while the indirect method involves a lot of preparation for the conversion of income.
- The accuracy indirect method is high due to a lack of any adjustments that are required. An indirect method has low accuracy since a lot of adjustments to the cash flows are required.
- The direct method of cash flow statement takes more amount of time to prepare than the indirect method of cash flow statement.
- Companies prefer using the indirect method since they are preparing a balance sheet and income statement based on accrual accounting, and the indirect method use accrual accounting. If companies were to prepare a direct method of cash flow, they have to look at every transaction as a cash outflow or inflow.
Advantages and Disadvantages
Both the methods of preparing cash flow statements are useful, and they are used by companies depending on specific situations and various requirements as per standards. Generally, the indirect method is preferred by firms since pre-recording it takes a lot of time to prepare, and adjustments to both cash inflows and outflows are required. Also, an indirect method is less accurate. In the direct method of cash flow statement, preparation time is less as compared to the indirect method. But since cash transactions need to be separated from non-cash transactions, it will take a relatively large amount of time for bigger companies that have thousands of transactions daily.
The major disadvantage of the direct method is the consumption of time and difficulty it takes to list all the disbursements and receipts of cash, and it is more cumbersome for large companies who have a large number of transactions almost daily. Moreover, most companies follow the accrual method of accounting and prepare the balance sheet and income statement based on the same. Hence it makes sense of preparing a cash flow statement using the indirect method, which uses the accrual method of accounting. Another issue with the direct method is that in US GAAP, there is a requirement of disclosing the reconciliation of net income to net cash provided and used in cash flow from operations that needs to be disclosed publicly if a direct method is used to prepare the cash flow statement. Due to this added task that needs to be done, it makes sense for companies to use the indirect method rather than using the direct method.
Conclusion
Direct Method of Cash Flow Statement is one of how actual cash flow information is retrieved from the segments of the company’s operations and used instead of the accrual accounting values. Although the direct method of Cash Flow Statement has its advantages, such as it is more reliable and takes less preparation time, companies predominantly use the indirect method due to compliance requirements of accounting standards and the consumption of time and difficulty it takes to list all the disbursements and receipts of cash in the direct method.
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