One of the key differences between direct and indirect method is the the type of transactions used. The indirect method uses net income as the base and converts the income into cash flow through the use of adjustments. The direct method only takes the cash transactions into account and produces the cash flow from operations.
Another difference is that indirect method makes sure to convert the net income in terms of cash flow automatically. Cash flow direct method, on the other hand, records the cash transactions separately and then produces the cash flow statement.
The cash flow indirect method needs preparation as the adjustments that are made to require time. The preparation time for the cash flow direct method isn’t much since it only uses cash transactions.
Both the direct and indirect cash flow method are useful at different points and they can be used depending on the situation and the requirement. The indirect method is the most popular among companies. But it takes a lot of time to prepare (before recording) and it’s not very accurate as many adjustments are used.
The direct method, on the other hand, doesn’t need any preparation time other than segregating the cash transactions from the non-cash transactions. And it’s more accurate than the indirect method.
Question: Why the indirect method is not accurate?
And why the indirect method is used more widely? (except the reason that it is far easier, and the direct method is complicated in a real company)
The indirect method considers the opening and closing balance of ledger accounts in determining the movements and computing cash flows. If there are wrong postings in the ledger account the cash flows determined are not accurate since only opening and closing balances are considered. In direct method since each line item of ledger is classified into cash and non cash it leads to accurate computation of cash flows.
The indirect method is more widely used because the opening balance and closing balance of accounts are easily available in the published financial statements and hence the users of cash flow statement can correlate the balances with published results of financial statements. It makes sense since all the information is available at one place and users can question management on any particular cash flow which is not clear to them.
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