Question

What is the differences between the indirect and direct methods of preparing the statement of cash flows. What do you believe are the most significant advantages and disadvantages of using each method? Explain your reasoning.*PLEASE DO NOT REPOST PREVIOUS RESPONSES. I am looking for a fresh approach.

Answer 1

The main difference between the direct method and the indirect method involves the cash flows from operating activities, the first section of the statement of cash flows. (There is no difference in the cash flows reported in the investing and financing activities sections.)

Under the direct method, the cash flows from operating activities will include the amounts for lines such as cash from customers and cash paid to suppliers. In contrast, the indirect method will show net income followed by the adjustments needed to convert the total net income to the cash amount from operating activities.

The direct method must also provide a reconciliation of net income to the cash provided by operating activities. (This is done automatically under the indirect method.)

Nearly all corporations prepare the statement of cash flows using the indirect method.

Cash Flow Statement

The statement of cash flows contains sections for three sets of activities: operating, investing and financing. Only the operations section deals with the question of direct versus indirect cash flows. By comparing the operations section with the income statement, you can identify the differences in timing between income and cash collections. Comparison also reveals timing differences between expenses and cash payments. Large differences might indicate that the company is very aggressive in recognizing income, or that the company spends a lot of cash to buy or maintain assets, a fact not apparent from the income statement.

Direct Method

When using the direct method, you list cash flows in the operations section of the cash flow statement. Cash flows due to operations arise from customer collections and cash paid to suppliers, employees and others. The section also reports cash paid for income tax and interest. The problem in trying to use the direct method is that a company might not keep the information in the required form. For example, companies using accrual accounting lump together cash and credit sales -- they would have to make special provision to track cash sales separately.

Indirect Method

In the indirect method, you adjust net income to convert it from an accrual to a cash basis. This requires you to add back non-cash expenses such as depreciation, amortization, loss provision for accounts receivable and any losses on the sale of a fixed asset. You also adjust net income for changes between the starting and ending account balances in current assets -- excluding cash -- and current liabilities for the period. These accounts include accounts receivable, inventory, supplies, prepaid assets, payable liabilities and unearned revenues.

Considerations

The indirect method uses readily available information and most companies find it easier to employ. Management and shareholders might fret if a company consistently reports net income exceeding cash flows -- they will want to identify the sources of non-cash income and determine whether these are masking serious problems with the business. If you believe that “cash is king,” you will look to the cash flow statement to measure the company’s liquidity -- the ability to pay bills and avoid defaulting on debt. Cash shortages can lead to bankruptcy, whereas excess cash might indicate a need to take steps such as increasing investments, paying down debt, increasing executive salaries or distributing dividends.

Advantages and disadvantages

Direct Method

The direct method is one way for a company to prepare its cash flow statement for presentation to shareholders. Both U.S. generally accepted accounting principles (GAAP) and International Accounting Standards (IAS) recommend companies present operating cash flows using the direct method format. In addition, the direct method is straightforward and easier to understand. Essentially, the direct method sorts all of a company's transactions and summarizes them into categories akin to taking a bank statement and sorting out checks, type of bill paid and deposits by source of inflow. For example, under operating activities, the direct method itemizes cash collected from customers, a cash inflow, and lists cash outflows such as rent paid as negative numbers to derive cash from operations.

Indirect Method

The indirect method is a little more difficult to understand. It essentially presents a reconciliation of accrual accounting net income to cash from operating activities. Accrual accounting records revenues and expenses when they occur regardless of when cash changes hands. For example, in accrual accounting, a company records a sale even if the customer has yet to pay his invoice. Under the indirect method, the company starts with net income as reported on the income statement and adjusts net income on an accrual basis rather than cash basis. For instance, since depreciation is a noncash expense, the indirect method adds the amount to net income. An increase in accounts receivable is a use of cash because, essentially, the company is providing a good to a client on credit.

Reporting

Most companies opt to report the cash flow statement using the indirect method because accrual accounting provides a better measure of the ebbs and flows of business activity. In addition, the indirect method proves to be less complex for reporting purposes. Imagine a company such as General Electric using the direct method to prepare its cash flow statement, which essentially is like going through the company's entire bank statement. However, companies may prepare the cash flow statement using the direct method with reconciliation to the indirect method as supplementary information.