Cash Flow Statement Direct vs Indirect Method
The statement of cash flows is one of the main financial statements that companies prepare, and it shows the cash inflows and outflows during a specific period. There are two primary methods for preparing the statement of cash flows: the direct method and the indirect method. Each method presents the same information but in a different manner, with different levels of detail. Here’s a comparison of the two methods:
Direct Method:
- Presents cash inflows and outflows from operating activities in detail, showing cash receipts and payments from various sources such as customers, suppliers, employees, and interest payments.
- Offers more transparency into the actual sources and uses of cash during a period, making it easier to understand the cash movement.
- Is less commonly used because it requires more detailed information, which may not be readily available or may be time-consuming to collect and analyze.
- Preferred by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) because of its transparency.
Indirect Method:
- Starts with the net income (accrual basis) and adjusts it for non-cash items, such as depreciation and amortization, and changes in working capital (i.e., changes in current assets and current liabilities).
- Provides a reconciliation between the company’s net income and its cash flow from operations, offering insights into the relationship between accrual-based profitability and actual cash generation.
- Is more commonly used because it is simpler to prepare and relies on data readily available from the income statement and balance sheet.
- May be considered less transparent because it does not directly present the actual cash inflows and outflows, but rather focuses on adjustments to net income.
Both direct and indirect methods ultimately provide the same information about a company’s cash flows, but they approach the presentation differently. The direct method provides a more detailed view of actual cash transactions, while the indirect method focuses on reconciling net income with cash flow from operations. Although the direct method is preferred by standard-setting bodies, the indirect method is more commonly used in practice due to its simplicity and reliance on readily available financial data.
Example of Cash Flow Statement Direct vs Indirect Method
Let’s consider a hypothetical example of a company called TechCo and create a simple cash flow statement for its operating activities during the year using both the direct and indirect methods. The following financial data is available for TechCo:
Direct Method Data:
- Cash received from customers: $350,000
- Cash paid to suppliers: $120,000
- Cash paid for salaries: $100,000
- Interest paid: $20,000
- Income tax paid: $30,000
Indirect Method Data:
- Net income: $80,000
- Depreciation: $20,000
- Increase in accounts receivable: $10,000
- Increase in accounts payable: $15,000
- Increase in salaries payable: $5,000
- Decrease in interest payable: $2,000
- Decrease in income tax payable: $3,000
Cash Flow Statement – Operating Activities (Direct Method):
- Cash received from customers: $350,000
- Cash paid to suppliers: -$120,000
- Cash paid for salaries: -$100,000
- Interest paid: -$20,000
- Income tax paid: -$30,000
Net cash flow from operating activities (Direct Method): $80,000
Cash Flow Statement – Operating Activities (Indirect Method):
- Net income: $80,000
- Adjustments for non-cash items:
- Depreciation: $20,000
- Adjustments for changes in working capital:
- Increase in accounts receivable: -$10,000
- Increase in accounts payable: $15,000
- Increase in salaries payable: $5,000
- Decrease in interest payable: -$2,000
- Decrease in income tax payable: -$3,000
Net cash flow from operating activities (Indirect Method):
= Net income + Non-cash items + Changes in working capital
= $80,000 + $20,000 – $10,000 + $15,000 + $5,000 – $2,000 – $3,000
= $80,000
This example demonstrates how the direct and indirect methods of preparing a cash flow statement result in the same net cash flow from operating activities but present the information differently. The direct method shows the actual cash inflows and outflows, while the indirect method starts with net income and adjusts for non-cash items and changes in working capital.