Introduction
Understanding the cash flow within a business is fundamental to determining its financial health and successful administration and planning. The statement of cash flows, as a key financial statement, provides this essential insight. Drafting this statement can follow one of two paths: the direct or the indirect method. Both methods aim to accurately represent a company’s cash activities, but their approaches differ significantly.
Direct vs. Indirect Cash Flow
Similarities
First, it is essential to notice that these methods share some common elements. They aim to ascertain the exact change in net cash over a specific timeframe (Wahlen et al., 2022). It is separated into three major categories: operating, investing, and financing activities (Klammer, 2018).
Differences
Where the two paths diverge is in the manner in which they represent operating activities. The direct method delineates the primary categories of significant monetary transactions, both incoming and outgoing (Klammer, 2018). The indirect method, however, adjusts for non-cash transactions, deferred income, and changes in working capital to reconcile net income to cash flow (Klammer, 2018). It may not provide the explicit detail of each cash inflow and outflow that the direct method offers. Still, it does illuminate the difference between net income and cash flow from operations.
Choice of a Method
Preferences between these two methods can vary based on the level of detail a company wishes to disclose and the ease of preparation. The direct method, with its detailed breakdown of cash transactions, is often favored by external users of financial statements (Wahlen et al., 2022). However, from a practical standpoint, many enterprises prefer the indirect method due to its straightforward nature and wide acceptance. Required information can be readily sourced from existing financial statements (Tuovila, 2022).
From a regulatory perspective, the Financial Accounting Standards Board (FASB) does not strictly dictate one method. While the FASB’s Statement No. 95 encourages the use of the direct method due to its detailed information, it acknowledges the difficulty in assembling this data (Klammer, 2018). Consequently, many companies also accept and actively use the indirect method.
Conclusion
In conclusion, the direct and indirect methods of creating a statement of cash flows provide different ways to present the same financial picture. The choice between the two typically depends on the level of detail a business wishes to present and the ease of preparing the statement. While the FASB encourages the use of the direct method, the practicality of the indirect method often makes it the method of choice among businesses.
References
Klammer, T. (2018). Statement of cash flows: preparation, presentation, and use. John Wiley & Sons.
Tuovila, A. (2020). Direct method: complexities of cash flow method of accounting. Investopedia. Web.
Tuovila, A. (2022). How to use the indirect method to prepare a cash flow statement? Investopedia. Web.
Wahlen, J. M., Bradshaw, M. T., & Baginski, S. P. (2022). Financial reporting statement analysis, and valuation: a strategic perspective (10th ed.). Cengage.