The direct method of cash flow statement is a method of preparing the statement of cash flows that uses actual cash inflows and outflows from the company’s operations, instead of modifying the operating section from accrual accounting to a cash basis. Accrual accounting recognizes revenue when it is earned versus when the payment is received from a customer. Conversely, the direct method measures only the cash that’s been received, which is typically from customers and the cash payments or outflows, such as to suppliers. The inflows and outflows are netted to arrive at the cash flow. The direct method is also known as the income statement method.
Key Facts
- Definition: The direct method measures cash as it is received or paid, rather than using the accrual accounting method.
- Cash Flow from Operations: The direct method determines changes in cash receipts and payments from operating activities, which are reported in the cash flow from operations section.
- Presentation: Under the direct method, the cash flow from operations section lists the cash receipts and cash payments made during the accounting period. The cash outflows are subtracted from the cash inflows to calculate the net cash flow from operating activities.
- Financial Statements: The direct method is used to prepare the statement of cash flows, which is one of the three main financial statements along with the balance sheet and income statement.
- Categories: The cash flow statement prepared using the direct method includes three categories: cash flow from operating activities, cash flow from financing activities, and cash flow from investing activities.
- Complexity: The direct method can be time-consuming and complex because it requires listing all the cash disbursements and receipts, which is why the indirect method is more commonly used.
- Reconciliation: Companies using the direct method are required to disclose the reconciliation of net income to the cash flow from operating activities that would have been reported if the indirect method had been used.
- Detailed View: The direct method provides a more detailed view of where a company’s cash came from and how it was disbursed, which can be helpful to investors and creditors.
Cash Flow from Operations
The direct method determines changes in cash receipts and payments from operating activities, which are reported in the cash flow from operations section. Under the direct method, the cash flow from operations section lists the cash receipts and cash payments made during the accounting period. The cash outflows are subtracted from the cash inflows to calculate the net cash flow from operating activities.
Presentation
The direct method provides a more detailed view of where a company’s cash came from and how it was disbursed, which can be helpful to investors and creditors. For this reason, the Financial Accounting Standards Board (FASB) recommends companies use the direct method.
Financial Statements
The direct method is used to prepare the statement of cash flows, which is one of the three main financial statements along with the balance sheet and income statement. The cash flow statement prepared using the direct method includes three categories: cash flow from operating activities, cash flow from financing activities, and cash flow from investing activities.
Complexity
The direct method can be time-consuming and complex because it requires listing all the cash disbursements and receipts, which is why the indirect method is more commonly used. Companies using the direct method are required to disclose the reconciliation of net income to the cash flow from operating activities that would have been reported if the indirect method had been used.
Detailed View
The direct method provides a more detailed view of where a company’s cash came from and how it was disbursed, which can be helpful to investors and creditors.
Sources
- https://gocardless.com/guides/posts/direct-method-cash-flow-explained/
- https://www.investopedia.com/terms/d/direct_method.asp
- https://online.hbs.edu/blog/post/how-to-prepare-a-cash-flow-statement
FAQs
What is the direct method of cash flow statement?
The direct method of cash flow statement is a method of preparing the statement of cash flows that uses actual cash inflows and outflows from the company’s operations, rather than modifying the operating section from accrual accounting to a cash basis.
How is the direct method used to calculate cash flow from operations?
Under the direct method, the cash flow from operations is calculated by listing the cash receipts and cash payments made during the accounting period and then subtracting the cash outflows from the cash inflows.
What are the advantages of using the direct method?
The direct method provides a more detailed view of where a company’s cash came from and how it was disbursed, which can be helpful to investors and creditors. It is also recommended by the Financial Accounting Standards Board (FASB).
What are the disadvantages of using the direct method?
The direct method can be time-consuming and complex because it requires listing all the cash disbursements and receipts. It also requires a reconciliation of net income to the cash flow from operating activities that would have been reported if the indirect method had been used.
When is the direct method required to be used?
The direct method is required to be used when a company has a material difference between its net income and its cash flow from operations.
What is the difference between the direct method and the indirect method of cash flow statement?
The direct method uses actual cash inflows and outflows, while the indirect method uses accrual accounting information and adjusts net income for changes in the asset and liability accounts to arrive at cash flow from operations.
Which method is more commonly used, the direct method or the indirect method?
The indirect method is more commonly used because it is less time-consuming and complex.
What is the purpose of the statement of cash flows?
The purpose of the statement of cash flows is to provide information about the cash receipts and cash payments of a company during a specific period of time.