Key Facts
- Objective of the Cash Flow Statement: The primary objective of the cash flow statement is to provide relevant information about an entity’s cash receipts and cash payments.
- Direct Method vs. Indirect Method: The direct method and the indirect method are two approaches used to generate a cash flow statement. The direct method reports actual cash inflows and outflows from the company’s operations, while the indirect method modifies the operating section from accrual accounting to a cash basis.
- FASB’s View: FASB considers the direct method to better achieve the cash flow statement’s primary objective and the overall objective of financial reporting, which is to provide information that is useful to users in making investment and credit decisions.
- User Preference: Many financial statement users, including financial analysts, prefer the direct method as it enables them to forecast future cash flows of an entity more effectively than the indirect method.
- Enhanced Understanding: The direct method provides more detailed information about the operating cash flow accounts, making it easier for users to understand where a company’s cash came from and how it was disbursed.
FASB’s Preference for the Direct Method in Cash Flow Reporting
Objective of the Cash Flow Statement
The primary objective of the cash flow statement is to provide relevant information about an entity’s cash receipts and cash payments. This information is crucial for users to assess the entity’s liquidity, solvency, and overall financial health.
Direct Method vs. Indirect Method
There are two primary approaches to generating a cash flow statement: the direct method and the indirect method. The direct method reports actual cash inflows and outflows from the company’s operations, while the indirect method modifies the operating section from accrual accounting to a cash basis.
FASB’s View
The Financial Accounting Standards Board (FASB) considers the direct method to better achieve the cash flow statement’s primary objective and the overall objective of financial reporting, which is to provide information that is useful to users in making investment and credit decisions. FASB believes that the direct method provides more relevant and reliable information about an entity’s cash flows.
User Preference
Many financial statement users, including financial analysts, prefer the direct method as it enables them to forecast future cash flows of an entity more effectively than the indirect method. The direct method provides more detailed information about the operating cash flow accounts, making it easier for users to understand where a company’s cash came from and how it was disbursed.
Enhanced Understanding
The direct method provides more detailed information about the operating cash flow accounts, making it easier for users to understand where a company’s cash came from and how it was disbursed. This information is particularly valuable for investors and creditors who are evaluating the company’s financial performance and risk profile.
Conclusion
FASB’s preference for the direct method is based on its belief that this method provides more relevant and reliable information about an entity’s cash flows. The direct method is also preferred by many financial statement users as it enables them to better forecast future cash flows and understand the company’s financial performance.
Sources:
- https://saylordotorg.github.io/text_financial-accounting/s20-02-cash-flows-from-operating-acti.html
- https://www.investopedia.com/terms/d/direct_method.asp
- https://www.cpajournal.com/2017/04/20/preparing-statement-cash-flows-using-direct-method/
FAQs
What is the primary objective of the cash flow statement?
The primary objective of the cash flow statement is to provide relevant information about an entity’s cash receipts and cash payments.
What are the two methods used to generate a cash flow statement?
The two methods used to generate a cash flow statement are the direct method and the indirect method.
Why does FASB prefer the direct method?
FASB prefers the direct method because it believes that this method provides more relevant and reliable information about an entity’s cash flows.
What are the advantages of the direct method?
The advantages of the direct method include:
- Provides more detailed information about the operating cash flow accounts
- Easier for users to understand where a company’s cash came from and how it was disbursed
- Enables users to better forecast future cash flows
What are the disadvantages of the direct method?
The disadvantages of the direct method include:
- Can be more time-consuming and complex to prepare
- May require additional disclosures and reconciliations
Which method is more commonly used in practice?
The indirect method is more commonly used in practice, primarily due to its simplicity and the fact that most accounting software only supports the indirect method.
Can a company use both the direct and indirect methods in its cash flow statement?
Yes, a company can use both the direct and indirect methods in its cash flow statement. However, this is not required and is rarely done in practice.
What is the future of the direct method?
FASB has expressed its preference for the direct method and has taken steps to encourage its use. It is possible that the direct method may become more widely adopted in the future.