The difference between the direct and indirect cash flow methods
/What is the Direct Method?
Under the direct method, actual cash flows are presented for items that affect cash flow. Examples of the items that are usually presented under this approach are cash collected from customers, interest and dividends received, cash paid to employees, cash paid to suppliers, interest paid, and income taxes paid.
What is the Indirect Method?
Under the indirect method, the calculation of cash flows from operating activities begins with net income, which is then adjusted for changes in balance sheet accounts to arrive at the amount of cash generated or lost by operating activities. For example, the statement may include line items for changes in the ending balance of accounts receivable, inventory, and accounts payable. The intent is to convert the entity’s net income derived under the accrual basis of accounting to cash flows from operating activities.
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The Interpretation of Financial Statements
Comparing the Direct and Indirect Cash Flow Methods
The differences between the direct and indirect cash flow methods are as follows:
Presentation differences. The main difference between these methods lies in the presentation of information within the cash flows from operating activities section of the statement. There are no presentation differences between the methods in the other two sections of the statement, which are the cash flows from investing activities and cash flows from financing activities.
Usage level. Either method may be used by a reporting entity. Nearly all organizations use the indirect method, since it can be more easily derived from a firm’s existing general ledger records and accounting system.
Preferred usage. The Financial Accounting Standards Board prefers that reporting entities use the direct method, since it more clearly identifies the cash flows experienced by an organization.