Direct vs. indirect cash flow method

Written by kirk thomason
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The statement of cash flows is a financial statement companies prepare each month. Companies using the accrual accounting method are primary users of the statement of cash flows. Two preparation methods are possible for this statement: direct and indirect. Each method approaches cash flow reporting from a different perspective, although each will result in the same end number for an accounting period.

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Direct

A direct statement of cash flows will identify a company's sources and uses of cash. The statement has three sections that report cash receipts and cash payments. These sections include operating, investing and financing activities. Operating activities include receipts and payments from normal business operations; investing activities include the purchase or sale of long-term asset and investments; and financing activities relate to borrowing money and making payments to creditors and investors.

Indirect

The indirect statement of cash flow method does not include as much information as the direct method. Companies prepare the indirect statement by starting with net income as reported in the income statement. Accountants then make adjustments to this figure for all non-cash items. Essentially, the indirect preparation method takes an accrual-based income statement and converts it to a cash-basis income statement.

Preference

Both statements of cash flow preparation methods are allowable under basic accounting standards. The Financial Accounting Standards Board, however, prefers the direct method for the statement of cash flows. FASB prefers the method because business stakeholders find the statement easier to read than the indirect statement of cash flows. Companies prefer the indirect method as it is easier to prepare since the financial information is already at hand.

Disclosures

Companies can include disclosures with either the direct or indirect statement of cash flows. These disclosures can detail any non-cash financing and investing activities. FASB often requires disclosures with the statement of cash flows. Companies can prepare a secondary statement noting any significant non-cash activities for stakeholders.

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