Question

Financial statement preparers have two choices in preparing the statement of cash flows: the indirect method and the direct method. The indirect method is used extensively in practice even though the F.A.S.B. has expressed a preference for the direct method.

In your initial post, discuss the similarities and differences between the direct and indirect methods, and the advantages of using each method. Your answer should illustrate understanding of the cash flow statement. A minimum of 200 to 200 words is required for your answer.

Answer 1

Similarities

• Cash flow from investing activities are shown in similar way
• Cash flow from financing activities are also shown in similar way

Differences

The differences are in the way the operating cash flow is shown in Cash flow statement

• Direct method of cash flow statement shows the cash flow through actual movement of cash that is cash received from customers , cash paid to suppliers, Cash paid for operating expenses, Cash paid for interest payments and cash paid for income tax payments
• Indirect method of cash flow statement adjusts the non cash items like depreciation and amortization expense, losses and gain on sale of fixed assets, investment and then adds or deducts the changes in working capital to arrive at cash flow from operating activities. For example Increase in Account Receivable will decrease the cash inflow, Increase in Account payable will increase the cash inflow. So cash flow from Operating activities = Net Income Add back Depreciation and amortization , adjust for gains or losses and then see inflow and outflow of cash due to working capital movements.

Advantages of Direct cash flow method

• It is more conceptual based since it shows cash receipts and cash payments
• This method gives accurate movement of cash receipts and payments
• This method is easily understandable by investors and other users of financial statements

Advantages of indirect cash flow method

• It helps in reconciling net income with cash flow from operating activities
• Cash flow statement can be directly drawn from the balances in the financial statements
• It is less time consuming since large organisation may not be able to give direct cash flow statement due to huge volume of transactions.