Question

Discuss differences between Direct and Indirect methods to prepare a Statement of Cash Flow.

Answer 1

From the below discussion you can understand what are the main differences between direct and indirect method of statement of cash flow,

• Direct Method to prepare statement of cash flow

• Information Required

(a) Gross receipts and gross cash payments may be obtained from the accounting records to ascertain cash flows from operating activities.

(b) For example,

(i) information about cash received from trade receivables,

(ii) payment to trade payables, cash expenses etc., which may be obtained by an analysis of cash book.

(c) In actual practice, the relevant information is obtained by adjusting sales, cost of sales and other items in the profit and loss accounts for:

• Changes during the period in inventories and operating receivables and payables;
• Other non-cash items such as depreciation on fixed assets, goodwill written off, preliminary expenses written off, loss or gain on sale of fixed assets etc.; and
• Other items for which the cash effects are investing or financing cash flows. Examples are interest received and paid, dividend received and paid etc., which are related to financing or investing activities and are shown separately in the cash flow statement.

• ​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​The direct method provides information which may be useful in estimating future cash flows and which is not available under the indirect method and is, therefore, considered more appropriate than the indirect method.
• However, indirect method of determining the cash from operating activities is more popular in actual practice.

• Indirect Method to prepare statement of cash flow

• Under the indirect method, the net cash from operating activities is determined by adjusting net profit or loss instead of individual items appearing in the profit and loss account. Net profit or loss is also adjusted for the effect of:

  (a) changes during the period in inventories and operating receivables and payables;

  (b) non-cash items such as depreciation; and

  (c) all other items for which the cash effects are financing or investing cash flows.

CONCLUSION ;

1. It is worth noting that both direct and indirect methods adjust current assets and current liabilities related to operating activities to determine cash from operating activities.

2. But direct method adjust individual items of profit and loss account and indirect method adjusts overall net profit (or loss) to determine cash from operation.

3. Therefore, indirect method fails to provide break-up of cash from operations.