Question

Which method for preparing the operating section of the statement of cash flows typically leads to a higher operating cash flow total? 

• The direct method 

• The indirect method 

• They both lead to the same amount 

• It depends on the circumstances
  

Answer 1

The answer is " they both lead to the same amount"

Explanation:

I will divide the explanation in 2 parts

• Meaning of the Direct and Indirect methods and how the cash flows are calulated under both methods.
• Proof that the operating cash flows would be same under both the methods.

Part 1: Explanation

Direct Method:

1. Direct method uses only the cash transactions, i.e., cash spent and cash received to prepare the cash flow statement.
2. All non-cash transactions like depreciation are ignored.

Indirect Method:

1. The indirect method uses net income as a base( i.e from income statement) and adds non-cash expenses like depreciation, deducts non-cash incomes like profit on the sale of scraps, and net adjustments between current assets & liabilities.

Part 2 : Proof

Pls note that very less line items have been considered in the below example just to make you understand how the answer would be same under both methods.

Question: Assume the below transactions:

1. Company has newly started in the current year with a capital of $10000 and sales amount is $30000 received in cash.
2. New asset purchased for $10,000 and depreciation is $3000 on it.
3. Expenses paid $4000 during the year

So based on the above assumed transactions,the below is the Profit and loss account(income statement) , Balance sheet prepared. You can also see the Cash flow statement under direct method and indirect method which are prepared based on the Profit and loss account and Balance sheet.