Question

Differentiate between the direct method and indirect method of the statement of cash flows by discussing the details of each.

Answer 1

In the direct method the cash flows from operating activities is calculated by considering the total receipts and total payments.

In the indirect method the cash flows from operating activities is calculated beginning from the net income of the company to which non cash expenses are added back.

From the balance sheet and income statement we first calculate the cash collection from customers in direct method and then deduct the amount of payment made to suppliers and payment made for operating expenses.

In the indirect method we begin by adjusting the net income to operating cash flow by adding non cash expense and then using the balance sheet for working capital changes calculate the net operating cash flow.

Below shows the format for direct method

Direct method

Cash flow from customers

XXX

Cash paid to suppliers

-XXX

Cash paid for operating expenses

-XXX

Net operating cash flows

XXX

Indirect method

Net income

XXX

Add: Non cash expense

XXX

Less: Changes in working capital

Increase in accounts receivable

-XXX

Increase in inventory

-XXX

Decrease in accounts payable

-XXX

Decrease in expenses payable

-XXX

Net operating cash flows

XXX

The items which would lead to cash outflow are deducted and items which lead to cash inflow are added.