What are the advantages and disadvantages of using the direct method for cash flow statements? (2024)

The direct method is a way of presenting the cash flow statement that shows the actual cash inflows and outflows from operating activities. Operating activities are the main sources and uses of cash for a business, such as selling goods or services, paying salaries, or buying supplies. The direct method lists the cash receipts and payments from each category of operating activity, such as customers, suppliers, employees, taxes, and interest. The net cash flow from operating activities is the difference between the total cash inflows and outflows.

The indirect method is another way of presenting the cash flow statement that starts with the net income from the income statement and adjusts it for non-cash items and changes in working capital. Non-cash items are expenses or revenues that do not affect cash, such as depreciation, amortization, or gains or losses on asset sales. Working capital is the difference between current assets and current liabilities, such as accounts receivable, inventory, accounts payable, or accrued expenses. The indirect method reconciles the net income with the net cash flow from operating activities by adding back non-cash expenses and subtracting non-cash revenues, and by adding or subtracting changes in working capital.

The direct method of preparing a cash flow statement has several advantages over the indirect method. It offers more detailed and transparent information about the sources and uses of cash from operating activities, allowing users to better understand the cash cycle and profitability of the business. Additionally, it is easier to compare with other businesses in the same industry or sector, as it eliminates the effects of different accounting policies or estimates on net income. Furthermore, it is consistent with international accounting standards (IAS) and financial reporting standards (FRS) that recommend its use for presenting the cash flow statement.

The direct method of preparing a cash flow statement has some drawbacks compared to the indirect method. It requires more data collection and analysis, as it tracks the cash receipts and payments from each operating activity separately. This can be time-consuming and costly for companies with complex transactions or multiple revenue streams. Additionally, it may not be compatible with the accrual basis of accounting that most businesses use for their income statement and balance sheet. The accrual basis of accounting recognizes revenues and expenses when they are earned or incurred, not when they are received or paid in cash, which can create discrepancies between the cash flow statement and other financial statements. Furthermore, it is not required by the generally accepted accounting principles (GAAP) in the United States, so some businesses may opt to use the indirect method to avoid extra work or disclosure.

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

Cash Flow

+ Follow

Thanks for your feedback

Your feedback is private. Like or react to bring the conversation to your network.