Under US GAAP, the cash flow statement can be prepared using either an indirect or a direct method. In this article, we will compare those two methods.

1. Purpose of the cash flow statement

The cash flow statement (also called statement of cash flows) is probably the most important statement as it answers questions about cash inflows and outflows.  And as we know, cash is king.

By substance, the cash flow statements traces the flow of funds to and out of the business and reconciles cash from the beginning to the end of the period. In contrast to the balance sheet and income statement, the cash flow statement is prepared using the cash basis of accounting. Non-cash transactions, such as depreciation, amortization, interest accretion, etc. are not directly part of the statement making it hard to manipulate the statement.

Financial managers may utilize the cash flow statement to assess timing and amounts of future cash flows or use it for budgeting. For investors this report helps to assess liquidity and adaptability of a company. Although the cash flow statement is free from accounting judgments it is considered to be a complex financial report for non-accountants to interpret.

2. Components of the cash flow statements under the direct and indirect method

The standards require that the cash flow statement consist of three sections: operating, investing and financing. The direct and indirect methods of preparing the cash flow statement only differ in the operating activities section, while inflows and outflows for investing and financing activates are the same under both methods.

The direct method reports operating cash flows by their nature, i.e. cash received from sales cause inflows of funds, while payments to other vendors create their outflows.

Under the indirect method, the operating cash flows start with profit or loss after tax that is adjusted by non-monetary expenses and changes in working capital.

Using any of the methods would result in the same amount of the net cash flow from operating activities.

Let us look at a short (simplified) example comparing the operating activities sections under the two methods:

Investing activities cover buying and selling long-term assets and other investments. For example, a company increases its cash by selling fixed assets or shares of a subsidiary. Investing cash outflows are caused by purchases of new equipment or land, providing loans, and acquisition of stock, among other things.

Financing activities deal with cash flows that change the company’s equity and debt structure. For example, placement of own shares or raising a loan will cause inflow of funds, while loan settlement, bonds redemption, repurchase of own securities, repayment of dividends will lead to outflows of cash.

3. Usefulness and limitations of the cash flow methods

In theory, the direct method looks more simple and straightforward, i.e., all cash received is shown as revenue and all cash paid out is grouped by clear types of expenses in the operating activities section of the cash flow statement. However, it may not be easy for a company to prepare the statement of cash flows using the direct method. Generally, the company handles thousands of transaction that may not necessarily involve cash.  Accounting records are typically kept on accrual basis, making it time consuming and expensive to collect required data for the preparation of the cash flow statement using the direct method. On the other hand, the indirect method uses already available information from the balance sheet and income statement or accounting records, e.g., an increase or decrease in receivables is determined as the difference in accounts receivable at the end and at the beginning of a period.  In addition, the direct method is rarely used by companies, whereas it requires disclosure of sensitive information regarding cash receipts from customers and cash payments to suppliers that may be used by competitors.

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