Direct And Indirect Cash Flows
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When companies utilize the accrual method of accounting, they will prepare a cash flow statement in order to understand the flow of cash. We call this method the cash flow statement and it can be prepared in two different methods which would be indirect and direct. The methods are different but they both will be conducted with the same results for the accounting period. The direct method of the cash method will identify the main sources of cash and is made up of three areas which include operating, investing and financial activities. It included all activities associated with cash payments and receipts. The operating activities include receipts and payments from normal operations, while investing activities include the purchase or sale of asset and/or investments.
The financing activities relate to loans, payment to creditors as well as shareholders. The indirect cash flow statement method does not include the level of detail that you would get by using the direct method. The indirect method takes the net income as reported in another monthly financial statement such as the income statement. Then adjustments are made for all l noncash items and then takes accrual-based income statement and converts it to a cash-based income statement. The Financial Accounting Standard Board allows both methods because they both report on the cash flow from operating activities. The direct method is easier to understand, it takes all the major classes of cash payments and receipts to determine the net cash from operating, investing, and financing activities. While the indirect method utilizes the net income, reported from the income statement before making adjustments for all cash and non-cash items.
When it comes to the easier to understand, I would have to say that would be the direct method. The direct method is also referred to as the income statement method, reports major classes of operating cash receipts and payments, while the indirect, or reconciliation, method focuses on the difference between net income and net cash flow from operations. In any business understanding the flow of cash is essential because it can impact the company’s ability to pay shareholders, meet their financial obligations and survive in their market.
Weygandt, J., Kimmsel, P., & Kieso, D. (2010). Financial Accounting. Hoboken, NJ: Wiley