Direct Method

Direct Method

What is the direct method?

The direct method is one of the two accounting treatments used to generate a statement of cash flows. The direct method of the statement of cash flows uses the actual cash inflows and outflows from the activities of the company, instead of changing the operating section from accrual to cash accounting. Accrual accounting records income when it is earned against payments received from a customer.

Conversely, the direct cash flow method measures only the cash received, which generally comes from customers and payments or cash outflows, such as suppliers. The inflows and outflows are offset to arrive at the cash flow. The direct method is also known as the income statement method.

Key points to remember

  • Cash flow from operations for a given period can be determined using the direct or indirect method.
  • The direct cash flow method determines changes in cash inflows and outflows, which are presented in the cash flows in the operations section.
  • The indirect method takes the net income generated over a period of time and adds or subtracts changes in the asset and liability accounts to determine the implicit cash flow.
  • The direct method for the statement of cash flows provides more details on the operating cash flow accounts, even if it takes time.

The direct cash flow method takes actual cash inflows and outflows to determine changes in cash during the period.

Understanding the direct method

The three main financial statements are the balance sheet, the income statement and the statement of cash flows. The cash flow table is divided into three categories: cash flows from operations, cash flows from financing and cash flows from investing activities. The cash flow statement can be prepared using the direct or indirect method. The cash flows from the financing and investing activities sections will be identical using the indirect and direct method.

The indirect method of calculating operating cash flows uses accrual accounting information and always starts with the net income from the income statement. Net income is then adjusted based on changes in the asset and liability accounts on the balance sheet by adding or subtracting from net income to derive operating cash flows.

Under the direct method, the only section of the statement of cash flows that will differ in presentation is the cash flow of the operations section. The direct method lists the cash inflows and outflows made during the accounting period. Cash outflows are subtracted from cash inflows to calculate net cash flows from operating activities, before net cash from investing and financing activities is included to obtain the net increase or decrease in the company’s cash flow for this period.

Advantages and disadvantages of the direct method

The difficulty and time required to list all cash disbursements and receipts – required for the direct method – make the indirect method a preferred and more commonly used practice. Since most companies use the accrual method of accounting, business activities are recorded on the balance sheet and income statement in accordance with this method.

For example, a business using accrual accounting will report sales on the current period income statement even if the sale has been made on credit and the customer has not yet received cash. This same amount would also appear on the balance sheet in accounts receivable. Businesses that use accrual accounting also do not collect and store transactional information by customer or supplier on a cash basis.

Another complexity of the direct method is that the FASB requires a company that uses the direct method to disclose the reconciliation of net earnings to cash flows from operating activities that would have been reported if the indirect method had been used. to prepare the state. The reconciliation report is used to verify the accuracy of operating activities and is similar to the indirect report. The reconciliation report begins by listing the net income and adjusting it for non-monetary transactions and changes in the balance sheet accounts. This additional task makes the direct method unpopular among companies.

Example of direct method

Examples of the direct method for the statement of cash flows included in the operations section are:

  • Salaries paid to employees
  • Cash payment to sellers and suppliers
  • Money collected from customers
  • Interest income and dividends received
  • Income tax paid and interest paid

A simple presentation of the operating cash flow section using the direct method looks a bit like this:

Cash flows from operating activities:

Cash receipt from customers

$ 1,500,000

Salaries and treatments

(450,000)

Cash payment to sellers

(525,000)

Interest income

175,000

Income before taxes

$ 700,000

Interest paid

(125,000)

Income taxes paid

(237,500)

Net cash from operating activities

$ 337,500

Listing information in this way provides the user of the financial statements with a more detailed view of where a company’s cash flow came from and how it was paid out. For this reason, the Financial Accounting Standards Board (FASB) recommends that companies use the direct method.

Although it has its drawbacks, the direct statement of cash flow method identifies direct sources of cash receipts and payments, which can be useful to investors and creditors.

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