Direct Method Cash Flow: Definition, Examples & Advantages

Direct method cash flow
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Direct method cash flow accounting is one of two accounting practices for generating a cash flow statement. Cash flow may be efficiently managed by using the cash flow statement, a crucial financial report that shows how money leaves and enters a business. This article will cover, with an example, the direct vs. indirect method cash flow statement. 

What Is Direct Method Cash Flow Statement

One of the two ways to make a cash flow statement with accounting is the direct method. Instead of changing the operating section from accrual accounting to a cash basis, the direct method of the statement of cash flows uses the actual cash coming in and going out of the business.

A cash flow statement can be generated using either the direct or indirect method of accounting. Actual cash flows from the company’s operations are considered instead of accrual accounting. In the case of accrual accounting, a company acknowledges revenue as soon as it is earned rather than when the consumer actually pays.

Instead of changing the operational section from accrual accounting to a cash basis, the statement of cash flows direct method employs actual cash inflows and outflows from the company’s activities.

The direct method cash flow statement shows how much money a business brings in and how much it spends over a certain period. This method also looks for changes in cash payments and receipts because of how a business operates. It tells a business what its financial situation is like, which helps them make decisions and plans for the future.

Cash receipts, such as those from clients, are subtracted from cash payments. This is made throughout the accounting period, using the direct method cash flow statement, as an example. Calculating net cash flow from operating expenses resulted in this calculation. To calculate the company’s net change in cash flow for the period, you can only add investment and financing activities after the company’s net cash flow from operations.

Understanding the Direct Method

The balance sheet, income statement, and cash flow statement are the three primary financial statements. The cash flow statement also has three parts: cash flow from operations, cash flow from financing, and cash flow from investing. You can make the cash flow statement in two ways: directly or indirectly. Whether you use the indirect or direct method, the cash flow from financing and investing will be the same.

The indirect method uses accrual accounting data and always starts with income statement net income.. To calculate cash flow from operations, add or subtract net income from asset and liability balance sheet movements. The accrual technique differs from cash accounting, which requires reporting financial transactions when the actual cash inflow or outflow occurs.

To calculate cash flow from operations, you’d need to adjust the net income for changes in the asset and liability accounts on the balance sheet by adding to or subtracting from net income.

Only the cash flow from operations can be shown in a different way with the direct method. The direct method makes a list of all cash receipts and cash payments made during the day accounting period. Therefore, to measure the total cash flow from operating projects, deduct the cash outflows from the cash inflows, then add the net cash from investing and funding activities to get the net cash increase or decrease in the business for that period.

An Example of a Direct Method Cash Flow Statement

The following are some examples of the direct method for the statement of cash flows in the operations section:

  • Payment of Salaries to Employees
  • Dividends and interest income 
  • Payment to Vendors and Suppliers 
  • Payment from Customers 
  • Income Taxes and Interest Payments

This method of listing details gives the recipient of a financial statement a more accurate view of where a company’s cash comes in and out. As a result, the Financial Accounting Standards Board (FASB) advises businesses to use the direct approach.

The statement of cash flows direct process, despite its drawbacks, records the direct sources of cash receipts and payments, which can be useful to investors and creditors.

Indirect Method vs. Direct Method Cash Flow

Cash flows from operating transactions, cash flows from investing activities, and cash flows from funding activities are all included in a cash flow statement. The total amount of cash received from operating activities via direct and indirect means is largely the same. The direct method essentially presents actual cash inflows and outflows on a cash basis as the cash flow from operating operations. The indirect method, which starts with a person’s accumulated net income, is very different from this. Both indirect vs. direct methods of cash flow are applicable to measure the investing and financing parts of the statement.

However, a ton of accountants favor the deceptive strategy. This is due to the fact that using information from the income statement and balance sheet makes preparation simpler. The income statement and balance sheet will include these figures because the majority of businesses employ accrual accounting. The direct technique offers a better picture of cash flows into and out of the organization. Hence, the Financial Accounting Standards Board (FASB) advises businesses to utilize it. It’s crucial to reconcile the balance sheet and cash flow statement even if you choose to go the straight route.

The indirect method of preparing a cash flow statement is the most common. It’s because most companies around the world adhere to international accounting standards and GAAP (Generally Accepted Accounting Principles). It mandates the use of accrual rather than cash accounting methods. Let’s take a look at the indirect method of cash flow below.

What is the Indirect Method of cash flow?

The indirect cash flow method starts with the company’s net income, which you can find on the income statement, and adds back depreciation. Then, on the balance sheet, you list the changes in current liabilities, current assets, and other sources (like non-operating losses or gains from non-current assets).

Keep in mind that an income statement isn’t perfect, so you’ll need to make changes to account for things like interest and earnings before taxes. To figure out the cash flow for the company’s operating expenses, you also need to account for things like accounts payable, accounts receivable, inventory, depreciation, and expenses that have already been paid.

Advantages and Disadvantages of Direct Method Cash Flow

The advantages and disadvantages of the direct cash flow method are as follows:

Advantages Direct Cash Flow

Although there are various ways to make calculations, one method isn’t always superior to another. Each business, however, uses what suits them the best. The advantages of employing the direct cash flow strategy are as follows:

#1. Transparency

Creditors and investors may find the direct sources of cash payments and receipts reported by the direct cash flow technique useful.

#2. Simple to Understand

The direct cash flow method divides a company’s transactions into two categories: negative, which includes cash outflows like employee salaries and rent payments; and positive, which includes cash flows like accounts receivable payments received and cash collected from customers. As a result, the direct cash flow method is the simplest to understand and read. The direct cash flow method and a bank statement are extremely similar in this regard

#3. Accuracy

A more reliable way to track cash flows is to prepare financial reports using real-time data.

Disadvantages Direct Cash Flow

Even though some businesses opt to employ the direct cash flow approach, others discover that it doesn’t match their requirements for bookkeeping. Utilizing the direct cash flow method has some disadvantages, such as:

#1. Time and Effort

You must list every single receipt and payment you make using the direct cash flow approach, which can take a lot of time and work.

#2. FASB Specifications

A corporation adopting the cash flow method must reveal to the FASB its reconciliation of net income to cash flow from operational operations in accordance with generally accepted accounting standards (GAAP).

The accuracy of the operating activities is confirmed by the reconciliation report. The report includes adjustments for non-cash transactions, changes to the balance sheet accounts, and net income. Accounting professionals choose this method less since it involves more work in the reporting and accounting processes.

Conclusion

The Financial Accounting Standards Board (FASB) prefers the Direct Method because it gives a better picture of how cash moves through a business. It does this by putting cash receipts and cash payments into two main groups. The Cash Flow Statement is much more detailed and easy to use because these transactions are grouped together.

FAQs

What is direct method with example?

The direct method lists main cash receipts and payments on the cash flow statements. Customers, commissions, and tenants commonly report cash receipts. Inventory, wages, interest, rent, and taxes are common cash payments.

Why use the indirect cash flow method?

The indirect cash flow method is easier to use because it doesn’t need as much information as the direct cash flow method.

What is the Accrual Concept, and how does it work?

The accrual accounting principle, also known as accrual accounting, is an accounting method that specifies the accounting of financial components of an entity as and when they occur

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