I’m often asked about the two different ways of preparing cash flow statements. They are methods. Just methods. We all have our favorite way of doing things and they work for our purposes. Sometimes we can’t even explain why we use one technique over another. The best answer we can muster is, “that’s the way I was trained”. In accounting, as long as we adhere to the guiding principles, most every method has a reasonable explanation. Preparing a statement of cash flow for a company is no different.
But there has to be a reason why nearly all companies use the indirect method versus the direct method.
There is – and the answer isn’t that interesting. It’s just easier. So let’s discuss what the primary differences are so you can come to your own conclusion about which method you prefer.
The main difference involves one section on the cash flow statement – cash flows from operating activities. There isn’t a material difference in the other two sections – financing and investing activities.
Under the direct method, the preparer will include line items for cash received from customers and cash paid to suppliers. Sometimes this information is not readily available as companies record cash and credit sales together, or do not separate cash and credit payments to suppliers. The task of gathering or collecting this type of information is an additional step not found in the indirect method.
The indirect method starts with net profit and makes adjustments to convert your accounting system from the accrual basis to the cash basis.These adjustments come in the form of adding back in non-cash expenses and changes in a company’s typical balance sheet accounts. With the exception of cash, you adjust the changes in current assets and liabilities like accounts receivable, inventory, prepaid assets, and unearned revenues.
It’s easier because the indirect method uses information already reported in the company’s financial statements. It doesn’t require a special tracking mechanism to separate cash sales from the net sales amount. The cash flow statement helps measure the company’s ability to pay bills and avoid default.
The final difference between the two methods is their focus. Most experts believe the direct method is the preferred way of calculating cash flow. It more accurately identifies the timing of receiving and paying for supplies with cash. The unfortunate part of the equation is the time and effort it takes to collect the data. The direct method focuses on the reconciliation between net profit and cash flow from operations. It is mathematical proof of how cash flows through the company.
The indirect method highlights differences and changes in account balances but does not require the level of detail to perform.
I’ve heard the cash flow statement regarded as the missing link between the balance sheet and the income statement. The cash flow statement uses elements of both the snapshot of the company’s assets and liabilities and an overview of the revenues and expenses throughout the year to connect the operation to its cash. Chance are, if you are handed a statement of cash flows, it was prepared using the indirect method. And now you know why.