Notes

Learn about types of cash flow accounting. Examine the benefits of and differences between the direct method and the indirect methods of cash flow accounting.
Reporting Operating Activities
Practically every business has to prepare a cash flow statement, which shows how money moves in and out of the organization. And if your company isn't doing this, it should! One thing people are surprised to learn is that while the cash flow statement has three different sections, only one of them is consistently different depending on the method used to prepare it.

The Operations Section
In this lesson, we're going to look at the direct and indirect methods of preparing the operations section of the cash flow statement. As we'll see, different companies choose to use different methods for their own reasons. We'll also look at an example of each method in action.

Direct Method
The direct method of preparing the operation sections of cash flow statements is the method that is preferred by both small businesses and the accounting standard-setting bodies. The reason for this is pretty simple - the direct method gives you a much more detailed image of how cash is moving through the organization. However, you don't get as good of an idea of non-cash assets, things like depreciation and amortization of assets.

So what does the direct method entail? Simply put, there's more detail to the specifics of cash itself. As a result, a direct method statement will have line items for cash paid to suppliers, cash paid as wages, and cash revenues from customers. Also, at the end of the cash flow statement, a reconciliation is given for any income from non-cash assets, like interest.

Let's look at an example of an operations section of a cash flow statement using the direct method:

Category Income Expenses
Cash from customers $400,000
Cash paid to suppliers $150,000
Cash paid as wages $125,000
Interest paid $15,000
Income taxes paid $10,000
Net Cash Flow $100,000
Indirect Method
So what about the indirect method? This one is actually preferred by larger businesses. The reason for this is pretty simple - the indirect method can be calculated from information found in published financial statements. Investors can do the indirect method at home. The indirect method reconciles cash at the start of the year with cash at the end.

As a result, much of what is represented in the indirect method gets boiled down to one figure: net income. From there, additions for amortization and depreciation are made since they are non cash items and have already been deducted from income. So we add them back. Changes in working capital are made separately. There is also an adjustment for inventory, but we will assume this company has none. Now, let's look at an example of this in action, this time for a different company:

Category Amount
Yearly income $800,000
Depreciation and Amortization $35,000
Changes in working capital accounts $15,000
Cash generated from operations $850,000
Plus cash at start of the year $40,000
Cash at end of year $890,000
Operating Section Only
Something that cannot be stressed enough is that the direct and indirect methods only impact the cash flow statements for the operating section. Both the financing section and the investment section are identical on each form. The only exception is that the direct method has to include some form of reconciliation for non-cash assets at the bottom. Of course, the indirect method does not require this, since it's integral to the method already.

Lesson Summary
In this lesson, we took a look at the differences between the direct and indirect methods of cash flow statement preparation for the operations section. Remember that this is the only section impacted. The direct method focuses more on understanding money moving in from customers and money moving out through costs. For that reason, many small businesses prefer direct method. Conversely, the indirect method focuses more on amortization and depreciation, treating net income as a single line item. As a result, many larger companies prefer to use the indirect method.