Convert Cash Flows from the Indirect to Direct Method

Sometimes, a company may prepare the cash flow from the operations section of its cash flow statement using the indirect method. However, users of its financial statements may desire to review the direct-format cash flow from operations. This may arise from the need to review, for example, trends in the cash the company paid to its suppliers and the cash it received from its customers.

It is possible to convert the indirect method to the direct method. The accuracy of this conversion will depend on the accuracy of the adjustments that are made using data that is available in published financial reports.

Steps in Converting Cash Flows from Indirect Method to Direct Method

In converting cash flows from the indirect method to the direct method, the following three-step process is applied:

• net income is disaggregated into total revenues and total expenses;
• non-operating and non-cash items are removed from aggregated revenues and expense amounts and the remaining items are broken down into relevant cash flow items; and
• accrual amounts of revenues and expenses are converted into cash flow amounts of receipts and payments by adjusting for changes in working capital accounts.

Question 1

What is the starting point for converting operation cash flows from the indirect method to direct method?

1. Net income.
2. Cash flow from operations.
3. Cash received from customers.

Solution

The correct answer is A.

The very first step in the three-step process for converting cash flows from the indirect method to the direct method is the disaggregation of net income into total revenues and total expenses.

Question 2

Which of the following components of cash flow statements could be prepared using two different methods?

1. Investing.
2. Operating.
3. Financing.

Solution

The correct answer is B.

Only the operating cash flow section of the cash flow statement can be prepared using the direct or the indirect method. The investing and financing sections of the statement are prepared using one method, by directly listing the investing/financing cash inflows and outflows.