Direct and Indirect Methods – Cash from Operating Activities

Cash flow from Operating Activities may be reported in either presentation format: the direct method and the indirect method.

Both IFRS and US GAAP encourage the use of the direct method but will allow either method to be used. Under US GAAP, however, companies must present a reconciliation between net income and cash flow when they use the direct method. Ironically, this is equivalent to the indirect method.

Irrespective of the method used to prepare the cash flow from the operating activities section of the cash flow statement, the cash flow from investing and financing activities is each prepared using one format only.

The Direct Method

In the direct method, each cash inflow and cash outflow related to cash receipts and payments are shown, while the impact of accruals is eliminated.

The primary argument favoring the direct method is that it provides information on the specific sources of operating cash receipts and payments. This information can be useful in understanding a company’s historical performance and capacity to repay existing obligations. In addition, the direct method can be useful in the prediction of the future financing needs of a company.

Below, you will find an example of the cash flow from the operations segment of a cash flow statement prepared under IFRS using the direct method:

$$ \begin{array}{l|r|r} \text{} & \bf {\text{Dec }31,2016} & \bf {\text{Dec }31,2015} \\ \text{} & \bf{$} & \bf{$} \\ \hline \textbf{Cash flow from operating activities} & {} & {} \\ {\quad \quad \text{Cash received from customers}} & {25,900} & {23,478} \\ {\quad \quad \text{Cash paid to suppliers and employees}} & {-15,658} & {-17,534} \\ {\quad \quad \text{Dividend received}} & {1,200} & {178} \\ {\quad \quad \text{Net interest and other financial expenses paid}} & {-5,426} & {-4,789} \\ {\quad \quad \text{Taxes paid}} & {\underline {-1963} } & {\underline {-750}} \\ \textbf{Net cash from operating activities} & {{\bf{4,053}}} & {{\bf{583}}} \\ \end{array} $$

The Indirect Method

The indirect method only provides the net results of receipts and payments. Net income, the starting point for the Indirect method, is reconciled with cash flow from operations after making adjustments for non-cash items, non-operating items, and net changes in operating accruals.

The main arguments in support of the indirect method are:

• the method shows the reasons for differences between net income and operating cash flows;
• the method mirrors a forecasting approach. It commences with forecasting future income and then derives cash flows by adjusting for changes in balance sheet accounts. The changes in balance sheet accounts are attributed to timing differences between accrual accounting and cash accounting; and
• adjusting net income to operating cash flows is easier and less costly than reporting gross operating cash receipts and payments, which is the case with the direct method.

Below is an example of the cash flow from the operations segment of a cash flow statement prepared under IFRS using the indirect method:

$$ \begin{array}{l|r|r} {} & {\bf{\text{Dec }31,2016}} & {\bf{\text{Dec }31,2015 }} \\ {} & {\bf{$}} & {\bf{ $} }\\ \hline {\textbf{Cash flow from operating activities}} & {} & {} \\ {\text{Net profit}} & {3,457} & {4,256} \\ {\quad \quad {\text{Taxation}}} & {1,200} & {1,189} \\ {\quad \quad {\text{Net finance costs}}} & {536} & {245} \\ {\text{Operating profit}\text{ (continued and discontinued operations}) }& {5,193} & {5,690} \\ {\quad \quad \text{Depreciation, amortization and impairment}} & {1,028} & {1,001} \\ {\quad \quad \text{Changes in working capital}} & {1,517} & {1,501} \\ {\quad \quad \quad \quad \text{Inventories}} & {245} & {657} \\ {\quad \quad \quad \quad \text{Trade and other receivables}} & {536} & {426} \\ {\quad \quad \quad \quad \text{Trade payable and other current liabilities}} & {736} & {418} \\ {\quad \quad \text{Provision less payments}} & {-275} & {-74} \\ {\quad \quad { \text{Elimination of profits or losses on disposals} } } & {54} & {-1,567} \\ {\quad \quad \text{Non cash charge for share base compensation}} & {167} & {195} \\ {\quad \quad \text{Other adjustments}} & {17} & {32} \\ {\textbf{Cash flow from operating activities}} & {\overline {\bf{7,701}}} & {\overline {\bf {6,778}}} \\ \end{array} $$

Question 1

Which of the following is least likely to be shown in the cash flow from operations section of the cash flow statement using the indirect method?

1. Net profit.
2. Cash received from clients.
3. Changes in working capital.

Solution

The correct answer is B.

Cash received from clients is not reflected under the indirect method. Net profit and changes in working capital are usually reflected.

Question 2

Which of the below sections would differ between cash flow statement prepared using the direct method, and another prepared using the indirect method?

1. Investing cash flow.
2. Financing cash flow.
3. Operating cash flow.

Solution

The correct answer is C.

The only difference between the two methods is how they report operating cash flow. The indirect method starts with net income, then deducts/adds non-cash items. The direct method shows cash inflows and outflows directly.