Direct and Indirect Methods – Cash from Operating Activities

Introduction

Cash flow from Operating Activities may be reported in one of two presentation formats: 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, when companies use the Direct Method, they are required to present a reconciliation between net income and cash flow, which is equivalent to the Indirect Method.

Irrespective of which method is used to prepare the cash flow from operating activities section of the cash flow statement; the cash flow from investing and financing activities are 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 is shown, while the impact of accruals is eliminated.

The primary argument in favor of 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, its capacity to repay existing obligations and can assist with predicting its future financing needs.

An example of the Cash Flow from Operations segment of a Cash Flow Statement prepared under IFRS, using the Direct Method:

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The Indirect Method

The Indirect Method provides only the net results of receipts and payments. Net income, which is 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 which commences by forecasting future income and then derives cash flows by adjusting for changes in balance sheet accounts which occur because of 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, as in the Direct Method.

An example of the Cash Flow from Operations segment of a Cash Flow Statement prepared under IFRS, using the Indirect Method:

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Question 1

Which of the following is not likely to be shown in the cash flow from operations section of the cash flow statement using the Indirect method?

A. Cash received from clients

B. Net profit

C. Changes in working capital

Solution

The correct answer is A.

Cash received from clients is not reflected in 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?

A. Financing cash flow

B. Operating cash flow

C. Investing cash flow

Solution

The correct answer is B.

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.

 

Reading 26 LOS 26d:

Distinguish between the direct and indirect methods of presenting cash from operating activities and describe arguments in favor of each method


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