Convert Cash Flows from the Indirect to Direct Method

Introduction

Oftentimes a company has prepared the cash flow from 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 paid by the company to its suppliers and cash received from its customers. It is possible however to convert from 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 remaining items are broken out into relevant cash flow items; and
  • Accrual amounts of revenues and expenses are converted to cash flow amounts of receipts and payments by adjusting for changes in working capital accounts.

Question 1

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

A. Cash flow from operations

B. Cash received from customers

C. Net income

Solution

The correct answer is C.

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?

A. Operating

B. Investing

C. Financing

Solution

The correct answer is A.

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

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Convert cash flows from the indirect to direct method

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