Question

An essay on your understanding of the differences between the direct and indirect method of preparing a cash flow statement and indicate the preferred method according to the U.S. GAAP

Answer 1

Cash flow is simple terms means flow of cash in a business or institution. The amount of cash and cash equivalent which the company recieves or gives out by the way of payments to creditors is known as cashflow. Cash flow analysis are often used to analyse the liquidity position of the company. It gives a snapshot of the amount of cash coming into the business, from where, and amount flowing out. It has three main activities:- operating activity , investing activity and financing activity.

Cash flow statement can be prepared by two methods : direct and indirect method. Regardless which method we use, the bottom line of the cash flow statement will be same and it will be equal to the closing cash balance shown in balance sheet.

Both direct and indirect method are different from each other. The main difference between the direct and indirect method involves the cash flow from operating activites, the first section of the cash flow statement (Their is no difference between investing and financing activities in both of the methods). Under direct method, the cash flow from operating activities will include amounts for line such as cash from customer and cash paid to supplier. In contrast, indirect method will show net income followed by the adjustments need to convert total net income to the cash amount from operating activities. The direct method must also provide a reconciliation of net income to the cash provided by operating activities.(This is done automatically under indirect method).

As per us gaap Direct method is given preference over indirect method because direct method shows detailed breakdown of operating cash receipt and payments under operating activities.