Question

Indirect method vs. Direct method for Cash Flow Statement

The indirect method considers the opening and closing balance of ledger accounts in determining the movements and computing cash flows. If there are wrong postings in the ledger account the cash flows determined are not accurate since only opening and closing balances are considered. In direct method since each line item of ledger is classified into cash and non cash it leads to accurate computation of cash flows.

The indirect method is more widely used because the opening balance and closing balance of accounts are easily available in the published financial statements and hence the users of cash flow statement can correlate the balances with published results of financial statements. It makes sense since all the information is available at one place and users can question management on any particular cash flow which is not clear to them.

Question: The opening and closing balances are the same regardless of which method you are using. The cash flow statement is prepared after the books have been closed. If there are erroneous postings, then the closing balances will be affected as well, not just individual line items that impact cash. Also, think of the journal entry method used in the direct method in this text. Aren't we using ending ledger balances to determine cash flows? For example, if Sales =$500, and A/R has decreased by $2, then cash collected per direct method is $502.

Dr. Cash 502
Cr. A/R 2
Cr. Sales 500

If we use the indirect method, net income, which includes sales of $500, is increased by the $2 decrease in A/R, per the formula, and $502 is one component of operating cash flows. Is it not the same result?

Answer 1

Cash Flow Direct Method Vs Cash Flow Indirect Method -

1st and foremost important thing is both the cash flow gives same result and movement in cash for the financial year. The calculation of activities are different for cash from operating activities.

Direct Method use deep analysis of Cash Collection and payment where as indirect method use net income and difference between working capital chages.

At the end of all the calculation both the methods end up giving same result of cash from operating activities.

Like in the given example sale and debtors reduction gave $502 inflow of cash and as per indirect method changes in the accounts receivable more by 2 decrease shows positive change in the receivables and adding $500 sales to it would be $502 as cash from operating activities.

Although Direct method consider to be more accurate and proper way of generating cash flow statement.

There could be chances of error in the indirect statement if there was error posting a journal affect the cash balance not to get tally.

But if we are appropriate with the income statement and other posting then both the statements are valid for calculating cash flows.