Question

Why do you think most companies use the Direct method although GAAP recommends the Indirect method?

Answer 1

Cash Flow Statement

The cash flow statement breaks down a company's sources and uses of cash into three categories: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. Of the three, cash flow from operating activities provides an assessment of the organization's cash position from its core business. Growing or steady cash from operations is a good indication of the company's long-term viability. Cash from investing activities represents cash from investing in plant, property and equipment, disposition of assets and profit and losses from investments. Cash flow from financing activities represents sources and uses of cash from bank loans, loan repayments, debt and equity offerings and dividend payments.

Direct Method

The direct method is one way for a company to prepare its cash flow statement for presentation to shareholders. Both U.S. generally accepted accounting principles (GAAP) and International Accounting Standards (IAS) recommend companies present operating cash flows using the direct method format. In addition, the direct method is straightforward and easier to understand. Essentially, the direct method sorts all of a company's transactions and summarizes them into categories akin to taking a bank statement and sorting out checks, type of bill paid and deposits by source of inflow. For example, under operating activities, the direct method itemizes cash collected from customers, a cash inflow, and lists cash outflows such as rent paid as negative numbers to derive cash from operations.

Indirect Method

The indirect method is a little more difficult to understand. It essentially presents a reconciliation of accrual accounting net income to cash from operating activities. Accrual accounting records revenues and expenses when they occur regardless of when cash changes hands. For example, in accrual accounting, a company records a sale even if the customer has yet to pay his invoice. Under the indirect method, the company starts with net income as reported on the income statement and adjusts net income on an accrual basis rather than cash basis. For instance, since depreciation is a noncash expense, the indirect method adds the amount to net income. An increase in accounts receivable is a use of cash because, essentially, the company is providing a good to a client on credit.