Statement of cash flows can be prepared and presented by two methods, namely, direct method and indirect method. In both methods, there is no difference in cash flows from investing activities and cash flows from financing activities. The difference lies in the presentation of cash flows from operating activities.
In this post, we’ll discuss both methods of preparing statement of cash flows.
What do you do in operations? You make sales or provide services and get cash from customers. You buy goods, materials and pay for them. You hire staff and pay them salaries. You incur other day-to-day operational expenses such as utilities, repair and maintenance, advertising expenses etc. and pay for them.
Under the direct method, actual cash inflows and out flows from operating activities are presented. Cash flows from operating activities under direct method would look something like this:
Illustration: Cash flows from operating activities (Direct Method)
Simple, isn’t it!
It is not that simple though, as this information is not readily available in the accounting records prepared as per accrual method. Cash receipts and payments can be worked out with the help of opening and closing balance sheet and the income statement for the accounting period.
Following T-accounts can be used to calculate the cash receipts and payments. Using the information in the accounting records prepared as per accrual concept, cash receipts and payments can be calculated as shown below (the balancing figures in the T-accounts).
Here is a link to an example of statement of cashflows presented under direct method.
As the name suggests, cash flows from operating activities is presented in an indirect manner. The starting point under this method is the profit or loss before taxation. This profit or loss is adjusted for the effects of transactions of a non‑cash nature and for accrual concept based adjustments (for e.g., income recognized in current year whereas payment was received in previous year, an expense recorded in current year whose payment will be made in future etc.). Furthermore, items of income or expense that are related to investing or financing activities are also excluded from the profit or loss figure.
Cash flows from operating activities under indirect method would look something like this.
Illustration: Cash flows from operating activities (Indirect Method)
Which method is recommended?
Accounting standards allow both direct and indirect methods, however, “IAS 7 Statement of Cash Flows” encourages entities to use the direct method. Reason being that the direct method provides information which may be useful in estimating future cash flows of an entity, which helps the users in their decision making (for e.g., for estimating the market value of an entity, for estimating the future liquidity position etc.). Such information is not available under the indirect method.
Having said that, you would be surprised that almost all the companies, or at least all the bigger companies use indirect method of statement of cash flows as practically, direct method is a bit complex and greater time and effort is required to extract the relevant information.