The Statement of Cash Flows has three sections: operating activities, investing activities, and financing activities. The direct and indirect methods used in developing this financial statement are primarily different in the structure of the operating activities section.
The Direct Method
The direct method of developing the cash flow statement lists operating cash receipts (e.g., receipt from customers) and cash payments (e.g., payments to employees, suppliers, operations, etc.) in the operating activities section. In this section, any interest paid on outstanding debt is also reported along with all income taxes paid. Using the direct method, the result is cash receipts minus cash disbursements, and the final figure is net cash flows from operations.
Issues With the Direct Method
One of the problems with the direct method is the level of complexity involved in preparing the cash flows statement. If your business is small, then listing your cash receipts and cash payments is simple. As a business grows, imagine all of the cash receipts and cash payments from different sources that would have to be listed. The direct method becomes very complex, which is why the majority of companies use the indirect method of developing a cash flow statement.
Another problem with the complexity of the direct method is that all accounting transactions affect two accounts. In addition to all the cash transactions to contend with, each cash transaction affects another account, such as inventory or accounts receivable, and you have to consider those accounts when developing the statement of cash flows.
Operating Section Format
The direct method is also called the income statement method. The simplest format of the direct method looks something like this:
Cash Flow from Revenue
- Cash Payments for Expenses
= Income Before Income Taxes
- Cash Payment for Income Taxes
= Net Cash Flow From Operating Activities
The first two line items, cash flow from revenue and cash payments from expenses, are subject to the problems of complexity discussed above.
Here's an example of what you may encounter. Let's say you are accounting for all your payments to suppliers for the time period. In addition to maintaining a high level of detail for that account, you have to keep the same level of detail in the other accounts those payments affect, such as inventory accounts payable and cost of goods sold. When you think of every transaction that can entail, few firms can manage it even though the Financial Accounting Standards Board (FASB) prefers this method.
Operating Section Format: Indirect Method
The information needed to prepare the Statement of Cash Flows using the indirect method comes from three sources: two years of comparative balance sheets, the current income statement, and the general ledger.
Using the indirect method to calculate net cash from operating activities is relatively easy. You take the net revenue from the income statement and add back depreciation. You then look at the comparative balance sheet and record the changes in current assets, current liabilities, and other sources (e.g., non-operating gains/losses from non-current assets). There you have it - the net cash flow from operating activities.