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The direct method of presenting statements of cash flows shows how cash was received and used in a business, and is important to investors and bankers. It is classified into three sections: operating, investing, and financing activities, with differences between the direct and indirect methods affecting only the operating activities section. The direct method shows the history of cash, while the indirect method reconciles net income to the cash balance. The direct method requires all cash transactions to be classified and summarized.
In accounting, the direct method is a way of presenting statements of cash flows, showing how cash was received and used in the business over a certain period of time. It is a standardized report, presenting information about cash that is not available in other types of financial reports. This statement is important to bankers and investors, and to anyone interested in cash requests from a business. Statements of cash flows in the United States can be prepared using the direct method or the indirect method.
Under both methods, the statements of cash flows are classified into three sections: cash from operating activities, investing activities, and financing activities. Below each section, there are lines that summarize the information. In investment activities, this could include the purchase of securities, while in financing activities, it could include the issuance of shares. The differences between the direct and indirect methods affect only cash transactions in the operating activities section; the other two sections remain the same under either method.
The direct method shows the history of cash, from the beginning balance to the ending balance, classified into the main classes of operating cash receipts and payments. Non-monetary items such as depreciation expense are excluded. Items that are generally found under the direct method are payments to employees, rent, and cash received from customers. Cash flows under the direct method are easy to understand, although identifying all cash transactions can become a burden for many businesses.
The indirect method is easier to compile, but the information provided is not as easy to parse as the direct method. Instead of providing clear information about the use of cash, the indirect method reconciles net income to the cash balance. Increases and decreases are reported in certain accounts, rather than in the major classes of receipts and payments. Non-monetary items are shown as reconcilable items, including depreciation. Items that can be found under this method are any increase in accounts receivable, an increase in inventory, and a decrease in accounts payable.
To obtain the information to use the direct method, all cash transactions must be classified and summarized. Payments are sorted by type of expense, and deposits are also sorted by type and counted as cash inflow. Cash transfers between accounts are ignored. Each line in the operating activities section corresponds to a classified summary cash transaction. Traditionally, the first item in operating activities under this method is cash from customers, cash coming in.
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