When financial statements of cash flows are prepared, companies can opt to use either the indirect or direct method. There are key differences between these two methods such the type of transactions that are utilized to produce a cash flow statement. The indirect method of cash flow uses net income as a base and converts the income into cash flow using adjustments. In contrast, the direct method solely uses cash transactions (e.g. cash spent/received) to produce the cash flow statement (Kimmel, Weygandt, & Kieso, 2019). When using the indirect method, net income is automatically converted in the form of cash flow. Reconciliation is completed to separate the cash flow from others. During the conversion of net income into cash flow statement, preparations are necessary and all factors are considered. The direct method does not require preparations and ignores all non-cash transactions such as depreciation. It takes less amount of time to prepare cashflow statements as opposed to the direct method. Many companies prefer to use the indirect method but it is not as accurate since many adjustments are used. Very few companies choose to use the direct method however, it is far more accurate as adjustments aren’t used. The advantage of using the indirect method is that accrual accounting offers a superior gauge of the ebbs and flows of business activity. The advantage of using the direct method is that companies would be compliant with policies and procedures as outlined by GAAP and IAS, who also recommend that the direct method is used.
Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. (2019). Financial accounting: Tools for business decision making (8th ed.). Retrieved from https://www.vitalsource.com
Financial statement preparers have the option to use indirect and direct methods when preparing financial statements. Both methods will produce the same results for net cash but the steps in which each method arrives to net cash from operating activities are different. Companies tend to favor the indirect method most because it is easier to prepare and the cost to prepare is relatively inexpensive. According to the information in chapter 12 of this week’s required reading, 98% of companies use the indirect method when preparing financial statements (Kimmel, Weygandt & Kieso, 2019). Indirect methods not only are cost efficient and easy to use verses direct methods but also differs in the fact that it evaluates the differences between net income and net cash flow from operating activities. In terms of direct methods, the report shows operating cash receipts and payments. Determination of operating cash receipts and payments are calculated through adjusting each item in the income statement form the accrual basis to cash basis (Kimmel, Weygandt & Kieso, 2019).
The Financial Accounting Standard Board which was established in 1973, is recognized by the SEC and is designated as the accounting setter for public companies and are also recognized by private sector organizations such as state Boards of Accountancy and the American Institute of CPAs. According to the FASB, the direct method is preferred for preparing financial statements even though the majority of companies tend to use the indirect method (“About the FASB,”n.d).
I think that the reason why most companies like to use the indirect method is because of the ease of use for the financial preparer. With the main reason being ease of use, financial prepares can generate statements quickly and move on to the next task at hand. Resulting in cost savings for the company.
Financial Accounting Standards Boards. (n.d). About the FASB.
https://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176154526495 (Links to an external site.)
Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. (2019). Financial accounting: Tools for business decision making (8th ed.). Retrieved from