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Importance of the Differences Between the Direct and Indirect Method
The most critical financial statement a company can provide is the statement of cash flows. The reason this statement is so important is that it can be used to measure the overall health of a company with relevant information from both its balance sheet and income statement. This statement is especially important to investors who can use it as a performance indicator and determine the company’s potential future prospects. The Statement of Changes in Financial Position was replaced by the Statement of Cash Flows introduced by the Financial Accounting Standards Board (FASB – SFAS 95) in 1987. This change was the FASB’s failed attempt to encourage company management to use the direct method of reporting as opposed to the indirect method that is still very popular today.
The direct method, also called the income statement method, uses cash receipts and disbursements to report its operating activities. The direct method is the SEC preferred method, but is not mandatory for companies to use in their reporting. The real difference between the direct and indirect methods is found in the presentation of the operating section of the company’s statement. The only difference is the reason; The direct method subtracts operating cash payments from operating cash receipts to yield net cash flow from operating activities. Some enthusiasts of the direct method argue that it provides a better presentation of a company’s ability to maintain cash flow from operations as opposed to investing and financing. Companies that are better able to generate cash from operations can pay their debts more easily. The presentation of information using the direct method indicates that the net cash flow from operations is better because it is presented using the cash basis.
In contrast, the indirect method, otherwise known as the reconciliation method, will show net income with adjustments that convert it into net cash flow from operating activities. While the direct method requires a reconciliation of net income to cash from operations, the indirect method provides this reconciliation automatically. Almost every corporation, while preparing its financial statements, prepares a statement of cash flows using the indirect method. Many people argue that this method is preferred by most companies because it is straightforward and easy to understand. Others argue that this method provides a better correlation of information in a corporation’s financial statements.
A cash flow statement consists of three sections: cash from operating activities, cash from investing activities, and cash from financing activities. These segments break down a company’s sources and uses of cash into easily identifiable and relevant information that investors often rely on to assess financial stability and strength. A company with strong cash flow from operating activities shows that it is well positioned to continue and potentially expand its business. Firms with excessive cash flows from investing or financing activities indicate weakness and the possibility of future failure.
The cash from operating activities section of the statement of cash flows shows the cash inflows and cash outflows from a company’s current assets and current liabilities. The inflows and outflows of this segment can be determined by examining the income statement for the period. Cash received from investing activities can be classified as non-current assets, usually long-term asset items such as property, plant and equipment. Finally, the cash inflows and outflows shown in the financing activities section of the statement include non-current liabilities and stockholder’s equity.
Presentation of financial statements has been proven to assist management in decision making and cash flow information must be considered in making those decisions. Thus the controversy of direct versus indirect method should be noted. The SEC believes that the direct method provides more meaningful information because it breaks down key cash inflows and outflows. Those in favor of the indirect method argue that the only reason the Financial Accounting Standards Board (FASB) enacted SFAS 95 was to force corporations to distinguish between net income and cash inflows and outflows. Additionally, the indirect method is much less complicated because using the direct method for a large company is like going through all of their bank statements.
According to an article posted on the Association for Financial Professionals website in October 2010 by Salome Tinker, the FASB and the International Accounting Standards Board (IASB) are working together to redefine how companies present their financial performance. One of the most discussed topics during the meeting of these two boards was related to direct versus indirect method of cash flow accounting. Both boards concluded that if finalized, the direct method would be the only acceptable method of reporting a company’s statement of cash flows. They want standardization in a worldwide format that can more easily maintain a direct method. Since the majority of companies report using the indirect method, this news can be very important because switching methods can be expensive.
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