Direct and Indirect Methods Compared

Learning Outcomes

  • Distinguish between the direct and indirect methods of preparing a statement of cash flows

Cash flows from operating activities show the net amount of cash received or disbursed during a given period for items that normally appear on the income statement. You can calculate these cash flows using either the direct or indirect method. The direct method deducts from cash sales only those operating expenses that consumed cash. This method converts each item on the income statement directly to a cash basis. Alternatively, the indirect method starts with accrual basis net income and indirectly adjusts net income for items that affected reported net income but did not involve cash.

The direct method converts each item on the income statement to a cash basis. For instance, assume sales are stated at $45,785 on an accrual basis. If accounts receivable decreased by $15, from $1,750 to $1,735, cash collections from customers would have been $45,800, which you could calculate in a T account or in a table as follows:

Beginning balance $     1,750
Accrual basis sales 45,785
Balance before payments 47,535
Less: Ending balance 1,735
Cash payments from customers $   45,800

Here is a hypothetical example of a statement of cash flows prepared using the direct method:

Rumble Corp.
Statement of Cash Flows
for the year ended 12/31/x1
Description Amount Total
In millions
Subcategory, Cash flows from operating activities
Cash receipts from customers $ 45,800
Cash paid to suppliers (29,800)
Cash paid to employees (11,200)
Cash generated from operations Single Line
4,800
Interest paid (310)
Income taxes paid (1,700)
Net cash from operating activities Single Line Single Line
$2,790
Subcategory, Cash flows from investing activities
Purchase of property, plant, and equipment (580)
Proceeds from sale of equipment 150
Net cash used in investing activities Single Line Single Line
(430)
Subcategory, Cash flows from financing activities
Proceeds from issuance of common stock 1,000
Proceeds from issuance of long-term debt 500
Dividends paid (460)
Net cash used in financing activities Single Line Single Line
1,040
Net increase in cash and cash equivalents 3,400
Cash and cash equivalents at beginning of period 1,640
Cash and cash equivalents at end of period Single Line
$5,040
Double Line

The indirect method adjusts net income (rather than adjusting individual items in the income statement) for (1) changes in current assets (other than cash) and current liabilities, and (2) items that were included in net income but did not affect cash. We’ll explore this in more detail in a later section.

practice question