Direct method — statement of cash flows: concise explainer
Definition
– Direct method: a way to present the operating section of the statement of cash flows that shows actual cash receipts and cash payments during the reporting period (for example, cash collected from customers, cash paid to suppliers, cash paid for wages). It records cash movements rather than converting accrual-based income statement items into cash.
How it differs from the indirect method (and from accrual accounting)
– Indirect method: starts with net income (an accrual-based figure) and adjusts for noncash items (like depreciation) and changes in working capital to arrive at operating cash flow.
– Direct method: lists cash inflows and outflows directly and nets them to produce cash flow from operations.
– Accrual accounting: records revenues and expenses when earned or incurred, not when cash is exchanged. The direct method focuses only on actual cash transactions.
Key points
– Only the operating section differs between direct and indirect presentations. Investing and financing sections are the same under either method.
– U.S. GAAP and IFRS both permit the direct method. Under U.S. GAAP, a company that uses the direct method must also disclose a reconciliation of net income to cash flow from operations (essentially providing the indirect-format reconciliation as supplementary information).
– The Financial Accounting Standards Board (FASB) favors the direct method because it gives more transparent cash-flow detail, but many firms prefer the indirect method because it is easier to prepare from accrual accounting records.
Step-by-step: preparing the operating section using the direct method
1. Identify all cash receipts from operating activities (cash received from customers, interest received if classified operating, refunds, etc.).
2. Identify all cash payments related to operations (cash paid to suppliers, employees, interest paid if operating, taxes paid, and other operating expenditures).
3. Aggregate receipts into a cash-inflows subtotal and payments into a cash-outflows subtotal.
4. Subtract total cash outflows from total cash inflows to obtain net cash provided by (or used in) operating activities.
5. Prepare investing and financing sections (same as under indirect method).
6. If required by local rules (e.g., U.S. GAAP), prepare a reconciliation from net income to cash flow from operations and disclose it alongside the direct-format statement.
Short checklist (what you need before you start)
– General ledger with cash receipts and cash payments by category.
– Trial balance and balance sheet to map accrual accounts (accounts receivable, accounts payable, inventory, etc.).
– Schedule of noncash items (depreciation, amortization, gains/losses).
– Policies for classification of interest and dividends (operating vs. investing/financing).
– Template to present cash receipts and cash payments clearly, plus space for the required reconciliation if using direct method.
Worked numeric example (simple)
Assume a company over Period T has:
– Cash collected from customers: $150,000
– Cash paid to suppliers: $90,000
– Cash paid for wages: $25,000
– Cash paid for interest: $3,000
– Cash paid for income taxes: $7,000
Direct-method operating cash flow calculation:
– Total cash inflows: $150,000
– Total cash outflows: $90,000 + $25,000 + $3,000 + $7,000 = $125,000
– Net cash provided by operating activities = $150,000 − $125,000 = $25,000
Reconciliation (required under U.S. GAAP when direct method used). Suppose the accrual net income for Period T was $30,000 and depreciation expense was $5,000, while accounts receivable increased by $10,000 (a use of cash). The indirect reconciliation:
– Net income: $30,000
– Add back noncash depreciation: +$5,000
– Subtract increase in accounts receivable: −$10,000
– Net cash from operations = $30,000 + $5,000 − $10,000 = $25,000
This matches the direct-method result above.
Advantages and disadvantages
– Advantages: more granular disclosure of where cash is actually coming from and going to; useful for creditors and analysts tracking cash conversion and liquidity.
– Disadvantages: more time-consuming and data-intensive for firms using accrual accounting, because detailed cash receipts/payments by category may not be readily available. Also, when the direct method is used, U.S. GAAP requires an additional reconciliation to net income, adding extra work.
Related: three basic accounting methods (brief)
– Cash-basis accounting: record transactions only when cash is received or paid.
– Accrual accounting: record revenues when earned and expenses when incurred, regardless of cash movement.
– Modified cash-basis: a
hybrid that records some items on a cash basis and others on an accrual basis (commonly used by small businesses that want accrual-like matching for some accounts while preserving a cash