Direct Method

What is the 'Direct Method'

The direct method is a method of creating the cash flow statement in which actual cash flow information from the company's operations segment is used, instead of accrual accounting values.

The direct method is also known as the income statement method.

BREAKING DOWN 'Direct Method'

A company’s financial statement is usually presented in three parts – balance sheet, income statement, and cash flow statement. The cash flow statement has three sections – cash flow from operating (CFO or OCF), financing, and investing activities. The cash flow statement can be prepared using either the direct method or indirect method. The cash flow from financing and investing activities’ sections will be identical under both the indirect and direct method.

The indirect method for calculating cash flow from operations uses accrual accounting information, and always begins with the net income value. The net income is then adjusted for changes in the assets and liabilities account of the balance sheet by adding to or subtracting from net income to derive the operating cash flow.

Under the direct method, the only section of the cash flow statement that will differ in presentation is the cash flow from operations section. The direct method lists the cash receipts and payments made during a period for a business’ operations. The cash outflows are subtracted from the cash inflows to calculate the net cash flow from operating activities, before the cash from investing and financing activities are included to get the net cash increase or decrease in the company.

Direct Method Example

Examples of cash outflows and inflows included in a company’s OCF include salaries paid to employees; cash paid to vendors and suppliers; cash collected from customers, interest income and dividends received; income tax paid; and interest paid. The simplest presentation of the OCF using the direct method looks somewhat like this:

Cash flow from operating activities:

 

Cash receipt from customers

$1,500,000

Wages and salaries

(450,000)

Cash paid to vendors

(525,000)

Interest Income

175,000

Income before income taxes

$700,000

Interest paid

(125,000)

Income taxes paid

(237,500)

Net cash from operating activities

$337,500

Listing out information this way provides whoever is viewing the cash flow statement with a more detailed view of where a company’s cash came from and how it was disbursed. For this reason, the Financial Accounting Standards Board (FASB) recommends companies to use the direct method in preparing their statement of cash flows.

Disadvantages of Direct Method

However, the difficulty and time it takes to list all the cash disbursements and receipts makes the indirect method a preferred and more commonly used method. Since companies use the accrual method of accounting to prepare their financial statements, business activities are recorded on the balance sheet and income statement under accounts such as sales, materials, and inventory. Companies that practice accrual accounting do not collect and store transactional information per customer or supplier.

Another complexity of the direct method is that the FASB requires a business using this method to disclose the reconciliation of net income to the net cash provided and used by operating activities that would have been reported if the indirect method had been used to prepare the statement. The reconciliation report is used to check the accuracy of the operating activities, and is similar to the indirect report. The reconciliation report starts off with listing the net income and adjusting it for non-cash transactions and changes in the balance sheet accounts. This added task makes the direct method unpopular among companies.