The statement of cash flows from operating activities can be presented in a direct format, or an indirect format. Why do you choose one form over another? Let's take a look at the two different formats, and how you make the decision to choose one over the other.
First, let's point out that the information reported for the investing and financing activities, doesn't change. The format variable here affects only the operating activities cash statements.
The direct format or method of reporting cash flows is a very simple format, and reports only the information for the period covered, and does not attempt to tie the information reported to the income statement and balance sheet. The direct format uses the following form:
Cash flows from operating activities:
Cash received from customers xxxxxxxx
Deduct: Cash payments for merchandise: xxxxxx
Cash payments for Op. Exp. xxxxxx
Cash payments for interest xxxxxx
Cash payments for income taxes xxxxxx xxxxxxxx
Net cash flow from operating activities: xxxxxx
As you can easily see, there is no reference to net income or changes in accounts per the income statement or balance sheet. Although the information listed here seems fairly straightforward, it is not as easily available as the information used in the indirect format; and if you use the direct format, there must also be a reconciliation schedule attached, that is a carbon copy of the indirect format, simply on a separate sheet, or schedule. For many companies using accounting software and for accountants that use commercially purchased accounting software, the indirect method will be the most often recognized method for reporting.
Which brings us to the indirect format, and why it is the more often used format. The indirect method is used more frequently simply because it is the less expensive to use, and if you choose the direct method, you still must produce the reconciliation, which in essence is the indirect method.
The access to the information used to create a Statement of Cash Flows using the indirect method is more readily available due to one simply fact: changes in the cash account results in a change in one or more non-cash accounts; the changes to these accounts is presented on the Income Statement and the Owner Equity Statement. Then it is simply a matter of pulling information from those statements in order to prepare the Statement of Cash Flows.
Most businesses use the indirect method or format for their Financial Statement reporting, and if you utilize commercial software for small businesses, the indirect method will be the method that is created from computer generated preset templates. Occasionally, not-for-profit organizations will utilize the direct method, simply because for their particular situation, it is often the easier to produce. But, these non-profits often aren't concerned with reconciling Financial Statements in order to determine the profitability of the business. For the vast majority of businesses, and in order to present accurate information to stockholders and investors, the indirect method or format will be used.
Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.