Overview:

The direct method of developing the cash flow statement lists operational cash receipts and cash payments within the operational activities section. In this section, any interest paid on outstanding debt is also reported, and all income taxes are paid.

Using the direct technique, cash receipts minus cash disbursements are used, and the final figure is net cash flows from operations.

Under the direct method, the sole section of the cash flow statement which will differ in presentation is that the cash flow from the operations section.

The direct technique lists the money receipts and payments created during a period for a business’ operations.

The cash outflows are deducted from the cash inflows to calculate the net cash flow from operating activities before the cash from investment and finance activities are included to get the net cash increase or decrease within the company.

Explanation:

The direct method of presenting the statement of cash flows presents the specific cash flows related to things that affect cash flow. Items that usually do this include:

  • Cash collected from customers
  • Interest and dividends received
  • Cash paid to staff
  • Cash paid to suppliers
  • Interest paid

The advantage of the direct technique over the indirect method is that it reveals operational cash receipts and payments.

One of the issues with the direct methodology is that the levels of complexities involved in getting ready for the cash flow statement. The issue and time it takes to list all the cash disbursements and receipts make the indirect methodology a most well-liked and many ordinarily used methods.

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Since corporations use the accrual methodology of accounting to prepare their financial statements, business activities are recorded on the balance sheet and income statement under accounts like sales, materials, and inventory.

Corporations that practice accrual accounting don’t collect and store transaction information per client or provider.

Another complexity of the direct technique is that the FASB needs a business using this method to disclose the reconciliation of net income to the net cash provided and utilized by operational activities reported if the indirect method had been used to prepare the statement.

To test the accuracy of the operational activities, the reconciliation report is used and is comparable to the indirect report.

The reconciliation report starts by listing the net income and adjusting it for non-cash transactions and changes in the balance sheet accounts. This extra task makes the direct technique unpopular among corporations.

Preparing the statement of cash flows using the direct method would be an easy task if all corporations maintained very elaborate cash account records that might be simply summarized.

Most corporations record an especially sizable amount of transactions in their brokerage account and don’t record enough detail for the knowledge to be summarized.

Therefore, the statement of cash flows is ready by analyzing all accounts except the cash accounts. Keep in mind that in accounting, all transactions affect a minimum of 2 accounts. If money will increase or decreases, a minimum of one different account additionally changes.

If money increases, that increase may additionally decrease another quality account, like assets (payment from the client on account) or instrumentation (sale of equipment), or increase the sales account (cash sales).

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Similarly, if cash decreases, there could also be a rise in another quality account, like inventory (purchase of inventory) or instrumentation (purchase of equipment), a decrease in a very liability account, like accounts due (payment to the creditor) or notes payable (payment on loan), or a rise in expense accounting (payment to the vendor).