The Statement of Cash Flows has three parts as discussed in the Statement of Cash Flows Using the Indirect Method. The first of those three parts is the Cash Flows from Operating Activities. The other two sections are Cash Flows from Investing Activities and Cash Flows from Financing Activities. The direct method of developing the cash flow statement and the indirect method of developing the cash flow statement are primarily different in the first section of the financial statement - the Cash Flows from Operating Activities section.
How is the Direct Method Used in Cash Flow Statement Development?
The direct method of developing the cash flow statement uses major classes of cash receipts from customers as its starting point. It reports all cash receipts in the operating section of the cash flow statement from any source, including customers. Next, the direct method reports all cash payments or disbursements in the operating section of the statement of cash flows. Examples of disbursements would be payments to employees, suppliers, operations, and more. Any interest the company has paid on outstanding debt is reported along with all income taxes paid in this section. Using the direct method, you end up with, essentially cash receipts minus cash disbursements and your final figure is net cash flows from operations.
What are the Problems with the Direct Method?
One of the problems with the direct method of preparing the Statement of Cash Flows is the level of complexity required. If your business is small, then listing your cash receipts and cash payments is a simple matter. As a business gets larger and larger, imagine for a moment all the cash receipts and cash payments from different sources that would have to be listed. The direct method becomes very complex, which is why the majority of companies use the indirect method of developing a cash flow statement.
Another problem wit the complexity of the direct method is that all accounting transactions affect two accounts. In addition to the complexity of all the cash transaction you have to deal with if you are using the direct method, each cash transaction affects another account such as inventory, accounts receivable, or others and you have to take into accounts those accounts as well if you are developing the statement of cash flows with the direct method.
Format of the Operating Section of the Cash Flow Statement Using the Direct Method
The direct method is also called the income statement method. The simplest format of the direct method looks something like this:
Cash Flow from Revenue
Minus: Cash Payments for Expenses
Equals: Income Before Income Taxes
Minus: Cash Payment for Income Taxes
Equals: Net Cash Flow From Operating Activities
The first two line items, cash flow from revenue and cash payments from expenses, are subject to the problems of complexity discussed above.
Here's an example of the complexity you will encounter. Let's say you are accounting for all your payment to suppliers for the time period. In addition to keeping the level of detail required to do that via the direct method, you have to keep the same level of detail in the other two accounts that particular transaction affects - inventory accounts payable and cost of goods sold. When you think of every transaction in that kind of detail, few firms can manage it.
Here is a good example of the development of a statement of cash flows using the direct method.
Format of the Operating Section of the Cash Flow Statement Using the Indirect Method
The information to prepare the Statement of Cash Flows using the indirect method comes from three sources: comparative balance sheets for the last two years of firm data, data from the firm's current income statement, and selected data from the general ledger.
Using the indirect method to calculate net cash from operating activities is easily computed using this method. You take the Net Revenue from the income statement and add back depreciation. Then you look at the comparative balance sheet and record the changes in a sources and uses format for the asset and liabilities accounts. There you have it - the net cash flow from operating activities. You can see a good example of this type of cash flow statement here.
The Financial Accounting Standards Board (FASB) prefers the direct method in preparing the statement of cash flows.