What Are the Differences Between the Cash Flow Methods?
There are two methods used to calculate a cash flow statement: indirect and direct. There are also three separate sections of the cash flow statement: operating cash flows, investing cash flows, and financing cash flows. Regardless of the accounting method used, calculating the investing and financing sections of the cash flow statement remains the same. The only difference between the indirect and direct cash flow methods appears when calculating cash flows from operations.
The direct method of cash flow calculation is more straightforward, and it shows all your major gross cash receipts and gross cash payments. The indirect method backs into cash flow by adjusting net profit or net income with changes in non-cash transactions. To perform this calculation, start with net income, add back non-cash expenses, then adjust for gains and losses on the sale of assets. Next, account for changes in non-cash current assets and changes in working capital accounts, except for notes payable and dividends payable.
You can use both the direct and indirect method to arrive at the same conclusion. The indirect method is more commonly used by businesses, as the statistics used in the indirect method are used in other financial statements, which makes the method easier to calculate.
Advantages and Disadvantages of Using the Indirect Method
While most businesses like the indirect method because it’s easy to use, the folks at the International Accounting Standards Board prefer the direct method because it gives a clear view of cash flow receipts and payments. In other words, the main advantage of the indirect method is that it’s easier, while the main disadvantage of the indirect method is that it lacks transparency.
Canadian GAAP Vs. the IFRS
The statement of cash flows is one of three financial statements required under both Canadian generally accepted accounting principles and the International Financial Reporting Standards. In general, the two sets of standards are consistent between the statement of cash flows. Both allow you to present cash flow from operations using either the direct or indirect method. As Canada moves to IFRS, there is one major difference of which you should be aware. Under the IFRS, interest and dividends can be grouped as operating, investing, or financing. Under Canadian GAAP, if interest and dividends are shown on the income statement, they must also be shown as cash flows from operations, not investing or financing.
You can produce your cash flow statement using the indirect or direct method of cash flows, but there are pros and cons to both methods. The indirect method may be easier for you, as the direct method requires additional account information and takes more time for you to calculate.