Cash flows from operating activities can be calculated using the indirect or direct method. Briefly describe how the two methods differ yet arrive at the same information about the net cash flows from operating activities

Answer 1

The indirect method starts with net income and converts it to the net cash flows from operating activities. There are two types of adjustments: (1 ) changes in current assets and current liabilities and (2 ) noncash charges and credits. For example, an increase in accounts receivable is deducted from net income and an increase in accounts payable is added to net income. Similarly, a noncash charge for depreciation expense is added to net income. The adjustments are the difference between net income and the net cash provided by operating activities.

Under the direct method, net cash provided by operating activities is computed by adjusting each item in the income statement from the accrual to the cash basis. Within the operating activities section, only major classes of operating cash receipts and cash payments are reported. The classes include cash receipts from customers and cash payments to suppliers. The difference between these major classes is the net cash provided by operating activities.

The same adjustments are used in both methods, regardless of whether net income is adjusted or individual revenues and expenses are adjusted. Therefore, both methods arrive at the same result.