Discuss the indirect and direct methods in deriving cash flow from operations
The direct method's presentation of cash flow requires less understanding of the contrast between cash and accrual accounting, but its derivation requires the same understanding as does the indirect method. Every addback and subtraction in the indirect presentation appears in the direct method's derivation.
To see the relation between the indirect and direct methods, consider the following contrast
of the equivalent arithmetic used for the two derivations of cash flow from operations.
The indirect method starts with the total for net income. Then it adds amounts for expenses
not using cash in the amount of the expense and subtracts for revenues not producing cash in the amount of the revenue. Then it removes the effects of nonoperating gains and losses—subtracting the amount of the gains and adding back the amount of the losses. Finally, it adds or subtracts balance sheet changes involving non-cash operating accounts.
The direct method starts with the components of income, the individual revenues and expenses, but not gains and losses, then adds or subtracts the same balance sheet changes
involving the same operating accounts. Take an income statement line, then list next to it,
horizontally, additions and subtractions.
The indirect method presents the net of revenues less expenses, then adds to, and subtracts
from, that total. The direct method starts with a line of the income statement, then adds to,
and subtracts from, that component. Because the amounts for balance sheet changes added
and subtracted are the same, the final result—cash flow from operations—must be the same.
Few firms use the direct method in their public presentations.
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