Direct Method Cash FlowDefined with Examples
What is the Direct Method of Cash Flow?
Direct Method is one of the methods employed by companies to compute the Cash Flow Statement for a period.
Under this method of accounting, companies only measure the cash inflows based on cash receipts typically coming from customers and cash outflows based on cash payments to suppliers.
When the cash inflows and cash outflows are netted, the cash flow is arrived at.
The accrual method of accounting recognizes revenue when income is earned, irrespective of the cash receipt – the same is true for expenses.
But with the Direct Method Cash Flow, only actual cash inflows and outflows are used, which is presented in the operations section of the Cash Flow statement.
The other term used for Direct Method Cash Flow is the Income Statement Method.
Understanding the Direct Method
A Cash Flow Statement has three sections: Cash flow from Investing, Cash Flow from Financing and Cash Flow from Operating activities.
There are two methods of preparing a cash flow statement: Direct Method and Indirect Method.
Under both methods, the Cash Flow from Financing and Investing are the same.
The difference between the two methods is in the section of Cash Flow from Operating activities.
Using the indirect method, the statement starts from Net Income and then adjusted for the changes in the asset and liability accounts of the Balance Sheet to come up with the cash flow from operating activities.
With the direct method, the company first presents all the cash receipts and then subtracts the cash payments for the period.
When the receipts and payments are netted against each other, the net cash flow from operating activities is arrived at.
From there, the net cash from investing and financing activities are included to derive the net cash increase or decrease for the period.
The Statement of Cash Flow is one of the main financial reports that companies produce at the end of each accounting period, along with the Balance Sheet, Income Statement and Statement of Changes in Equity.
Complexities of the Direct Method
While some companies prefer the Direct Method of preparing the Cash Flow Statement, there are complexities involved in opting to go ahead with this method: it is time-consuming and FASB requires a reconciliation report to be disclosed.
Time Consuming
Listing all of the cash receipts and cash payments for a whole accounting period is very time consuming.
Unlike the indirect method, preparing the cash flow statement is easier because companies use the accrual basis of accounting where the income statement and balance sheet are consistent with the cash flow method used.
Required Reconciliation Report
The Direct Method will be a double work for companies because the FASB requires that a reconciliation report be submitted which is very much similar to the indirect method of presenting the Cash Flow Statement.
The disclosure of the reconciliation report requirement means that while companies prepare the direct method cash flow, they also have to prepare this report which lists the net income for the period and then adjusts the non-cash expenses and changes in the balance sheet.
The need for the Reconciliation Report to be disclosed is so that the FASB can check that the operating activities of the company are reported accurately.
Direct Method Example
Company X is in the process of preparing their Statement of Cash Flow and will be employing the Direct Method.
The section of their Cash Flow from Operating activities include the following information:
| Cash Receipts from Customers | $790,000 |
| Cash Paid to Suppliers | 350,000 |
| Cash Paid to Employees | 180,000 |
| Cash Generated from Operations | 275,000 |
| Interest Paid | 7,500 |
| Income Taxes Paid | 95,000 |
Additionally, the section of the Cash Flow from Financing and Investing activities include these data:
| Purchase of Property, Plant and Equipment | $63,000 |
| Proceeds from the Sale of Equipment | 30,000 |
| Proceeds from Issuance of Common Stock | 125,000 |
| Proceeds from Issuance of Long-Term Debt | 200,000 |
| Dividends Paid | 150,000 |
Based on the above data, Company X was able to present the Cash Flow Statement for the year ended December 31, 2021.
| Company X | ||
| Cash Flow Statement | ||
| For the Year Ended Dec. 31, 2021 | ||
| Cash Flow from Operating Activities | ||
| Cash Receipts from Customers | 790,000.00 | |
| Cash Paid to Suppliers | (350,000.00) | |
| Cash Paid to Employees | (180,000.00) | |
| Cash Generated from Operations | 275,000.00 | |
| Income Before Income Taxes | 535,000.00 | |
| Interest Paid | (7,500.00) | |
| Income Taxes Paid | (95,000.00) | |
| Net Cash from Operating Activities | 432,500.00 | |
| Cash Flow from Investing Activities | ||
| Purchase of Property, Plant and Equipment | (63,000.00) | |
| Proceeds from the Sale of Equipment | 30,000.00 | |
| Net Cash Used in Investing Activities | (33,000.00) | |
| Cash Flow from Financing Activities | ||
| Proceeds from Issuance of Common Stock | 125,000.00 | |
| Proceeds from Issuance of Long-Term Debt | 200,000.00 | |
| Dividends Paid | (150,000.00) | |
| Net Cash Used in Financing Activities | 175,000.00 | |
| Net Increase in Cash and Cash Equivalents | 574,500.00 | |
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