Which is the recommended method for preparation of cash-flow statement?

          Cash Flow Statement: Direct and Indirect Method

Usually Indirect Method is followed.

Cash flow statements are dealt with in International Accounting Standard7 "Cash flow

statements". This standard is largely used throughout the world.

Accounting information necessary to report the operating activities using both the direct and indirect methods of presentation can be obtained :

a.IN A DIRECT WAY, by collecting figures directly from the accounting records of the

enterprise ( as indicated in IAS7 paragraphs19a and20/2nd indent)

b. IN AN INDIRECT WAY, by adjusting items shown in the profit and loss account ( as described

in IAS7 paragraphs19b and20/1st indent).

The way of obtaining the financial information indicated sub a. ("direct way") requires the

company to have available an accounting system that enables the correct recording and

allocation of cash inflows and outflows immediately when they occur : for this reason it is at

present uncommon.

Direct and Indirect Method:

Indirect Method:

Unlike the major financial statements, cash flow statement is not prepared from the adjusted trial balance. The information to prepare this statement usually comes from three sources:

1.       Comparative balance sheets provide the amount of the changes in assets, liabilities, and equities from the beginning to the end of the period.

2.      Current income statement data help the reader determine the amount of cash provided by or used by operations during the period.

3.      Selected transaction data from the general ledger provide additional detailed information needed to determine how cash was provided or used during the period

Preparing the statement of cash flows from the data sources above involves three major steps:

Step1. Determine the change in cash:This procedure is straight forward because the difference between the beginning and the ending cash balance can be easily computed from an examination of the comparative balance sheet.

Step2. Determine the net cash flow from operating activities:This procedure is complex. It involves analyzing not only the current year’s income statement but also comparative balance sheets and selected transitions data.

Step3. Determine net cash flows from investing and financing activities:All other changes in the balance sheet accounts must be analyzed to determine their effects on cash.

Direct Method:

(also called the income statement method) reports cash receipts and cash disbursements from operating activities. The difference between these two amounts in the net cash flow from operating activates. In other words, the direct method deducts from operating cash receipts the operating cash disbursements. The direct method results in the presentation of a condensed cash receipts and cash disbursements statement.

If we have to choose then option b) Indirect Method is the recommended one. However both methods can be used.

Muhammad Iqbal Abubaker and Mr. VENKITARAMAN KRISHNA MOORTHY VRINDAVAN 

has given very useful and detailed answers to which I totally agree.

If you have an enterprise system or solution, direct method is more recommended, because it shows new details that concern superior reports users rather than using statement of financial position items and net changes of assets or liabilities to modify net income which is pure numeric calculation.  Usually we use direct method for management pack, and we do indirect method to match results and check accounts integrity.   

Both methods could be used. But commonly used is indirect method.

b.

b. Indirect Method.

It is B indirect method

The Direct MethodThe direct method is the preferred method under FASB95 and presents cash flows from activities through a summary of cash outflows and inflows. However, this is not the method preferred by most firms as it requires more information to prepare.Cash Flow from OperationsUnder the direct method, (net) cash flows from operating activities are determined by taking cash receipts from sales, adding interest and dividends, and deducting cash payments for purchases, operating expenses, interest and income taxes.

The Indirect MethodThe indirect method is preferred by most firms because is shows a reconciliation from reported net income to cash provided by operations.Calculating Cash flow from OperationsHere are the steps for calculating the cash flow from operations using the indirect method:

1. Start with net income.
2. Add back non-cash expenses.
   • (Such as depreciation and amortization)
3. Adjust for gains and losses on sales on assets.
   • Add back losses
   • Subtract out gains
4. Account for changes in all non-cash current assets.
5. Account for changes in all current assets and liabilities except notes payable and dividends payable.

Financial Accounting Standard Board (FASB) allows both methods to report cash flows from operations, but has a preference for Direct Method.

But if we present cash flow in Direct Method, then the reconciliation must also be provided in separate schedule. Therefore Indirect method is prevalent, because it does not require a separate reconciliation, because already it includes reconciliation from Operating income based on accrual basis and then adjustments to arrive at operating income on cash basis. Which is then called cash flows from operating activities.