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The main difference between the direct method and the indirect method involves the cash flows from operating activities, the remaining sections (i.e. investing & financing activities remain unchanged).
Direct Method
Under the direct method, each line item of the accrual-based income statement is converted into cash receipts or cash payments. Under the accrual method of accounting, the timing of revenue and expense recognition may differ from the timing of the related cash flows. Under cash-basis accounting, revenue and expense recognition occur when cash is received or paid. Simply stated, the direct method converts an accrual-basis income statement into a cash-basis income statement.
Indirect Method
Under the indirect method, net income is converted to operating cash flow by making adjustments for transactions that affect net income but are not cash transactions. These adjustments include eliminating noncash expenses (e.g., depreciation and amortization), non-operating items (e.g., gains and losses), and changes in balance sheet accounts resulting from accrual accounting events.
Benefits / Drawbacks:
The primary advantage of the direct method is that it presents the firm's operating cash receipts and payments, while the indirect method only presents the net result of these receipts and payments. Therefore, the direct method provides more information than the indirect method. This knowledge of past receipts and payments is useful in estimating future operating cash flows.
The main advantage of the indirect method is that it focuses on the differences in net income and operating cash flow. This provides a useful link to the income statement when forecasting future operating cash flow. Analysts forecast net income and then derive operating cash flow by adjusting net income for the differences between accrual accounting and the cash basis of accounting.
