You may have come across the terms “direct” and “indirect” when preparing a cash flow statement. These are two different methods used for this purpose, and the main difference between the two is how accountants prepare cash flow statements from operating activities.

Tax accounting professionals in Chicago, Odoni Partners, LLC, expound on using direct vs. indirect cash flow when preparing cash flow statements in this blog post.

What Are Direct vs. Indirect Cash Flow Methods?

In a direct method, accountants calculate net cash flows by beginning with each of a company’s operating activities, deriving its total revenue from these activities, and then subtracting its total expenses from this amount. This results in net cash flow from operating activities.

An indirect method works a little differently.

Accountants begin with income statement data rather than cash flow data. They subtract non-cash expenses (such as depreciation) and add non-cash revenues (like amortization on loans).

From here, they derive net income or loss, which is then added to or subtracted from changes in balance sheet accounts to arrive at net cash flows from operating activities.

Companies use both of these methods to report their financial health to investors and other stakeholders.

What Are the Differences Between Direct vs. Indirect Cash Flow Methods?

If you’re not sure of whether to use direct vs. indirect cash flow methods when preparing cash flow statements, here are some key differences to help you decide:

Types of Transactions

Indirect method: This method uses net income as the base and converts the income into the cash flow through by using adjustments on accounts receivable and accounts payable.

Direct method: This method only takes the cash transactions into account and produces the cash flow from operations.

Time Required

The cash flow indirect method requires more preparation than the direct method, which can take time away from other important tasks. The direct method doesn’t need as much preparation because it only relies on cash transactions.

Cash Flow Statement Preparation Method

With the cash flow indirect method, you record all of your transactions except those involving cash, then calculate your net income without accounting for any changes in accounts receivable or accounts payable. Then, you account for changes in those accounts to find your total change in operating assets, which you can use as part of your total cash inflows.

The indirect method, on the other hand, records all of your cash transactions separately from other transactions and calculates them separately to produce a final cash flow statement.

Accuracy

Deciding whether you should use the cash flow indirect or direct method for your business can be tricky.

The cash flow indirect method is a little less accurate because it uses adjustments to calculate revenue and expenses. In contrast, the direct method doesn’t use any adjustments to calculate revenue and expenses.

Get the Proper Tax Accounting Advice from a Professional Chicago Accounting Firm

While both methods conform to generally accepted accounting principles (GAAP), most companies still use the indirect method because the direct method requires more time and effort to prepare.

At Odoni Partners, LLC, we can help you discern which method to use for your business to achieve the most accurate results, including reporting common tax forms and statement of cash flows preparation.

Contact our accounting professionals today to schedule your free consultation in Chicago, IL.