The Direct vs the Indirect approach to preparing the Operating Activities

The operating activities section of Peak’s statement of cash flows  in the section Statement of Cash Flows is prepared based on the direct approach. Under the direct approach, a separate line item is provided for each type of operating cash inflow and outflow. These items usually correspond to categories on the income statement. For example, cash received from customers corresponds to sales revenue on the income statement. Keep in mind,however, that the income statement and the statement of cash flows provide different information.

For example, the income statement discloses sales made to customers during the year, regardless of whether cash has been collected during the year. The statement of cash flows indicates the amount of cash collected during the year from customers for the current year’s sales, past years’ sales,and even future sales if the firm has collected cash prior to the point of sale.

An acceptable alternative in preparing the operating activities section is the indirect approach. This method begins with net income and makes adjustments to it in order to arrive at cash generated by operating activities.

Although both the direct and indirect approaches produce the same figure for cash provided from operating activities, the internal compositions of the statements differ substantially. A major advantage of the direct method is that the primary sources and uses of cash are listed. As will be seen in a later section, this is highly useful information.

A major advantage of the indirect method is that the reasons for the difference between net income and cash generated by operations is detailed.This can help reduce uncertainties or answer questions raised by financial statement readers. As you know,under the indirect approach,depreciation expense is added to net income. Because of this, some financial statement readers erroneously believe that depreciation expense is a source of cash. It is not. Depreciation expense is added to net income in arriving at cash provided from operating activities because it has already been subtracted in the computation of net income and it does not involve any cash outflow. Adding depreciation expense to net income therefore eliminates the effect of this noncash expense.

The FASB has expressed a preference for the direct approach. In spite of that, the indirect approach is used more frequently. This is partly due to historical convention; the indirect approach is similar to the statement that was required prior to SFAS No. 95. Additionally, a firm using the direct approach must provide a schedule that reconciles net income with cash provided by operating activities. This reconciliation essentially consists of the information contained in the indirect approach. Thus, a firm that opts for the direct approach must really provide both methods. Some firms are reluctant to do this, either because additional costs are involved or because they feel that the statement will become too cluttered and, therefore, less informative.

Noncash Investing and Financing Activities

A firm may engage in investing and financing activities that do not involve cash.For example, a firm might acquire property by issuing common stock.Although no cash is involved, this transaction is both an investing activity (the acquisition of a noncurrent asset) and a financing activity (the issuance of stock). Because these transactions do not involve cash, they do not appear in the major sections of the statement of cash flows. However, noncash investing and financing activities are summarized in a schedule that appears at the end of the statement.This provides readers of the cash flow statement with a complete picture of a firm’s investing and financing activities.

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