Financial Reporting:

Direct- versus Indirect-Method Reporting for Cash Flows

 

Should operating cash flows be reported using the direct or the indirect method?

Position: Operating cash flows should be reported using the direct method.

Rationale: Two general methods are available for reporting cash flows generated or consumed by operations, the direct method and the indirect method. The direct method reports cash inflows of cash, e.g., from sales, and cash outflows for payment of expenses, e.g., purchases of inventory. The indirect method begins with the net income number, a mixture of cash (e.g., cash proceeds from sales) and non-cash components (e.g., depreciation) and (1) removes non-cash or accrual items, then (2) adjusts for the cash effects of transactions not yet reflected in the income statement (e.g., cash payments for inventory not yet sold).

 

However, only the direct method reports actual sources and amounts of cash inflows and outflows, the information investors need to understand to evaluate the liquidity, solvency, and long-term viability of a company. Although the standards generally allow managers to select either method for reporting cash flows, the overwhelming majority have chosen to use the indirect method, the approach that provides the least useful information for investment decisions.

 

The Centre has argued that not only should the direct method be required, but in addition that the reconciliation inherent in the indirect method should also be required to enable investors to better understand the effects of non-cash estimates on earnings, and the changes in current assets and liabilities. Since the late 1980s, the CFA Program has required CFA candidates to understand both the direct and indirect methods and to be able to convert an indirect method statement to the direct method. However, such adjustments are very costly in time and effort. Hence, the Centre has encouraged standard-setters to consider changing the requirements to require a direct method statement with the reconciliation of net income to operating cash flows. 

Where stated: Letter to FASB on Acquisitions of Certain Financial Institutions File 1019-002 24 June 2002; Comprehensive Business Reporting Model