difference between the direct method and indirect method of reporting operating expense on statement of cash?

Answer 1

The Cash Flow Statement has three sections: Cash Flow from Operating Activities, Cash Flows from/for Investment Activities and Cash Flows from/for Financing Activities.

The Direct Method is less commonly used than the Indirect Method. What is the Direct Method? It adds up the cash flows (as opposed to accruals, which the income statement and balance sheet are based upon) in and out of the business in each of the three areas of Operations, Investments and Financing. The upside to the Direct Method is that it is easy to understand (money in, money out = what's left over), but the downside is that it isn't much help except in tell you what you already know. That is, it tells you some money came in, money came out and you have money left over. The Direct Method is more common in Commonwealth countries (e.g Australia) for some reason, but I'm not sure why.

The Indirect Method is the much more common method, which starts with Net Profit (or another profit line item) and then adjusts the balance for non-cash items (e.g. depreciation), changes in balance sheet items (e.g. accounts receivables, accounts payable, inventory). The Indirect Method is less intuitive when looking at it by itself, but is much more helpful when used in conjuction with the income statement and balance sheet.

Why is this important?

First, remember that accounting rules are based on dual entry. You credit somewhere, you debit somewhere else. If your debits don't equal your credits, you messed up somewhere. Furthermore, income statement and balance sheet accounting is based on accrual basis, not cash basis. This is important because the cash flow statement acts as a RECONCILIATION of the income statement and balance sheet. In some pretty corny terms that I made up, your income has to come in to your retained earnings, your balance sheet has to balance - otherwise your cash flows won't flow. Yeah, dumb - but true.

Secondly, the Indirect Method shows where cash went and where it came from. The Direct Method lumps it all together and nets them at the three major sub-totals. The Indirect Method is much more informative. This is important so you, at the company's very basic needs, doesn't run out of cash. In more advanced terms, it ensures that you know where cash is coming from, where it is going, where the Company is getting stronger, where it needs help and most of all - that it's financial statements are robust and error free.

Answer 2

When using the direct method, you list cash flows in the operations section of the cash flow statement. Cash flows due to operations arise from customer collections & cash paid to suppliers, employees & others. In the indirect method, you adjust net income to convert it from an accrual to a cash basis. This requires you to add back non-cash expenses such as depreciation, amortization, loss provision for accounts receivable & any losses on the sale of a fixed asset. Source(s): losangelescpa(dot)org