What is the Direct Method?
The direct method is one of the two methods used while preparing a cash flow statement. It is a form of accounting treatment used on the financial components of an organization that are to be accounted for in the cash flow statement.
- The direct method is a form of accounting treatment used on the financial components of an organization that are to be accounted for in the cash flow statement.
- It requires the use of the actual cash inflows and outflows of the organization.
- The actual inflows received and the outflows paid for, and not accrued, are added and subtracted from the cash flow statement using the direct method. The accrued transactions are recorded in future cash flows when the incomes are actually received and the payments are actually made.
How is a Cash Flow Statement Prepared Using the Direct Method?
The direct method requires the use of the actual cash inflows and outflows of the organization, i.e., the actual cash inflow and outflow that took place within the company when the incomes and payments are actually realized and not when they are accrued.
The actual inflows received and the outflows paid for, and not accrued, are added and subtracted from the cash flow statement using the direct method. The accrued transactions are recorded in future cash flows when the incomes are actually received, and the payments are actually made.
The net balance, after adding all inflows and subtracting all outflows, is the actual cash flow of the firm under the direct method at the end of the financial year.
What is the Accrual Concept?
The accrual accounting concept, simply known as accrual accounting, is basically an accounting method that stipulates the accounting of financial components of an organization as and when they are accrued, i.e., as and when revenues are earned and/or expenses are incurred, not when the payment for that transaction is actually received or made and the actual inflow our outflow of cash takes place.
The accrual method is in contrast to the cash accounting method, which stipulates the accounting of financial components in an organization not when the income is earned or the expense is incurred, but when the actual cash inflow or outflow for the same takes place.
The cash flow statement direct method basically advocates for the use of the cash accounting concept as opposed to the accrual accounting concept.
What is the Indirect Method?
The other method used to prepare cash flow statements of an organization is the indirect method. It is different from the direct method in the sense that it uses the line items of the balance sheet to determine the net cash flow of the company.
It begins with the net income or loss derived from the profit and loss statement of the company and adds and/or subtracts the increases and decreases of the balance sheet items of the financial year to arrive at the net cash flow amount of the company.
Direct Method vs. Indirect Method
The indirect method is the more popular method of preparing a cash flow statement. It is because most businesses around the world follow uniform international accounting standards and the GAAP (Generally Accepted Accounting Principles), both of which stipulate the use of the accrual concept of accounting, as opposed to the cash concept of accounting.
It is because the accrual concept requires the recording of transactions as and when they occur, not when the actual payment for the transaction is made or received. Such a process makes it easy to record transactions when they happen and to keep an organized record, instead of postponing each transaction to its receipt.
It is essentially important because the entire world of finance revolves around credit and debit. Hence, it is easier to record transactions when they happen, instead of deferring the recording of a transaction to when it is actually received.
The recording of business transactions is much easier with the accrual concept, while the direct method makes the process of gathering and assembling all information tedious and exaggerated.
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