Which section of the statement of cash flows is prepared using either the direct or indirect method?

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Publication date: 29 Nov 2020   

us Financial statement presentation guide 6.4

ASC 230 allows a reporting entity to prepare and present its statement of cash flows using either the direct or indirect method (see
FSP 6.4.2), though
ASC 230-10-45-25 encourages using the direct method.

6.4.1 Sample statement of cash flows

Figure FSP 6-1
is an illustrative cash flow statement prepared using the indirect method. It reflects certain captions required by ASC 230 (bolded), and other common captions. Not all captions are applicable to all reporting entities.
In addition, some captions may be reflected in other classification categories depending on facts and circumstances.

Presentation and disclosure requirements are addressed in the relevant sections of this chapter and cross referenced in the last column of the figure. Not all items discussed within this chapter are presented in the figure.

Figure FSP 6-1
Sample consolidated statement of cash flows

* These line items generally should be presented gross; however, for ease of reference in Figure FSP 6-1, the inflows and outflows are reflected in the sample statement on one line.

6.4.2 Direct versus indirect method

As discussed in
ASC 230-10-45-28, cash flows related to operating activities may be presented in one of two ways — the direct method or the indirect method. The presentation of investing and financing activities are
identical under the direct and indirect methods. Although the presentation of operating cash flows differs between the two methods, both methods result in the same amount of net cash flows from operations. While
ASC 230-10-45-25 encourages the use of the direct method, the large majority of reporting entities elect to use the indirect method. The concepts underlying classification within
ASC 230 were conceived and explained solely from the perspective of the direct method. While the indirect method represents an alternative presentation model, it is not an alternative classification methodology.
Accordingly, even when a reporting entity is using the indirect method, it should consider the direct method framework when evaluating the proper classification of a cash flow.

As discussed in ASC
230-10-45-25, the direct method requires the presentation of major types of gross cash receipts and gross cash payments and their arithmetic sum, which represents the net cash flow from operating activities. At a minimum, the following types of operating receipts and disbursements are required in a direct method presentation:

• Cash collected from customers, including lessees, licensees, etc.
• Interest and dividends received (except
  for return of capital)
• Other operating cash receipts, if any
• Cash paid to employees and other suppliers of goods or services, including suppliers of insurance, advertising, etc.
• Interest paid
• Income taxes paid
• Other operating cash payments, if any

To illustrate how operating cash flows (prepared on the cash basis of accounting) relate to net income (prepared on the accrual method of accounting), as discussed in
ASC 230-10-45-28, the direct method also requires a reconciliation of net income to net cash flows from operating activities. Net income, including earnings attributable to the controlling and
noncontrolling interests, is the starting point to reconcile cash flows from operating activities. The reconciliation removes the effects of the following:

• All deferrals of past operating cash receipts and payments, and all accruals of expected future operating cash receipts and payments (for example, changes during the period in receivables and payables pertaining to operating activities)
• All items included in net income that do not
  affect operating cash receipts and payments (for example, all items for which cash effects are related to investing or financing activities (e.g., depreciation, amortization, gains or losses on dispositions of long-lived assets, and foreign currency gains and losses from the retirement of foreign denominated debt))
• As discussed in
  ASC 230-10-45-25 and
  ASC 230-10-45-28, when the indirect method is used, a reporting entity does not report the gross cash receipts and gross payments required by the direct method. Instead, only the reconciliation of net
  income to net operating activities, as described above, is reported. In addition, as discussed in ASC 230-10-50-2, when the indirect method is used, amounts of interest paid (net of amounts capitalized)
  and income taxes paid during the period must be disclosed, either on the face of the statement of cash flow or in the footnotes.
• Adjustments for noncash items in the reconciliation of net income to net cash flows from operating activities may include items such as:
  • Depreciation and amortization relating to fixed assets, definite-lived intangible assets, capital leases, premiums, or discounts on debt (including
    debt issuance costs)
  • Lessee’s amortization of right-of-use assets (see FSP 6.9.18)
  • Provisions for bad debts and inventory
  • Share-based incentive compensation
  • Deferred
    income taxes
  • Impairment losses
  • Unrealized foreign currency transaction gains or losses
• Adjustments for cash flows from investing and financing activities recognized in net income adjusted to arrive at cash flows from operating activities may include items such as:
  • Gains or losses from the sale of long-lived assets or businesses
  • Gains or losses from the settlement of asset
    retirement obligations
  • Gains or losses from the extinguishment of debt
  • Realized foreign currency transaction gains or losses related to investing or financing activities

Reporting entities have latitude in how they present an indirect method reconciliation, as there is no prescribed format. As with most forms of practical expediency, the indirect method yields information that is less useful than the direct method. For example, because the individual line
items within a reconciliation of net income to net operating cash flows do not represent cash flows, they by themselves provide no incremental information about a reporting entity’s cash flows.

Although ASC 230
encourages the use of the direct method, a reporting entity can change from the indirect to direct method (or vice versa) retrospectively. This retrospective change in the presentation of the statement of cash flows would not be considered a discretionary accounting change and would not require an assessment of preferability.

Even when a reporting entity is using the indirect method, the direct method may be helpful in evaluating the proper classification of cash flows.
Example FSP 6-1 illustrates how a reporting entity can use the direct method to isolate cash flows from operations to ensure that the presentation under the indirect method of cash flows from operations is the same.

EXAMPLE FSP 6-1
Foreign currency cash flows in operating and financing cash flows

FSP Corp is a US dollar functional currency entity with two Euro denominated liabilities: a €1,000 account payable due in 30 days and a €100,000 long-term note
due in 3 years that may be repaid at any time, in any increment. At the beginning of the quarter, the spot rate for Euros was $1.20 per €1. The account payable was remeasured at the beginning of the quarter at $1,200 and the long term note at $120,000. FSP Corp has $50,000 of cash and cash equivalents on the balance sheet at the beginning of the quarter.

A week later, when the spot rate for Euros is $1.15 per €1, FSP Corp pays the €1,000 account payable and settles €40,000 of the note
payable. When preparing its financial statements at the end of the quarter, the exchange rate for remeasurement of the remaining €60,000 of long-term note payable is $1.10 per €1. FSP Corp records the following journal entries.

To settle the outstanding account payable (foreign exchange gains of $50 (€1,000 x ($1.20-$1.15)) and cash of $1,150 (€1,000 x $1.15).

To partially repay the long term note payable (foreign exchange gains of $2,000 (€40,000 x ($1.20-$1.15)) and cash of $46,000 (€40,000 x $1.15).

To record the foreign exchange gain on the remeasurement of the outstanding debt of $6,000 (€60,000*($1.20-$1.10)).

Ignoring interest and taxes, what is the treatment in the cash flow statement for these three journal entries under the direct and indirect methods?

Analysis

Treatment on the cash flow statement:

A common error when preparing the cash flow statement is to present the repayment of €40,000 of the note payable as an outflow of $48,000 (the amount of the debt repayment remeasured to US dollars at the beginning of the period). This results the foreign exchange gain on the retirement of debt being included in cash flows from operations. In this example, reporting the foreign exchange gain in operations (rather than financing) would
have resulted in $850 of net cash inflows from operations, rather than the $1,150 net outflow from operating activities. See FSP 6.11 for further discussion of foreign currency cash flows.

6.4.3 Cash flow performance measures prohibited

Whether a reporting entity uses the direct or indirect method to present its operating cash flows,
ASC 230-10-45-3 prohibits disclosure of cash flow per share or any component of cash flow per share.

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Was the statement of cash flows prepared using the direct or indirect method?

The direct method is one of two accounting treatments used to generate a cash flow statement. The statement of cash flows direct method uses actual cash inflows and outflows from the company’s operations, instead of modifying the operating section from accrual accounting to a cash basis.

Which part of the statement of cash flows does the indirect method apply to?

The indirect method presents the statement of cash flows beginning with net income or loss, with subsequent additions to or deductions from that amount for non-cash revenue and expense items, resulting in cash flow from operating activities.

In what element does direct and indirect method in statement in cash flows differ?

Using the direct method, actual cash inflows and outflows are known amounts. The cash flow statement is reported in a straightforward manner, using cash payments and receipts. Using the indirect method, actual cash inflows and outflows do not have to be known.

How do you prepare a statement of cash flows using the indirect method?