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While expressing the preference for the direct method, U.S. GAAP and IAS also include the requirement that when the direct method is presented on the face of the cash flow statement, the notes to the statement must include a reconciliation of accrual accounting net income to cash from operating activities. This reconciliation constitutes the indirect method format. A cash flow statement, using the indirect method, is presented below.

This indirect format links the cash from operating activities to the accrual accounting income statement results, clarifying the distinction between the two. The income statement reflects the operations of the firm, measured on the accrual basis, rather than on a cash basis. Most of the items in an income statement are related to operating activities as defined by the cash flow statement rules. Therefore, it is possible to reconcile the net income from the income statement to the cash from operating activities. This is accomplished by removing the effects of items that appear on the income statement but do not affect cash such as depreciation and amortization expense, items where the timing between accrual and cash is different (e.g., changes in accounts receivable, accounts payable, prepaids) as well as a few items that appear on the income statement but are not categorized as operating activities for cash flow purposes (e.g., gains or losses from sale of PP&E—remember, cash flows from sale of PP&E are included in the investing activities section)

Companies can choose to do one of the following:

• Report the cash flow statement under the direct method, with an indirect reconciliation provided as supplementary information.
• Report the cash flow statement under the indirect method.

Understandably, most firms opt to create only one format, the indirect method, and present it on the face of the cash flow statement. Only rarely does a firm provide the direct method format.

For more information, see all articles on: Accounting, Financial Statement Analysis, Fundamental Analysis

See also:

Cash Collected from Customers

Converting an Indirect Method Statement of Cash Flows to the Direct Method

Cash Paid to Suppliers

Cash Analysis: Sources and Uses

Reconciling Net Income to Cash Flow From Operations: Working Capital Adjustments