What are the major advantages of the indirect method of reporting cash flows from operating activities?
According to an article by Bassam M. Abu-Abbas of Princess Sumaya University for Technology in Amman, Jordan, some of the major advantages of reporting cash flows from operating activities using the indirect method, instead of the direct method, are that:
- direct cash flows can be derived from information in indirect reports (making direct cash flow reporting redundant);
- the indirect method of reporting cash flows is more cost effective and easier to put together than the direct method;
- an indirect cash flow report is easier for creditors and investors to make use of in decision making;
- indirect cash flow reports provide a clearer understanding of the "lead and lag between cash flows and income information" since net income is reconciled to net cash flows from operating activities in the indirect reporting method (while the direct method reports "gross inflows and outflows components of cash flows from operations") (Abu-Abbas).
"Direct, Indirect, or Both Methods of Reporting Operating Statement of Cash Flows" by Bassam M. Abu-Abbas, Princess Sumaya University for Technology, Amman, Jordan, published in International Journal of Finance and Accounting, SAP, 2014.
When reporting cash flows from operating activities, the indirect method first displays the net income and then shows the alterations required to transform the total net income to operating cash flows.
The indirect method helps the business owner understand the sources of cash flow, since it eliminates non-cash transactions, such as depreciation, and non-operational gains and losses, such as a gain on the sale of an item.
The indirect method also helps the business owner organize and link the income statement with the balance sheet, since it requires information from both accounts. The adjustments made on the net cash flow require the business owner to change some figures on the revenues and expenses section of the income statement, which also affects the assets and liabilities section of the balance sheet.
Since the indirect method reconciles net income with real cash flows from operating activities, it helps the business owner understand the difference between profitability and liquidity.
The indirect method of reporting cash flows is useful for simplifying your operational activities to investors. It can also be used to present investing and financial activities. The main purpose is to present as easy-to-digest version of the company's financial state that includes net income or loss and non-cash expenses and activities that led to the current net income.
The use of indirect method should not change the amount of total cash generated from operations when compared with the direct method. The operating cash flow can be found by subtracting expenses from the previous net income and adding to the liability column.
While the direct method lists every receipt and payment from each source, the indirect method just provides results. Individual payment information can be retrieved in the accounting system. Cash and assets need to be balanced, as does liability with net income. The indirect method is preferred by many organizations because it saves time and resources.
In regards to operating activities a company’s cash flow statement provides a view of a company’s cash position from its primary business operations. A stable or growing operational cash flow is an indication of good financial health and secure long term prospects. The indirect method uses accrual accounting to record expenses and revenue, this method records a transaction at the time they occur rather than at the exchange of cash. The primary advantages of the indirect method are:
- It is less complex to use for reporting purposes
- It provides a better view of business activity
- Information is more up to date and available
- Balanced cash income
- It shows combined financial statements
- Reveals non-cash organizational transactions
- It is an Industry standard used by most organizations