Question
Indirect method vs. Direct method for Cash Flow Statement The indirect method considers the opening and closing balance of ledger accounts in determining the movements
Indirect method vs. Direct method for Cash Flow Statement
The indirect method considers the opening and closing balance of ledger accounts in determining the movements and computing cash flows. If there are wrong postings in the ledger account the cash flows determined are not accurate since only opening and closing balances are considered. In direct method since each line item of ledger is classified into cash and non cash it leads to accurate computation of cash flows.
The indirect method is more widely used because the opening balance and closing balance of accounts are easily available in the published financial statements and hence the users of cash flow statement can correlate the balances with published results of financial statements. It makes sense since all the information is available at one place and users can question management on any particular cash flow which is not clear to them.
Question: The opening and closing balances are the same regardless of which method you are using. The cash flow statement is prepared after the books have been closed. If there are erroneous postings, then the closing balances will be affected as well, not just individual line items that impact cash. Also, think of the journal entry method used in the direct method in this text. Aren't we using ending ledger balances to determine cash flows? For example, if Sales =$500, and A/R has decreased by $2, then cash collected per direct method is $502.
Dr. Cash 502 Cr. A/R 2 Cr. Sales 500
If we use the indirect method, net income, which includes sales of $500, is increased by the $2 decrease in A/R, per the formula, and $502 is one component of operating cash flows. Is it not the same result?
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