Accountants use numerous specialized methods.
The direct and indirect methods of accounting represent two distinct ways of preparing the cash flow statement. These two methods should produce the same result, despite using different input from the firm's financial statements. As such, they help the accountant check the calculations for accuracy.
Cash Flow Statement
The cash flow statement of a corporation is among its most important financial statements. This breakdown not only shows whether the firm generated cash or burned through cash reserves during the period in question, but also reveals the sources of cash generation and usage. Notice that the net change in a firm's cash balance and the results revealed by the cash flow statement are usually very different. The cash flow statement reveals the change in cash position as a result of the firm's business activities, while the net cash in the balance sheet accounts for all sources of cash. A firm may have ended up with more cash in its balance sheet because it borrowed a lot from a bank, for example. The cash flow statement, on the other hand, may reveal the firm used up considerable cash as a result of regular activities during the period, and would have recorded a significant reduction in cash reserves if it weren't for the bank loan.
Direct Method
If the accountant prepares the cash flow statement by using the information in the income statement, she is using the direct method. Under such a scenario, she identifies and adds up all cash sales and collections of receivables from credit sales during previous periods. She subtracts all cash payments to arrive at the net cash flow from operating activates. The accountant disregards all cash movement from non-operating activities, such as bank loans or distribution of cash to shareholders in the form of dividends. A positive result indicates a net cash gain from ongoing activities, while a negative result reveals that the firm's regular activities used up more cash than they generated.
Indirect Method
When using the indirect method, also known as the reconciliation method, the accountant starts with net income and makes adjustments for all activities that would impact the cash flow without resulting in a change in net income or vice versa. The three steps in this adjustment involve the change in accounts receivable, change in accounts payable and investing and financing activities. The accountant deducts any increase in accounts receivable from net income; if there is a reduction, he subtracts the net reduction. Next, he adds the increase in accounts payable to the result from the prior step; if there is a decline, he must subtract the net decline. The final step is a little more complicated and involves a thorough review of net cash flows from investments and financing activities. At the end of this third step, the accountant arrives at the net cash flow from operations.
Uses
Both internal as well as external accountants utilize these two methods when examining a company's financials. The accounting department prepares cash flow statements for top management, which uses such data to ensure cash reserves will be sufficient to meet payment obligations. In addition, independent auditors use both the direct and indirect methods to ensure the firm's accounting records accurately represent its financial condition. Such independent accounting experts are also known as forensic accountants.
Tags: cash flow, flow statement, cash balance, cash flow statement, cash flow statement, cash reserves, accounts payable