What is the Direct Cash Flow Method?
The direct cash flow method is a preparation style for the statement of cash flows. This statement is one of three important financial statements prepared and released by a company. Under the direct cash flow method, companies use actual receipts and other paperwork to show all the movements of cash within a company. The direct method is typically the preferred method for preparing the statement of cash flows in accordance with accounting and government agencies.
The statement of cash flows includes three sections: operating, investing and financing. Each section has specific information taken from the company’s other financial statements. Operating activities include cash receipts from revenue and cash outflows relating to expenditures in a specific accounting period. Investing activities include receipts and payments from the sale and purchase of long-term assets. Financing activities relate to the receipts from borrowing funds or issuing common stock and the outflows incurred from the repayment of borrowed funds and payment of dividends to investors.
Under the direct cash flow method, each section — operating, investing and financing — lists all cash inflows first, followed by the cash outflows. A brief description provides information as to the nature of cash movement. At the bottom of the statement, the total from each section provides the total increase or decrease in cash for the month. This total is then added to the beginning balance on the statement of cash flows; this balance represents the ending balance from the previous month’s statement of cash flows. The resulting total indicates the total cash generated for the entire accounting period, usually the current calendar year.
Some non-cash transactions may also go on the statement of cash flows. The purpose of these items is to inform financial statement users about other transactions that may involve cash in the future. The direct cash flow method allows for this information on the bottom of the statement. These transactions are typically called non-cash investing and financing activities. Examples of these transactions include issuing a bond for a long-term asset, obtaining a mortgage for a building or similar transactions.
Reporting cash flows on a separate statement is necessary when companies use the accrual-based accounting method. Accrual accounting records transactions as they occur, which does not account for the movement of cash in a business. Since most companies use the accrual accounting method, the direct cash flow method helps companies manage cash. Another reason for the statement of cash flows is that companies can report a net loss for a year but still have a positive cash flow. This occurs because some non-cash transactions — typically depreciation or amortization expenses — do not involve cash, but negatively affect the income statement.
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