Tax Returns vs. Accrual Statements in Assessing Borrower Risk
Q: What is the difference between the indirect and direct format of the FASB 95 Statement of Cash Flows?
A: Both formats provide the user with a complete breakdown of cash flow driven by activity in both the income statement and the balance sheet. The cash flows are grouped into three different activities - operating, investing, and financing activities. Use of the indirect or direct methodology affects only the presentation of the operating activities. The investing and financing activities are identical under either approach.
The indirect format begins with net income in organizing operating cash flow activities. The presentation continues by adding non-cash expenses to define traditional cash flow. The balance sheet operating accounts are counterparts to the income statement accounts and are integrated into the cash flow operating activities as a group following the order in which each appears on the balance sheet. The net change in each of the balance sheet counterpart accounts for the period is then either added or subtracted from traditional cash flow. The result is identified as Net Cash Provided by Operating Activities.
The direct cash flow format begins with sales and adjusts revenue accounts on the income statement by adding or subtracting the net change in the associated balance sheet counterpart account, such as changes in accounts receivable and deferred revenue, to identify cash receipts. It then adjusts cost of goods sold and operating expenses by their balance sheet counterpart accounts, such as prepaid expenses, accounts payable, and accrued liabilities, to identify cash payments to suppliers and employees. It records, as well, any miscellaneous cash receipts or cash expenses related to operations. Cash receipts, cash payments to suppliers and employees, and other cash receipts or expenses sum to Net Cash Provided by Operating Activities – an amount identical to Net Cash Provided by Operating Activities in the indirect format.
Course overview: Tax Returns vs. Accrual Statements in Assessing Borrower Risk