Most companies prefer the direct method of preparing the statement of cash flows than the indirect method.

Question: Most companies prefer the direct method of preparing the statement of cash flows than the indirect method.

If you are studying accounting, you may have encountered the statement of cash flows, which is one of the main financial statements that shows how a company generates and uses cash. There are two methods of preparing the statement of cash flows: the direct method and the indirect method. The direct method shows the actual cash inflows and outflows from operating activities, while the indirect method starts with net income and adjusts it for non-cash items and changes in working capital. 

So, which method is better? According to a survey by the Financial Accounting Standards Board (FASB), most companies prefer the direct method over the indirect method. Why is that? Here are some possible reasons:

- The direct method provides more useful information for users of financial statements, such as investors, creditors, and analysts. It shows the sources and uses of cash from operating activities in a clear and detailed way, which can help users evaluate the company's liquidity, solvency, and profitability.

- The direct method is more consistent with the objective of the statement of cash flows, which is to report the cash effects of operating activities. The indirect method, on the other hand, mixes cash and accrual items, which can obscure the true cash flow situation of the company.

- The direct method is easier to understand and interpret for users who are not familiar with accounting concepts and terminology. The indirect method requires users to make adjustments and reconciliations between net income and cash flow from operations, which can be confusing and time-consuming.

However, despite these advantages, the direct method is not widely used in practice. According to a study by Deloitte, only 7% of companies in the S&P 500 use the direct method in their statement of cash flows. Why is that? Here are some possible reasons:

- The direct method is more difficult and costly to prepare for companies. It requires more data collection and analysis than the indirect method, which can be challenging for companies that have complex transactions and multiple revenue streams. It also requires companies to disclose a reconciliation of net income to cash flow from operations, which adds to the reporting burden.

- The direct method is not required by accounting standards or regulators. The FASB allows companies to choose either the direct or the indirect method for their statement of cash flows, as long as they provide sufficient information for users to understand their cash flow situation. Similarly, the Securities and Exchange Commission (SEC) does not mandate a specific method for public companies.

- The direct method is not preferred by auditors or tax authorities. Auditors may find it harder to verify the accuracy and completeness of the cash flow information reported by the direct method, as it involves more judgments and estimates than the indirect method. Tax authorities may also prefer the indirect method, as it shows how net income is derived from cash flow from operations, which can help them assess the tax liability of the company.

In conclusion, although most companies prefer the direct method of preparing the statement of cash flows than the indirect method, they do not use it in practice due to various practical challenges and constraints. However, this may change in the future as accounting standards evolve and technology improves. The FASB has indicated that it plans to revisit the issue of cash flow reporting in its future agenda, and may consider requiring or encouraging the use of the direct method. Moreover, advances in data analytics and artificial intelligence may make it easier and cheaper for companies to prepare and present their cash flow information using the direct method.

Rjwala

Rjwala is your freely Ai Social Learning Platform. here our team solve your academic problems daily.