In Accounting, what is Direct Method?

In accounting, the direct method is a way to present cash flow statements, showing how cash was received and used in the business as of a certain period of time. It is a standardized report, presenting information on cash not available in other types of financial reports. This statement is important for bankers and investors, and anyone interested in cash applications of a business. Cash flow statements in the US can be prepared using the direct method or the indirect method.

Under both methods, cash flow statements are classified in three sections: cash from operating activities, investing activities, and financing activities. Under each section, there are lines summarizing information. Under investing activities this might include the purchase of securities, while under financing activities, it could include the issuance of stock. Differences between the direct and indirect methods affect only the cash transactions from operating activities section; the other two sections remain the same under either method.

The direct method shows the history of cash, from beginning balance to ending balance, classified in major classes of operating cash receipts and payments. Non-cash items, such as depreciation expenses, are excluded. Items usually found under the direct method are payments to employees, rent, and cash received from customers. Cash flows under the direct method are easy understand, although identifying all cash transactions can become a burden to many businesses.

The indirect method is easier to compile, but the information provided is not as easy to analyze as in the direct method. Instead of providing clear information on cash use, the indirect method reconciles net income to cash balance. Decreases and increases in certain accounts are reported, instead of major classes of receipts and payments. Non-cash items are shown as reconciling items, including depreciation. Items that can be found under this method are any increase in accounts receivable, an increase in inventory, and a decrease in accounts payable.

In order to get the information to use the direct method, all cash transactions have to be classified and summarized. Payments are sorted by type of expense, and deposits are also sorted by type as well as counted as inflow of cash. Cash transfers between accounts are ignored. Each line in the operating activities section corresponds to a classified summarized cash transaction. Traditionally, the first line item in the operating activities under this method is the cash from customers — cash coming in.