 In this presentation we will compare and contrast the direct method versus the indirect method for the statement of cash flows. It's important to note that when we're comparing the direct and indirect methods we're really only talking about the top part the operating activities portion of the statement of cash flows. Support accounting instruction by clicking the link below giving you a free month membership to all of the content on our website broken out by category further broken out by course each course then organized in a logical reasonable fashion making it much more easy to find what you need than can be done on a YouTube page. We also include added resources such as excel practice problems pdf files and more like quickbooks backup files when applicable so once again click the link below for a free month membership to our website and all the content on it. In other words the investing activities and financing activities and in result will remain the same we're going to end up at the same result which of course will be the ending cash that we can tie out to the balance sheet and we'll have the change of cash here which is really kind of the what we're looking for in the statement of cash flows what's going to differ is the operating activities why are they going to differ why would we have the operating activities differ remember that the operating activities have to do with kind of the income statement you can think of it basically as the income statement being reformatted to a cash flow statement versus an accrual statement so the income statement that we use is on an accrual basis and we recognize revenue when it's earned rather than when cash is received expenses when expenses are incurred rather than when cash is paid that's going to be on on an accrual basis if we were to convert that to something that would be on a cash basis that would be similar to something that would be on the cash flow statement just for the operating activities so there are other now the operating activities is usually the longest part of the statement because when we tell the story of what's happening within a company whether that be through activities in terms of income statement what's happening in terms of normal operations or through a cash flow statement what's happening through cash flow we typically are most of the transactions then most of the detail most of the story is going to be in the operating activities section so this is usually the largest section in other words but there are other things here the investing and financing where we could have cash flows that are not part of the of the kind of the income statement section the normal operating type of activities section so we're going to compare and contrast this now the direct method then makes more sense to us or at least intuitively it makes more sense because that would be similar to us going through the income statement line by line and just fixing it so that like sales or revenue would be reported on a cash flow basis rather than on a revenue recognition basis from a from a cash basis rather than the cruel basis that makes sense however note that we've already calculated net income on a on a cruel basis and so in a sense it'd be easier for us and it might make more sense in terms of just tying out the two seeing the difference to start with net income and then reverse the things that are not related to cash and that's the indirect method so oftentimes we will often use actually the indirect method the less intuitive method for a few different reasons one it could be required it's often required to have the indirect method and two which is probably the reason why we were required to have an indirect method because you might think why would we want that method when the other method seems more straightforward if I was to explain to someone how this works if I looked at the indirect versus the direct method I think it would be easier to look at the direct method here to say hey we're trying to explain to an investor this is the cash flow from operations this is similar to the income statement we're going to take cash received from customers cash paid for merchandise cash paid for other operating expenses cash paid for taxes and you can see that these kind of list out and line up in a similar fashion as you might see on an income statement this is the direct method the method that typically may not be the most used and even if we do use the direct method oftentimes we're still required to have an indirect method calculation and the indirect method is more difficult to explain to most people typically because it starts with net income and then we kind of back out these changes which makes sense but it's a little confusing to think about these changes and we'll get into a lot more detail on why this worked and how these changes are going to be adjusted the bottom line of course will remain the same so we end up in the same total it's just the different approaches that we're going to get to get in that total now why would we do this i mean this makes more sense just intuitively why would we require if someone did the direct method to then do the indirect method as well well it might be useful for us to see this reconciliation because we'd want to know what what is the difference between net income and the cash flow from operations we want to know those reconciling items so when we do the direct method it's nice because we've reconstructed everything line by line and we can kind of compare line by line the the income statement versus the cash flow statement in terms of the operating activities but this method the indirect method gives us kind of the exact difference the changes the reconciliation between net income on an accrual basis and the cash flows from operations which is kind of like net income from a cash flow basis so for this reason typically uh in order to if we're trying to not do as little work as possible right not have the two statements then a lot of times we'll see the indirect method and not have the direct method so a lot of textbooks will focus and a lot of companies and will focus oftentimes on the indirect method a lot because it's typically going to be the required method and therefore the method that will be used and the method that gives a lot of information for us so remember that the direct method is going to is going to basically redline out everything so we're going to say the income statement starts with revenue we're now going to say it's going to be cash received from customers and therefore the difference between those two we'll have to look at the and we'll talk more about this when we do the direct method but we'll have to look at the revenue account and decide which what's a cash revenue basis what would be recorded as revenue if we were on a cash flow basis rather than an accrual basis and we'll do the same for other components of the statement of cash flow of the of the income statement and then in the indirect method we're going to go over here and start with net income the bottom line on the income statement and then we're going to reverse things out that are not cash related for example depreciation gain or loss are not cash related we'll talk more about that when we construct the indirect method cash flow statement and then we've got the differences from accounts receivable inventory prepaid expenses and we'll talk more about where these differences come from why are these not cash related and to do that we're going to have to look we're going to have to think about these accounts and say how do they go up or down and then reverse these out now doing this is going to be really helpful to us to just understand normal accrual accounting if you can understand you know the cash flow statement and make one then you're really kind of reconstructing the accrual basis and thinking about the accrual basis versus the cash basis so even if you don't plan on making a lot of cash flow statements the practice of doing so really helps for us to understand you know different accounts what different accounts are doing and the difference between a cash basis and an accrual basis