Question

There are two options for reporting the Operating Section of the statement of cash flows. What are the distinct differences between the two methods, and why do you think that FASB chose the direct method as the preferred method, and why do the vast majority of companies still use the indirect method? Explain, with examples, the importance of this financial statement. Please take into consideration how it might be used to enhance or supplement the other three statements.

Answer 1

Answer:

The statement of cash flows is one of the most important financial statements of a company, since a company might be very profitable but if it doesn't have enough cash to function, then it will go bankrupt. This is normally more important when things are not going well, e.g. Ford didn't go bankrupt during the great recession because it had lots of cash, while GM and Chrysler ran out of cash and had to be bailed out.

Companies can survive without making any profits during many years and still be a success, e.g. Amazon, but no company can survive without cash. In finance and investing, cash is king.

The two ways to calculate cash flows are the direct and indirect method. The direct method is calculating through the differences between cash inflows and outflows. On the other hand, the indirect method starts with net income and is then adjusted for depreciation and amortization, increase in accounts receivables, etc.  

Personally, I prefer the indirect method because it is much more simple to prepare and understand. Folks at FASB and IASB prefer the direct method because according to them it provides a clearer picture of the company's cash outflows and inflows. It sounds reasonable until you learn that companies that present the cash flows using the direct method must also present them using the indirect method. Or the companies can simply present the indirect method. So I'm not really sure that their argument is very solid.