Chapter 16, Problem 1DQ

To determine

Determine the advantage and disadvantage of the direct method of reporting cash flows from operating activities.

Explanation of Solution

Statement of cash flows: It is one of the financial statement, that shows the inflow and outflow of cash and cash equivalents of a company for a particular period. It determines the net changes in cash through reporting the sources and uses of cash due to the operating, investing, and financing activities of a company.

Direct method: This method uses only cash basis for preparing the cash flows statement. In this method non-cash items like depreciation are not considered for preparing statement of cash flows.

Cash flows from operating activities: These refer to the cash received or cash paid in day-to-day operating activities of a company.  In this direct method, cash flow from operating activities is determined by using all cash receipts and cash payments during the year.

Cash Receipts: It encompasses all the cash receipts from sale of goods and account receivables.

Cash Payments: It encompasses all the cash payments that are made to suppliers of goods and all expenses that are paid.

The below table shows the way of calculation of cash flows from operating activities:

Cash flows from operating activities (Direct method)

Add: Cash receipts.

Cash receipt from customer

Less: Cash payments:

To supplier

For operating expenses

Income tax expenses

Net cash provided from or used by operating activities

Advantages and disadvantages of the direct method of reporting cash flows from operating activities are as below:

Advantages:

• The main advantage of direct method is that it provides the accurate picture of the cash flows for its users. The users relies more on the statement of cash flows prepared under direct method.
• Because of its simplicity and accuracy, the direct method of preparing the statement of cash flows is preferred, and endorsed by the accounting standards setting organizations.

Disadvantages:

• The main disadvantage is that the cash receipts and cash payments data’s might not be readily available in the accounting records.
• This method (direct method) not frequently prepared or used in practice as it does not provide the complete picture of cash flows by disregarding the noncash items.
• The required data to calculate operating activities section will be an expensive one and it is a time –consuming process particularly for a big business with multiple sections or branches.