The direct method is a way of presenting cash flows from operating activities in the statement of cash flows by listing the main categories of operating cash receipts and payments. Instead of starting with net income and adjusting it, the statement shows items such as cash collected from customers, cash paid to suppliers, cash paid to employees, interest paid and income taxes paid. The total is net cash provided by, or used in, operating activities.
US GAAP permits either the direct method or the indirect method and the FASB has long encouraged the direct method, yet most US companies use the indirect method. A company that chooses the direct method must also provide a reconciliation of net income to operating cash flow, which is essentially the indirect method as a supporting schedule. In cost accounting, "direct method" also refers to the direct allocation method for service department costs, covered separately.
The direct method in plain terms
Imagine checking a household's finances by reading its bank statement line by line: money in from salaries, money out for rent, groceries and the electricity bill. That is the direct method. It tells you plainly where the cash came from and where it went.
The indirect method works backwards instead. It starts from the family's "profit" on paper and then adjusts for bills not yet paid and income not yet received. Both arrive at the same answer, but the direct method is usually easier for a newcomer to follow, because it describes real cash moving in and out.
How the direct method works
Most companies keep their books on the accrual basis, so the direct-method figures are usually worked out by converting each income statement line to cash, using changes in the related balance sheet accounts:
- Cash from customers equals sales minus the increase in accounts receivable, or plus a decrease.
- Cash paid to suppliers equals cost of goods sold, plus an increase or minus a decrease in inventory, then plus a decrease or minus an increase in accounts payable.
- Cash paid for operating expenses equals those expenses, excluding noncash items, adjusted for changes in prepaid expenses and accrued liabilities.
- Income taxes paid equals income tax expense adjusted for changes in taxes payable and deferred taxes.
Depreciation expense and other noncash expenses do not appear in a direct-method operating section, because no cash moves.
Worked example
A distributor reports sales of $500,000, cost of goods sold of $300,000, cash operating expenses of $100,000, depreciation of $30,000 and income tax expense of $25,000, giving net income of $45,000. During the year receivables rose by $20,000, inventory fell by $10,000, payables fell by $5,000, prepaid expenses rose by $2,000 and taxes payable rose by $3,000.
| Operating cash flows (direct method) | Amount |
|---|---|
| Cash received from customers ($500,000 minus $20,000) | 480,000 |
| Cash paid to suppliers ($300,000 minus $10,000 plus $5,000) | (295,000) |
| Cash paid for operating expenses ($100,000 plus $2,000) | (102,000) |
| Income taxes paid ($25,000 minus $3,000) | (22,000) |
| Net cash from operating activities | 61,000 |
The indirect method gives the same $61,000: net income of $45,000, plus depreciation of $30,000, minus the $20,000 rise in receivables, plus the $10,000 fall in inventory, minus the $5,000 fall in payables, minus the $2,000 rise in prepaid expenses, plus the $3,000 rise in taxes payable.
Direct and indirect methods compared
The two methods differ only in the operating section; investing and financing activities are presented the same way. Supporters of the direct method argue that it is more informative, because it shows gross cash receipts and payments that help users forecast future cash flows. Preparers have generally favored the indirect method because it is easier to produce from accrual records, it highlights the differences between profit and cash, and the direct method still requires the reconciliation as well. Lenders and analysts who want the gross figures sometimes reconstruct them from the balance sheet and income statement themselves.
The direct method in cost allocation
In management accounting the phrase is a short form of the direct allocation method, which assigns the costs of service departments, such as maintenance or IT, directly to producing departments and ignores services that service departments provide to each other. It is the simplest of the three common allocation methods; the others are the step-down and reciprocal methods.