What's the difference between the direct and indirect methods for the cash flow statement?

Question

AcadiFi · Accepted Answer

Both the direct and indirect methods calculate the **same Cash Flow from Operations (CFO)** -- they just get there differently. The difference only affects the **operating activities section**.

**Indirect Method (Most Common)**

Starts with **net income** and adjusts for non-cash items and working capital changes:

```mermaid
flowchart TD
    A["Net Income"] --> B["+ Depreciation & Amortization"]
    B --> C["+ Loss on Asset Sale / - Gain on Asset Sale"]
    C --> D["- Increase in Receivables / + Decrease"]
    D --> E["- Increase in Inventory / + Decrease"]
    E --> F["+ Increase in Payables / - Decrease"]
    F --> G["= Cash Flow from Operations"]
```

**Direct Method**

Lists actual cash receipts and payments:

| Line Item | Amount |
|---|---|
| Cash received from customers | $850,000 |
| Cash paid to suppliers | ($420,000) |
| Cash paid to employees | ($180,000) |
| Cash paid for interest | ($30,000) |
| Cash paid for taxes | ($55,000) |
| **CFO** | **$165,000** |

**Worked Example -- Silverline Apparel Co.:**

Given: Net income $150,000; Depreciation $40,000; Receivables increased $25,000; Inventory decreased $10,000; Payables decreased $15,000; Gain on sale of equipment $5,000.

**Indirect method:**

| Adjustment | Amount |
|---|---|
| Net income | $150,000 |
| + Depreciation | $40,000 |
| - Gain on sale | ($5,000) |
| - Increase in receivables | ($25,000) |
| + Decrease in inventory | $10,000 |
| - Decrease in payables | ($15,000) |
| **CFO** | **$155,000** |

**Key Points for the Exam:**
1. Both IFRS and US GAAP **prefer** the direct method, but the indirect method is used by ~95% of companies
2. Under IFRS, interest paid can be classified as CFO or CFF; under US GAAP, it **must** be CFO
3. Under IFRS, interest received can be CFO or CFI; under US GAAP, it **must** be CFO
4. Under IFRS, dividends paid can be CFO or CFF; under US GAAP, **must** be CFF

**Converting Indirect to Direct:** You need additional data -- specifically, you need the beginning and ending balance sheet plus the income statement to reconstruct actual cash receipts and payments.

Check out our detailed CFO analysis practice problems in the CFA Level I question bank.

What's the difference between the direct and indirect methods for the cash flow statement?

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Practice Questions

Line Item	Amount
Cash received from customers	$850,000
Cash paid to suppliers	($420,000)
Cash paid to employees	($180,000)
Cash paid for interest	($30,000)
Cash paid for taxes	($55,000)
CFO	$165,000

Adjustment	Amount
Net income	$150,000
+ Depreciation	$40,000
- Gain on sale	($5,000)
- Increase in receivables	($25,000)
+ Decrease in inventory	$10,000
- Decrease in payables	($15,000)
CFO	$155,000