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Direct and Indirect Cash Flows

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Direct and Indirect Cash Flows
The statement of cash flows is one of the components of a company’s set of financial statements that show the changes in the balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing and financing activities (Accountingtools, 2016). Companies must adjust the effect of the use of accrual accounting to determine cash flows. In order to prepare this statement, the information needed usually comes from three sources: comparative balance sheets, current income statement, and any additional information such as transaction data that are needed to determine how cash was provided or used during the period. In order to determine net cash provided/used by operating activities a company must convert net income from an accrual basis to a cash basis. This conversion can be done by two different methods: the indirect method or the direct method. The indirect method works by adjusting the net income for items that do not affect cash such as depreciation, amortization, loss provision for accounts receivable and any losses on the sale of a fixed asset. According to Bassam (2014) these are some of the advantages of the indirect method: “provide more meaningful information, tells reader if sales are increasing or decreasing, easier for the preparers to create, simple for users to analyze…”

The second method is the direct method. The direct method shows operating cash receipts and payments, making it more consistent with the objective of a statement of cash flows. “It provides gross inflows and outflows components of cash flows from operations (ie. Cash from customers and cash paid to suppliers) (Bassam, 2014).” Companies are generally encouraged to use the direct method, however 99% of companies use the indirect method.
The reason that either method may be used is because...

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