Essay: Methods for Preparing Statement of Cash Flows

Essay: Methods for Preparing Statement of Cash Flows
12/04/2011 Comments Off on Essay: Methods for Preparing Statement of Cash Flows Academic Papers on Business Studies,Sample Academic Papers admin

Sample Essay

The two methods applied in preparing a statement of cash flows are the direct method and indirect method. Both of these methods are same except the cash flow from operating activities which is different. The cash flow from operating activities under the indirect method is prepared by adjusting the net income with noncash items and taking the effect of increase and decrease in current assets and liabilities which make up the working capital of the company. The indirect method begins with the net income of the company and adjustments of noncash items such as depreciation and amortization are made to reconcile this amount with the actual cash basis income or operating income of the company. The changes in working capital due to increase or decrease in current assets and liabilities are added and deducted to arrive at the cash flow used in operations or cash flow generated from operations (Shim and Siegel 2005).

The cash flow from operating activities in the direct method is prepared by taking into consideration the actual receipts and payments of cash in a company. Unlike the indirect method, the direct method uses the actual receipts and payments of the company to arrive at the cash flow from operations. The cash flow from operations calculated using the direct method yields the same result as an indirect method, the only difference between the two methods is the representation of amounts in the statement during calculation of cash flow from operating activities. Both the direct and indirect methods are acceptable under Generally Accepted Accounting Principles (Sands 2004).

The two methods of preparing cash flow statements may be used alternatively in various companies according to nature and management of the organization. The indirect method of preparing cash flows includes the excess or shortage of revenues over expenses and the direct method includes the actual cash components of the revenue and expenses. This basic difference is only depicted in the cash flow from operations. The cash flow from operations in the direct method include the actual cash receipts and payments for the operations of the business whereas the indirect method starts with the net income to which adjustments are made to reconcile it with operating cash flows (Gross, McCarthy and Shelmon 2005).

Although the indirect method of preparing cash flow statements is used commonly in corporations due to ease in application some authors prefer the direct method for preparing the statement. Although the direct method for preparing a statement of cash flows is quite difficult and time consuming the preference is given by these authors as the direct method indicates the actual receipts and payments in the operations of a business and a true reflection of cash receipts and payments is presented which gives a clear and simple reflection of the actual cash transactions that have taken place during a particular period. A company can use the direct and indirect method to prepare cash flows but it would be quite easier for users of the statement to interpret the cash flows if the direct method is used to prepare the statement (Epstein, Nach and Bragg 2008).

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