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The statement may be prepared using either the direct or the indirect method of presenting net cash from operating activities.

 Direct method—presents major classes of gross cash receipts and payments and their sum.

 Indirect method—reconciles net income and net cash flow from operating activities

The FASB has long expressed a preference for the direct method. Conversely, the indirect method has always been vastly preferred by preparers.

The Direct Method The direct method shows the items that affected cash flow during the reporting period. Cash received and cash paid are presented, as opposed to converting accrual‐basis income to cash flow information. At a minimum, entities using the direct method are required to report separately the following classes of operating cash receipts and payments:

1 Cash collected from customers, including leases, licensees, and the like

2 Interest and dividends received

3 Other operating cash receipts

4 Cash paid to employees and other suppliers

5 Interest paid, including the portion of the payments made to settle zero‐coupon debt instruments attributed to accreted interest related to the debt discount

6 Income taxes paid

7 Other operating cash payments(ASC 230‐10‐45‐25)

Entities are encouraged to make further breakdowns that would be useful to financial statement users. For example, disaggregating number 4 above, “cash paid to employees and suppliers,” might reveal useful information.

The direct method portrays the amounts of cash both provided by and used in the reporting entity's operations, instead of presenting net income and reconciling items. The direct method reports only the items that affect cash flow (inflows/outflows of cash) and ignores items that do not affect cash flow (depreciation, gains, etc.) as in the indirect method described below. The general formats of both the direct method and the indirect method are shown below.

The direct method allows the user to clarify the relationship between the company's net income and its cash flows. For example, payments of expenses are shown as cash disbursements and are deducted from cash receipts. In this way, the user is able to understand the cash receipts and cash payments for the period. The information needed to prepare the operating activities section using the direct method can often be obtained by converting information already appearing in the statement of financial position and income statement. Formulas for conversion of various income statement amounts for the direct method of presentation from the accrual basis to the cash basis are summarized below.

The Indirect Method The indirect method is the most widely used presentation of cash from operating activities, because it is easier to prepare. It focuses on the differences between net income and cash flows. The indirect format begins with net income, which is obtained directly from the income statement. An entity using the indirect method to provide information about major classes of operating cash receipts and payments must report the same amount of net cash flow from operating activities indirectly. This is done with an adjustment to net income to reconcile it to net cash from operating activities by removing:

 The effects of all deferrals of past operating activities, and

 All items included in net income that do not affect cash provided for or used for operating activities.(ASC 230‐10‐45‐28)

Thus, the statement of cash flows prepared using the indirect method emphasizes changes in the components of most current asset and current liability accounts. Changes in inventory, accounts receivable, and other current accounts are used to determine the cash flow from operating activities. Preparers calculate the change in accounts receivable using the balances net of the allowance account in order to ensure that write‐offs of uncollectible accounts are treated properly. Other adjustments under the indirect method include changes in the account balances of deferred income taxes and the income (loss) from investments reported using the equity method. However, short‐term borrowing used to purchase equipment is classified as a financing activity.

The major drawback to the indirect method involves the user's difficulty in comprehending the information presented. This method does not show the sources or uses of cash. Only adjustments to accrual‐basis net income are shown. In some cases, the adjustments can be confusing. For instance, the sale of equipment resulting in an accrual‐basis loss would require that the loss be added to net income to arrive at net cash from operating activities. (The loss was deducted in the computation of net income, but because the sale will be shown as an investing activity, the loss must be added back to net income.)

Reconciliation of Net Income and Net Cash Flow from Operating Activities When the direct method is used, a schedule reconciling net income to net cash flows from operating activities must also be provided. That reconciliation must be presented in a separate schedule. (ASC 230‐10‐45‐30) That schedule reports the same information as the operating activities section prepared using the indirect method. Therefore, a firm must prepare and present both the direct and indirect methods when using the direct method for reporting cash from operating activities.

Reconciliation of Net Income to Net Cash Flow from Operating Activities
Type of Entity	Method	Presentation
Business	Direct	A separate schedule
Indirect	Within the statement of cash flows or in a separate schedule.*
Not‐for‐profit	Direct	Not required, see ASC 953‐320‐45‐29)
Indirect	Same as above for business entities.
ASC 230‐10‐45‐29 through 45‐32D

^* If presented separately, the statement of cash flow reports only the net cash flow from operating activities. If the reconciliation is presented in the statement of cash flows, adjustments to net income to determine net cash flow from operating activities must be identified as reconciling items. (ASC 230‐10‐45‐31 and 45‐32)