Direct vs. Indirect – It’s Your Financial Statement

As the administrator of an organization you are constantly reminded that you are responsible “for the preparation and fair presentation” of the financial statements. You are reminded of this in the engagement letter, again in the representation letter, which you copy on to your letterhead, and finally in the second paragraph of the audit report. Auditors are persistent in reminding you that these are “your financial statements.”

Accrual basis accounting is “generally accepted” in accounting parlance, but “cash basis” financial statements are not an accepted format. It is ironic, however, that one of the required statements in an audit report is the statement of cash flows, which is prepared as a cash basis statement.

The Statement of Cash Flows illustrates the sources and uses of cash as defined by three categories:

Operating activities,

Investing activities, and

Financing activities

Accounting standards have two cash flow methods of presentation – direct and indirect. A recent survey showed that 98% of cash flow statements are prepared using the “indirect” method. Is this truly a superior approach over the seldom used “direct” method? I don’t think so.

The main difference in presentation occurs with accounting for “operating activities.” Otherwise, the reporting of investing and financing activities is the same under either method.

Operating activities detail what it is we are in the business of doing. Under the direct method, the various revenue sources are listed with the amounts of cash received for each major category of income.

Suppose we are the recipient of several grants or contracts. Accrual basis income expresses revenues of $900,000. To adjust to cash basis using the direct method you would take the $900,000 accrual basis revenue, add the prior year’s grants or contracts receivable of $70,000, as in theory this would have been received in the reporting year, and deduct the current year’s receivable balance of $30,000 as it has not been received. This would yield cash basis income under the direct method of $940,000 ($900,000 + $70,000 – $30,000). It is shown in the statement of cash flows as:

Direct Method:

Cash flows from grants and contracts $ 940,000

The Indirect method merely compares the balance in grants receivable from the previous reporting period to that of the current period. In this case the difference is $40,000 ($70,000 compared to $30,000) and is illustrated as such:

Indirect Method:

Decrease in receivables                            $ 40,000

Clients would often ask during my exit conferences, “What does that mean?” Translation – You collected $40,000 above the accrual basis revenues. Which method is more meaningful to you?

The same process applies to expenses by adding or subtracting the change over the period of time (a year) in accounts payable or accrued payroll. The indirect method would express a $6,000 reduction in accounts payable or an increase of $20,000 in accrued payroll. How do you interpret these and what benefit does such an approach offer you?

Somewhere along the way I knew it was time to bring the client beyond this cryptic world of cash flow “operating activities.” As you are so often reminded “these are your financial statements.” Insist on making the “direct method” the favored presentation to better understand where you get your cash and where it is being spent. Put an end to trying to interpret what a $40,000 change in a financial statement balance means when you can look at a line item and know that you received $940,000 in grant income.

You make the call. It’s your financial statement.

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Sunday, March 15th, 2020