The difference between direct and indirect methods from the accounting system's point of view
In a company that accounts on a cash basis, P/L and balance of payments are consistent because profit or loss is recognized when the cash is transferred, regardless of when the transaction occurs.
However, since general companies use accrual basis accounting, profits and losses are recognized at the time the transaction occurs regardless of the movement of cash, there may be a gap between profit and income at the end of the month, and a separate cash flow statement (C/F) is required to manage income and loss.
In the "cash flow from operating activities" part of C/F, if the direct method is used, the balance of cash and cash equivalents is calculated by adding up the pluses and minuses of cash and cash equivalents (Cash/Bank) in each transaction unit (this is called the total amount).
On the other hand, if we use the indirect method, we adjust the gap between the net income (gross profit ⇒ operating income ⇒ ordinary income ⇒ net income) based on the accrual basis based on operating activities and the cash basis by adjusting the portion of cash and deposits that is not an expense or income, and then calculate the balance of cash and deposits in the same way.
Direct method: Cash flow from operating activities is calculated by aggregating the positive and negative cash and cash equivalents on a transaction-by-transaction basis (showing the total amount).
- (+)Income from A/R settlement ⇒ Add C/F code to A/R settlement journal
- (-)Expenditure by direct material cost payment ⇒ Add C/F code to the journal of direct material cost payment
- (-)Expenditure by manufacturing overhead ⇒ Add C/F code to indirect labor cost and expense payment journal.
- (-)S.G. & A. expenses ⇒ Add C/F code to S.G. & A. expense payment journal
Indirect method: Net cash provided by operating activities as calculated by Cash/Bank's net worth portion of Net Profit
- (+)Net Profit ⇒ Net income on an accrual basis
- (+)Depreciation and amortization expenses ⇒ Negative net profit in P/L on an accrual basis
- (-)A/R increase ⇒ Amount not deposited as Cash/Bank
- (+)Increase in A/P ⇒ Amount not withdrawn as Cash/Bank
From the accounting system, in the case of the direct method, when inputting transactions in which cash and deposits move, the relevant cash flow code is set and tabulated in the relevant part of the C/F.
The indirect method, on the other hand, does not require a cash flow code and is generated from the account balance.
Realized and unrealized gains and losses in the statement of cash flows
In case of creating C/F from the accounting system, if you use the direct method, you need to aggregate the transactions into cash flow code units for each accounting month, and if you use the indirect method, you need to aggregate the ledger G/L (General Ledger) for each accounting month and calculate the amount carried forward at the beginning of the month and the balance at the end of the month.
Regardless of the method used, the balance in C/F will not match the actual balance of cash and deposits unless the foreign exchange valuation adjustments to the foreign currency cash and deposit account balance at the end of the month are made in C/F.
There are two main types of foreign exchange gains and losses
- Foreign exchange gains and losses at the time of settlement are realized gains and losses (Forex Gain-Realized).
⇒Gains and losses on claims (A/R) and liabilities (A/P) are not recorded in C/F (because they are not cash and deposits). - Unrealized foreign exchange gains and losses from revaluation of foreign currency at the end of the month (Forex Gain-Unrealized)
⇒All marginal gains and losses related to cash and deposits are recorded in C/F (because they are cash and deposits), but marginal gains and losses related to A/R and A/P are not recorded in C/F (because they are not cash and deposits).
The problem is that in the case of the indirect method, if A/R and A/P are a mixture of those related to operating activities and those arising from investment activities not related to operating activities, it will be difficult to calculate the amount of foreign exchange gains and losses posted on C/F after adjusting the movement of cash and deposits from net income on P/L based on accrual basis.