April 29, 2022 April 29, 2022/ Steven Bragg
The indirect method for the preparation of the statement of cash flows involves the adjustment of net income with changes in balance sheet accounts to arrive at the amount of cash generated by operating activities. The statement of cash flows is one of the components of a company's set of financial statements, and is used to reveal the sources and uses of cash by a business. It presents information about cash generated from operations and the effects of various changes in the balance sheet on a company's cash position.
The format of the indirect method appears in the following example. In the presentation format, cash flows are divided into the following general classifications:
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities
The indirect method of presentation is very popular, because the information required for it is relatively easily assembled from the accounts that a business normally maintains in its chart of accounts. The indirect method is less favored by the standard-setting bodies, since it does not give a clear view of how cash flows through a business. The alternative reporting method is the direct method.
For example, Lowry Locomotion constructs the following statement of cash flows using the indirect method:
Lowry LocomotionStatement of Cash Flows
for the year ended 12/31x1
| Cash flows from operating activities | ||
| Net income | $3,000,000 | |
| Adjustments for: | ||
| Depreciation and amortization | $125,000 | |
| Provision for losses on accounts receivable | 20,000 | |
| Gain on sale of facility | (65,000) | |
| 80,000 | ||
| Increase in trade receivables | (250,000) | |
| Decrease in inventories | 325,000 | |
| Decrease in trade payables | (50,000) | |
| 25,000 | ||
| Cash generated from operations | 3,105,000 | |
| Cash flows from investing activities | ||
| Purchase of property, plant, and equipment | (500,000) | |
| Proceeds from sale of equipment | 35,000 | |
| Net cash used in investing activities | (465,000) | |
| Cash flows from financing activities | ||
| Proceeds from issue of common stock | 150,000 | |
| Proceeds from issuance of long-term debt | 175,000 | |
| Dividends paid | (45,000) | |
| Net cash used in financing activities | 280,000 | |
| Net increase in cash and cash equivalents | 2,920,000 | |
| Cash and cash equivalents at beginning of period | 2,080,000 | |
| Cash and cash equivalents at end of period | $5,000,000 |
April 29, 2022/ Steven Bragg/
The indirect method is one of two accounting treatments used to generate a cash flow statement. The indirect method uses increases and decreases in balance sheet line items to modify the operating section of the cash flow statement from the accrual method to the cash method of accounting.
The other option for completing a cash flow statement is the direct method, which lists actual cash inflows and outflows made during the reporting period. The indirect method is more commonly used in practice, especially among larger firms.
- Under the indirect method, the cash flow statement begins with net income on an accrual basis and subsequently adds and subtracts non-cash items to reconcile to actual cash flows from operations.
- The indirect method is often easier to use than the direct method since most larger businesses already use accrual accounting.
- The complexity and time required to list every cash disbursement—as required by the direct method—makes the indirect method preferred and more commonly used.
The cash flow statement primarily centers on the sources and uses of cash by a company, and it is closely monitored by investors, creditors, and other stakeholders. It offers information on cash generated from various activities and depicts the effects of changes in asset and liability accounts on a company's cash position.
The indirect method presents the statement of cash flows beginning with net income or loss, with subsequent additions to or deductions from that amount for non-cash revenue and expense items, resulting in cash flow from operating activities.
The indirect method is simpler than the direct method to prepare because most companies keep their records on an accrual basis.
Under the accrual method of accounting, revenue is recognized when earned, not necessarily when cash is received. If a customer buys a $500 widget on credit, the sale has been made but the cash has not yet been received. The revenue is still recognized in the month of the sale.
The indirect method of the cash flow statement attempts to revert the record to the cash method to depict actual cash inflows and outflows during the period. In this example, at the time of sale, a debit would have been made to accounts receivable and a credit to sales revenue in the amount of $500. The debit increases accounts receivable, which is then displayed on the balance sheet.
Under the indirect method, the cash flows statement will present net income on the first line. The following lines will show increases and decreases in asset and liability accounts, and these items will be added to or subtracted from net income based on the cash impact of the item.
In this example, no cash had been received but $500 in revenue had been recognized. Therefore, net income was overstated by this amount on a cash basis. The offset was sitting in the accounts receivable line item on the balance sheet. There would need to be a reduction from net income on the cash flow statement in the amount of the $500 increase to accounts receivable due to this sale. It would be displayed as "Increase in Accounts Receivable (500)."
The cash flow statement is divided into three categories—cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. Although total cash generated from operating activities is the same under the direct and indirect methods, the information is presented in a different format.
Under the direct method, the cash flow from operating activities is presented as actual cash inflows and outflows on a cash basis, without starting from net income on an accrued basis. The investing and financing sections of the statement of cash flows are prepared in the same way for both the indirect and direct methods.
Many accountants prefer the indirect method because it is simple to prepare the cash flow statement using information from the other two common financial statements, the income statement and balance sheet. Most companies use the accrual method of accounting, so the income statement and balance sheet will have figures consistent with this method.
However, the Financial Accounting Standards Board (FASB) prefers companies use the direct method as it offers a clearer picture of cash flows in and out of a business. However, if the direct method is used, it is still recommended to do a reconciliation of the cash flow statement to the balance sheet.