Indirect Method (for the Statement of Cash Flows)
The indirect method is a common approach to prepare the cash flow statement’s operating section. It converts accrual-basis net income into cash flow from operating activities by adjusting for noncash items and changes in balance sheet accounts.
How it works
- Start with net income (accrual basis).
- Add back noncash expenses (for example, depreciation and amortization).
- Remove nonoperating gains or add back nonoperating losses (because they affect net income but not operating cash).
- Adjust for changes in working capital accounts:
- Increase in current assets (e.g., accounts receivable, inventory) → subtract from net income.
- Decrease in current assets → add to net income.
- Increase in current liabilities (e.g., accounts payable) → add to net income.
- Decrease in current liabilities → subtract from net income.
- The result is cash provided by (or used in) operating activities.
Common adjustments
- Depreciation and amortization (add back)
- Gains or losses on sales of assets (remove gains, add back losses)
- Changes in:
- Accounts receivable
- Inventory
- Prepaid expenses
- Accounts payable
- Accrued liabilities
Short example
A company records $500 of revenue on credit (accounts receivable increases by $500). Net income includes that $500, but no cash was received. Under the indirect method:
– Net income is reduced by the $500 increase in accounts receivable (shown as “Increase in Accounts Receivable (500)”), reflecting that the revenue did not produce cash during the period.
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Indirect vs. Direct method
- Direct method: Lists actual cash receipts and cash payments (explicit cash inflows and outflows).
- Indirect method: Starts with net income and reconciles to cash by adjusting for noncash items and working capital changes.
- Both methods produce the same total cash flow from operating activities; they differ only in presentation.
- Many companies prefer the indirect method because it’s easier to prepare from the income statement and balance sheet. The Financial Accounting Standards Board (FASB), however, favors the direct method for greater transparency.
When to use it
- Useful for companies that maintain accrual accounting and want a simple way to reconcile net income to operating cash flow.
- Particularly common among larger firms with established accrual-based records.
Bottom line
The indirect method reconciles accrual net income to operating cash flow by adding back noncash expenses and adjusting for changes in working capital. It is widely used because it’s efficient to prepare, while the direct method shows cash flows more explicitly and is preferred by standards setters for clarity.