The indirect method is a technique used in financial accounting to prepare the cash flow statement, particularly the operating activities section, by converting data from the accrual accounting method to the cash method. This method utilizes changes in balance sheet accounts to adjust net income for items that impacted reported net income but did not affect actual cash flow.
Key Principles of the Indirect Method
Adjusting Net Income
The starting point of the indirect method is the net income figure from the income statement. Various adjustments are then made to reconcile net income to net cash provided by operating activities:
- Add back non-cash expenses: Depreciation, amortization, and other non-cash charges are added back because these expenses reduce net income but do not involve cash outflows.
- Adjust for changes in working capital: Increases or decreases in current asset accounts (e.g., accounts receivable, inventory) and current liability accounts (e.g., accounts payable) are accounted for to reflect cash flow changes.
Adding Back Non-Cash Expenses
Depreciation and amortization are added back to net income since these are non-cash expenses. Other non-cash items might include deferred income taxes and impairment losses.
Working Capital Adjustments
Changes in working capital balances also impact cash flow:
- Accrued liabilities: An increase in accrued liabilities means more expenses were recognized than paid, thus increasing cash flow.
- Inventory: A rise in inventory indicates that cash was used to purchase additional stock, decreasing cash flow.
Step-by-Step Preparation Using the Indirect Method
1. Start with Net Income
Begin with the net income from the company’s income statement.
2. Add Non-Cash Expenses
Add back depreciation, amortization, and other non-cash charges to net income.
3. Adjust for Changes in Working Capital
Reflect changes in current assets and current liabilities:
- If accounts receivable increases, subtract the increase from net income.
- If accounts payable increases, add the increase to net income.
4. Consider Other Adjustments
Add or subtract any other gains/losses that resulted from investing or financing activities but are included in net income (e.g., gains from asset sales).
Example of the Indirect Method
Consider a company, ABC Corp., with the following simplified financial figures for the year:
- Net Income: $100,000
- Depreciation Expense: $10,000
- Increase in Accounts Receivable: $5,000
- Decrease in Accounts Payable: $3,000
Using the indirect method:
- Start with Net Income: $100,000
- Add Depreciation: $10,000
- Subtract Increase in Accounts Receivable: -$5,000
- Subtract Decrease in Accounts Payable: -$3,000
Historical Context and Applicability
The indirect method is widely accepted under both U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). While some prefer the direct method for its straightforward approach, the indirect method is often favored for its simplicity and because it uses readily available data from the balance sheet and income statement.
Comparisons to Direct Method
While the direct method involves listing all major operating cash receipts and payments, the indirect method starts with net income and makes adjustments for items that affected reported net income but did not involve cash.
Related Terms and Definitions
- Accrual Accounting: An accounting method that records revenues and expenses when they are earned or incurred, regardless of when cash is exchanged.
- Depreciation: The allocation of the cost of a tangible asset over its useful life.
- Working Capital: The difference between a company’s current assets and current liabilities, indicating short-term financial health.
FAQs
Why is the indirect method commonly used in practice?
Is the indirect method compliant with GAAP and IFRS?
References
- Financial Accounting Standards Board (FASB). Statements of Financial Accounting Standards.
- International Accounting Standards Board (IASB). International Financial Reporting Standards.
Summary
Understanding the indirect method for preparing a cash flow statement is crucial for financial analysis and reporting. By converting net income from the accrual method to the cash method through adjustments of non-cash expenses and working capital changes, the indirect method provides valuable insights into an entity’s cash-generating capabilities from its operating activities.
