BUS103: Introduction to Financial Accounting

The indirect method starts with net-income while adjusting for non-cash transactions and from all cash-based transactions.

Learning Objective

• Explain how to use the indirect method to calculate cash flow

Key Points

• The indirect method adjusts net income (rather than adjusting individual items in the income statement).
• The most common example of an operating expense that does not affect cash is depreciation expense.
• Depreciation expense must be added back to net income.

Terms

• accrual

  A charge incurred in one accounting period that has not been paid by the end of it.

• income statement

  A calculation that shows the profit or loss of an accounting unit (company, municipality, foundation, etc.) during a specific period of time, providing a summary of how the profit or loss is calculated from gross revenue and expenses.

• indirect method

  a way to construct the cash flow statement using net-income as a starting point, and making adjustments for all transactions for non-cash items, then adjusting from all cash-based transactions

Example

• Consider a firm that reports a revenue of $125,000. During the reporting period, the firm's accounts receivables increased by $36,000. Therefore, cash collected from these revenues was $89,000. Operating expenses reported during the period were $85,000, but accounts payable increased by $5,000. Therefore, cash operating expenses were only $80,000.The net cash flow from operating activities, before taxes, would be:
  • Cash flow from revenue: $89,000
  • Cash flow from expenses: $(80,000)
  • Net cash flow: $9,000
• The indirect method would find these cash flows as follows:
  • Revenue: $125,000
  • Expenses: $(85,000)
  • Net Income: $40,000
• The adjustments for cash flow would then be made to this amount of net income. $36,000 would be subtracted due to the increase in accounts receivable, and $5,000 would be added due to the increase in accounts payable. This leaves us with the amount of $9,000 for net income.

Calculating Cash Flows

Two different methods can be used to report the cash flows of operating activities. There is the direct method and the indirect method.

The Indirect Method

The indirect method adjusts net income (rather than adjusting individual items in the income statement) for:

1. changes in current assets (other than cash) and current liabilities, and
2. items that were included in net income but did not affect cash.

The indirect method uses net income as a starting point, makes adjustments for all transactions for non-cash items, then adjusts for all cash-based transactions. An increase in an asset account is subtracted from net income, and an increase in a liability account is added back to net income. This method converts accrual-basis net income (or loss) into cash flow using a series of additions and deductions. The following rules can be followed to calculate cash flows from operating activities:

• Decrease in non-cash current assets are added to net income;
• Increase in non-cash current assets are subtracted from net income;
• Increase in current liabilities are added to net income;
• Decrease in current liabilities are subtracted from net income;
• Expenses with no cash outflows are added back to net income (depreciation and/or amortization expense are the only operating items that do not affect cash flows in the period);
• Revenues with no cash inflows are subtracted from net income;
• Non-operating losses are added back to net income;
• Non-operating gains are subtracted from net income.

Under the indirect method, since net income is a starting point in measuring cash flows from operating activities, depreciation expenses must be added back to net income. So, depreciation expense is shown (or captioned) on the statement of cash flows. Also, in the indirect method, cash paid for taxes and cash paid for interest must be disclosed.