What is the Indirect Method?

The indirect method is a way of preparing the cash-flow statement of a company, where the starting point is the net income or operating profit. This method involves adjustments to account for non-cash transactions, changes in working capital, and other items that reconcile it with the net cash flow generated from operating activities. Its primary differences from the direct method lie in the starting point and how the cash inflows and outflows are presented.

Key Components

Net Income: The starting point.
Adjustments for Non-Cash Transactions: Add back non-cash charges such as depreciation and amortization.
Changes in Working Capital: Include adjustments for increases or decreases in accounts receivable, accounts payable, inventory, etc.
Other Adjustments: Incorporate other items like deferred taxes, gains or losses on sales of assets, etc.

Examples

Depreciation and Amortization: If a company records $50,000 in depreciation for the year, this amount is added back to net income when using the indirect method.
Accounts Receivable: If accounts receivable increase by $10,000, this amount is subtracted from net income because it’s revenue recorded that hasn’t yet been received in cash.
Accounts Payable: If accounts payable increase by $5,000, this is added to net income since it’s an expense recorded on credit, hence not reducing cash.

Frequently Asked Questions (FAQ)

Q1: Why is the indirect method commonly used?

A1: The indirect method is generally easier and less expensive to prepare since it uses information readily available from a company’s financial records. It also provides a reconciliation of net income to cash flows from operating activities, which can be insightful for financial statement users.

Q2: What are some common non-cash adjustments in the indirect method?

A2: Common non-cash adjustments include depreciation, amortization, deferred taxes, unrealized gains/losses, and changes in working capital items like accounts receivable, inventory, and accounts payable.

Q3: How is the indirect method different from the direct method?

A3: While the indirect method starts with net income and adjusts for non-cash transactions and changes in working capital, the direct method lists cash receipts and cash payments from operating activities directly.

Q4: Is the indirect method preferred by any accounting standards?

A4: Both the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) prefer the direct method for its detailed information. However, the indirect method is more commonly used in practice due to its simplicity.

Q5: Can both methods be used together?

A5: Yes, companies can use the direct method for presenting cash-flow from operations and supplement it with a reconciliation of net income to net cash flows from operating activities, essentially incorporating aspects of the indirect method.

Cash-Flow Statement: A financial statement that summarizes the amount of cash and cash equivalents entering and leaving a company.
Direct Method: An alternative method for preparing the cash-flow statement, where cash receipts and cash payments from operating activities are itemized.
Operating Activities: Business activities that generate revenues or involve the primary functions of the organization.
Non-Cash Charges: Expenses that do not require cash outlay, such as depreciation and amortization.
Working Capital: The difference between a company’s current assets and current liabilities.

Online Resources

Suggested Books for Further Study

“Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, Terry D. Warfield: An in-depth look at accounting principles, including the cash-flow statement.
“Financial Accounting” by Robert Libby, Patricia A. Libby, and Frank Hodge: Covers fundamentals of financial accounting methods, including detailed discussions on cash-flow statements.
“Accounting for Non-Accountants” by Wayne Label: A simpler guide for those new to accounting, providing extensive insights on various financial statements, including how the indirect method applies to the cash-flow statement.

Accounting Basics: “Indirect Method” Fundamentals Quiz

### What is the first step in the indirect method for preparing a cash-flow statement? - [x] Start with net income. - [ ] List all cash receipts. - [ ] List all cash payments. - [ ] Start with changes in cash balances. > **Explanation:** The indirect method begins with net income before adjusting for non-cash transactions to reconcile it with net cash flow from operating activities. ### Which of the following is a non-cash charge that is added back in the indirect method? - [ ] Revenue from sales - [x] Depreciation - [ ] Increase in accounts payable - [ ] Decrease in inventory > **Explanation:** Depreciation is a non-cash charge added back to net income in the indirect method. ### If accounts receivable increase during the period, how is this treated in the indirect method? - [ ] It is added to net income. - [ ] It is ignored. - [x] It is subtracted from net income. - [ ] It is treated as a non-cash expense. > **Explanation:** An increase in accounts receivable indicates that revenue has been recorded but cash hasn't been received, so it is subtracted from net income. ### Which method provides a reconciliation from net income to net cash flow from operating activities? - [ ] Direct method - [x] Indirect method - [ ] Accrual method - [ ] Cash method > **Explanation:** The indirect method provides a reconciliation from net income to net cash flow from operating activities. ### In the indirect method, what does an increase in accounts payable represent? - [ ] A cash inflow - [x] A reduction in cash outflows - [ ] An increase in expenses - [ ] A non-cash transaction > **Explanation:** An increase in accounts payable means that expenses have been recorded on credit, reducing the cash outflows for the period, so it is added back to net income. ### How does amortization affect the cash flow statement using the indirect method? - [ ] It is an outflow under investing activities. - [x] It is added back to net income. - [ ] It is subtracted from net income. - [ ] It is treated as cash received. > **Explanation:** Amortization is a non-cash charge that is added back to net income during reconciliation in the indirect method. ### What is a major advantage of the indirect method? - [ ] It provides more detailed cash inflows and outflows. - [x] It is easier and less costly to prepare. - [ ] It completely ignores working capital changes. - [ ] It is required by all accounting standards. > **Explanation:** The indirect method is generally easier and less costly to prepare than the direct method. ### Under the indirect method, which change in working capital is subtracted from net income? - [x] Increase in inventory - [ ] Increase in accounts payable - [ ] Decrease in accounts receivable - [ ] Decrease in retained earnings > **Explanation:** An increase in inventory is subtracted from net income as it represents cash outflow for purchase. ### What does the indirect method improve comprehension of, compared to the direct method? - [ ] Detailed cash transactions - [ ] Revenue recognition - [x] Reconciliation of net income to cash flow - [ ] Non-cash asset valuations > **Explanation:** The indirect method is particularly useful for understanding the reconciliation of net income to cash flow from operating activities. ### Which type of financial statement is primarily prepared using the indirect method? - [ ] Balance sheet - [ ] Income statement - [x] Cash-flow statement - [ ] Equity statement > **Explanation:** The indirect method is primarily used to prepare the cash-flow statement.

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Indirect Method