What Is the Indirect Method?
The indirect method is a pivotal accounting technique for creating the cash flow statement. This method utilizes changes in balance sheet line items to adjust the operating section of the cash flow statement from the accrual method to the cash method of accounting.
While the direct method lists actual cash inflows and outflows, the indirect method is more commonly used, particularly among larger firms.
Key Insights
- The cash flow statement under the indirect method starts with net income on an accrual basis and then adds or subtracts non-cash items to adjust to cash flows from operations.
- The indirect method is often simpler than the direct method for most larger businesses that already use accrual accounting.
- The indirect method is preferred due to the complexity and time required to list every cash transaction as required by the direct method.
Understanding the Indirect Method
The cash flow statement focuses on a company’s cash sources and uses, monitored closely by investors, creditors, and stakeholders. It reflects cash generated from activities and the effect of changes in assets and liabilities on the company’s cash position.
With the indirect method, the statement begins with net income or loss and adjusts for non-cash revenue and expenses, delivering cash flow from operating activities. This approach is more straightforward since most companies maintain accrual accounting records.
Indirect Method Example
Here’s a practical example:
Under the accrual method, revenue is recorded when earned, not necessarily when cash is received. If a customer buys a $500 product on credit in February, the revenue is recognized then, even if the cash arrives later.
The indirect method reverts these records to reflect actual cash flows. At the sale time, a debit to accounts receivable and a credit to sales revenue for $500 occurs, representing an increase in accounts receivable on the balance sheet.
To reconcile net income to actual cash flow, the cash flow statement starts with net income, then adjusts for increases and decreases in asset and liability accounts.
In our example, with no cash received yet, the $500 recognized as revenue overstated net income on a cash basis. The accounts receivable would show an increase, thus the statement needs a $500 reduction in net income under
Related Terms: direct method, accrual accounting, cash accounting, net income, accounts receivable.
References
- The CPA Journal. “The Statement of Cash Flows Turns 30”.
Get ready to put your knowledge to the test with this intriguing quiz!
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## In the statement of cash flows, where is the "indirect method" primarily used?
- [x] Operating activities
- [ ] Investing activities
- [ ] Financing activities
- [ ] Non-cash activities
## What is the main purpose of the indirect method in the statement of cash flows?
- [ ] To show investment decisions
- [ ] To breakdown outgoing dividends
- [x] To reconcile net income with cash flow from operating activities
- [ ] To track borrowings and repayments
## In the indirect method, how is net income adjusted initially?
- [x] By adding back non-cash expenses such as depreciation and amortization
- [ ] By subtracting all non-cash transactions
- [ ] By excluding all gains and losses
- [ ] By factoring in changes in inventory
## How are changes in working capital components like receivables and payables reflected in the indirect method?
- [x] Adjustments to net income
- [ ] Separately listed in investing activities
- [ ] Omitted from the cash flow statement
- [ ] Calculated as financing activities
## What are "non-cash" transactions in the context of the indirect method?
- [x] Transactions that affect net income but do not involve actual cash flow
- [ ] Transactions that occur in cash but are not recorded in net income
- [ ] All forms of fixed asset transactions
- [ ] Transactions related to shareholders' equity
## When using the indirect method, how is a decrease in accounts receivable generally treated?
- [x] Added to net income
- [ ] Subtracted from net income
- [ ] Ignored as it's not a cash transaction
- [ ] Treated as a cash outflow directly
## How is depreciation expense treated in the indirect method?
- [x] Added back to net income
- [ ] Subtracted from net income
- [ ] Listed under investing activities
- [ ] Ignored since it's a non-operating item
## How does the indirect method handle losses from the sale of equipment?
- [x] Added back to net income
- [ ] Subtracted from net income
- [ ] Treated as an investing activity
- [ ] Omitted completely
## What component of the income statement is primarily focused on by the indirect method?
- [x] Net income
- [ ] Gross revenue
- [ ] Operating expenses
- [ ] Net sales
## Which of the following is NOT a common adjustment in the indirect method?
- [x] Direct purchases of long-term assets
- [ ] Changes in accounts payable
- [ ] Depreciation expense
- [ ] Amortization of intangibles
