What Is the Indirect Method?
Let me explain the indirect method to you—it's one of two main ways to prepare a cash flow statement in accounting. This approach takes increases and decreases in balance sheet items and uses them to tweak the operating section of the cash flow statement, shifting it from accrual accounting to a cash basis.
When you're calculating cash flow from operating activities with the indirect method, you start right from net income and make adjustments for the effects of accruals during the period. Think of common ones like depreciation and amortization.
Now, compare that to the direct method, which just lists out the actual cash coming in and going out over the period. I see why the indirect method gets used more often, especially by bigger companies—it's straightforward and ties directly into the balance sheet.
Understanding the Indirect Method
The cash flow statement is all about showing where a company's cash comes from and where it goes. Investors, creditors, and other stakeholders pay close attention to it because it reveals cash generated from different activities and how changes in assets and liabilities affect the cash position.
With the indirect method, you begin with net income and strip out non-cash items, along with any non-operational gains or losses, to get to the cash flow from operating activities. You also adjust for changes in related accounts to turn those accrual figures into actual cash balances.
Here's something important: the indirect method is simpler to put together than the direct method, mainly because most companies already keep their books on an accrual basis.
Example of the Indirect Method
Under accrual accounting, revenue gets recorded when it's earned, not when the cash actually hits your account. Take this example: if a customer buys a $500 widget on credit, you recognize that revenue in the sale month, even without the cash in hand.
The indirect method on the cash flow statement steps in to adjust net income so it reflects the real cash inflows and outflows for the period. In that sale, you'd debit accounts receivable and credit sales revenue for $500, boosting accounts receivable on the balance sheet.
But since no cash changed hands, that $500 revenue overstates your net income on a cash basis. The offset is in accounts receivable, so the cash flow statement subtracts that $500 increase, showing it as 'Increase in Accounts Receivable (500).'
On the statement itself, net income leads off, followed by lines for increases and decreases in asset and liability accounts. You add or subtract these based on their impact on cash.
Indirect Method vs. Direct Method
Every cash flow statement breaks down into three parts: cash flows from operating activities, investing activities, and financing activities. The total cash from operating activities ends up the same whether you use the indirect or direct method, but the presentation differs.
The direct method lays out actual cash inflows and outflows for operations without starting from net income. The investing and financing sections stay the same for both methods.
Many accountants lean toward the indirect method because it's easier to prepare using data from the income statement and balance sheet. Since most companies use accrual accounting, those figures align perfectly.
Which Method Does the Financial Accounting Standards Board Prefer?
The Financial Accounting Standards Board (FASB) favors the direct method because it gives a clearer view of cash moving in and out of the business. That said, if you go with the direct method, they still suggest including a reconciliation to the balance sheet.
What Is Net Income?
Net income is what's left after subtracting all of a company's expenses from its revenues. Those expenses cover things like cost of goods sold, interest, taxes, amortization, depreciation, and other non-production costs.
What Are Operating Activities?
Operating activities are the core actions a business takes to produce and deliver its goods and services to customers. Cash outflows here might include payments for taxes or even refunds.
The Bottom Line
Companies have a choice between the indirect and direct methods for their cash flow statements. The indirect method starts with net income, adjusts for non-cash items and balance sheet changes, and it's simpler and more common, especially for larger firms, due to its efficiency.
On the other hand, the direct method lists out actual cash inflows and outflows, providing a clearer, more detailed picture. While the indirect method is popular, the FASB recommends the direct method for its transparency. In the end, both methods report the same total cash from operating activities.
Key Takeaways
- Under the indirect method, the cash flow statement starts with net income on an accrual basis.
- Non-cash items are then added or subtracted to reconcile to actual cash flows from operations.
- The indirect method is often easier for larger businesses because they typically use accrual accounting.
- Listing every cash disbursement, as required by the direct method, can be complex and time-consuming.
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