Indirect method

Definition

The indirect method is a technique used in financial accounting to prepare the statement of cash flows by adjusting net income for changes in balance sheet accounts to calculate cash from operating activities. This approach starts with net income and makes adjustments for non-cash transactions and changes in working capital, providing insights into the company’s cash flows without directly tracking cash inflows and outflows.

5 Must Know Facts For Your Next Test

1. The indirect method is widely used because it is easier to prepare, as it starts with net income, which is readily available from the income statement.
2. Adjustments in the indirect method include adding back non-cash expenses like depreciation and subtracting gains from sales of assets.
3. Changes in working capital accounts like accounts receivable, inventory, and accounts payable are also adjusted to convert net income to cash flows.
4. This method helps analysts understand the differences between net income and actual cash flow, revealing insights into a company's liquidity.
5. While both the indirect and direct methods ultimately arrive at the same total cash flow from operating activities, they differ significantly in presentation.

Review Questions

• How does the indirect method provide insights into a company's cash flow compared to other methods?
  • The indirect method begins with net income and adjusts it for non-cash items and changes in working capital accounts. This provides insights into how net income relates to actual cash flows by highlighting discrepancies caused by accrual accounting. By understanding these adjustments, users can better assess a company's liquidity and operational performance compared to methods that track cash transactions directly.
• What key adjustments are made when using the indirect method to convert net income into cash flow from operating activities?
  • When using the indirect method, key adjustments include adding back non-cash expenses like depreciation and amortization, adjusting for changes in working capital accounts such as accounts receivable and inventory, and subtracting gains on asset sales. These adjustments reflect the timing differences between when revenues and expenses are recognized versus when cash is received or paid out, allowing for an accurate representation of cash flows from operations.
• Evaluate the advantages and disadvantages of using the indirect method for preparing a statement of cash flows.
  • The indirect method has several advantages, such as its ease of preparation since it starts with readily available net income figures. It also provides a reconciliation between net income and cash flows, enhancing transparency regarding a company's liquidity position. However, its disadvantages include potentially obscuring important details about specific cash inflows and outflows since it doesn't track them directly. Users may find it less intuitive than the direct method, especially when trying to understand actual cash transactions.

Related terms

net income: The total profit of a company after all expenses, taxes, and costs have been deducted from total revenue.

cash flows from operating activities: Cash inflows and outflows directly related to the core business operations of a company, essential for assessing its liquidity and operational efficiency.

direct method:

An alternative technique for preparing the statement of cash flows that calculates cash inflows and outflows directly from operating activities, providing a clearer view of cash transactions.