Indirect method

Definition

The indirect method is a way of preparing the statement of cash flows by starting with net income and adjusting for changes in balance sheet accounts to calculate operating cash flow. It contrasts with the direct method, which lists actual cash receipts and payments during the period.

5 Must Know Facts For Your Next Test

1. The indirect method adjusts net income for non-cash items like depreciation and changes in working capital accounts.
2. Common adjustments include changes in accounts receivable, inventory, accounts payable, and accrued expenses.
3. The indirect method is more commonly used than the direct method because it is easier to prepare from existing financial statements.
4. It provides a reconciliation between net income on the income statement and operating cash flow on the cash flow statement.
5. GAAP allows both methods, but the indirect method is preferred for its simplicity and ease of preparation.

Review Questions

• What are some common adjustments made when using the indirect method?
• Why might a company prefer to use the indirect method over the direct method?
• How does the indirect method reconcile net income to operating cash flow?

Related terms

Direct Method:

A way of preparing the statement of cash flows that reports actual cash inflows and outflows from operations.

Depreciation:

A non-cash expense that reduces taxable income but does not involve actual outflow of cash.

Working Capital:

Current assets minus current liabilities; used in assessing a company's efficiency and short-term health.