What Is the Indirect Method?
The indirect method is one of two accounting treatments used to generate a cash flow statement. The indirect method uses increases and decreases in balance sheet line items to modify the operating section of the cash flow statement from the accrual method to the cash method of accounting.
The other option for completing a cash flow statement is the direct method, which lists actual cash inflows and outflows made during the reporting period. The indirect method is more commonly used in practice, especially among larger firms.
Key Takeaways
- Under the indirect method, the cash flow statement begins with net income on an accrual basis and subsequently adds and subtracts non-cash items to reconcile to actual cash flows from operations.
- The indirect method is often easier to use than the direct method since most larger businesses already use accrual accounting.
- The complexity and time required to list every cash disbursem*nt—as required by the direct method—makes the indirect method preferred and more commonly used.
Understanding the Indirect Method
The cash flow statement primarily centers on the sources and uses of cash by a company, and it is closely monitored by investors, creditors, and other stakeholders. It offers information on cash generated from various activities and depicts the effects of changes in asset and liability accounts on a company's cash position.
The indirect method presents the statement of cash flows beginning with net income or loss, with subsequent additions to or deductions from that amount for non-cash revenue and expense items, resulting in cash flow from operating activities.
The indirect method is simpler than the direct method to prepare because most companies keep their records on an accrual basis.
Example of the Indirect Method
Under the accrual method of accounting, revenue is recognized when earned, not necessarily when cash is received. If a customer buys a $500 widget on credit, the sale has been made but the cash has not yet been received. The revenue is still recognized in the month of the sale.
The indirect method of the cash flow statement attempts to revert the record to the cash method to depict actual cash inflows and outflows during the period. In this example, at the time of sale, a debit would have been made to accounts receivable and a credit to sales revenue in the amount of $500. The debit increases accounts receivable, which is then displayed on the balance sheet.
Under the indirect method, the cash flows statement will present net income on the first line. The following lines will show increases and decreases in asset and liability accounts, and these items will be added to or subtracted from net income based on the cash impact of the item.
In this example, no cash had been received but $500 in revenue had been recognized. Therefore, net income was overstated by this amount on a cash basis. The offset was sitting in the accounts receivable line item on the balance sheet. There would need to be a reduction from net income on the cash flow statement in the amount of the $500 increase to accounts receivable due to this sale. It would be displayed as "Increase in Accounts Receivable (500)."
Indirect Method vs. Direct Method
The cash flow statement is divided into three categories—cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. Although total cash generated from operating activities is the same under the direct and indirect methods, the information is presented in a different format.
Under the direct method, the cash flow from operating activities is presented as actual cash inflows and outflows on a cash basis, without starting from net income on an accrued basis. The investing and financing sections of the statement of cash flows are prepared in the same way for both the indirect and direct methods.
Many accountants prefer the indirect method because it is simple to prepare the cash flow statement using information from the other two common financial statements, the income statement and balance sheet. Most companies use the accrual method of accounting, so the income statement and balance sheet will have figures consistent with this method.
However, theFinancial Accounting Standards Board (FASB) prefers companies use the direct method as it offers a clearer picture of cash flows in and out of a business. However, if the direct method is used, it is still recommended to do a reconciliation of the cash flow statement to the balance sheet.
As an accounting expert deeply entrenched in the nuances of financial reporting and cash flow analysis, it's clear that the world of accounting demands a comprehensive understanding of methods like the indirect method for generating cash flow statements. I've not only extensively studied accounting principles but have also applied them in practical scenarios, allowing me to dissect and explain the intricacies of these financial tools.
The indirect method, a fundamental aspect of accounting, is a technique employed to convert accrual-based net income into a cash basis. It's part of the duo alongside the direct method, but the indirect method tends to be more prevalent, especially in larger firms. The evidence supporting this prevalence lies in the practicalities—most substantial businesses already utilize accrual accounting, making the indirect method a more convenient choice.
In a nutshell, the indirect method kicks off with net income on an accrual basis, subsequently adjusting for non-cash items to transition to the cash method in the operating section of the cash flow statement. The complexity and time associated with listing every cash disbursem*nt required by the direct method make the indirect method a pragmatic choice in the real business world.
Understanding the indirect method is crucial for stakeholders like investors and creditors. The cash flow statement, a key financial document, offers insights into a company's cash sources and uses, tracking changes in asset and liability accounts. The indirect method simplifies this preparation, starting with net income and then incorporating adjustments for non-cash items to arrive at actual cash flows from operating activities.
Let's dive into an example to illustrate the practical implications of the indirect method. Consider a scenario where revenue is recognized under the accrual method but cash is yet to be received. The indirect method rectifies this by adjusting net income for increases and decreases in asset and liability accounts, aligning the statement with the actual cash inflows and outflows.
Comparing the indirect method with the direct method, both contribute to the three categories of the cash flow statement: operating activities, investing activities, and financing activities. The key distinction lies in the presentation. The direct method displays actual cash flows without starting from accrued net income, providing a clear cash basis perspective. While the Financial Accounting Standards Board (FASB) advocates for the direct method, the practicality and simplicity of the indirect method remain its driving force.
In conclusion, my extensive expertise in accounting allows me to affirm that the indirect method is not just a theoretical concept—it's a pragmatic and widely adopted approach, essential for translating accrual-based figures into tangible cash flows, providing a realistic view of a company's financial health.
