What Is the Indirect Method?

The indirect method is one of two accounting approaches used to create a cash flow statement. It uses increases and decreases in balance sheet line items to modify the operating section of the cash flow statement from the 澳洲幸运5官方开奖结果体彩网:accrual method to the cash method of accounting.

The indirect method for calculating cash flow from operating activities begins with net income and adjusts for accrual impacts during the reporting period. Common adjustments include depreciation and amortization.

The other option for completing a cash flow statement is the 澳洲幸运5官方开奖结果体彩网:direct method, which involves listing actual cash inflows and outflows during the reporting period. The indirect method is more commonly employed, particularly among larger firms, due to its ease o🦂f use and direct connection to the bala🦩nce sheet.

Understanding the Indirect Method

The cash flow statement primarily centers on a company's cash sources and uses. It's closely monitored by investors, creditors, and other stakeholders. It provides information on cash generated from various activities and depicts the effects of changes in asset and 澳洲幸运5官方开奖结果体彩网:liability accounts on a company's cash position.

The indirect method starts with 澳洲幸运5官方开奖结果体彩网:net income and then removes noncash items, nonoperational gains, and losses to calculate cash flow from operating activities. Adjustments are made for changes in connector accounts to convert accrual accounting figures to cash balances.

Example of the Indirect Method

Revenue is recognized when it's earned under the accrual method of accounting, not necessarily when cash is received. For example, if a customer buys a $500 widget on credit, the revenue 🐼is recognized in the month of the sale, even though the cash haဣsn't yet been received.

The indirect method of the cash flow statement adjusts net income to reflect actual cash inflows and outflows during the period. At the time of the sale, a debit is made to 澳洲幸运5官方开奖结果体彩网:accounts receivable and a credit to sales revenue for $500. This increases accounts receiℱvable, which is then displayed on the balance sheet.

Even though no cash has been received in this example, $500 in revenue is recognized, overstating net income on a cash basis by this amount. The offset sits in the accounts receivable line item on the balance sheet. To adjust, the cash flow statement reduces net income by the $500 increase in accounts receivable, displayed as "Increase in Accounts Receivable (500)."

In the cash flow statement using the indirect method, net income is presented on the first line. Subsequent lines show increases and decreases in asset and liability accounts, which are added to or subtracted from net income based on their cash impact.

Indirect Method vs. Direct Method

The cash flow statement is divided into three categories: Cash flows from 澳洲幸运5官方开奖结果体彩网:operating activities, cash flows from 澳洲幸运5官方开奖结果体彩网:investing activities, and cash flows from 澳洲幸运5官方开奖结果体彩网:financing activities. The total cash💖 generated from operating activities is the same under both the direct and indirect methods, though the information is presented differently.

Under the direct method, cash flow from operating activities is shown as actual cash inflows and outflows without starting from net income on an accr💖ued basis. T🌠he investing and financing sections are prepared similarly for indirect and direct methods.

Many accountants prefer the indirect method because it's simpler to prepare the cash flow statement using information from the 澳洲幸运5官方开奖结果体彩网:income statement and the 澳洲幸运5官方开奖结果体彩网:balance sheet. Most companies use the accrual method of accounting, so the figures on the income statement and balance sheet will be cons🐎istent with this method.

The Bottom Line

Businesses can generate cash flo🦄w statements using e♚ither the indirect or direct method.

The indirect method, starting with net income and adjusting for noncash items and balance sheet changes, is simpler and more commonly used, especially by larger firms, because it's efficient and easy to prepare.

Conversely, the direct method lists actual cash inflows and outfl💖ows and offers a clearer and more detailed picture of cash flows.

While the indir♔ect method is widely preferred, the Financial Accounting Standards Board recommends the direct method for its transparency. Regardless of the method used, both approaches ultimately report the same total cash generated from operating activities.