• Identify Cash Flows using the indirect method

 

The indirect method adjusts net income (rather than adjusting individual items in the income statement) for (1) changes in current assets (other than cash) and current liabilities, and (2) items that were included in net income but did not affect cash.

The most common example of an operating expense that does not affect cash is depreciation expense. The journal entry to record depreciation debits an expense account and credits an accumulated depreciation account. This transaction has no effect on cash and, therefore, should not be included when measuring cash from operations. Because accountants deduct depreciation in computing net income, net income understates cash from operations. Under the indirect method, since net income is a starting point in measuring cash flows from operating activities, depreciation expense must be added back to net income.

Consider the following example. Company A had net income for the year of $20,000 after deducting depreciation of $10,000, yielding $30,000 of positive cash flows. Thus, Company A had $30,000 of positive cash flows from operating activities. Company B had a net loss for the year of $4,000 but after deducting $10,000 of depreciation, it had $6,000 of positive cash flows from operating activities, as shown here:

Companies may add other expenses and losses back to net income because they do not actually use company cash in addition to depreciation. The items added back include amounts of depletion that were expensed, amortization of intangible assets such as patents and goodwill, and losses from disposals of long term assets or retirement of debt.

To illustrate the add back of losses from disposals of noncurrent assets, assume that Rumble Corp. sold a piece of equipment for $150. The equipment had a cost basis of $160 and had accumulated depreciation of $100. The cash would be reported in the investing section as proceeds from the sale of a long term asset. The difference between the book value of $60 and the cash received $150 is the gain of $90 which was reported on the income statement but is not a cash item.

Therefore, Rumble subtracts the gain from net income in converting net income to cash flows from operating activities.

The same process would apply to losses on sales of long term assets or retirement of debt. Since the cash will be accounted for in later cash flow sections we want to remove the effect from net income so any accrual-basis losses will be added back to net income.

As a general rule, an increase in a current asset (other than cash) decreases cash inflow or increases cash outflow. Thus, when accounts receivable increases, sales revenue on a cash basis decreases (some customers who bought merchandise have not yet paid for it). When inventory increases, cost of goods sold on a cash basis increases (increasing cash outflow). When a prepaid expense increases, the related operating expense on a cash basis increases. (For example, a company not only paid for insurance expense but also paid cash to increase prepaid insurance.) The effect on cash flows is just the opposite for decreases in these other current assets.

An increase in a current liability increases cash inflow or decreases cash outflow. Thus, when accounts payable increases, cost of goods sold on a cash basis decreases (instead of paying cash, the purchase was made on credit). When an accrued liability (such as salaries payable) increases, the related operating expense (salaries expense) on a cash basis decreases. (For example, the company incurred more salaries than it paid.) Decreases in current liabilities have just the opposite effect on cash flows. A short term notes payable from a bank would be treated as a financing activity and not an operating activity.

 

Watch the following video example:You can view the transcript for “Statement of Cash Flows: Operating Activities Example – Financial Accounting video” here (opens in new window).

 

To summarize, the indirect method for calculating the operating activities of a statement of cash flows includes:

Here is the income statement for Rumble Corp.:

RUMBLE CORP
Income Statement
Year Ended December 31, 20X1

Description	Amount	Total
	In millions
Service Revenue		$45,785
Subcategory, Expenses
Wages	11,280
Depreciation expense	125
Other expenses	29,832
Total Expenses	Single Line	41,237
Operating income		Single Line4,548
Subcategory, Other income and expenses
Gain on sale of assets		90
Interest expense		(310)
Net income before income tax		Single Line4,328
Provision for income taxes		1,718
Net Income		Single Line $2,610 Double line

And the comparative balance sheets:

RUMBLE CORP
Balance Sheets
As of

Description	Amount	Total
	In millions
Panel A – Balance Sheet	12/31/X1	12/31/X0
Cash	$5,040	$1,640
Accounts Receivable	1,735	1,750
Equipment	24,920	24,500
Accumulated Depreciation	(1,565)	(1,540)
Total Assets	Single line $30,130 Double line	Single line $26,350 Double line
Accounts Payable	$1,039	$1,007
Wages Payable	135	55
Income Taxes Payable	60	42
Note Payable – Long Term	500	0
Total Liabilities	Single line 1,734	Single line 1,104
Common Stock	13,500	12,500
Retained Earnings	14,896	12,746
Total Liabilities and Owner’s Equity	Single line $30,130 Double line	Single line $26,350 Double line

And here is the information we need to complete the cash flows from operations section of the statement of cash flows (all numbers represent millions of dollars):

1. Depreciation expense was $125 (add back to net income because it was a non-cash expense used to compute accrual basis net income).
2. Accounts receivable decreased by $15 (add back).
3. Gain on the sale of equipment $90 (subtract from accrual basis net income because it was a non-cash revenue and the actual proceeds will be reported in the investing section).
4. Accounts payable increased by $32 (add back).
5. Wages payable increase by $80 (add back).
6. Income taxes payable increased by $18 (add back).

We can then create the operating section of the statement of cash flows:

Rumble Corp.
Statement of Cash Flows
for the year ended 12/31/x1

Description	Amount	Total
	In millions
Subcategory, Cash flows from operating activities
Net income		$ 2,610
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	125
Decrease in Accounts Receivable	15
Gain on sale of equipment	(90)
Increase in Accounts Payable	32
Increase in income taxes payable	80
Increase in other liabilities	18
Total adjustments		180
Net cash from operating activities	Single Line	Single Line $2,790

Now let’s compare it again to the direct method:

Rumble Corp.
Statement of Cash Flows
for the year ended 12/31/x1

Description	Amount	Total
	In millions
Subcategory, Cash flows from operating activities
Cash receipts from customers	$ 45,800
Cash paid to suppliers	(29,800)
Cash paid to employees	(11,200)
Cash generated from operations	Single Line 4,800
Interest paid	(310)
Income taxes paid	(1,700)
Net cash from operating activities	Single Line	Single Line $2,790

Notice that the bottom line is the same, it’s just the method of getting there that is different.