8A. Appendix: Indirect Method

Now that you have some experience with sources and uses of cash, and making adjustments in operating section of the Statement of Cash Flows, let’s look at a different way of presenting this information. Before we move on, I want to make clear that the direct method is the best way of presenting cash flow information. But many companies still use the indirect method to prepare their operating section, so let’s take a look.

The indirect method starts with net income and backs out all non-cash amounts and accruals. Basically, the indirect method is a calculation of cash provided by (used in) operating activities. But because the items are not grouped into sources and uses of cash, for example cash from customers, cash paid to suppliers, etc.. Because adjustments are listed with no grouping or contextual information, the indirect method is not the preferred method of preparing the operating activities section. However, many companies still use this method because it is easier and still allowed, so we will cover it briefly here.

You’ll notice that the indirect method and the direct method make the same adjustments, and the ending cash provided by (used in) operating activities is identical under both methods. The difference lies in the starting point and groupings. The indirect method does not group by source/use of cash, while the direct method yields helpful groupings that provide information on how the company gets its cash and how it uses its cash. For example, a company get its cash from customers, and pays cash to suppliers, for operating expenses, for interest, and for income taxes. It’s no wonder that financial statement users prefer the direct method to the indirect method: it provides the best information!!

Template for operating activities: indirect method:

We start with Net Income, not Operating Income. This is somewhat problematic because Net Income might include items that either (1) are not current cash transactions or (2) have nothing to do with operating activities. The idea here is to remove all account balances that are not cash or not operating activities as a starting point for making our working capital adjustments. In the direct method we didn’t have to do this because we pulled out the accounts we needed and left the rest. For example, Cash from customers started with sales revenue; cash paid to suppliers started with cost of goods sold; and cash paid for income taxes started with income tax expense. Any income statement accounts that did not affect operating activities were just not included. But when we start from Net Income, a bunch of accounts are included that we really do not want.

Specifically, there are two activities in the Income Statement adjustments: depreciation expense and asset sales.

Depreciation Expense:

Depreciation is the systematic allocation of an asset’s cost over its useful lifeUseful Life:
The length of time a company expects to use the asset, or the number of units a company expects the asset to produce while they own it.. As a reminder, the journal entry goes like this:

DR		Depreciation Expense
	CR	Accumulated Depreciation

Wait; there is no impact to cash in this journal entry! And that is exactly the point. The cash was spent when the asset was purchased, and that transaction was reflected on the Statement of Cash Flows in the year the asset was purchased. What is the cash flow for depreciation? Zero; there is no cash flow for depreciation! But depreciation expense appears on the Income Statement and decreases Net Income. So we need to remove its balance from Net income by adding it back. In other words, to reverse a negative number from Net Income, we add the number back. And poof – it is almost like depreciation was never there!

Asset Sale:

The sale of an asset will appear on the Other income and expenses; gains and losses section in the Income Statement as a gain or a loss on sale. Hold on; an asset sale involves non-current assets, PPE or long-term investments, so the sale is an investing activity! Yes, that’s exactly the issue here. A sale of non-current assets, including the gain or loss, belongs in the investing section – not the operating section.

Gain on the sale of PPE: the transaction is that a non-current asset was sold for a higher price than it was recorded in the accounting records. The gain increased net income on the Income Statement, so to remove its effect on operating activity cash flows, we need to subtract the gain.

Loss on the sale of PPE or non-current investments: Losses work just the opposite. A loss decreases net income, so to remove its effect we need to add the loss in operating activity cash flows.

If you continue in accounting, and I hope you do, there are other income statement adjustments that belong in this section. But those adjustments are for transactions we haven’t covered. So for now you’ll only be responsible for these two income statement adjustments: depreciation expense and gains and losses.

Let’s re-work the examples that we completed previously but using the indirect method this time.

My Turn:

The following information is replicated from above for Dexter’s Dog Supplies. Remember that cash from operating activities is $68,000. Let’s see if we can get the same result using the indirect method.

Statement of Financial Position (Selected Information):

	20X2	20X1
Current Assets:
A/R	50,000	42,000
Inventory	30,000	39,000
Prepaid Insurance	10,000	—
Trading Investments	7,000	5,000
A/P	20,000	32,000
Unearned Revenue	—	15,000
Salaries Payable	35,000	26,000
Interest Payable	2,000	3,000
Income Tax Payable	19,000	12,000

20X2 Income Statement Information:

Sales were $620,000, COGS $370,000, salaries expense $80,000, other operating expenses $50,000, depreciation $18,000, interest expense $10,000, gain on sale of equipment $5,000, income tax expense 19,000. Net income was $78,000.

Required:

Prepare the operating activities section of Dexter’s Statement of Cash Flows using the indirect method.

My Turn:

Here’s the full Statement of Cash Flows for Ansul’s Army Supply using the indirect method. Notice that the Cash provided by (used in) operating activities has the same total ($443,500) using the indirect method as it did earlier in this chapter when we used the direct method.