Indirect method

What Is the Indirect Method?

The indirect method is a financial reporting technique used to prepare the operating activities section of a company's statement of cash flows. It falls under the broader category of financial accounting. Instead of listing actual cash inflows and outflows for operating activities, this method begins with net income (from the income statement) and adjusts it for non-cash items, as well as changes in working capital accounts like accounts receivable, accounts payable, and inventory. The goal of the indirect method is to reconcile net income, which is based on accrual accounting, to the actual cash generated or used by operations during a period.

History and Origin

The requirement for companies to provide a statement of cash flows, and the establishment of guidelines for its presentation, largely stems from the efforts of the Financial Accounting Standards Board (FASB). In November 1987, FASB issued Statement No. 95, "Statement of Cash Flows," which superseded Accounting Principles Board (APB) Opinion No. 19. This landmark statement mandated that a statement of cash flows be included as part of a full set of financial statements for all business enterprises.²⁵, ²⁶, ²⁷

FASB Statement No. 95 defined and classified cash receipts and payments into three main categories: operating, investing, and financing activities. While the statement encouraged the use of the direct method for presenting cash flows from operating activities, it also provided for the indirect method as an acceptable alternative.²², ²³, ²⁴ This allowed companies to continue using a method that was often less time-consuming to prepare, given that it starts with net income, which is readily available from the income statement.¹⁹, ²⁰, ²¹ The Securities and Exchange Commission (SEC) has historically emphasized the importance of high-quality cash flow information for investors.¹⁸ In 2023, the FASB initiated a project to make targeted improvements to the statement of cash flows, particularly for financial institutions, to enhance its decision usefulness for investors.¹⁵, ¹⁶, ¹⁷

Key Takeaways

• The indirect method begins with net income and adjusts for non-cash items and changes in working capital to arrive at operating cash flow.
• It is a widely used method for preparing the operating section of the statement of cash flows.
• This method is generally considered easier and faster to prepare than the direct method.
• It highlights the differences between a company's net income (accrual-based) and its operating cash flow (cash-based).
• While permitted by generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS), it offers less transparency into individual cash inflows and outflows.

Formula and Calculation

The indirect method does not use a "formula" in the traditional sense, but rather a reconciliation process. It starts with net income and then systematically adjusts it for items that affected net income but did not involve actual cash movements, or that relate to investing or financing activities.

The general approach is:

Here's a breakdown of some key adjustments:

• Depreciation and Amortization: These are non-cash expenses that reduce net income but do not involve an outflow of cash. Therefore, they are added back to net income.
• Gains and Losses on Sale of Assets: When an asset is sold for a gain or loss, the gain or loss itself is a non-cash item affecting net income. The actual cash proceeds from the sale are reported under investing activities. To remove the effect of the gain/loss from operating activities, gains are subtracted, and losses are added back.
• Changes in Current Assets:
  • A decrease in a current asset (e.g., accounts receivable, inventory) means cash was collected or less cash was used, so it's added back.
  • An increase means cash was tied up, so it's subtracted.
• Changes in Current Liabilities:
  • An increase in a current liability (e.g., accounts payable) means the company received goods or services but hasn't paid cash yet, so it's added back.
  • A decrease means cash was used to pay down the liability, so it's subtracted.

Interpreting the Indirect Method

The indirect method provides a comprehensive view of how a company's accrual-based net income translates into its actual cash-generating ability from core operations. By starting with net income, it highlights the reconciliation between profitability (as measured by net income) and liquidity (as measured by cash flow).

Analysts often use the indirect method to understand the impact of non-cash items and changes in working capital on a company's cash position. For example, a company might report strong net income, but if there's a significant increase in accounts receivable (meaning sales were made on credit but cash hasn't been collected), the operating cash flow reported via the indirect method would be lower than net income, signaling potential liquidity issues. Conversely, a decrease in inventory might boost cash flow, even if sales are stagnant, indicating efficient inventory management. This method helps users of financial statements assess the quality of a company's earnings by showing how much of its profit is backed by actual cash.

Hypothetical Example

Let's consider a hypothetical company, "GreenThumb Landscaping," for the fiscal year ended December 31, 2024.

Income Statement Excerpts (Accrual Basis):
Net Income: $150,000
Depreciation Expense: $20,000
Gain on Sale of Equipment: $5,000

Balance Sheet Changes (2023 vs. 2024):
Accounts Receivable: Increased by $10,000
Inventory: Decreased by $5,000
Accounts Payable: Increased by $8,000
Prepaid Expenses: Decreased by $2,000

Calculating Operating Cash Flow using the Indirect Method:

1. Start with Net Income: $150,000
2. Add back Depreciation Expense: Depreciation is a non-cash expense, so it's added back.
   $150,000 + $20,000 = $170,000
3. Subtract Gain on Sale of Equipment: The gain is a non-operating, non-cash item included in net income. The cash from the sale is reported in investing activities.
   $170,000 - $5,000 = $165,000
4. Adjust for Changes in Current Assets/Liabilities:
   • Accounts Receivable (Increase): An increase means GreenThumb made sales on credit, tying up cash. So, subtract the increase.
     $165,000 - $10,000 = $155,000
   • Inventory (Decrease): A decrease means inventory was sold, converting it into cash (or accounts receivable that will become cash). So, add the decrease.
     $155,000 + $5,000 = $160,000
   • Accounts Payable (Increase): An increase means GreenThumb incurred expenses but hasn't paid cash yet, effectively saving cash. So, add the increase.
     $160,000 + $8,000 = $168,000
   • Prepaid Expenses (Decrease): A decrease means GreenThumb used up a prepaid asset without a current cash outflow. So, add the decrease.
     $168,000 + $2,000 = $170,000

Net Cash Flow from Operating Activities (Indirect Method): $170,000

This example illustrates how the indirect method systematically adjusts net income to reflect the actual cash generated from GreenThumb Landscaping's primary operations, providing insight into its true cash flow generation.

Practical Applications

The indirect method is widely used by companies when preparing their financial statements for external reporting. This is largely due to its relative ease of preparation, as it leverages information readily available from the income statement and balance sheet.¹³, ¹⁴

For investors and analysts, the indirect method is crucial for:

• Assessing Earnings Quality: It helps differentiate between reported profits and actual cash generation. A company with high net income but low operating cash flow (due to large increases in receivables or inventory) may have lower-quality earnings.
• Forecasting Future Cash Flows: Understanding the components of non-cash adjustments helps in projecting a company's ability to generate cash in the future, which is vital for valuation models and assessing a company's capacity to pay dividends or repay debt.
• Credit Analysis: Lenders often rely on operating cash flow to assess a borrower's ability to service its debts. The indirect method provides this critical figure without requiring detailed tracking of every cash transaction.
• Compliance: Most companies adhere to the indirect method for their statutory reporting under accounting standards like GAAP in the U.S. and IFRS internationally.¹² The SEC monitors and provides guidance on the classification and presentation of items within the statement of cash flows, emphasizing its importance for investors.¹⁰, ¹¹

Limitations and Criticisms

While widely accepted, the indirect method has several limitations and has faced criticism:

• Lack of Detail: The primary criticism of the indirect method is its lack of transparency regarding specific cash inflows and outflows from operating activities. It aggregates various non-cash adjustments and changes in working capital accounts, making it difficult for users to see the actual cash received from customers or paid to suppliers and employees.⁷, ⁸, ⁹ This contrasts with the direct method, which explicitly lists these details.
• Less Intuitive: For many non-accountants, the reconciliation process of the indirect method can be less intuitive to understand compared to the straightforward presentation of actual cash receipts and payments in the direct method.⁶
• Obscures Operational Efficiency: Because it focuses on reconciling net income, the indirect method may not as clearly highlight the efficiency of a company's day-to-day cash management. For instance, a substantial increase in accounts payable might artificially inflate operating cash flow in the short term, but it doesn't necessarily indicate improved operational performance; rather, it could suggest delayed payments to suppliers. This can make it challenging to discern actual operational efficiency.
• Potential for Misinterpretation: Without a clear breakdown of major cash receipts and payments, users might misinterpret the underlying drivers of a company's operating cash flow, potentially overlooking red flags related to delayed collections or extended payment terms.

Despite these criticisms, the indirect method remains prevalent due to its simplicity in preparation, particularly for large companies.⁵ The Financial Accounting Standards Board (FASB) encourages the use of the direct method, but both methods remain permissible under generally accepted accounting principles.⁴

Indirect Method vs. Direct Method

The indirect method and the direct method are two distinct approaches to presenting the cash flows from operating activities on a statement of cash flows. While both methods arrive at the same net cash flow from operating activities, they differ significantly in their presentation and the level of detail they provide.

The direct method itemizes the major classes of gross cash receipts and payments, such as cash collected from customers, cash paid to suppliers, and cash paid for operating expenses. In contrast, the indirect method starts with net income and then adjusts for the effects of deferrals of past operating cash receipts and payments, accruals of expected future operating cash receipts and payments, and items included in net income that do not affect operating cash flows.², ³ The choice between the indirect method and direct method often depends on the company's internal accounting systems and reporting preferences, though analysts often prefer the direct method for its clear insights into cash generation.¹

FAQs

What is the primary purpose of the indirect method in the statement of cash flows?

The primary purpose of the indirect method is to reconcile a company's net income, which is prepared on an accrual basis, to the actual cash generated or used by its operating activities. It helps users understand the differences between a company's profitability and its cash-generating ability.

Why do most companies use the indirect method?

Many companies prefer the indirect method because it is generally easier and less time-consuming to prepare. It starts with readily available figures from the income statement and balance sheet, eliminating the need to track every individual cash transaction for operating activities separately. This can lead to cost efficiencies in financial reporting.

Does the indirect method provide as much detail as the direct method?

No, the indirect method provides less detail than the direct method. While both methods result in the same net cash flow from operating activities, the indirect method presents a reconciliation of net income, whereas the direct method explicitly lists the major categories of cash receipts (e.g., from customers) and cash payments (e.g., to suppliers, employees). This difference impacts the level of transparency for financial analysis.

Is the indirect method compliant with GAAP and IFRS?

Yes, the indirect method is fully compliant with both Generally Accepted Accounting Principles (GAAP) in the United States and International Financial Reporting Standards (IFRS). While both standards encourage the use of the direct method, they allow the indirect method as an acceptable alternative for presenting operating cash flows.

How does depreciation affect the indirect method?

Depreciation is a non-cash expense, meaning it reduces net income on the income statement but does not involve an actual outflow of cash. When using the indirect method, depreciation expense is added back to net income to reverse its effect and reflect the true cash flow from operations. This adjustment is crucial because the goal is to convert accrual-based net income to a cash basis.