Indirect method for operating activities

The statement of cash flows can be prepared and presented in either of two ways that differ only in the preparation of the operating activities section. The financing and investing activities are the same in either format.

• The indirect method prepares the operating activities section by adjusting the net income by removing the impacts of investing and financing activities and converting the net income into a cash basis by adjusting it with the changes in working capital (current assets and current liabilities) and non-cash items.
• The direct method prepares the operating activities section by breaking it down into the major classes of gross cash receipts and payments. This is the format that Codification encourages.

The IMA Learning Outcome Statements specify that examinees are expected to know how to prepare the indirect method of cash flows only. Understanding the direct method clarifies how the indirect method differs.

Indirect method for operating activities

The indirect method of cash flow presentation for operating activities does not present gross cash receipts and payments but instead transforms the net income into the cash flows from operating activities through a series of adjustments. This method shows the total cash flows from operating activities but does not directly present the sources of the cash flows (i.e., cash receipts from customers, etc.), unlike the direct method. Both methods always produce the same total cash flows from operating activities.

Steps in preparing indirect method cash flows

The indirect method starts with the net income. The following adjustments are normally made to the net income to arrive at the cash flows from operating activities:

1. Adjustment 1: Remove non-cash income and expenses because these are items included in the net income but do not have cash impact.
2. Adjustment 2: Eliminate gains or losses that pertain to financing and investing activities. The cash impact of these items are included in the financing and investing activities.
3. Adjustment 3: Include the working capital adjustments. These are similar in nature to the balance sheet inputs in the direct method cash flows. They show the impact of the balance sheet items to the accrual-based amounts recorded in the net income to finally show the cash impact.

Only operating current assets and liabilities belong in this adjustment. Short-term notes payable, dividends payable, and the current portion of long-term debt are financing items and are excluded. A few operating reconciling items aren’t current at all: an increase in a deferred tax liability is added back and an increase in a deferred tax asset is deducted, the same direction as current liabilities and current assets (the deferred tax liabilities and deferred tax assets chapters cover these in detail).

Watch out for two common indirect-method traps:

• Gains on disposal of an asset are subtracted from net income (losses are added back) because the full sale proceeds belong in investing activities, not operating.
• Unrealized gains and losses on available-for-sale debt securities are recorded in other comprehensive income (OCI), not net income. Since they never affected net income, they are not reconciling items in the indirect method.

The following template will help in preparing cash flows from operating activities using the indirect method.

Net income	XX	Pick-up the amount of net income from the income statement
Adjustment 1: Non-cash items:
Add: Expenses	XX	Various expenses such as depreciation, impairment, and equity-method investee losses do not have cash impact but they were deducted to arrive at the net income. Therefore, to arrive at the cash-basis net income, we have to add them back to remove their impact.
Deduct: Income	(XX)	Various income such as equity-method investee income do not have cash impact but they were added to arrive at the net income. Therefore, to arrive at the cash-basis net income, we have to subtract them to remove their impact.
Adjustment 2: Non-operating items
Add: Losses	XX	Non-operating losses such as loss on disposal of PPE or loss on extinguishment of debt are part of investing and financing cash flows, respectively. They were deducted from the net income, therefore we need to add them back to remove their impact.
Deduct Gains	(XX)	Non-operating gains such as gains on sale of PPE or gains on extinguishment of debt are part of investing and financing cash flows, respectively. They were added to the net income, therefore we need to deduct them to remove their impact.
Adjustment 3: Working capital adjustments
Deduct: Increases in current assets	(XX)	An increase in current assets (like accounts receivable) means that a portion of revenues (recorded using accrual basis) remained in the balance sheet and therefore have not been received. This increase represents the non-cash component of the net income and therefore has to be deducted. Another easier way of thinking about it is through a double entry. An increase in current assets is represented by a debit and therefore to balance the entry, the cash impact is a credit. A credit in cash is an outflow.
Add: Decreases in current assets	XX	A decrease in current assets - for example, collecting accounts receivable, selling down inventory, or using up a prepaid expense - means cash is freed up that net income does not reflect: cash is collected this period for revenue recognized earlier, or an expense recognized this period didn’t require a new cash outflow because it was already paid for. Because net income does not reflect this current-period cash effect, the decrease in the current asset is added back to convert net income to cash flow. Another easier way of thinking about it is through a double entry. A decrease in current assets is represented by a credit and therefore to balance the entry, the cash impact is a debit. A debit in cash is an inflow.
Add: Increases in current liabilities	XX	An increase in current liabilities means that a portion of expenses (recorded using accrual basis) remained in the balance sheet and therefore have not been paid. This increase represents the non-cash component of the net income and therefore has to be added because under cash-basis, the expenses were overstated. Another easier way of thinking about it is through a double entry. An increase in current liabilities is represented by a credit and therefore to balance the entry, the cash impact is a debit. A debit in cash is an inflow.
Deduct: Decreases in current liabilities	(XX)	A decrease in current liability means that liabilities from previous periods have been paid in the current period. Using the accrual basis of accounting, these have been expensed in the previous year but for cash-basis of accounting, these expenses are recorded when paid in the current year. The decrease in the liability is cash paid this period for expenses that reduced a prior period’s net income, so cash paid exceeds this period’s accrual expense and the decrease is deducted. Another easier way of thinking about it is through a double entry. A decrease in current liabilities is represented by a debit and therefore to balance the entry, the cash impact is a credit. A credit in cash is an outflow.
Cash flows generated from (used in) operating activities	XX or (XX)	Sum total of all above items can be positive or negative.

Example: Indirect method cash flow reconciliation

Net income is $150,000. Depreciation expense of $20,000 is added back under Adjustment 1 because it reduced net income without using cash. A $5,000 gain on the sale of equipment is subtracted under Adjustment 2 because the full sale proceeds belong in investing activities. Accounts receivable increased by $8,000, which is deducted under Adjustment 3 because that amount of revenue has not yet been collected in cash. Accounts payable decreased by $3,000, which is also deducted under Adjustment 3 because that amount of cash was paid this period for an expense that reduced a prior period’s net income.

Answer: Cash flows from operating activities = $150,000 + $20,000 − $5,000 − $8,000 − $3,000 = $154,000

Disclosure considerations

When the indirect method is used, the following items shall be disclosed separately in the notes because they do not appear directly in the statement of cash flows:

• Interest paid in cash (net of amounts capitalized)
• Income taxes paid in cash during the period

Such disclosures already appear in the statement of cash flows under the direct method.

Under U.S. GAAP, interest paid, and interest and dividends received, are always classified as operating activities; IFRS permits classifying them as operating, investing, or financing, as long as the classification is applied consistently from period to period.

In addition, it is always required to present a reconciliation between the net income and the cash flows from operating activities regardless of the method used (direct or indirect).

In the case of the direct method, it will be presented separately in the notes.

As in the case of the indirect method, entities have the option to:

• Present the reconciliation directly in the statement of cash flows
• Present the reconciliation in a separate schedule (typically within the notes to the financial statements), while showing a single line cash flows from operating activities in the statement of cash flows