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A statement of cash flows is a statement of a company’s financial position that reflects how cash inflows and outflows are impacted by changes in the balance sheet and income. Direct and indirect methods are two accounting treatments of the operating activities section of the statement of cash flows. They are identical in all respects, except the process by which they recognize cash flow from operating activities. The given report focuses on the nature of the indirect method, its importance, and objectives, as well as advantages and disadvantages.
Nature of the Indirect Method
The indirect method is a technique that is extensively used in accounting for reporting cash flows from operating activities. When preparing the statement of cash flows using the indirect approach, companies rely on the information provided in the balance sheet and the statement of consolidated income. The indirect method converts the net income that was calculated on the accrual basis into cash flow from operating activities by using several different adjustments for any difference in timing between entries based on accrual accounting and actual cash receipts. It is worth noting that the net increase or decrease in cash and cash equivalents calculated using the indirect method is equal to that calculated using the direct method.
Importance and Objectives of the Indirect Method
The indirect method is the basic accounting of cash inflows and outflows from the company’s operating, investing, and financing activities. It attempts to determine the actual cash flows during a certain period. Its importance is represented by its popularity among business entities. They are allowed to present a statement of cash flows under either direct or indirect methods (Atrill & McLaney, 2017). However, since the information needed for the generation of the statement of cash flows under the indirect approach can be relatively easily assembled from the balance sheet and the income statement, the majority of corporations prefer this representation over the direct one. Moreover, the utilization of the direct method provides for a supplemental disclosure and a reconciliation of net income.
Under the indirect approach, the first item that is presented in the operating activities section of the statement of cash flows is net income, which is then adjusted. It is the changes in the assets and liabilities accounts, non-cash expenses, as well as non-operating losses and gains which are subtracted from or added to the net income (Hilton & Platt, 2016). Among the common components of the non-cash expenses are depreciation expense, depletion expense, and amortization expense. Changes in the asset accounts include changes in inventory, prepaid expenses, and accounts receivable. Changes in the liability account may contain accounts payable, income tax payable, accrued expenses, and unearned revenues.
For example, if an asset account increased, this may mean that a company purchased a new asset and paid for it in cash. Therefore, the net cash flow from operating activities will decrease by the amount of cash that a company paid to buy an asset. Net income can also be overstated on a cash basis if a company recognizes revenue for which cash has not been received. If an asset account decreased, this indicates that a company sold some of its assets and received cash. Thus, the net cash flow from operating activities will increase by the amount of cash that a company received.
Changes in a liability account impact net income in the opposite direction since liabilities have a credit balance instead of a debit balance. For instance, if the value of liabilities increased, the difference should be added to the net income. If an accounts payable balance increased, this means that a company purchased something without paying for it in cash. The formula for calculating net cash flow under the indirect method is as follows:
Net Cash Flow from Operating Activities = Net Income + Increase in Current Liabilities – Decrease in Current Liabilities + Decrease in Current Assets – Increase in Current Assets + Non-operating Gains – Non-operating Losses + Non-cash Expenses.
Table 1 shows an example of the operating activities section of the statement of cash flows generated using the indirect method.
Table 1. Cash Flows from Operating Activities.
|Adjustments to reconcile net income to net cash generated by operating activities:|
|Depreciation of fixed assets||1,500|
|Amortization of intangible assets||2,330|
|Changes in current assets:|
|Changes in current liabilities|
|Net cash provided by operating activities||3,060|
Cash flow from financing activities shows the sources of cash flows which a company used for funding. Items that may be included in the financing activities section are payment of dividends, repayment of the debt, repurchase of stock, and proceeds from long-term debt. Cash flow from investing activities reflects how much money has been spent on or generated from buying or selling long-term assets, both physical and financial. Some examples of the transactions that may appear in this section are the purchase of stocks or securities, purchase of equipment, proceeds from property and equipment incentive, and sales of marketed securities. As has been mentioned before, these two sections of the cash flow statement are equivalent to those generated under the direct approach.
Information Provided to the Users
A cash flow statement prepared using the indirect method provides information about the amount of cash and cash equivalents that enter and leave a business entity during a specific period (usually a quarter or a year). Shareholders and investors may use this statement of a company’s financial position to get a general understanding of its performance and determine whether it is efficient in generating cash from its daily operations. The higher the amount of cash provided by a company, the more likely it that it will pay its short- and long-term debt obligations successfully.
The quality of the company’s earnings can also be determined by comparing the value of net income that is reported in the income statement to net cash from operating activities. It is considered that earnings are of high quality if net income is smaller than the net cash generated from operating activities. At the same time, a negative divergence between the reported amount of income and net cash from operating activities may be viewed as a reason for concern. Another thing that investors can pick from a cash flow statement is whether a company raises money (debt or equity) to fund its losses from operations or finance investments.
Advantages and Disadvantages
The indirect method of reporting cash flows has several advantages. Firstly, it gives readers a more systematic view of the company’s statements of financial position by establishing a direct relationship with the balance sheet and the income statement. Secondly, it shows a clear difference between a company’s cash holding position and the amount of profit that has been reported. Thirdly, it discloses non-cash expenses, thus giving users a better understanding of a company’s performance. Fourthly, the indirect approach proves to be less complex for reporting compared to the direct approach. However, the indirect method provides unnecessary details that may be confusing to readers. Also, in contrast to the direct method, it gives a less clear view of cash inflows and outflows.
In summary, the indirect method of the presentation of a statement of cash flows involves the adjustments of net income or loss for non-cash items. This approach is commonly used by companies as they need only the information from the other two statements of financial position, which are the balance sheet and income statement. However, despite a number of advantages that the indirect method has over the direct one, it offers a less transparent picture of the flow of cash in and out of business.
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Benefits of the Project and Lessons Learned
The benefits of the project are associated with the comprehensive discussion of the preparation of cash flow statements using the indirect method. The majority of the aspects regarding the given approach have been discussed, and a clear review of its advantages and disadvantages has been provided. Besides, the indirect method has been compared to the direct one in order to make the report more holistic. Apart from learning how to prepare the cash flow statement under the indirect approach using the balance sheet and the income statement, it has been learned that even though non-cash transactions influence net income, they are not the sources of cash inflows and outflows.
Atrill, P., & McLaney, E. J. (2017). Accounting and finance for non-specialists (10th ed.). Harlow, UK: Pearson Education.
Hilton, R. W., & Platt, D. E. (2016). Managerial accounting: Creating value in a dynamic business environment (11th ed.). New York, NY: McGraw-Hill.