When using the indirect method to determine cash flows from operating activities Adjustments to net income should not include?

Imagine you started a small business. (Maybe you don’t have to imagine.) After a year of hard work, you want to take stock of your company’s financial performance. Money is coming through sales, but cash is also going out as equipment purchases and salary payments. How do you determine your cash position? How do you figure out how much cash is coming and going and what you’re left with?

Inhaltsverzeichnis Show

What is a cash flow statement?
What is the indirect method of a cash flow statement?
Lack of transparency in the indirect method
Direct cash flow method vs. indirect cash flow method
1. Obtain the relevant documentation
2. List the net income from the financial statements
3. List cash and noncash operating activities
4. List investing activities
5. List financing activities
6. Tabulate the total
7. List the final cash balance

One way is to use the indirect method of cash flow statements. With this method, you can determine precisely how much money you’ve spent and brought in, how much you should have on hand, and get a solid grasp of your business’s financial stability over a given period.

What is a cash flow statement?

A cash flow statement (CFS) is a financial statement summarizing cash and cash equivalents (CCE) entering and leaving a company during an accounting period. It measures a company’s ability to pay debts and expenses—handy for short- and long-term planning and regulating operations. Along with the balance sheet and the income statement, a cash flow statement is one of the three primary financial statements that help determine a business’s financial health.

Cash flow is measured by subtracting the incoming money from the outgoing money. In other words, it’s the difference between cash inflows and cash outflows. A cash flow statement typically includes three main components:

Operating activities. Cash spent or received from core business operations, such as providing products or services.
Investing activities. Cash spent or received from the purchase or sale of long-term assets and other investments not included in cash equivalents, i.e., securities, loans, and capital expenditures.
Financing activities. Cash spent or received from funding mechanisms such as equity, dividends, and debt.

Your cash flow can be positive or negative, depending on how much you make and spend. When your flow is positive, you can use the excess cash on investments or financing or put it into your savings. If your cash flow is negative, you may have to look into potential investors or dip into your savings to balance your books.

What is the indirect method of a cash flow statement?

In general terms, the indirect method is a way to calculate cash flow using transactions to determine payments and expenses rather than cash on hand. The indirect method measures how much a company made or spent through various sources over a given period. It helps evaluate a business’s current or relative health and financial stability and whether or not it has money to spend on growth and other investments.

The indirect cash flow method calculates cash flow by adjusting net income with differences from noncash transactions. It starts with a business’s net income and then lists cash flows, both received and paid, for various activities (i.e., the three cash flow categories: operating, investing, and financing). These activities are then added or subtracted from the business’s net income to determine its final net cash increase or decrease over the specified period.

The indirect method uses accrual basis accounting in its calculations. With accrual accounting, revenue is recorded when it is earned rather than when it is received—i.e., when a sale takes place, not when the money reaches the bank account. If a landscaping company that charges $30 per hour bills a client for four hours of work, under the accrual method, it would record $120 in revenue before any money changed hands. This method allows the company to account for all cash and credit sales, providing a clearer picture of the business’s financial health.

Lack of transparency in the indirect method

Although the indirect method is easy to prepare, it lacks transparency. It can be hard to track down and tally what’s been paid and what hasn’t, meaning it doesn’t always accurately represent a business’s cash on hand. Moreover, because all cash flow statements are typically calculated over a quarter or fiscal year, they only provide a limited snapshot of a company’s financial health, making it challenging to draw longer-term conclusions.

Direct cash flow method vs. indirect cash flow method

The direct cash flow method includes all the inflows and outflows of cash from operating activities. Rather than accrual accounting, it uses cash basis accounting, which recognizes revenues when cash is received and expenses when they’re paid, providing a real-time look at cash inflows and outflows. The direct method then tallies these payments and expenses similarly to the indirect method to determine a business’s net cash flow.

The direct method is straightforward and transparent but can be more time-consuming, as it requires parsing which expenses and income have been paid and which haven’t—one reason many larger companies prefer the indirect method.

Using the indirect method to prepare a cash flow statement might seem intimidating. Breaking the process down can help.

1. Obtain the relevant documentation

Gathering your company’s financial information is the critical first step. This includes the two other basic financial statements: the balance sheet, which shows assets and liabilities, and the income statement, which lists expenses and revenue.

2. List the net income from the financial statements

Pull your company’s net income from its income statement, and list it on the first line of the cash flow statement. This is also where you add adjustments for finances, like asset depreciation, which you can insert in parentheses.

3. List cash and noncash operating activities

List your company’s cash and non-cash expenses and income, line by line. These typically include items like accounts receivable, asset sales, or amortization.

4. List investing activities

List out, line by line, the cash generated or lost through purchasing or selling stocks, securities, or loans.

5. List financing activities

List out, line by line, the cash your company generated or lost through funding mechanisms such as equity, dividends, and debt.

6. Tabulate the total

Add cash and non-cash operating, investing, and financing activities. If the resulting sum is negative, subtract it from the initial net income figure. If it’s positive, add it to the net income figure.

7. List the final cash balance

The result of this subtraction or addition is your net cash flow. A positive number indicates your business is relatively healthy, bringing in more cash than it spent over the period in question. If your company has a negative cash flow, you may be spending beyond your means, which could be unsustainable over the long term.

The direct cash flow method uses cash basis accounting rather than accrual accounting, providing a detailed look at cash inflows and outflows when determining a business’s net cash flow. The direct method can be more time-consuming but gives an accurate and detailed summary of a business’s cash flow operations.

The indirect method uses accrual basis accounting in its calculations, which means that the company may not have the cash on hand in some cases.

Moreover, as cash flow statements are typically calculated over a quarter or a fiscal year, they only provide a snapshot of a company’s financial state during a limited-time window. It can be challenging to draw any long-term conclusions about viability from these without considering factors such as significant market trends or the company’s history.

Operating cash flow (OCF) is the cash made from the sales of goods and services minus the money a company spends on operating expenses. The formula for calculating operating cash flow is:

Operating cash flow = Total cash received for sales − Cash paid for operating expenses

Operating cash flow can be calculated using direct or indirect cash flow statement methods.

At the end of this section, students should be able to meet the following objectives:

Explain the difference in the start of the operating activities section of the statement of cash flows when the indirect method is used rather than the direct method.
Demonstrate the removal of noncash items and nonoperating gains and losses in the application of the indirect method.
Determine the effect caused by the change in the various connector accounts when the indirect method is used to present cash flows from operating activities.
Identify the reporting classification for interest revenues, dividend revenues, and interest expense in creating a statement of cash flows and describe the controversy that resulted from this handling.

Question: As mentioned, most organizations do not choose to present their operating activity cash flows using the direct method despite preference by FASB. Instead, this information is shown within a statement of cash flows by means of the indirect method. How does the indirect method of reporting operating activity cash flows differ from the direct method?

Answer: The indirect method actually follows the same set of procedures as the direct method except that it begins with net income rather than the business’s entire income statement. After that, the three steps demonstrated previously are followed although the mechanical process here is different.

Noncash items are removed.
Nonoperational gains and losses are removed.
Adjustments are made, based on the change registered in the various connector accounts, to switch remaining revenues and expenses from accrual accounting to cash accounting.

Question: In the income statement presented above for the Liberto Company, net income was reported as $100,000. That included depreciation expense (a noncash item) of $80,000 and a gain on the sale of equipment (an investing activity rather than an operating activity) of $40,000. In applying the indirect method, how are noncash items and nonoperating gains and losses removed from net income?

Answer: Depreciation is an expense and, hence, a negative component of net income. To eliminate a negative, it is offset by a positive. Adding back depreciation serves to remove its impact from the reporting company’s net income.

The gain on sale of equipment also exists within reported income but as a positive figure. It helped increase profits this period. To eliminate this gain, the $40,000 amount must be subtracted. The cash flows resulting from this transaction came from an investing activity and not an operating activity.

In applying the indirect method, a negative is removed by addition; a positive is removed by subtraction.

Figure 17.7 Operating Activity Cash Flows, Indirect Method—Elimination of Noncash and Nonoperating Balances

In the direct method, these two amounts were simply omitted in arriving at the individual cash flows from operating activities. In the indirect method, they are both physically removed from income by reversing their effect. The impact is the same in the indirect method as in the direct method.

Question: After all noncash and nonoperating items are removed from net income, only the changes in the balance sheet connector accounts must be utilized to complete the conversion to cash. For Liberto, those balances were shown previously.

Accounts receivable: up $19,000
Inventory: down $12,000
Prepaid rent: up $4,000
Accounts payable: up $9,000
Salary payable: down $5,000

Each of these increases and decreases was used in the direct method to turn accrual accounting figures into cash balances. That same process is followed in the indirect method. How are changes in an entity’s connector accounts reflected in the application of the indirect method?

Answer: Although the procedures appear to be different, the same logic is applied in the indirect method as in the direct method. The change in each of these connector accounts has an impact on the cash amount and it can be logically determined. However, note that the effect is measured on the net income as a whole rather than on individual revenue and expense accounts.

Accounts receivable increased by $19,000. This rise in the receivable balance shows that less money was collected than the sales made during the period. Receivables go up because customers are slow to pay. This change results in a lower cash balance. Thus, the $19,000 should be subtracted in arriving at the cash flow amount generated by operating activities. The cash received was actually less than the figure reported for sales within net income. Subtract $19,000.

Inventory decreased by $12,000. A drop in the amount of inventory on hand indicates that less was purchased during the period. Buying less merchandise requires a smaller amount of cash to be paid. That leaves the balance higher. The $12,000 should be added. Add $12,000.

Prepaid rent increased by $4,000. An increase in any prepaid expense shows that more of the asset was acquired during the year than was consumed. This additional purchase requires the use of cash; thus, the balance is lowered. The increase in prepaid rent necessitates a $4,000 subtraction in the operating activity cash flow computation. Subtract $4,000.

Accounts payable increased by $9,000. Any jump in a liability means that Liberto paid less cash during the period than the debts that were incurred. Postponing liability payments is a common method for saving cash and keeping the reported balance high. The $9,000 should be added. Add $9,000.

Salary payable decreased by $5,000. Liability balances fall when additional payments are made. Those cash transactions are reflected in applying the indirect method by a $5,000 subtraction. Subtract $5,000.

Therefore, if Liberto Company uses the indirect method to report its cash flows from operating activities, the information will take the following form.

Figure 17.8 Liberto Company Statement of Cash Flows for Year One, Operating Activities Reported by Indirect Method

As with the direct method, the final total is a net cash inflow of $133,000. In both cases, the starting spot was net income (either as a single number or the income statement as a whole). Then, any noncash items were removed as well as nonoperating gains and losses. Finally, the changes in the connector accounts that bridge the time period between U.S. GAAP recognition and the cash exchange are determined and included so that only cash from operating activities remains. The actual cash increase or decrease is not affected by the presentation of this information.

In reporting operating activity cash flows by means of the indirect method, the following pattern exists.

A change in a connector account that is an asset is reflected on the statement in the opposite fashion. As shown above, increases in both accounts receivable and prepaid rent are subtracted; a decrease in inventory is added.
A change in a connector account that is a liability is included on the statement as an identical change. An increase in accounts payable is added whereas a decrease in salary payable is subtracted.

A quick visual comparison of the direct method and the indirect method can make the two appear almost completely unrelated. However, when analyzed, the same steps are incorporated in each. They both begin with the income for the period. Noncash items and nonoperating gains and losses are removed. Changes in the connector accounts for the period are factored in so that only the cash from operations remains.

Question: When reporting cash flows from operating activities for the year ended December 31, 2008, EMC Corporation listed an inflow of over $240 million labeled as “dividends and interest received” as well as an outflow of nearly $74 million shown as “interest paid.”

Unless a company is a bank or financing institution, dividend and interest revenues do not appear to relate to its central operating function. For most businesses, these inflows are fundamentally different from the normal sale of goods and services. Monetary amounts collected as dividends and interest resemble investing activity cash inflows because they are usually generated from noncurrent assets. Similarly, interest expense is an expenditure normally associated with noncurrent liabilities rather than resulting from daily operations. It could be argued that it is a financing activity cash outflow.

Why is the cash collected as dividends and interest and the cash paid as interest reported within operating activities on a statement of cash flows rather than investing activities and financing activities?

Answer: Authoritative pronouncements that create U.S. GAAP are the subject of years of intense study, discussion, and debate. In this process, controversies often arise. When FASB Statement 95, Statement of Cash Flows, was issued in 1987, three of the seven board members voted against its passage. Their opposition, at least in part, came from the handling of interest and dividends. On page ten of that standard, they argue “that interest and dividends received are returns on investments in debt and equity securities that should be classified as cash inflows from investing activities. They believe that interest paid is a cost of obtaining financial resources that should be classified as a cash outflow for financing activities.”

The other board members were not convinced. Thus, inclusion of dividends collected, interest collected, and interest paid within an entity’s operating activities became a part of U.S. GAAP. Such disagreements arise frequently in the creation of official accounting rules.

The majority of the board apparently felt that—because these transactions occur on a regular ongoing basis—a better portrait of the organization’s cash flows is provided by including them within operating activities. At every juncture of financial accounting, multiple possibilities for reporting exist. Rarely is complete consensus ever achieved as to the most appropriate method of presenting financial information.

Following is the conclusion of our interview with Robert A. Vallejo, partner with the accounting firm PricewaterhouseCoopers.

Question: Any company that follows U.S. GAAP and issues an income statement must also present a statement of cash flows. Cash flows are classified as resulting from operating activities, investing activities, or financing activities. Are IFRS rules the same for the statement of cash flows as those found in U.S. GAAP?

Rob Vallejo: Differences do exist between the two frameworks for the presentation of the statement of cash flows, but they are relatively minor. Probably the most obvious issue involves the reporting of interest and dividends that are received and paid. Under IFRS, interest and dividend collections may be classified as either operating or investing cash flows whereas, in U.S. GAAP, they are both required to be shown within operating activities. A similar difference exists for interest and dividends payments. These cash outflows can be classified as either operating or financing activities according to IFRS. For U.S. GAAP, interest payments are viewed as operating activities whereas dividend payments are considered financing activities. As is common in much of IFRS, more flexibility is available.

Most reporting entities use the indirect method to report cash flows from operating activities. This presentation begins with net income and then eliminates any noncash items (such as depreciation expense) as well as nonoperating gains and losses. Their impact on net income is reversed to create this removal. The changes in balance sheet connector accounts for the year (such as accounts receivables, inventory, accounts payable, and salary payable) must also be taken into consideration in converting from accrual accounting to cash. An analysis is made of the effect on both cash and net income in order to make the proper adjustments. Cash transactions that result from interest revenue, dividend revenue, and interest expense are all left within operating activities because they happen regularly. However, some argue that interest and dividend collections are really derived from investing activities and interest payments relate to financing activities.