What Is the Indirect Method?

The indirect method is one of two accounting treatments used to generate

a cash flow statement. The indirect method uses increases and decreases in
balance sheet line items to modify the operating section of the cash flow
statement from the accrual method to the cash method of accounting.

The other option for completing a cash flow statement is the direct method,
which lists actual cash inflows and outflows made during the reporting period.
The indirect method is more commonly used in practice, especially among
larger firms.

KEY TAKEAWAYS

 Under the indirect method, the cash flow statement begins with net
income on an accrual basis and subsequently adds and subtracts non-
cash items to reconcile to actual cash flows from operations.
 The indirect method is often easier to use than the direct method since
most larger businesses already use accrual accounting.
 The complexity and time required to list every cash disbursement—as
required by the direct method—makes the indirect method preferred
and more commonly used.

Understanding the Indirect Method

The cash flow statement primarily centers on the sources and uses of cash
by a company, and it is closely monitored by investors, creditors, and other
stakeholders. It offers information on cash generated from various activities
and depicts the effects of changes in asset and liability accounts on a
company's cash position.

The indirect method presents the statement of cash flows beginning with net
income or loss, with subsequent additions to or deductions from that amount
for non-cash revenue and expense items, resulting in cash flow from
operating activities.

Example of the Indirect Method

Under the accrual method of accounting, revenue is recognized when
earned, not necessarily when cash is received. If a customer buys a $500
widget on credit, the sale has been made but the cash has not yet been
received. The revenue is still recognized in the month of the sale.

The indirect method of the cash flow statement attempts to revert the record
to the cash method to depict actual cash inflows and outflows during the
period. In this example, at the time of sale, a debit would have been made
to accounts receivable and a credit to sales revenue in the amount of $500.
The debit increases accounts receivable, which is then displayed on the
balance sheet.

Under the indirect method, the cash flows statement will present net income
on the first line. The following lines will show increases and decreases in
asset and liability accounts, and these items will be added to or subtracted
from net income based on the cash impact of the item.

In this example, no cash had been received but $500 in revenue had been
recognized. Therefore, net income was overstated by this amount on a cash
basis. The offset was sitting in the accounts receivable line item on the
balance sheet. There would need to be a reduction from net income on the
cash flow statement in the amount of the $500 increase to accounts
receivable due to this sale. It would be displayed as "Increase in Accounts
Receivable (500)."

Indirect Method vs. Direct Method

The cash flow statement is divided into three categories—cash flows from
operating activities, cash flows from investing activities, and cash flows from
financing activities. Although total cash generated from operating activities is
the same under the direct and indirect methods, the information is presented
in a different format.

Under the direct method, the cash flow from operating activities is presented
as actual cash inflows and outflows on a cash basis, without starting from net
income on an accrued basis. The investing and financing sections of the
statement of cash flows are prepared in the same way for both the indirect
and direct methods.

Many accountants prefer the indirect method because it is simple to prepare

the cash flow statement using information from the other two common
financial statements, the income statement and balance sheet. Most
companies use the accrual method of accounting, so the income statement
and balance sheet will have figures consistent with this method.
However, the Financial Accounting Standards Board (FASB) prefers
companies use the direct method as it offers a clearer picture of cash flows in
and out of a business. However, if the direct method is used, it is still
recommended to do a reconciliation of the cash flow statement to the balance
sheet.