The

indirect method 

A Three-Step Process
•Indirect Method
 adjusts net income to
net cash provided by
operating activities
using a three-step
process.
A Three-Step Process
Step 1:
The first step is to add depreciation
charges to net income.
Depreciation Charges are the
credits to the Accumulated
Depreciation account during the
period – the sum total of the entries
that have increased  Accumulated
Depreciation.
To compute the credits to the Accumulated Depreciation
account use the equation for contra-assets:

Basic Equation for Contra-Asset Accounts

         Beginning Balance – Debits + Credits = Ending Balance

Example:
     Assume the Accumulated Depreciation account had
beginning and ending balances of $300 and $500,
respectively. Also, assume that the company sold equipment with
accumulated depreciation of $70 during the period. 
         Beginning Balance – Debits + Credits = Ending Balance
           $300 - $70 + Credits = $500
                                Credits = $500-$300+$70
                                Credits = $270
Accumulated Depreciation T-account

Accumulated Depreciation

Sale of                           Beg. Bal. 

 $300  
equipment   70                                 270

                                        End. Bal.   $500 
 For service and merchandising companies, the credits
to the Accumulated Depreciation T-account equal the
debits to the Depreciation Expense account.

The adjustment in step one consists of adding

depreciation expense to net income. 
 For manufacturing companies, some of the credits to
the Accumulated Depreciation T-account relate to
depreciation in production assets that are debited to
work in process inventories rather than expense.

The depreciation charges do not simply equal

depreciation expense. 
A Three-Step
Process
Step 2:
The second step is to
analyze net changes in
noncash balance sheet
accounts that impact net
income. 
General Guidelines for Analyzing How Changes in
Noncash balance Sheet Accounts Affect Net Income on
the Statement  
Exhibit 14-2 Increase in Account Decrease in Account
Balance Balance
Current Assets
Accounts Inventory …..      subtract add
Inventory …..      subtract add
Prepaid expenses …..      subtract add
Current Liabilities
Accounts Payable …..           add            subtract
Accrued liabilities …..           add              subtract
Income taxes payable …..           add              subtract
A Three-Step
Process
Step 3:
The third step in
computing the net cash
provided by operating
activities is to adjust for
gain/losses included in the
income statement.
 The cash proceeds from the sale of
noncurrent assets must be included in the
investing activities section of the statement
of cash flows.
- Under U.S. GAAP and IFRS rules

To make adjustment, 
Subtract gains from net income and
add losses to net income in the
operating activities section. 
Investing and
Financing
Activities: This Photo by Unknown author is licensed under CC BY-SA.

Gross Cash
Flows
 U.S. GAAP and IFRS require that the
investing and financing sections of the
statement of cash flows disclose gross cash
flows.

Gross method of reporting cash flows is not

used in the operating activities section of
the statement of cash flows, where debits
and credits are netted against each other.
General Guidelines for Analyzing How Changes in
Noncash Balance Sheet Accounts Affect the Investing
and Financing Sections of the Statement of Cash Flows
                                          Increase in Account   Decrease in Account
                                                                  Balance                        Balance
Noncurrent Assets
 (Investing Activities)
Property, plant, and equipment ......            subtract                                    add  
Long-term Investment....................            subtract                                    add
Loans to other entities ….................            subtract                                    add

Liabilities and Stockholders' Equity

         (Financing Activities) 
Bonds payable ….............................                add                                      subtract
Common stock …............................               add                                      subtract
Retained earnings …........................                 *                                               *
q Property, Plant and Equipment
-  When a company purchases property, plant, or
equipment it debits the Property, Plant and
Equipment account for the amount of the purchase.

- When it sells or disposes of these kind of assets, it

credits the Property, Plant and Equipment account
for the original cost of the asset.

Basic Equation for Asset Accounts:

Beginning Balance + Debits – Credits = Ending Balance
Example: 
       Assume that a company's beginning and
ending balances in its Property, Plant, and
Equipment account are $1,000 and $1,800,
respectively. In addition, during the period
the company sold a piece of equipment
for $40 cash that originally cost $100 and had
accumulated depreciation of $70. The
company recorded a gain on the sale of $10,
which had been included in net income. 
Beginning Balance + Debits – Credits = Ending Balance
                         $1,000 + Debits - $100 = $1,800
                                                     Debits = $1,800 - $1,000 + $100
                                                     Debits = $900

          Property, Plant, and Equipment T-account

                            Property, Plant, and Equipment

Beg. Bal.   $1,000                        Sale of equipment    100

Additions  900

End. Bal.   $1,800 
qRetained Earnings
-  When a company earns net income it
credits the Retained Earnings account
and when it pays a dividend it debits
the Retained Earnings Account.

Basic Equation for Stockholders' Equity Accounts

Beginning Balance - Debits + Credits = Ending Balance
Example: 
       Assume that a company's beginning and
ending balances in its Retained Earnings
account are $2,000 and $3,000, respectively. In
addition, the company reported net income
of $1,200 and paid a cash dividend, but we
don't know how much.  We start by
calculating the $1,000 increase in the
Retained Earnings account.
Beginning Balance - Debits + Credits = Ending Balance
                         $2,000 - Debits + $1,200 = $3,000
                                                     $3,200  = $3,000 + Debits
                                                     $3,200  = $200

                  Retained Earnings T-account

                                           Retained Earnings 

                                                             Beg. Bal.                $2,000    

    
Dividend                     900               Net Income             1,200

                                                             End. Bal.                $3,200 

 SUMMARY
OF KEY
CONCEPTS

This Photo by Unknown author is licensed under CC BY-NC-ND.

Key Concept #1
The statement of cash flows is divided three sections:
Operations Activities
Net cash provided by (used in) operating activities                $ xx      
Investing Activities
Net Cash provided by (used in) investing activities                  xx
Financing Activities
Net Cash provided by (used in) financing activities                 xx
                 
                               Net increase/decrease in cash and cash equivalents     xx
                               Beginning cash and cash equivalents                                 xx
                               Ending cash and cash equivalents                                    $ xx
Key Concept #2
U.S. GAAP and IFRS allow two methods for preparing
the operating activities section of the statement of cash
flows:
Direct Method (Appendix 14A)
Cash receipts from customers                                                        $ xx      
Cash paid for inventory purchases                                                (xx)
Cash paid for selling and administrative expenses                  (xx)
Cash paid for income taxes                                                               (xx)
Net cash provided by (used in) operating activities                 $ xx                 
  Indirect Method
Net income                                                                                            $  xx
Various adjustments                                                                              xx
Net Cash provided by (used in) operating activities                $  xx 
Key Concept #3
Computing the net cash provided by operating
activities using the indirect method is a three step
process:
Operating Activities
              Net Income                                                                                $ xx      
              Adjustments to convert to net income to a cash basis:                         
Step 1            Add: Depreciation                                                            xx

                  Analyze net changes in noncash balance sheet accounts:

                 Increase in current asset accounts                                  (xx)
 Step 2    Decrease  in current asset account                                    xx
                 Increase in current liability accounts                              xx
                 Decrease in current liability accounts                            (xx)
Key Concept #3
Computing the net cash provided by operating
activities using the indirect method is a three step
process:
Operating Activities
       
                   Adjust for gains/losses:
Step 3       Gain on sale                                                                                       (xx)
                   Loss on sale                                                                                         xx
                   Net cash provided by (used in)                                                  $ xx
                        operating activities
Key Concept #4
The investing and financing sections of the statement
of cash flows must report gross cash flows:

Net cash provided by (used in) operating activities                  $ xx

Investing Activities
Purchase of Property, plant, and equipment                              (xx)
Sale of property, plant, and equipment                                          xx
Purchase of long-term investments                                               (xx)
Sale of long-term investments                                                           xx 
Net cash provided by (used in) investing activities                   (xx)
Key Concept #4
The investing and financing sections of the statement
of cash flows must report gross cash flows:

Net cash provided by (used in) operating activities                  $ xx

Financing Activities
Issuance of bonds payable                                                                 (xx)
Replaying principal on bonds payable                                            xx
Issuance of common stock                                                                (xx)
Purchase own shares of common stock                                        (xx)
Paying dividend                                                                                    (xx) 
Net cash provided by (used in) financing activities                   xx   
Key Concept #4
The investing and financing sections of the statement
of cash flows must report gross cash flows:

Net increase/decrease in cash and cash equivalents                   xx

Beginning cash and cash equivalents                    xx
Ending cash and cash equivalents                         $ xx
An Example of a
Statement of Cash
Flows
A statement of cash flows for a merchandising company
called Apparel, Inc.
Apparel, Inc.
Income Statement
(dollars in millions)
Sales …...........................................................................    $ 3,638
Cost of Goods sold ................................................       2,469
Gross Margin ........................................................        1, 169
Selling and administrative expenses ...................           941
Net Operating income ..........................................           228
Nonoperating items: gain on sale of store ...........               3
Income before taxes .............................................            231
Income taxes .........................................................             91
Net income ............................................................       $  140
A statement of cash flows for a merchandising company called
Apparel, Inc.
Apparel, Inc.
Comparative balance Sheet
(dollars in millions)

Assets                                                Ending        Beginning          

Current Assets:                              Balance       Balance          Change
    Cash and equivalents ….........................    $     91                $  29                        + 62
     Accounts receivable..............................         637                 654                         - 17
     Inventory ..............................................        586                 537                        + 49
Total Current assets .................................       1,314               1,220   
Property, plant, and equipment ..............       1,517               1,394                       + 123
     Less accumulated depreciation ...........         654                 561                        + 93
Net property, plant, and equipment .........        863                 833
Total Assets ................................................ $  2,177            $ 2,053 
A statement of cash flows for a merchandising company called
Apparel, Inc.
Apparel, Inc.
Comparative balance Sheet
(dollars in millions)

Liabilities and                                       Ending        Beginning          

Stockholders' Equity                         Balance       Balance     Change
Current Liabilities:                                                   
     Accounts payable..............................    $  264             $  220              +44
     Accrued liabilities ............................        193                 190               +3
    Income Taxes Payable........................          75                  71                +4
Total current liabilities.........................        532                481               
Bonds payable ......................................         479               520               -41
Total liabilities .....................................         1,011          1, 001
A statement of cash flows for a merchandising company called
Apparel, Inc.
Apparel, Inc.
Comparative balance Sheet
(dollars in millions)

                                                                   Ending        Beginning          
Stockholders' Equity                         Balance       Balance     Change           
                                     
     Common Stock..............................           157                155              +2
     Retained Earnings ............................   1,009              897              +112
Total Stockholders' equity ....................   1,166              1,052             
Total liabilities and
Stockholders' equity ..........................    $ 2,177            $ 2,053