Definition and Explanation:
Normally, two methods are used to prepare
statement cash flows. One is the
direct method and other is the
indirect method. On this page we are going to
explain indirect method. This method is also known as
reconciliation method and starts with net income and
converts it to net cash flow from operating
activities. In other words, the indirect method
adjusts net income for items that affected net
income but did not affect cash. To compute
net cash flow from operating activities, non-cash
charges in the income statement are added back to
net income, and non-cash credits are deducted from
net income.
Example:
To
illustrate indirect method of statement cash flows, we
will use the first year of operation for Tax
Consultants Inc. The company started on 1st January
2003, When it issued 60,000 shares of $1 par value
common stock for $60,000 cash. The company rented
its office space and furniture and equipment, and it
performed tax consulting services throughout the
first year. The comparative balance sheets at the
beginning and end of the year 2003 appear as
follows:
Tax
Consultants Inc.
Comparative Balance Sheets
Assets |
Dec. 31, 2003 |
Jan. 1, 2003 |
Change (Increase/Decrease) |
Cash |
$49,000 |
$-0- |
$49,000 Increase |
Accounts receivable |
36,000 |
-0- |
36,000 Increase |
|
|
|
|
Total |
$85,000 |
-0- |
|
|
|
|
|
Liabilities and Stockholders'
Equity |
|
|
|
Accounts payable |
$5,000 |
$-0- |
$5,000 Increase |
Common stock ($1 par) |
60,000 |
-0- |
60,000 Increase |
Retained earnings |
20,000 |
-0- |
20,000 Increase |
|
|
|
|
Total |
$85,000 |
$-0- |
|
|
|
|
|
|
The income
statement and additional information for tax consultants Inc.
are as follows:
Tax
Consultants Inc.
Income Statement
For the year ended Dec. 31, 2003
Revenues |
$125000 |
Operating expenses |
85000 |
|
|
Income before income taxes |
40,000 |
Income tax expenses |
6,000 |
|
|
Net income |
$34,000 |
|
|
Additional Information:
Examination of selected data
indicates that a dividend of $14,000 was
paid during the year.
|
Read the following 3 steps for
the preparation of statement cash flows of Tax consultant Inc.
carefully:
Step 1: Determine the Change in
Cash:
To prepare a statement cash flows, the first step is to determine the
change in cash. This is a simple step. Tax
Consultants Inc. had no cash on hand at the
beginning of the year 2003, but $49000 was on hand
at the end of the year 2003. Thus the change in cash
for 2003 was an increase of $49,000.
Step2: Determine
Net Cash Flow From Operating Activities:
Explanations for
the two adjustments to net income in this example -
namely, the increase in accounts receivable and
accounts payable - are as follows:
Increase in
accounts receivable: When accounts
receivable increase during the year, revenues on an
accrual basis are higher than revenues on a cash
basis because goods sold on account are reported as
revenues. In other words, operations of the period
led to increase revenues, but not all of these
revenues resulted in an increase in cash. Some of
the increase in revenues resulted in an increase in
accounts receivable. To convert net income to net
cash flow from operating activities using indirect
method, the increase of $36000 in accounts
receivable must be deducted from net income.
Increase in
accounts payable: When accounts payable increase
during the year, expenses on an accrual basis are
higher than they are on a cash basis because
expenses are incurred for which payment has not been
taken place. To convert net income to net cash flow
from operating activities, the increase of $5,000 in
accounts payable must be added to net income as
follows:
Net income |
|
$34,000 |
Adjustments to reconcile net
income to net cash provided by
operating activities: |
|
|
increase in accounts receivable |
$(36,000) |
|
increase in accounts payable |
5,000 |
(31,000) |
|
|
|
Net cash provided by operating
activities |
|
$3,000 |
|
|
|
Net
cash provided by operating activities
are same whether the
direct method or indirect method is
used
|
Step 3: Determine Net Cash Flows from Investing
and Financing Activities:
Once the net cash
from operating activities is computed, the next step
is to determine whether any other changes in balance
sheet accounts caused an increase or decrease in
cash.
For example, an
examination of the remaining balance sheet accounts
for Tax Consultation Inc. shows that both common
stock and retained earnings have increased. The
common stock increase of $60,000 resulted from the
issuance of common stock for cash. The issuance of
common stock is a receipt of cash from a financing
activity and is reported as such in the statement of
cash flows. The retained earnings increase of
$20,000 is caused by two items:
- Net income of
$34000 increased earnings.
- Dividends
declared of $14,000 decreased retained earnings.
Net income has been
converted into net cash flow from operating
activities, as explained earlier. The additional
data indicate that the dividend was paid. Thus, the
dividend payment on common stock is reported as a
cash outflow, classified as a financing activity.
The net cash
provided or used by investing and financing
activities is calculated and reported in the same
way under
direct method and indirect methods.
The statement cash flows of Tax Consultants Inc. is as follows:
Tax Consultants INC.
Statement of Cash Flows
For the year ended December 31, 2003
Cash Flows from
Operating Activities |
|
|
Net income |
|
$34,000 |
Adjustments to
reconcile net income to net cash provided by
operating activities: |
|
|
increase in accounts receivable |
$(36,000) |
|
increase in accounts payable |
5,000 |
$(31,000) |
|
|
|
|
|
|
Net cash provided
by operating activities |
|
$3,000 |
Cash Flows from
Investing Activities |
|
|
Issuance of common stock |
60,000 |
|
Payment of cash
dividends |
(14,000) |
|
|
|
|
Net cash provided
by financing activities |
|
46,000 |
|
|
|
Net increase in
cash |
|
49,000 |
Cash, January 1
2003 |
|
-0- |
|
|
|
Cash, December 31,
2003 |
|
$49,000 |
|
|
|
As indicated,
the $60,000 increase in common stock results in a cash
inflow from a financing activity. The payment of $14,000 in
cash dividends is classified as a use of cash from a
financing activity. The $49000 increase in cash reported in
the statement of cash flows agrees with the increase of
$49,000 shown as the change in the cash account in the
comparative balance sheet. There were no investing activity
effecting cash during the year.
Advantages of Indirect Method:
The principle
advantage of indirect method is that it focus on the
differences between net income and net cash flow from
operating activities. That is, it provides a useful link
between the statement of cash flows and the income statement
and
balance sheet.
Many companies contend that it
is less costly to adjust net income to net cash flow from
operating activities than it is to report gross operating
cash receipts and payments. Supporters of the indirect
method also state that the direct method, which effectively
reports income statement information on a cash rather than
an accrual basis, may erroneously suggest that net cash flow
from operating activities is as good as, or better than, net
income as a measure of performance.
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