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Home Statement of Cash Flows Statement of Cash Flows - Indirect Method
 
 

Statement of Cash Flows - Indirect Method:

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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:

  1. Net income of $34000 increased earnings.
  2. 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.

More study material from this to
 

More study material from this topic:

Definition, Explanation and Purpose of the Statement of Cash Flows
Classification of Cash Flows
Format and Sections of Statement of Cash Flows
Steps in Preparing Statement of Cash Flows
Statement of Cash Flows - Direct Method
Statement of Cash Flows - Indirect Method
Direct versus Indirect Method of Cash Flows

 

 
 

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