What Does the Indirect Method Mean?
There are two ways to make a cash flow statement: the straight method and the indirect method. The indirect method changes the operating part of the cash flow statement from the accrual method to the cash method by adding or removing line items from the balance sheet.
The direct method is the other way to make a cash flow statement. It shows the real cash coming in and going out during the reporting period. In real life, the indirect way is used more often, especially by prominent companies.
How to Use the Indirect Method
The cash flow sheet shows where a company gets its cash and where it spends it. Investors, creditors, and other essential people closely monitor it. It shows how changes in a company’s asset and liability accounts affect its cash situation and how much different activities bring in.
With the indirect method, the statement of cash flows starts with net income or loss and then adds to or subtracts from that amount for non-cash income and expenses. This leaves us with cash flow from operating operations.
If your company keeps records on an accrual system, the indirect method is easier to set up than the direct method.
A Case of the IM
With the accrual method of accounting, income is recorded when it is made, not always when cash is received. If a customer borrows $500 to buy a widget, the deal is done, but the money hasn’t arrived yet. The money is still counted as income in the month it was sold.
The indirect method of the cash flow statement tries to change the record back to the cash method to show how much cash came in and went out during the time. In this case, it would have been $500 taken out of accounts receivable and added to sales income at the time of the sale. Accounts receivable go up because of the debt shown on the balance sheet.
With this method, the first line of the cash flow sheet will show net income. The following lines will show how the asset and debt accounts have gone up or down. These changes will be added to or removed from net income depending on how much money they make or lose.
In this case, no cash had been received, but $500 had been recorded as income. On a cash base, this means that net income was higher than it was. It was in the balance sheet, in the accounts receivable line item. On the cash flow sheet, net income would decrease by $500. And accounts receivable would increase because of the sale. The message would say, “Increase in Accounts Receivable (500).”
The Direct Method vs. the Indirect Method
There are three parts to the cash flow statement. Cash flows from investing activities, cash flows from financing activities, and cash flows from running activities. The direct and indirect methods give the same amount of cash created from operating activities. But they do so differently.
The direct method shows the cash flow from operating activities as real cash coming in and going out. Based on a cash basis instead of starting with net income and adding it up.
For both the indirect and direct methods, the investing and purchasing parts of the statement of cash flows are made in the same way.
This is because it is easy to make the cash flow statement using income and balance sheet data, the other two famous financial statements. The income statement and balance sheet will have numbers that align with the accrual way of accounting, which is what most businesses do.
If a company wants a better idea of how much cash comes in and out of the business, the Financial Accounting Standards Board (FASB) recommends using the direct way. Even though the direct way is used, it is still a good idea to match the cash flow statement and the balance sheet.
Conclusion
- With this method, the cash flow statement starts with net income calculated on an accrual basis. It then adds and subtracts non-cash items to get the actual cash flows from activities.
- Most big businesses already use accrual accounting, so the indirect method is often more accessible than the direct method.
- The indirect method is better and more widely used. Because it is easier and takes less time to list every cash disbursement than the direct method.
