The Indirect Method for Cash Flows from Operating Activities

The Indirect Method for Cash Flows from Operating Activities

• Overview:

  • The indirect method begins with net income and adjusts it for changes in cash flows associated with operating activities. It is often preferred by companies due to its simplicity in linking net income to cash flows.

• Additions in the Indirect Method:

  • Non-Cash Items:

  • Depreciation Expense:

    • Reflects the allocation of tangible assets' cost over their useful lives, reducing reported net income but not cash flows.

  • Amortization Expense:

    • Similar to depreciation but applies to intangible assets (e.g., patents).

  • Depletion Expense:

    • Represents the allocation of the cost of natural resources (like minerals) over time.

  • Amortization of Bond Discount:

    • Used for bonds issued below par; increases interest expense, thus affecting net income.

  • Non-Operating Losses:

  • Loss on Sale or Write-Down of Assets:

    • Reflects losses when assets are sold for less than their carrying value.

  • Loss on Retirement of Debt:

    • Loss incurred when debt is repaid prior to maturity, affecting reported income.

  • Loss on Investments:

    • Losses arising from investments managed under the equity method are added back as they do not involve cash outflow.

• Other Important Adjustments:

  • Increase in Deferred Income Tax Liability:

  • Indicates that taxes due in the future have increased, positively impacting cash flows.

  • Changes in Working Capital:

  • Accrued Expenses:

    • Higher accrued expenses due to recognizing more expenses than cash paid, increases cash flow.

  • Revenues:

    • Lower receipts from revenues than recognized decreases cash flow.

  • Decrease in Current Operating Assets:

    • Reduction in accounts receivable, inventory, and prepaid expenses indicates an increase in cash flow.

  • Increase in Current Operating Liabilities:

    • Higher accounts payable and accrued expenses signal additional cash available to the business.