Financial statements provide crucial information about a company’s finances to its stakeholders. Most users prefer the balance sheet and income statement. However, they do not provide essential information about cash transactions during the year. Therefore, companies also prepare a cash flow statement that satisfies this requirement.
Accounting standards require companies to provide a cash flow statement using the indirect method. Before discussing this method, it is crucial to understand what this statement includes.
What is the Cash Flow Statement?
The cash flow statement is one of the crucial financial statements prepared by companies. It provides details of cash transactions during a financial period. However, it does not report on profitability or other aspects of finances. While the income statement provides that information, it uses the accrual principle. On the other hand, the cash flow statement does not follow the same principle.
The cash flow statement does not include accruals when reporting cash transactions. On top of that, it does not account for accounting methods that result in a non-cash transaction. For example, it does include depreciation or amortization. Companies can prepare cash flow statements using the direct method. However, the indirect method is the standard way of reporting this statement.
What is the Indirect Method of Cash Flow Statement?
The indirect method of cash flow statement is a format used to report cash transactions. This format starts with net profits or losses obtained from the income statement. Then, it adjusts for non-cash transactions and other items to that amount. Subsequently, it involves reporting cash flows in three areas. These include operating, investing, and financing activities.
The indirect method of cash flow statement also reconciles the opening and closing cash balance for the period. The movements during this period come from the information reported above. Though the direct method is more straightforward, the indirect method has become the norm for preparing the cash flow statement. Accounting standards also prefer this method when reporting cash transactions.
Indirect Method vs Direct Method of Cash Flow Statement: What are the differences?
The indirect and direct methods of cash flow statement differ significantly. Some of the differences between these two formats include the following.
- The indirect method starts with net profits from the income statement. From there, it adjusts for non-cash transactions and reports cash flows in three categories. On the other hand, the direct method shows these activities directly. It does not complicate the calculation by using net profits and adjusting for non-cash transactions.
- The direct method categorizes cash flows into cash received and paid in different sections. On top of that, it also includes the same activities, including operating, investing, and financing. However, the indirect method does not segregate cash received and paid directly.
- The indirect method of cash flow statement tries to reconcile accrual and cash accounting differences. On the other hand, the direct method focuses on the latter only.
Example
Given below is an example of the indirect method of cash flow statement.
| Cash flows from operating activities | |
| Net income | $000 |
| Adjustments for: | |
| Depreciation and amortization | $000 |
| Gain/loss on sale of assets | ($000)/$000 |
| Increase/Decrease in inventories | ($000)/$000 |
| Increase/Decrease in trade receivables | ($000)/$000 |
| Increase/Decrease in trade payables | $000/($000) |
| Net cash generated/used from operations | $000/($000) |
| Cash flows from investing activities | |
| Purchase of property, plant, and equipment | ($000) |
| Proceeds from the sale of equipment | $000 |
| Net cash generated/used in investing activities | $000/($000) |
| Cash flows from financing activities | |
| Proceeds from a stock issue | $000 |
| Debt received | $000 |
| Dividends paid | ($000) |
| Net cash generated/used in financing activities | $000/($000) |
| Net increase/decrease in cash and cash equivalents | $000/($000) |
| Cash and cash equivalents at the beginning of the period | $000 |
| Cash and cash equivalents at the end of the period | $000 |
Conclusion
The cash flow statement is one of the financial statements that reports cash activities. Companies use the indirect method, which reconciles accrual and cash accounting records. On the other hand, the direct approach does not have the same format. The indirect method is also a requirement under accounting standards.
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