Steps Using the Indirect Method
There are three steps to prepare the statement of cash flows using the indirect method.
Step 1: Establish the amount of the change in cash by finding the difference between beginning and ending cash shown on comparative balance sheets.
Step 2: Establish the amount of the net cash flows from operating activities by analyzing the income statement, comparative balance sheets, and selected transaction data. Start with net income, and convert it to net operating activities by adjusting items that affected reported net income but did not affect cash.
Step 3: Establish the amount of net cash flows from investing and financing activities by analyzing effects on applicable accounts shown on the comparative balance sheet.
Step 2 requires obtaining the net income amount from the income statement. Step 2 items require an adjustment to net income (an accrual amount) to obtain net cash flow from operating activities (a cash basis amount). Various common additions and subtractions from net income are part of this adjustment in order to derive net cash flow from operating activities.
Adjustments to Net Income
| Adjustments to Add to Net Income: | Adjustments to Subtract from Net Income: |
|---|---|
| Depreciation expense | |
| Amortization of discount on bonds payable | Amortization of premium on bonds payable |
| Amortization of intangibles or deferred charges | Decrease in deferred income taxes payable |
| Loss on sale of property, plant, and equipment | Gain on sale of property, plant, and equipment |
| Decrease in receivables | Increase in receivables |
| Decrease in inventory | Increase in inventory |
| Decrease in prepaid expenses | Increase in prepaids |
| Increase in payables or accrued liabilities | Decrease in payables or accrued liabilities |
Comparative Balance Sheets and Selected Transactions
Step 2: Start the operating activities section with net income, $11,000. Convert net income to net operating activities by adjusting items that affected reported net income but did not affect cash. This includes Depreciation Expense of $8,000 on the income statement, the increase in Accounts Receivable of $13,000 from the comparative balance sheets, the increase in Inventory of $10,000 from the comparative balance sheets, and the increase in Accounts Payables of $5,000 from comparative balance sheets.
Step 3: Include the effects of investing and financing activities. For investing activities, these include the purchase of building, $5,000 from comparative balance sheets; financing activities, sale of common stock, $20,000 from comparative balance sheets and selected information; and financing activities payment of dividends, $11,000 from selected information.Three Primary Steps of Indirect Method
Cash Flows from Operating, Investing, and Financing
After determining the net cash flow from operating activities, the next step is to obtain cash flows from investing activities. This process is the same for both the indirect and the direct methods of preparation of the statement of cash flows. Investing activities often include free cash flow, which is the discretionary cash flow amount available for purchasing additional investments, retiring debt, or increasing company liquidity. Investing cash inflows include cash from the sale of property, plant, and equipment; cash from the sale of debt or equity securities of other entities; and cash from the collection of principal on loans to other entities. Investing cash outflows for this section include cash to purchase property, plant, and equipment; cash to purchase debt or equity securities of other entities; and cash to make loans to other entities.
Financing activities are determined next and generally include cash changes in long-term liability and equity items. Financing cash inflows for this section include cash from the sale of equity securities and cash from the issuance of debt (such as notes and bonds). Financing cash outflows for this section include cash to stockholders in the form of dividends and cash to redeem long-term debt or reacquire capital stock (e.g., treasury stock). Under both the investing and financing sections, add or subtract the amount that increased or decreased cash. Simply consider the amount of cash that was spent (subtraction) or the amount of cash that was received (addition).
After determining the three cash-flow activity sections of operating, investing, and financing, the amounts are summed and then added to the cash at the beginning of the period in order to derive the cash at the end of the period. This net increase or decrease in cash, derived from the three activities, should reconcile the beginning and ending cash balances as reported in the comparative balance sheets.
Any investing or financing transactions that did not involve the exchange of cash would go into a fourth section, called the noncash investing and financing section. An example of this would be the purchase of a fixed asset with a note payable.