Application of the Indirect Method of Reporting Cash Flows

Net income is computed using accrual accounting, which recognizes revenues when earned and expenses when incurred. Revenues and expenses do not necessarily reflect the receipt and payment of cash. The indirect method of computing and reporting net cash flows from operating activities involves adjusting the net income figure to obtain the net cash provided or used by operating activities. This includes subtracting noncash increases (credits) from net income and adding noncash charges (debits) back to net income.

Point: Noncash credits refer to revenue amounts reported on the income statement that are not collected in cash this period. Noncash charges refer to expense amounts reported on the income statement that are not paid this period.

To illustrate, the indirect method begins with Genesis’s net income of $38,000 and adjusts it to obtain net cash provided by operating activities of $20,000. Exhibit 16.11 shows the results of the indirect method of reporting operating cash flows, which adjusts net income for three types of adjustments. There are adjustments to ① reflect changes in noncash current assets and current liabilities related to operating activities, ② to income statement items involving operating activities that do not affect cash inflows or outflows, and ③ to eliminate gains and losses resulting from investing and financing activities (not part of operating activities). This section describes each of these adjustments.

EXHIBIT 16.11 Statement of Cash Flows— Indirect Method

① Adjustments for Changes in Current Assets and Current Liabilities  This section describes adjustments for changes in noncash current assets and current liabilities.
Adjustments for changes in noncash current assets. Changes in noncash current assets normally result from operating activities. Examples are sales affecting accounts receivable and building usage affecting prepaid rent. Decreases in noncash current assets yield the following adjustment:

Decreases in noncash current assets are added to net income.

To see the logic for this adjustment, consider that a decrease in a noncash current asset such as accounts receivable suggests more available cash at the end of the period compared to the beginning. This is so because a decrease in accounts receivable implies higher cash receipts than reflected in sales. We add these higher cash receipts (from decreases in noncash current assets) to net income when computing cash flow from operations.

Point: Operating activities are typically those that determine income, which are often reflected in changes in current assets and current liabilities.

In contrast, an increase in noncash current assets such as accounts receivable implies less cash receipts than reflected in sales. As another example, an increase in prepaid rent indicates that more cash is paid for rent than is deducted as rent expense. Increases in noncash current assets yield the following adjustment:

Increases in noncash current assets are subtracted from net income.

To illustrate, these adjustments are applied to the noncash current assets in Exhibit 16.10.
Accounts receivable. Accounts receivable increase $20,000, from a beginning balance of $40,000 to an ending balance of $60,000. This increase implies that Genesis collects less cash than is reported in sales. That is, some of these sales were in the form of accounts receivable and that amount increased during the period. To see this it is helpful to use account analysis. This usually involves setting up a T-account and reconstructing its major entries to compute cash receipts or payments. The following reconstructed Accounts Receivable T-account reveals that cash receipts are less than sales:




We see that sales are $20,000 greater than cash receipts. This $20,000—as reflected in the $20,000 increase in Accounts Receivable—is subtracted from net income when computing cash provided by operating activities (see Exhibit 16.11).

Merchandise inventory. Merchandise inventory increases by $14,000, from a $70,000 beginning balance to an $84,000 ending balance. This increase implies that Genesis had greater cash purchases than cost of goods sold. This larger amount of cash purchases is in the form of inventory, as reflected in the following account analysis:




Point: Refer to Exhibit 16.10 and identify the $5,000 change in cash. This change is what the statement of cash flows explains; it serves as a check.

The amount by which purchases exceed cost of goods sold—as reflected in the $14,000 increase in inventory—is subtracted from net income when computing cash provided by operating activities (see Exhibit 16.11).

Prepaid expenses. Prepaid Expenses increase $2,000, from a $4,000 beginning balance to a $6,000 ending balance, implying that Genesis’s cash payments exceed its recorded prepaid expenses. These higher cash payments increase the amount of Prepaid Expenses, as reflected in its reconstructed T-account:



The amount by which cash payments exceed the recorded operating expenses—as reflected in the $2,000 increase in Prepaid Expenses—is subtracted from net income when computing cash provided by operating activities (see Exhibit 16.11).

Adjustments for changes in current liabilities.  Changes in current liabilities normally result from operating activities. An example is a purchase that affects accounts payable. Increases in current liabilities yield the following adjustment to net income when computing operating cash flows:

Increases in current liabilities are added to net income.

To see the logic for this adjustment, consider that an increase in the Accounts Payable account suggests that cash payments are less than the related (cost of goods sold) expense. As another example, an increase in wages payable implies that cash paid for wages is less than the recorded wages expense. Since the recorded expense is greater than the cash paid, we add the increase in wages payable to net income to compute net cash flow from operations.
Conversely, when current liabilities decrease, the following adjustment is required:

Decreases in current liabilities are subtracted from net income.

To illustrate, these adjustments are applied to the current liabilities in Exhibit 16.10.
Accounts payable. Accounts payable decrease $5,000, from a beginning balance of $40,000 to an ending balance of $35,000. This decrease implies that cash payments to suppliers exceed purchases by $5,000 for the period, which is reflected in the reconstructed Accounts Payable T-account:



The amount by which cash payments exceed purchases—as reflected in the $5,000 decrease in Accounts Payable—is subtracted from net income when computing cash provided by operating activities (see Exhibit 16.11).

Interest payable. Interest payable decreases $1,000, from a $4,000 beginning balance to a $3,000 ending balance. This decrease indicates that cash paid for interest exceeds interest expense by $1,000, which is reflected in the Interest Payable T-account:



The amount by which cash paid exceeds recorded expense—as reflected in the $1,000 decrease in Interest Payable—is subtracted from net income (see Exhibit 16.11).

Income taxes payable. Income taxes payable increase $10,000, from a $12,000 beginning balance to a $22,000 ending balance. This increase implies that reported income taxes exceed the cash paid for taxes, which is reflected in the Income Taxes Payable T-account:



The amount by which cash paid falls short of the reported taxes expense—as reflected in the $10,000 increase in Income Taxes Payable—is added to net income when computing cash provided by operating activities (see Exhibit 16.11).



② Adjustments for Operating Items Not Providing or Using Cash  The income statement usually includes some expenses that do not reflect cash outflows in the period. Examples are depreciation, amortization, depletion, and bad debts expense. The indirect method for reporting operating cash flows requires that

Expenses with no cash outflows are added back to net income.

To see the logic of this adjustment, recall that items such as depreciation, amortization, depletion, and bad debts originate from debits to expense accounts and credits to noncash accounts. These entries have no cash effect, and we add them back to net income when computing net cash flows from operations. Adding them back cancels their deductions.
Similarly, when net income includes revenues that do not reflect cash inflows in the period, the indirect method for reporting operating cash flows requires that

Revenues with no cash inflows are subtracted from net income.

We apply these adjustments to the Genesis operating items that do not provide or use cash.
Depreciation.  Depreciation expense is the only Genesis operating item that has no effect on cash flows in the period. We must add back the $24,000 depreciation expense to net income when computing cash provided by operating activities. (We later explain that any cash outflow to acquire a plant asset is reported as an investing activity.)

③ Adjustments for Nonoperating Items  Net income often includes losses that are not part of operating activities but are part of either investing or financing activities. Examples are a loss from the sale of a plant asset and a loss from retirement of notes payable. The indirect method for reporting operating cash flows requires that

Nonoperating losses are added back to net income.

To see the logic, consider that items such as a plant asset sale and a notes retirement are normally recorded by recognizing the cash, removing all plant asset or notes accounts, and recognizing any loss or gain. The cash received or paid is not part of operating activities but is part of either investing or financing activities. No operating cash flow effect occurs. However, because the nonoperating loss is a deduction in computing net income, we need to add it back to net income when computing cash flow from operations. Adding it back cancels the deduction.
Point: An income statement reports revenues, gains, expenses, and losses on an accrual basis. The statement of cash flows reports cash received and cash paid for operating, financing, and investing activities.
Similarly, when net income includes gains not part of operating activities, the indirect method for reporting operating cash flows requires that

Nonoperating gains are subtracted from net income.

To illustrate these adjustments, we consider the nonoperating items of Genesis.

Loss on sale of plant assets.  Genesis reports a $6,000 loss on sale of plant assets as part of net income. This loss is a proper deduction in computing income, but it is not part of op-erating activities. Instead, a sale of plant assets is part of investing activities. Thus, the $6,000 nonoperating loss is added back to net income (see Exhibit 16.11). Adding it back cancels the loss. We later explain how to report the cash inflow from the asset sale in investing activities.

Gain on retirement of debt.  A $16,000 gain on retirement of debt is properly included in net income, but it is not part of operating activities. This means the $16,000 nonoperating gain must be subtracted from net income to obtain net cash provided by operating activities (see Exhibit 16.11). Subtracting it cancels the recorded gain. We later describe how to report the cash outflow to retire debt.

Summary of Adjustments for Indirect Method

Exhibit 16.12 summarizes the most common adjustments to net income when computing net cash provided or used by operating activities under the indirect method.

EXHIBIT 16.12 Summary of Selected Adjustments for Indirect Method * Excludes current portion of long-term debt and any (nonsales-related) short-term notes payable—both are financing activities.

The computations in determining cash provided or used by operating activities are different for the indirect and direct methods, but the result is identical. Both methods yield the same $20,000 figure for cash from operating activities for Genesis; see Exhibits 16.7 and 16.11.