A cash flow statement prepared with the indirect method is a statement of cash flows that reaches net cash provided by operating activities by reconciling net income to it, adjusting for non-cash charges, for gains and losses whose cash effects belong to investing or financing, and for changes in operating working capital. The name describes the operating section only. The investing section, the financing section and the reconciliation to the change in total cash are presented identically under either method.
Below the operating subtotal nothing changes between the two methods. FASB ASC Topic 230 illustrates the same entity’s year twice, once with a direct operating section at ASC 230-10-55-10 and once with an indirect one at ASC 230-10-55-13, and the two carry the same sections and the same amounts (FASB Accounting Standards Update 2016-18).
What each section holds, and how the closing total ties to the balance sheet, is set out in the cash flow statement. The adjustment line by line, and a worked example where both methods reach the same subtotal, are in the operating cash flow formula.
The Statement Format, Top to Bottom
The reconciliation of net income may be reported inside the statement of cash flows or provided in a separate schedule, with the statement reporting only the operating subtotal (FASB Accounting Standards Update 2016-14, ASC 230-10-45-31).
Reported inside the statement, the operating section has a shape the other two sections do not. It opens on net income, runs the adjustments beneath it, strikes a total for them, and only then reaches the subtotal.
Cash flows from operating activities:
Net income 760
... noncash charges, gains and losses, and the
change in assets and liabilities ...
Total adjustments 595
Net cash provided by operating activities 1,355
Cash flows from investing activities:
Net cash used in investing activities (1,165)
Cash flows from financing activities:
Net cash provided by financing activities 875
Net increase in cash, cash equivalents and
restricted cash 1,065
Cash, cash equivalents and restricted cash,
beginning of year 600
Cash, cash equivalents and restricted cash,
end of year 1,665Entity A’s illustrative statement of cash flows prepared using the indirect method, shown at its subtotals (FASB Accounting Standards Update 2016-18, ASC 230-10-55-13).
That run of adjustments is the only part of the statement that explains a figure already reported instead of adding up cash that moved.
Interest Paid and Income Taxes Paid Have to Be Disclosed
The indirect presentation takes two amounts off the face of the statement, and the standard puts them back as a disclosure. If the indirect method is used, amounts of interest paid, net of amounts capitalized, and income taxes paid during the period shall be disclosed (FASB Accounting Standards Update 2016-15, ASC 230-10-50-2).
The reason is visible in the pair of illustrations. A direct operating section reports both amounts as classes on its face, and an indirect section reports neither, because it never lists payments by class at all.
Where a Firm Builds It From
The standard’s own illustration is built from Entity A’s comparative statement of financial position and its statement of income for the year (FASB Accounting Standards Update 2016-18, ASC 230-10-55-19), and a firm builds a client’s statement from the same two documents. Two balance sheet dates and an income statement come out of a closed trial balance. A direct section needs receipts and payments sorted into cash classes, which the books usually do not already carry.
What It Is Confused With
The indirect method is not the cash basis: an indirect-method statement changes nothing on the accrual statements it sits beside, while restating a client onto the cash method rewrites the income statement itself and can require the Commissioner’s consent. That change of accounting method is covered in the accrual to cash adjustment.
Common Questions
Start from net income, apply the adjustments the reconciliation calls for, and report the result as net cash provided by operating activities. The arithmetic is in the operating cash flow formula.
The presentation of the operating section, and one disclosure that follows from it. The direct section lists classes of cash received and cash paid, interest paid and income taxes paid among them, which is why an indirect-method statement has to disclose those two amounts instead. A business entity presenting the direct method still prepares the same reconciliation, as the operating cash flow formula sets out.
As a change in a balance. The movement in the inventory balance between the two balance sheet dates is a reconciling item, and showing it on its own is not a presentation choice: the reconciliation has to report all major classes of reconciling items separately, and changes during the period in operating receivables, in inventory and in operating payables are the named minimum (FASB Accounting Standards Update 2016-14, ASC 230-10-45-29). A decrease in inventory raises the operating subtotal, and an increase lowers it.
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