Companies may choose to use the indirect method when determining cash flows from operating activities. The indirect method solves for cash flows by identifying non-cash transactions that are included in net-income calculation, and then excluding them from computing cash flows. A major advantage of the indirect method of cash flows is that the method provides a reconciliation between net income and cash flows. The indirect method also helps financial-statement users better understand different linkages among financial statements and is a simple way of preparing the statement of cash flows.
Reconciled Cash Income
The indirect method of cash flows reconciles the accrual-based accounting net income with the actual cash flows from operating activities, showing how it may be different between a company's stated profitability and its cash holding position. Net income often includes revenues from sales on credit without cash actually collected from customers, resulting in a better income number but without contributing more to cash flows. Net income also takes into account of any non-cash expenses that reduce net income as reported but don't affect cash flows as they currently stand.
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The indirect method of preparing cash-flow statement requires the establishment of a direct link between the income statement and the balance sheet, which helps statement users to have a more systematic view about a company's financial statements. Many of a company's current assets and current liabilities shown on the balance sheet can be traced back to the company's operating activities summarized in the income statement. For example, an increase in the current asset of accounts receivable or the current liability of accounts payable also increases a related revenue or expense in the income statement.
Disclosed Non-cash Transactions
The disclosure of non-cash transactions when using the indirect method helps statement users better understand how non-cash transactions are factors of net income but not sources of cash flows. For example, when a non-cash expense, such as depreciation expense, is added back to net income to produce a seemingly higher cash-flow number, the depreciation expense has not become a source of cash flows. The non-cash depreciation expense did not have a decreasing effect on cash flows when initially deducted for net income, and therefore, it must be added back to net income to maintain its zero impact on cash flows.
Simplified Statement Format
The alternative method to the indirect method of cash flows is the direct method that straightly reports all cash receipts and cash payments from operating activities. When using the direct method, companies are required to disclose separately cash receipts and cash payments with detailed subcategories, which can make the statement to appear too clustered. Accounting rule-setting authorities also requires companies that use the direct method provide an additional reconciliation schedule on net income and cash flows. On the other hand, companies are allowed to use the indirect method alone by disclosing only changes in current assets and liabilities in a simpler statement format.