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16.3 Prepare the Statement of Cash Flows Using the Indirect Method

Indirect Method​

Indirect Method:

  • Starts with net income
  • Adjusts for non-cash items
  • Adjusts for changes in current assets/liabilities
  • Shows cash from operations

Operating Activities (Indirect Method)​

Format:

Net Income
+ Depreciation Expense
+ Loss on Sale of Assets
- Gain on Sale of Assets
+ Decrease in Current Assets
- Increase in Current Assets
+ Increase in Current Liabilities
- Decrease in Current Liabilities
= Cash from Operating Activities

Example​

Information:

  • Net Income: €50,000
  • Depreciation: €10,000
  • Accounts Receivable increased: €5,000
  • Inventory increased: €3,000
  • Accounts Payable increased: €2,000
  • Salaries Payable decreased: €1,000

Calculation:

Net Income                          €50,000
+ Depreciation                       10,000
- Increase in Accounts Receivable    (5,000)
- Increase in Inventory              (3,000)
+ Increase in Accounts Payable        2,000
- Decrease in Salaries Payable       (1,000)
Cash from Operating Activities       €53,000

Explanation:

  • Net Income: Starting point
  • Depreciation: Added back (non-cash expense)
  • Increase in Accounts Receivable: Subtracted (cash not yet received)
  • Increase in Inventory: Subtracted (cash used to buy inventory)
  • Increase in Accounts Payable: Added (cash not yet paid)
  • Decrease in Salaries Payable: Subtracted (cash was paid)

Common Adjustments​

Non-Cash Items (Add Back):

  • Depreciation expense
  • Amortization expense
  • Loss on sale of assets
  • Bad debt expense (if using allowance method)

Non-Cash Items (Subtract):

  • Gain on sale of assets

Current Asset Changes:

  • Increase: Subtract (cash used)
  • Decrease: Add (cash freed up)

Current Liability Changes:

  • Increase: Add (cash not yet paid)
  • Decrease: Subtract (cash was paid)

Complete Example: Operating Activities​

Income Statement:

  • Net Income: €80,000
  • Depreciation: €15,000
  • Loss on Sale of Equipment: €2,000

Balance Sheet Changes:

  • Accounts Receivable: +€8,000
  • Inventory: -€3,000
  • Prepaid Expenses: +€1,000
  • Accounts Payable: +€5,000
  • Salaries Payable: -€2,000
  • VAT Payable: +€1,000

Calculation:

Net Income                          €80,000
+ Depreciation                       15,000
+ Loss on Sale of Equipment           2,000
- Increase in Accounts Receivable    (8,000)
+ Decrease in Inventory               3,000
- Increase in Prepaid Expenses       (1,000)
+ Increase in Accounts Payable        5,000
- Decrease in Salaries Payable       (2,000)
+ Increase in VAT Payable             1,000
Cash from Operating Activities       €95,000

Luxembourg Compliance Note​

Indirect method in Luxembourg:

  • Most common method
  • Must follow PCN format
  • Must show all adjustments
  • Must comply with standards

Think It Through​

Why does an increase in accounts receivable reduce cash from operations?