Operating activities section by indirect method

This article is focused on indirect method of preparing operating activities section of the statement of cash flows. If you are looking for direct method, please read ‘operating activities section by direct method’ article.

Contents:

• The indirect method
• Adjustments to reconcile net income to net cash flows from operating activities
• Formula
• Example of indirect method of operating activities section

The indirect method:

Under indirect method (also known as reconciliation method), we convert net operating income (or loss) to net cash provide (or used) by operating activities during the year. For this purpose, net operating income (or loss) figure is taken from the income statement and is adjusted for non cash expenses, timing differences and non operating gains or losses. The rest of this article explains how these adjustments are made to net operating income (or loss) to arrive at net cash flow from operating activities.

Adjustments to reconcile net income to net cash flows from operating activities:

Adjustments for non cash expenses:

Non-cash expenses reduce net operating income but do no affect cash. A popular example of non-cash expense is depreciation. The purchase of a depreciable asset is an investing activity and the outflow of cash that occurs as a result of such a purchase is reported under investing activities section.

As non-cash expenses reduce net operating income without reducing cash, they are added back to net operating income under indirect method. The other examples of expenses that require a similar treatment are depletion of natural resources, amortization of intangible assets and amortization of bond discounts etc. The following example illustrates the treatment of depreciation for preparing operating activities section.

Example:

The income statement of XYZ company shows a net income of $75,000 for the year ended 31 December, 2013. The only non cash expense reported in the income statement was depreciation of $2,200. How XYZ should treat the depreciation expense for preparing the operating activities section using indirect method?

Solution:

The depreciation is a non-cash expense that must be added back to net income as an adjustment to reconcile net income to net cash provided (or used) by operating activities. The proper presentation is given below:

Adjustments for timing differences:

Under accrual based accounting system, revenue is recognized when it is earned and expenses are recognized when the benefit is taken rather than the time the cash changes the hand.  For example, when we make a sale on account, we recognize it immediately rather than waiting for the time the customer will make the payment. We recognize it by debiting ‘Accounts Receivable’ account and crediting ‘Sales’ account. When a revenue is recorded without debiting cash, an asset is debited in place of cash or when an expense is recorded without crediting cash, a liability is credited in place of cash. The Accounts Receivable (an asset) in the above example is debited in place of cash on the event of a credit sale. So, recognition of revenues and expenses without debiting or crediting cash account give rise to assets and liabilities. The changes in the balances of such assets and liabilities over period represent differences between revenues and expenses recognized  for income statement purpose and the net cash flows from operating activities. The examples of accounts that create such timing differences include prepaid expenses, inventories, accounts receivable, accrued expenses payable, and accounts payable.

Adjustments for non operating gains or losses:

The gains and losses resulting from non operating activities are included in the income statement. Since these gains and losses are the result of non operating activities, their effect is eliminated by adding any non operating loss to and deducting any non operating gain from net operating income figure. For example, if a company sells some of its old equipment having a book value of $1,200 for $1,500. The gain of $300 ($1,500 – 1,200) will be considered for the computation of net operating income. If a statement of cash flows is prepared, the gain of $300 will, therefore, be deducted from the net operating income in the operating activities section and the total proceeds of $1,500 will be shown in the investing activities section of the statement of cash flows. Other examples of gains and losses that require a similar treatment are gains or losses on discontinued operations, and gains on early payment of debts etc.

Formula:

The above adjustments can be presented in the form of the following formula:

Example of indirect method of operating activities section:

The single step income statement for the year ending 2013 and the selected data from comparative balance sheet of XYZ company is given below:

Required: Prepare operating activities section of XYZ company using indirect method.

Solution:

• Note 1 – depreciation expense:
  It is a non-cash expense that reduces net income but does not affect cash. It is, therefore, added back to the net income.
• Note 2 – decrease in interest receivable:
  $6000 – $4,000
• Note 3 – increase in accounts payable: 
  $122,000 – $152,000
• Note 4 – increase in interest payable:
  $44,000 – $30,000
• Note 5 – loss on sale of marketable securities:
  It is a non operating loss. It reduces net income and is, therefore, added back to net income to calculate net cash flows from operating activities. Sale of marketable securities is an investing activity and the total cash received from such sale will be included in the investing activities section.
• Note 6 – increase in accounts receivable:
  $220,000 – $160,000
• Note 7 – increase in inventory:
  $200,000 – $180,000
• Note 8 – increase in prepaid expenses:
  $8,000 – $6,000
• Note 9 – decrease in operating expenses payable:
  $18,000 – $6,000
• Note 10 – decrease in income tax payable:
  $20,000 – 16,000
• Note 11 – gain on sale of plant assets:
  It is a non operating gain. It increases net income and is, therefore, deducted from net income to calculate net cash flows from operating activities. The sale of plant assets is an investing activity. The total sale proceeds will be reported in investing activities.