Wednesday, December 12, 2018

And Now...A Lesson In Accounting: Indirect Method Computing Cash Flows From Operating Activities

A small departure from the usual technical topics. As many of you know, I'm studying business these days. The lesson of the day is about how accountants arrive at the cash flows from operating activities for the cash flow statement.
The statement of cash flows is useful in understanding how cash moves (flows) through a company. You use it to evaluate the company's ability to repay debts. That will determine how much investors and creditors they're willing to invest or lend the company.

Indirect Method For Operating  Cash Flows

If the first section of the statement of cash flows seems odd, the accountant is probably using the indirect method of computing cash flows from operations. See, it's difficult to compute cash flows from operations directly. Instead, they start with your net income and factor out changes in current operating assets and liabilities that are not cash.

For example, let's say your company has a current asset of $100,000 in accounts receivable. In that case, you don't have the $100,000 in cash — at least not yet — so you can't count that as cash inflows. Your accountant subtracts it from your net income to factor it out.

For other types of non-cash accounts that contribute to net income, the balance may be added or subtracted depending on the type of account. Depreciation expense is added to net income. And, any gains on the sale of assets are subtracted from (losses are added to) net income. After all these adjustments are made, the result is the net cash flows from operating activities.

Direct Method for Investing and Financing Cash Flows

After the cash flows from operating activities, you should see the cash flows from investing activities followed by the cash flows from financing activities. These are shown using the direct method. The records for changes in cash due to investing and financing activities are readily available.

The Bottom Line

Once you have an understanding of how the statement of cash flows works, you should find it useful in understanding how a business is receiving (inflows) and using (outflows) cash.

Warren C., Reeve J. M. & Duchac J. (2016). Financial and managerial accounting (14th Ed.). Boston, MA: Cengage Learning.

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