Joanne M. Flood - Wiley GAAP - Financial Statement Disclosure Manual

Thus, the statement of cash flows prepared using the indirect method emphasizes changes in the components of most current asset and current liability accounts. Changes in inventory, accounts receivable, and other current accounts are used to determine the cash flow from operating activities. Preparers calculate the change in accounts receivable using the balances net of the allowance account in order to ensure that write‐offs of uncollectible accounts are treated properly. Other adjustments under the indirect method include changes in the account balances of deferred income taxes and the income (loss) from investments reported using the equity method. However, short‐term borrowing used to purchase equipment is classified as a financing activity.

The major drawback to the indirect method involves the user's difficulty in comprehending the information presented. This method does not show the sources or uses of cash. Only adjustments to accrual‐basis net income are shown. In some cases, the adjustments can be confusing. For instance, the sale of equipment resulting in an accrual‐basis loss would require that the loss be added to net income to arrive at net cash from operating activities. (The loss was deducted in the computation of net income, but because the sale will be shown as an investing activity, the loss must be added back to net income.)

Reconciliation of Net Income and Net Cash Flow from Operating ActivitiesWhen the direct method is used, a schedule reconciling net income to net cash flows from operating activities must also be provided. That reconciliation must be presented in a separate schedule. (ASC 230‐10‐45‐30) That schedule reports the same information as the operating activities section prepared using the indirect method. Therefore, a firm must prepare and present both the direct and indirect methods when using the direct method for reporting cash from operating activities.

*If presented separately, the statement of cash flow reports only the net cash flow from operating activities. If the reconciliation is presented in the statement of cash flows, adjustments to net income to determine net cash flow from operating activities must be identified as reconciling items. (ASC 230‐10‐45‐31 and 45‐32)

The following exhibit demonstrates the classification of cash receipts and disbursements in the investing and financing activities of a statement of cash flows (though without detail of the required operating activities section).

Operating Activities PresentationThe operating activities section of the statement of cash flows can be presented under the direct method or the indirect method.

Exhibit—Converting Income Statement Amounts from the Accrual Basis to the Cash Basis—Direct Method