20.2 Statement of Cash Flows: Indirect Method Review

The statement of cash flows using the indirect method has been discussed in most introductory accounting courses. Since the statement of cash flows can be challenging, a review of the basic concepts is presented below.

The purpose of the statement of cash flows is to provide a means “to assess the enterprise’s capacity to generate cash and cash equivalents, and to enable users to compare cash flows of different entities” (CPA Canada, 2016, Accounting, Part II, Section 1540.01 and IAS 7.4). This statement is an integral part of the financial statements for three reasons. First, this statement helps readers to understand where these cash flows in (out) originated from during the current year. This helps management, shareholders, and creditors to assess a company’s liquidity, solvency, and financial flexibility. Second, these historic cash flows in (out) can be used to predict future company performance. Third, the statement of cash flows can shed light on a company’s quality of earnings and if there may be a disconnect between reported earnings and net cash flows from operating activities, as explained earlier.

Two methods are used to prepare a statement of cash flows, namely the indirect method and the direct method. The indirect method was discussed in previous accounting courses and will be reviewed again in this chapter. The direct method introduced in this chapter may be new for many students. Both methods organize the reported cash flows into three activities: operating, investing, and financing. As discussed next, the difference between the two methods occurs only in the first section for operating activities.

The indirect method reports cash flows from operating activities into categories such as:

Net income/loss is reported.
A series of adjustments to net income/loss for non-cash items are reported in the income statement.
Changes in each non-cash working capital account. The current portion of long-term debt, including lease obligations and dividends payable, are not considered to be working capital accounts. They are included with their respective account to which they relate. For example, the current portion of long-term debt or lease is included with its related long-term liability account. Dividends payable is included with its related retained earnings account.

The direct method reports cash flows from operating activities into categories based on the nature of the cash flows, such as:

cash received for sales
cash paid for goods and services
cash paid to or on behalf of employees
cash received and paid for interest
cash received and paid for dividends
cash paid for income taxes

The statement of cash flows above for Wellbourn Services Ltd. is an example of a statement using the direct method. Note that the operating section line items using the direct method are based on the nature of the cash flows, whereas the indirect method line items are based on their connections with the income statement and working capital accounts.

There are some similarities between the two methods. For instance, the net cash flows from operating activities is the same for both methods, and the investing and financing activities are identical for both methods as well.

Below is an example of the format using the indirect method. Note the connections to the other financial statements.

Statement of Cash Flows

20.2.1. Differences Between IFRS and ASPE

There are differences in some of the reporting items between IFRS and ASPE. For example, ASPE has mandatory disclosures as follows:

cash dividends received and interest received or paid if reported in net income – operating section
interest or cash dividends debited to retained earnings – financing section
Cash paid income taxes are often reported separately but it is not a reporting requirement.

For IFRS, there are policy choices that, once made, should be applied consistently:

interest received – choice of operating or investing section
interest paid – choice of operating or financing section
dividends received – choice of operating or investing section
dividends paid – choice of operating or financing section
cash paid income taxes – separately reported

For simplicity, this chapter will use the following norms for both IFRS and ASPE:

interest received – operating section
interest paid – operating section
dividends received – operating section
dividends paid – financing section
income taxes paid – separately reported

As illustrated above, when using the indirect method, the sum of the non-cash adjustments to net income and changes to non-cash working capital accounts result in the total cash flows in (out) from operating activities. The other two activities for investing and financing follow. Any non-cash transactions occurring in the investing or financing sections are not reported in a statement of cash flows. Instead, they are disclosed separately in the notes to the financial statements. Examples of non-cash transactions would be an exchange of property, plant, or equipment for common shares, or the conversion of convertible bonds payable to common shares and stock dividends. If the transaction is a mix of cash and non-cash, the cash-related portion of the transaction is reported in the statement of cash flows with a note in financial statements detailing the non-cash and cash elements. The final section of the statement reconciles the net change in cash flows of the three activities, with the opening and closing cash and cash equivalents balances taken from the balance sheet.

20.2.2. Preparing a Statement of Cash Flows: Indirect Method

Presented below is the balance sheet and income statement for Watson Ltd.

Common (authorized, 400,000 shares; issued and outstanding (O/S) 250,000 shares for 2020);(2019: 200,000 shares issued and O/S)

Watson Ltd. Income Statement As at December 31, 2020
Sales	$3,500,000
Cost of goods sold	2,100,000
Gross profit	1,400,000
Operating expenses
Salaries and benefits expense	800,000
Depreciation expense	43,000
Travel and entertainment expense	134,000
Advertising expense	35,000
Freight-out expenses	50,000
Supplies and postage expense	12,000
Telephone and internet expense	125,000
Legal and professional expenses	48,000
Insurance expense	50,000
1,297,000
Income from operations	103,000
Other revenue and expenses
Dividend income	3,000
Interest income from investments	2,000
Gain from sale of building	5,000
Interest expense	(3,000)
7,000
Income from continuing operations before income tax	110,000
Income tax expense	33,000
Net income	77,000

The trading investment does not meet the criteria to be classified as a cash equivalent (see section 20.8 Specific Items for a discussion on cash equivalents) and no purchases or sales took place in the current year.
An examination of the intangible assets sub-ledger revealed that a patent had been sold in the current year. The intangible assets have an indefinite life.
No long-term investments were sold during the year.
No buildings or patents were purchased during the year.
There were no other additions to the long-term note payable during the year.
Common shares were sold for cash. No other share transactions occurred during the year.
Cash dividends were declared and paid.
The note receivable maturity date is January 31, 2021, and was for a sale.

The statement of cash flows is the most complex statement to prepare. This is because preparation of the entries requires analysis of multiple accounts. Moreover, the transactions resulting in cash inflows are to be differentiated from the transactions resulting in cash outflows for each account. Preparing a statement of cash flows is made much easier if specific sequential steps are followed. Below is a summary of those steps.

Complete the statement headings.
Operating activities section – record the net income/(loss).
Adjust out any non-cash line items reported in the income statement to remove them from the statement of cash flows. Examples of these are depreciation, amortization, and most gains or losses such as gains/losses from the sale of assets, gain/loss from redemption of debt, impairment losses, and fair value changes reported in net income.
Record the description and change amount for each non-cash working capital account (current assets and current liabilities) except for the current portion of long-term debt line item since it is not a working capital account. Subtotal the operating activities section.
Investment activities section – using T-accounts or other techniques, determine the change for each non-current (long-term) asset account. Analyze and determine the reason for the change(s). Record the reason and change amount(s) as cash inflows or outflows.
Financing activities section – add back to long-term debt any current portion identified in the SFP/BS for both years, if any. Using T-accounts, or other techniques, determine the change for each non-current (long-term) liability and equity account. Analyze and determine the reason for the change(s). Record the reason and change amount(s) as cash inflows or outflows. One anomaly occurs with pension benefit liability. This liability is non-current, but it is not a financing activity as its nature is to benefit employees. For this reason, any change in funding for the pension liability, even though classified as non-current, is to be reported in operating activities.
Subtotal the three sections. Record the opening and closing cash, including cash equivalents, if any. Reconcile the opening balance plus the subtotal from the three sections to the closing balance to ensure that the accounts balance correctly.
Complete any required disclosures.

Here is a summary of the steps above, labelled with a key word or phrase for you to remember:

Headings
Record net income/(loss)
Adjust out non-cash items
Current assets and current liabilities changes
Non-current asset accounts changes
Non-current liabilities and equity accounts changes
Subtotal and reconcile
Disclosures

Applying the Steps:

Step 1. Headings:

Step 2. Record net income/(loss):

As illustrated in step 3 below.

Step 3. Adjustments:

income sheet connections

Enter the amount of the net income/(loss) as the first amount in the operating activities section. Next, review the income statement and select all the non-cash items. Look for items such as depreciation, depletion, amortization, and gains or losses (such as with the sale or disposal of assets). In this case, there are two non-cash items to adjust from net income. Record them as adjustments to net income in the statement of cash flows.

Step 4. Current assets and liabilities:

Calculate and record the change between the opening and closing balances for each non-cash working capital account as shown below (with the exception of the current portion of long-term notes payable, which is netted with its respective long-term notes payable account) as shown below:

account equation and statement of cash flows

Cash inflows to the company are reported as positive numbers while cash outflows are reported as negative numbers using brackets. How does one determine if the amount is a positive or a negative number? A simple tool is to use the accounting equation to determine whether cash is increasing as a positive number or decreasing as a negative number. Recall the accounting equation:

Assets = Liabilities + Equity

This must always remain in balance. This equation can be applied when analyzing the various accounts to record the changes. For example, accounts receivable has increased from $165,000 to $249,510 for a total increase of $84,510. Using the accounting equation, this can be expressed as:

A = L + E

Expanding the equation a bit:

Cash + accounts receivable + all other assets = Liabilities + Equity

If accounts receivable INCREASES by $84,510, then this can be expressed as a black up-arrow above the account in the equation:

Holding everything in the equation constant, except for cash, if accounts receivable INCREASES, then the effect on the cash account must have a corresponding DECREASE in order to keep the equation balanced:

If cash DECREASES, then it is a cash outflow and the number must be negative with brackets as shown in the statement above.

Conversely, when analyzing liability or equity accounts, the same technique can be used. For example, an increase in account payable (liability) of $143,000 will affect the equation as follows:

Again, holding everything else constant except for cash, if accounts payable INCREASES as shown by the black up-arrow above, then cash must also INCREASE by a corresponding amount in order to keep the equation in balance.

If cash INCREASES, then it is a cash inflow and the number will be positive with no brackets as shown in the statement above.

Step 5. Non-current asset changes:

The next section to complete is the investing activities section. The analysis of all of the non-current assets accounts must also take into account whether there have been any current year purchases, disposals, or adjustments as part of the analysis. The use of T-accounts for this type of analysis provides a useful visual tool to help understand whether the changes that occurred in the account are cash inflows or outflows, as shown below.

Cash flows from investing activities

There are four non-current asset accounts: long-term investments, land, buildings, and intangible assets. The land account had no change, as there were no purchases or sales of land. Analyzing the investment account results in the following cash flows: