Definition: The indirect method is a reporting format for the cash flow statement that starts with net income and adjusts it for the cash operating activities during the year to arrive at the ending cash balance. In other words, it is a way to format the statement of cash flows and calculate the ending cash balance for the year.
What Does Indirect Method Mean?
Both the direct and indirect methods can be used to format the statement of cash flows and the ending outcome will be the same. They will both show the operating, investing, and financing cash activities, but the formatting is much different. Both of these methods present the investing and financing activities the same. The only difference between a direct cash flow statement and indirect one is the operating activities section.
Unlike the direct method, the indirect method does not list the individual cash items and transactions that were made throughout the year in the operating section. Instead, only the adjustments to income are listed in this section. You can think of it like listing account changes and how they affect income and or cash.
For example, let’s assume accounts receivable increased by $10,000 during the year. This means accounts receivable was debited $10k and income what credited $10k. So in order to adjust income for this non-cash transaction, we would reduce income by $10,000 in our operating activities section.
As you can see without having to list all transactions during a period, the statement becomes much easier to prepare and compute. It also shows how each account affects income. Although the FASB recommends preparing statements using the direct method, over 90% of companies use the indirect form of reporting.