Review of the indirect method - interim accounting 2 (2023)

The statement of cash flows using the indirect method has been covered in most introductory accounting courses. As the cash flow statement can be challenging, here is an overview of the basics.

The purpose of the statement of cash flows is to provide a means "to assess an entity's ability to generate cash and cash equivalents and to enable users to compare the 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 explanation helps readers understand where these year-to-date cash flows come from. This helps management, shareholders and creditors assess a company's liquidity, solvency and financial flexibility. Second, these historical cash inflows and outflows can be used to predict future business performance. Third, the statement of cash flows can provide information about the quality of a company's earnings and whether, as noted above, there may be a discrepancy between reported earnings and net cash flows from operations.

Two methods are used to prepare a statement of cash flows, namely the indirect method and the direct method. The indirect method has been discussed in previous accounting courses and will be reviewed in this chapter. The straightforward method presented in this chapter may be new to many students. Both methods divide the reported cash flows into three activities: operating, investing, and financing. As will be discussed later, the difference between the two methods is only in the first section for operational activities.

In the indirect method, cash flows from operating activities are broken down into categories such as:

• Net profit/loss is reported.
• A series of adjustments to net profit/loss for non-monetary items are recorded in the income statement.
• Changes in each non-cash working capital account. The current portion of long-term liabilities, including lease obligations and dividends payable, are not considered working capital accounts. They are included in the respective account to which they refer. For example, the current portion of a long-term liability or lease is recorded in the associated long-term liability account. Dividends payable are included in the associated retained earnings account.

In the direct method, cash flows from operating activities are categorized based on the nature of the cash flows, for example, for example:

• money received from sales
• Cash payment for goods and services.
• Money paid to or on behalf of employees
• money received and paid for interest
• Cash received and paid for dividends
• income tax paid in cash

The above cash flow statement for Wellbourn Services Ltd. is an example of a direct method demonstration. Note that items in the operating section that use the direct method are based on the nature of the cash flows, while items in the indirect method are based on their connections to the income statement and working capital accounts.

There are some similarities between the two methods. Net cash flows from operating activities are the same for both methods and investing and financing activities are also identical for both methods.

Below is an example of the format using the indirect method. Consider connections to other degrees.

20.2.1. Differences between IFRS and ASPE

There are differences in some elements of information between IFRS and ASPE. For example, ASPE has the following mandatory disclosures:

• cash dividends received and interest received or paid when indicated in the Net Income - Operations section
• Interest or cash dividends charged on retained earnings - Financing Section
• Income taxes paid in cash are usually reported separately, but this is not a reporting requirement.

There are policy decisions for IFRS that, once taken, must be applied consistently:

• Interest Received – choice of operation or investment phase
• Interest paid: choice of operational or financing phase
• Dividends received - Choice of operation or investment section
• Dividends paid: choice of operating or financial part
• Income tax paid in cash - separately disclosed

For simplicity, the following standards are used in this chapter for both IFRS and ASPE:

• Interest earned – part of the deal
• Interest paid: part of the deal
• Dividends Received - Business Unit
• Dividends Paid - Financing Section
• Income Tax Paid: Disclosed Separately

As shown above, using the indirect method, the sum of the non-cash adjustments to net income and the changes in the non-cash working capital accounts gives the total cash flow from operating activities. The other two investment and financing activities follow. Any non-cash transactions that occur in the investment or financing tranche are not reflected in the statement of cash flows. Instead, they are shown separately in notes. Examples of non-cash transactions would be the exchange of property, plant and equipment for common stock or the conversion of convertible debentures payable into common stock and stock dividends. If the transaction is a combination of cash and cash, the cash portion of the transaction is reflected in the statement of cash flows with a note to the financial statements detailing the cash and cash items. The final section of the statement reconciles the net change in cash flows for the three activities with the opening and ending balances of cash and cash equivalents on the balance sheet.

20.2.2. Preparing a Statement of Cash Flows: Indirect Method

Below is the balance sheet and profit and loss account for Watson Ltd.

Additional information:

• The business investment does not meet the criteria for classification as a cash equivalent (see Section 20.8 Specific Items for a discussion of cash equivalents) and there were no purchases or sales in the current year.
• An examination of the intangible assets auxiliary ledger revealed that one patent was sold in the current year. Intangible assets have an unlimited useful life.
• No long-term investments were sold during the year.
• No buildings or patents were acquired during the year.
• There were no new additions to long-term debt during the year.
• Common shares were sold for cash. There were no further stock transactions during the year.
• Cash dividends have been declared and paid.
• The due date of the bill of exchange receivable is January 31, 2021 and was intended for sale.

The cash flow statement is the most complex statement to prepare. This is because preparing the journal entries requires analyzing multiple accounts. Furthermore, the transactions that give rise to cash inflows and the transactions that give rise to cash outflows must be differentiated for each account. Preparing a statement of cash flows becomes much easier when certain sequential steps are followed. Below is a summary of these steps.

• Complete the sentence titles.
• Operations section: Record net profit/(loss).
• Correct all non-cash items reported on the income statement to remove them from the statement of cash flows. Examples include depreciation, amortization and most gains or losses, such as gains/losses on asset sales, gains/losses on extinguishment of debt, impairment losses and changes in fair value recognized in profit or loss.
• Record the description and variance amount for each non-cash working capital account (current assets and current liabilities) except the short-term portion of the long-term credit facility, as this is not a working capital account. Subtotal of the Operational Activities section.
• Investing activities section: Using T-accounts or other techniques, determine the change for each long-term (long-term) asset account. Analyze and determine the reason for the changes. Record the reason and amounts for the change as cash inflows or outflows.
• Financing Activities Section: Add the current portion identified in the SFP/BS for both years to Long-Term Debt, if applicable. Using T-accounts or other techniques, determine the change for each long-term (long-term) liability and equity account. Analyze and determine the reason for the changes. Record the reason and amounts for the change as cash inflows or outflows. An anomaly occurs in the social security obligation. This responsibility is long term but does not constitute a funding activity as its inherent intent is to benefit employees. For this reason, any change in the funding of the pension obligation, even if it is classified as long-term, must be reported in operating activities.
• Add the three sections. Take into account the opening and closing of cash funds, including cash equivalents, if any. Reconcile the opening balance plus the subtotal of the three sections with the ending balance to ensure the account balance is correct.
• Complete all necessary disclosures.

Here is a summary of the above steps, marked with a keyword or phrase to remember:

1. holders
2. Record the net profit/(loss).
3. Balance of non-monetary items
4. Changes in current assets and short-term liabilities
5. Changes to long-term asset accounts
6. Changes in long-term debt and capital accounts
7. Subtotal and reconcile
8. disclosure

Applying the steps:

Step 1. Headers:

Step 2. Record net profit/(loss):

As shown in step 3 below.

Step 3. Settings:

Enter the net profit/(loss) value as the first value in the Transactions section. Then review the income statement and select any non-cash items. Look for items such as depreciation, depletion, amortization, and gains or losses (for example, on the sale or disposal of assets). In this case, there are two non-cash items that must be adjusted from net income. Display these as adjustments to net income on 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 (except the current portion of long-term debt, which is offset by its respective debt account long term). As shown below:

Cash inflows to the business are given as positive numbers, while cash outflows are given as negative numbers in parentheses. How do you determine if the quantity is a positive or negative number? A simple tool is to use the balance sheet equation to determine whether cash increases as a positive number or decreases as a negative number. Remember the billing equation:

Assets = Liabilities + Shareholders' Equity

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

A = L + E

Expand the equation a little:

Cash + Accounts Receivable + All Other Assets = Liabilities + Shareholders' Equity

If accounts receivable INCREASE $84,510, this can be expressed as a black upward arrow on the account in the equation:

Keeping everything in the equation constant except cash, if claims ARE DUE, then the impact on the cash account must have a corresponding DECREASE to keep the equation in balance:

If the cash is LOW, it is a draw and the number must be negative in parentheses as demonstrated in the statement above.

On the other hand, the same technique can be used when analyzing liability or equity accounts. For example, an increase in accounts payable (accounts payable) by $143,000 would affect the equation as follows:

Holding everything else but cash constant, cash must also increase by a corresponding amount to keep the equation in balance as liabilities increase, as indicated by the black upward arrow above.

If the cash INCREASES, it is a cash entry and the number is positive without parentheses, as shown in the statement above.

Step 5. Changes to Fixed Assets:

The next section to complete is the Investing Activities section. When analyzing all property, plant and equipment accounts, as part of the analysis it is also necessary to take into account whether there were purchases, sales or adjustments during the current year. Using T-accounts for this type of analysis provides a useful visual tool to understand whether changes in the account are cash inflows or outflows, as shown below.

There are four long-term asset accounts: long-term investments, land, buildings, and intangible assets. The land account did not change since there was no purchase or sale of land. Analysis of the investment account results in the following cash flows:

The construction account analysis is a little more complex due to the impact of the accumulated depreciation offset account. In this case, the building account and its time trial account must be merged as the SFP/BS only reports the net book value. Analysis of the building account results in the following cash flows:

The sale of the patent is straightforward, as there have been no other sales, purchases, or cancellations in the current year (as noted in steps 2 and 4).

Step 6. Long-term debt and changes in equity:

There are five long-term equity and liability accounts: bonds, preferred stock, common stock, contributed surplus, and retained earnings. There was no change in the preferred stock and retained earnings accounts. Please note that the fact that an account balance has not changed during the year does not necessarily mean that there were no transactions. For example, old shares can be canceled and new shares issued with the same face value. These transactions must be reflected in the statement of cash flows even if the net change in the account is zero.

Analysis of the banknote lending account results in the following cash flows:

Note how the short-term portion of long-term debt has been included in the long-term debt analysis. The current installment element is a reporting requirement for the principal amount due one year after the reporting date. As it is not exactly a working capital account, it is outside the business unit and is included in the financing activity with its corresponding long-term liabilities account. For example, the opening balance of $325,000 above is the sum of the current installment ($45,000) plus the long-term installment ($280,000). Likewise, the ending balance of $306,000 is the sum of the current portion ($60,000) plus the long-term portion ($246,000).

The common stock and retained earnings accounts are straightforward, and a discussion of each is provided below.

Step 7. Subtotal and Match:

The three activities add up to a net cash increase of $57,500. When added to the starting cash balance of $250,000, the resulting total of $307,500 is the ending cash balance for the year ended December 31, 2020. This can be seen in the complete statement of cash flows after step 8.

Step 8. Required information:

In the statement of cash flows using the indirect method, cash flows must be presented separately for:

• interested payment
• interest income
• Dividends received (dividends paid are detailed in the Funding section)
• Income tax paid in cash
• Non-monetary transactions that may have occurred in the current year.

If not too long, these items can be disclosed in the notes or at the end of the statement. Payments of dividend income and interest income have been taken directly from the income statement, as there are no provision accounts on the balance sheet for these items. Cash payments of interest and income tax are calculated based on the analysis of their respective liability accounts on the balance sheet and expense accounts on the income statement.

Below is the full statement of indirect method cash flows with required disclosures for Watson Ltd. for the year ended December 31, 2020:

Disclosure:
Cash payment of income tax		38.880 $
()
Interest cash payment		11.400
()
Cash received from dividend income		3.000

Note that the $2,000 of interest income recognized in the income statement is not included in the additional disclosures listed above. This is because interest income was earned as an adjustment item against the company's assets, so it was not a cash receipt item.