Crash Course in Accounting and Financial Statement Analysis, Second Edition

Indirect Method

We already know that the income statement depicts a company’s revenues, expenses, and profitability arising from its daily operations, while cash flow from operations attempts to capture cash movement associated with these daily activities. Accordingly, we must convert the income statement from accrual accounting (by which it is prepared) to cash accounting (which governs the cash flow statement).

This conversion of the income statement from accrual to cash accounting can be performed via two methods:

1. Direct method ^[1]

   ^[1] See Appendix for a discussion of the direct method of preparation of the “Cash Flow from Operations” section.

2. Indirect method

The Financial Accounting Standards Board (FASB) allows companies to use both methods, which result in the same “Cash Flow from Operating Activities” figure; however, the indirect method is used by a majority of companies and will be our focus throughout this section.

The two methods apply only to the preparation of the operating activities section of the cash flow statement.