In Accounting, what is Indirect Method?

Indirect method is an accounting term that refers to the way a company can create the operational portion of its cash flow statement for a reporting period. Essentially, the indirect method enables a company to change accrual-basis net income into cash flow through several additions or subtractions. The indirect method is distinct from the direct method, which uses actual cash flow data to prepare its cash flow statement. This data would include items such as the actual amount of cash spent by the company for expenses like electricity or raw materials.

Using the indirect method, a company uses easily available accrual accounting information to show operational cash flow. For the other two sections of a cash flow statement — financing activities and cash provided from investing — the direct and indirect methods are exactly the same. The rationale behind the use of the indirect method is that the accounting information, which typically must be reported to other parties, is usually more readily available and easier to use than actual cash inflow and outflow data, which takes longer to collect and is often more difficult to secure.

Under the indirect method of cash flow accounting, accountants will use net income as a place to begin. Adjustments are then made for all non-cash items before making adjustments for all cash-based transactions. Generally, adjustments refer to the process of recording day-to-day business activities, such as customer sales or federal and state tax payments. If there is a resulting increase in a liability account, it is added back to net income. Likewise, if there is an increase in an asset account, such as bank deposits, receivables, merchandise, raw materials, finished goods, equipment, or land, it is subtracted from net income.

In the preparation of cash flow statements, the indirect method is used by more companies than the direct method, since accounting rules require that an additional report be prepared by companies that use the direct method. This additional report presents the operational cash flow as if it were computed using the indirect calculating method. Nevertheless, the direct method is considered by many accountants to produce a more easily understood report.

The direct and indirect methods each have advantages and disadvantages. While the direct method shows cash receipts and payments, it is frequently more expensive to compile and prepare the information. In contrast, the indirect method is less expensive and can highlight the differences between net cash flow from operations and profit, but there is less information reported on some portions of trading cash flows.