Sunflower Intelligence
Finance & Accounting

F02 · Introductory

Financial Statement Preparation

10 lessons

F02 · Module 3, lesson 2 · Lesson 8 of 10

The indirect method

Start from net income and reach cash from operating activities: add back noncash expenses, take out gains and losses, adjust for every change in operating working capital, then prepare a full statement from two balance sheets and reconcile it with the direct method.

About 80 minutes

Before you start

You will be able to

  • Explain why each adjustment in the indirect method is added or subtracted, using the accounting equation.
  • Calculate net cash from operating activities by the indirect method, including noncash expenses, gains and losses, and changes in operating current assets and liabilities.
  • Prepare a complete statement of cash flows from comparative balance sheets, an income statement and notes, including a disposal at a gain and a current portion of long-term debt.
  • Reconcile the indirect method with the direct method, line by line.
  • Identify and correct common errors, such as treating depreciation as a source of cash or reversing the sign of a working-capital change.

Review first

  • The statement of cash flows — The three activities, the classification rules and the direct method come from there.
  • Long-lived assets — Depreciation and the gain or loss on a disposal are the main noncash adjustments.
  • The balance sheet and equity — The method reads the changes between two classified balance sheets, including the current portion of long-term debt.

Fictional case A fictional coffee business founded by Ana Lim. It starts as a catering and barista-training service, opens its own cafés and an online shop for beans, and plans a canned cold brew.

The idea

Fictional case

Lantern’s accountant has prepared the direct-method statement, but US GAAP also asks for a reconciliation of net income to net cash from operating activities, in a separate schedule when the direct method is used (ASC 230-10-45-30). Ana has a question of her own. The income statement says Lantern earned $27,387; the statement of cash flows says operations brought in $39,940. Which items explain the $12,553 between them?

The indirect method answers Ana’s question directly. It starts from net income and adjusts it, item by item, until it reaches net cash from operating activities, so each adjustment names one reason why profit and operating cash differ. Only the operating section changes: the investing and financing sections are the same whichever method is used. Most companies present their operating cash flows this way.

The adjustments come in three kinds.

  1. Noncash expenses. Depreciation, amortisation and similar charges reduce net income but use no cash in the period. Each is an add-back: it is added to net income.
  2. Gains and losses on investing and financing transactions. When equipment is sold, the whole cash proceeds are an investing inflow. The gain is also in net income, so it is subtracted; a loss is added back.
  3. Changes in operating working capital. Each operating current asset other than cash, and each operating current liability, changes during the year. Each change means that cash and net income moved by different amounts, and the adjustment corrects for it.

Why the signs are what they are

Students often try to memorise the signs. It is quicker to derive them from the accounting equation you met in F01. Split assets into cash and everything else, and move everything else to the other side:

Cash=Liabilities+Equity−Noncash assets\text{Cash} = \text{Liabilities} + \text{Equity} - \text{Noncash assets}
ΔCash=ΔLiabilities+ΔEquity−ΔNoncash assets\Delta\text{Cash} = \Delta\text{Liabilities} + \Delta\text{Equity} - \Delta\text{Noncash assets}

Read the second line as a rule. An increase in a noncash asset must have been paid for with cash unless a liability or equity grew to fund it, so it subtracts from cash. An increase in a liability means the business kept cash it would otherwise have paid out, or received cash it hasn’t yet earned, so it adds. Equity grows by net income, the starting point. The indirect method applies this identity to the operating accounts; the noncurrent assets go to investing, and debt, stock and dividends to financing.

The four sign rules
Change during the yearAdjustmentWhyLantern
Operating current asset up (receivables, inventory, prepayments)SubtractRevenue recorded but not yet collected, or cash spent on items not yet expensedInventory up $5,800: beans bought, not yet sold
Operating current asset downAddEarlier sales collected, or items paid for earlier now expensedNone: every balance started at zero
Operating current liability up (payables, accruals, unearned revenue, taxes payable)AddExpenses recorded but not yet paid, or cash received before it is earnedAccounts payable up $9,210: bills not yet paid
Operating current liability downSubtractEarlier expenses paid now, or revenue earned from cash received earlierNone in the first year
Lantern’s first year: from net income to net cash from operating activities (fictional figures in dollars).

In depth

The method, step by step

  1. Start with net income from the income statement.
  2. Add back noncash expenses: depreciation, amortisation and impairment losses.
  3. Subtract gains and add back losses on selling long-term assets or settling debt; the cash from those transactions belongs to investing or financing.
  4. Adjust for the change in each operating current asset other than cash and each operating current liability: subtract increases in assets and decreases in liabilities; add decreases in assets and increases in liabilities.
  5. Leave out current items that belong to other activities: the current portion of long-term debt, short-term bank loans and dividends payable (financing), and short-term investments and loans made to others (investing).
  6. The total is net cash from operating activities. Prepare the investing and financing sections from the changes in the noncurrent accounts and the financing items, using the notes to find what the balances hide.

Lantern’s first year by the indirect method

Lantern’s reconciliation is below. Lantern began trading on 1 March 2026, so every opening balance is zero and each change equals the balance at 31 December. That is a feature of a first year only: in every later year you subtract the opening balance from the closing one.

Lantern Coffee Co.Cash flows from operating activities (indirect method) for the ten months ended 31 December 2026
Net income$27,387
Depreciation4,800
Increase in accounts receivable (net)(6,796)
Increase in inventory(5,800)
Increase in supplies(640)
Increase in prepaid insurance(300)
Increase in accounts payable9,210
Increase in wages payable2,100
Increase in interest payable750
Increase in unearned revenue6,100
Increase in income taxes payable3,129
Net cash from operating activities$39,940

Three lines need comment. Receivables are taken net of the allowance (7,380−584=6,7967{,}380 - 584 = 6{,}796), so bad debt expense of $1,404 is already inside that line and is not added back separately. The increase in inventory of $5,800 is measured after the $400 write-down to net realisable value (adjustment e7), so the write-down, though a noncash expense, needs no separate add-back either. Accounts payable rose $9,210: $8,400 for beans, $520 for supplies and the $290 December utility bill.

Two kinds of current liability are left out on purpose. The $5,000 current portion of the van note arose by reclassifying long-term debt (adjustment e8): no cash moved, and repaying it will be a financing outflow. Lantern has no dividends payable, but a dividend declared and not yet paid would be a financing item too. Putting either in the reconciliation would mix financing into operating cash flow.

Reconciling the two methods

The direct and indirect methods are two arrangements of the same arithmetic. Adjust each income statement line to cash and you have the direct method; add up the same adjustments by balance sheet account instead and you have the indirect method. The table shows Lantern’s year both ways.

Lantern: net income to operating cash flow, line by line
Income statement lineAccrual amount ($)Adjustments ($)Cash ($)
Net revenue193,320(2,100)191,220
Supplier-type expenses(105,800)2,470(103,330)
Wages(43,600)2,100(41,500)
Interest(1,200)750(450)
Income tax(9,129)3,129(6,000)
Depreciation(4,800)4,8000
Bad debt expense(1,404)1,4040
Net income; total adjustments; net cash from operating activities27,38712,55339,940

The first column adds up to net income and the last to the direct method’s operating total. Fictional figures.

Read down the middle column and you have the indirect method’s adjustments, grouped by income statement line. Regroup them by balance sheet account and you get the lines of Lantern’s reconciliation. The revenue adjustment (−7,380 for receivables, −820 for the write-off, +6,100 for unearned revenue) and the bad debt add-back become the net receivables line, −7,380−820+1,404=−6,796-7{,}380 - 820 + 1{,}404 = -6{,}796, and the unearned revenue line, +6,100. The supplier adjustment becomes the inventory, supplies, prepaid insurance and payables lines: −5,800−640−300+9,210=2,470-5{,}800 - 640 - 300 + 9{,}210 = 2{,}470. Both routes total $39,940.

A later year: opening balances, a disposal and the current portion of debt

From the second year on, every adjustment is a change between two balance sheets. The investing and financing sections also need some reconstruction, because a balance sheet shows only the net effect of purchases, disposals, borrowing and repayments. The tool is a roll-forward of each account: opening balance plus additions minus reductions equals closing balance. Know three of the four, and you can find the fourth.

  • Equipment: opening cost + purchases − cost of assets sold = closing cost.
  • Accumulated depreciation: opening + depreciation expense − accumulated depreciation on assets sold = closing.
  • Debt: opening total (current portion + noncurrent) + new borrowing − repayments = closing total. Moving next year’s instalment from noncurrent to current changes neither total and involves no cash.
  • Retained earnings and dividends: opening + net income − dividends declared = closing; dividends paid = dividends declared − the increase in dividends payable.

Gains and losses complete the picture. When a business sells equipment, the cash proceeds equal its book value plus any gain, or minus any loss, and the whole amount is an investing inflow. The gain is also inside net income, so the indirect method subtracts it; otherwise it would be counted twice, once in operating and once in investing. A loss is added back for the same reason. The challenging example below works through a full year for a business with all of these features.

One more source of information matters: the notes. They tell you about transactions the balances blur, such as equipment bought partly with a note to the seller. Under ASC 230-10-45-13(c) that note is a financing transaction with no cash, disclosed as a noncash activity, and the principal paid on it later is a financing outflow. Without the note you would see only the net increase in equipment and in debt, and might report both as cash flows.

Checking a reconciliation

A statement of cash flows prepared from two balance sheets has a built-in test: every change in every balance sheet account must be used exactly once. Each change goes to one of four places: the operating section (through net income or a working-capital line), the investing section, the financing section, or the noncash disclosure. An account left out, or used twice, shows up as a closing cash figure that disagrees with the balance sheet.

Preparers often lay this out as a worksheet: list the balance sheet accounts with their opening and closing balances, explain each change, and tick it off. For Blackthorn, the $26,000 increase in equipment is explained by the $50,000 press less the $24,000 press sold; the $50,000 splits into $30,000 of investing cash and a $20,000 noncash note. The $7,000 increase in accumulated depreciation is $22,000 of depreciation (operating, added back) less the $15,000 removed on the sale. Debt rose $2,000 on the current line and $8,000 on the noncurrent line, and neither change is a cash flow by itself: total debt rose $10,000, made up of the $20,000 note (noncash) less the $10,000 repaid (financing).

A second test compares the two methods. If a business presents the direct method, its operating total must equal the reconciliation’s; if it presents the indirect method, deriving the main direct-method lines (cash from customers, cash paid to suppliers) is a quick check on the working-capital lines. Lantern’s accountant does both: $39,940 by each route.

Formulas

Net cash from operating activities (indirect method)

CFO=NI+Noncash expenses+Losses−Gains−ΔCAop+ΔCLop\text{CFO} = \text{NI} + \text{Noncash expenses} + \text{Losses} - \text{Gains} - \Delta\text{CA}_{\text{op}} + \Delta\text{CL}_{\text{op}}
CFO\text{CFO}
Net cash from operating activities$
NI\text{NI}
Net income for the period$
Noncash expenses\text{Noncash expenses}
Depreciation, amortisation, impairment and similar charges$
Losses, Gains\text{Losses},\ \text{Gains}
Losses and gains on selling long-term assets or settling debt$
ΔCAop\Delta\text{CA}_{\text{op}}
Closing minus opening operating current assets other than cash (receivables net of the allowance, inventory, prepayments)$
ΔCLop\Delta\text{CL}_{\text{op}}
Closing minus opening operating current liabilities (payables, accruals, unearned revenue, income taxes payable)$

Assumes. Current items that belong to investing or financing (current portion of long-term debt, dividends payable, short-term loans and investments) are excluded.

Lantern: 27,387+4,800−13,536+21,289=39,94027{,}387 + 4{,}800 - 13{,}536 + 21{,}289 = 39{,}940.

The change in cash from the balance sheet

ΔCash=ΔLiabilities+ΔEquity−ΔNoncash assets\Delta\text{Cash} = \Delta\text{Liabilities} + \Delta\text{Equity} - \Delta\text{Noncash assets}
Δ\Delta
Closing balance minus opening balance
Noncash assets\text{Noncash assets}
Every asset except cash and cash equivalents, net of contra accounts$

The source of every sign rule: assets other than cash subtract, liabilities and equity add.

Cash proceeds from selling a long-term asset

Proceeds=(Cost−Accumulated depreciation)+Gain−Loss\text{Proceeds} = (\text{Cost} - \text{Accumulated depreciation}) + \text{Gain} - \text{Loss}
Cost−Accumulated depreciation\text{Cost} - \text{Accumulated depreciation}
The asset’s book value at the date of sale$
Gain, Loss\text{Gain},\ \text{Loss}
The gain or loss recorded on the sale (only one is non-zero)$
Proceeds\text{Proceeds}
Cash received: an investing inflow$

Blackthorn’s press: (24,000−15,000)+2,500=11,500(24{,}000 - 15{,}000) + 2{,}500 = 11{,}500.

Account roll-forward

Closing=Opening+Additions−Reductions\text{Closing} = \text{Opening} + \text{Additions} - \text{Reductions}
Opening, Closing\text{Opening},\ \text{Closing}
The account’s balances on the two balance sheets$
Additions, Reductions\text{Additions},\ \text{Reductions}
What increased and decreased the account during the year (purchases and disposals, borrowing and repayments, net income and dividends)$

Used to find the missing figure, such as purchases of equipment or dividends paid.

Worked examples

A first example: A bakery’s reconciliation

Fictional figures

Harrowgate Bakery, a fictional business, reports net income of $42,000 for 2027 after depreciation of $9,000. During the year its accounts receivable from cafés rose by $3,000, inventory fell by $1,500, prepaid rent rose by $400, accounts payable to flour and dairy suppliers rose by $2,200 and wages payable fell by $800. Find net cash from operating activities by the indirect method.

Harrowgate BakeryCash flows from operating activities for the year ended 31 December 2027 (indirect method)
Net income$42,000
Depreciation9,000
Increase in accounts receivable(3,000)
Decrease in inventory1,500
Increase in prepaid rent(400)
Increase in accounts payable2,200
Decrease in wages payable(800)
Net cash from operating activities$50,500

Fictional figures.

  1. Start with net income, $42,000, and add back depreciation, a noncash expense: 42,000+9,000=51,00042{,}000 + 9{,}000 = 51{,}000.
  2. Current assets: receivables up 3,000, subtract (sales not yet collected); inventory down 1,500, add (flour used that was paid for earlier); prepaid rent up 400, subtract (cash paid ahead of the expense).
  3. Current liabilities: payables up 2,200, add (supplies used, not yet paid); wages payable down 800, subtract (last year’s wages paid this year).
  4. Total: 51,000−3,000+1,500−400+2,200−800=50,50051{,}000 - 3{,}000 + 1{,}500 - 400 + 2{,}200 - 800 = 50{,}500.

Answer. Net cash from operating activities is $50,500.

What it means. Operating cash exceeds net income by $8,500, mostly because depreciation used no cash; the working-capital changes nearly cancel out (−$500 in total).

A harder example: A full statement for a later year

Fictional figures

Blackthorn Print Works, a fictional company, reports under US GAAP. Its 2027 income statement shows sales $412,000; cost of goods sold $236,000; wages $88,000; depreciation $22,000; rent $18,000; other operating expenses $14,500; a gain on sale of equipment of $2,500; interest expense $5,000; income tax at 25%. The notes say: an old press that cost $24,000, with accumulated depreciation of $15,000, was sold for $11,500 in cash; a new digital press costing $50,000 was bought for $30,000 in cash and a $20,000 note to the manufacturer; the bank loan’s $10,000 instalment due in 2027 was paid; dividends of $12,000 were declared. Prepare the 2027 statement of cash flows by the indirect method.

Blackthorn Print Works: balance sheets at 31 December (fictional)
2026 ($)2027 ($)
Cash18,40016,950
Accounts receivable, net19,80024,600
Inventory17,00015,200
Prepaid insurance2,1002,400
Equipment160,000186,000
Accumulated depreciation(64,000)(71,000)
Total assets153,300174,150
Accounts payable14,90012,300
Wages payable2,6003,100
Interest payable1,100900
Income taxes payable1,9002,800
Dividends payable2,0003,000
Current portion of long-term debt10,00012,000
Long-term debt40,00048,000
Common stock50,00050,000
Retained earnings30,80042,050
Total liabilities and equity153,300174,150
Blackthorn Print WorksStatement of cash flows for the year ended 31 December 2027 (indirect method)
Operating activities
Net income$23,250
Depreciation22,000
Gain on sale of equipment(2,500)
Increase in accounts receivable(4,800)
Decrease in inventory1,800
Increase in prepaid insurance(300)
Decrease in accounts payable(2,600)
Increase in wages payable500
Decrease in interest payable(200)
Increase in income taxes payable900
Net cash from operating activities$38,050
Investing activities
Proceeds from sale of equipment$11,500
Purchase of equipment(30,000)
Net cash used in investing activities($18,500)
Financing activities
Repayment of long-term debt($10,000)
Dividends paid(11,000)
Net cash used in financing activities($21,000)
Net decrease in cash($1,450)
Cash, 1 January 202718,400
Cash, 31 December 2027$16,950

Noncash investing and financing: a press costing $50,000 was acquired for $30,000 in cash (shown in investing) and a $20,000 note payable to the manufacturer. Supplemental: interest paid $5,200; income taxes paid $6,850. Fictional figures.

  1. Net income: operating income, which includes the gain on the press, is 412,000−236,000−88,000−22,000−18,000−14,500+2,500=36,000412{,}000 - 236{,}000 - 88{,}000 - 22{,}000 - 18{,}000 - 14{,}500 + 2{,}500 = 36{,}000; income before tax 36,000−5,000=31,00036{,}000 - 5{,}000 = 31{,}000; tax 31,000×0.25=7,75031{,}000 \times 0.25 = 7{,}750; net income 23,250.
  2. Noncash items and the gain: add depreciation 22,000; subtract the gain 2,500, because its cash is in the $11,500 of proceeds. Check the gain: 11,500−(24,000−15,000)=2,50011{,}500 - (24{,}000 - 15{,}000) = 2{,}500.
  3. Working capital, each as closing minus opening: receivables +4,800 (subtract), inventory −1,800 (add), prepaid insurance +300 (subtract), payables −2,600 (subtract), wages payable +500 (add), interest payable −200 (subtract), income taxes payable +900 (add): net −4,700-4{,}700. Dividends payable and the current portion of debt are financing items and are left out.
  4. Operating: 23,250+22,000−2,500−4,700=38,05023{,}250 + 22{,}000 - 2{,}500 - 4{,}700 = 38{,}050.
  5. Investing: proceeds 11,500 less the cash part of the new press, 30,000: −18,500-18{,}500. Roll-forwards confirm the notes: equipment 160,000+50,000−24,000=186,000160{,}000 + 50{,}000 - 24{,}000 = 186{,}000; accumulated depreciation 64,000+22,000−15,000=71,00064{,}000 + 22{,}000 - 15{,}000 = 71{,}000.
  6. Financing: debt 50,000+20,000−10,000=60,000=12,000+48,00050{,}000 + 20{,}000 - 10{,}000 = 60{,}000 = 12{,}000 + 48{,}000, so the only cash was the 10,000 repaid; dividends paid 12,000−(3,000−2,000)=11,00012{,}000 - (3{,}000 - 2{,}000) = 11{,}000. Financing: −10,000−11,000=−21,000-10{,}000 - 11{,}000 = -21{,}000.
  7. Net change 38,050−18,500−21,000=−1,45038{,}050 - 18{,}500 - 21{,}000 = -1{,}450; closing cash 18,400−1,450=16,95018{,}400 - 1{,}450 = 16{,}950, which agrees with the balance sheet.

Answer. Operating $38,050; investing ($18,500); financing ($21,000); net decrease $1,450; cash falls from $18,400 to $16,950. The $20,000 note is disclosed, and interest paid ($5,200) and taxes paid ($6,850) are given as supplemental information.

What it means. A profitable year ended with less cash because Blackthorn invested $30,000 in a new press, repaid $10,000 of debt and paid $11,000 of dividends, together more than operations and the old press’s sale produced. The current portion rose from $10,000 to $12,000 without any cash moving: next year’s instalments now include the new note.

Applied: a business decision: Profitable, growing and short of cash

Fictional figures

Tallowmere Candle Co., a fictional online candle maker, began selling to gift shops on 60-day terms in 2027. Its net income rose to $48,000, after depreciation of $6,000. During the year its receivables rose from $4,000 to $45,000, its inventory from $22,000 to $60,000 for the holiday season, and its accounts payable from $11,000 to $20,000. It started the year with $35,000 of cash, spent $8,000 on a new pouring machine and has no borrowing. The owner wants to pay herself a $20,000 dividend in January “because we made $48,000”. Should she?

  1. Operating cash flow: 48,000+6,000−41,000−38,000+9,000=−16,00048{,}000 + 6{,}000 - 41{,}000 - 38{,}000 + 9{,}000 = -16{,}000. Operations used cash in a profitable year.
  2. Working capital absorbed 41,000+38,000−9,000=70,00041{,}000 + 38{,}000 - 9{,}000 = 70{,}000, more than net income plus depreciation (54,000): growth in receivables and stock is consuming the profit.
  3. Cash at the year end: 35,000−16,000−8,000=11,00035{,}000 - 16{,}000 - 8{,}000 = 11{,}000. A $20,000 dividend would need $9,000 that the business doesn’t have.
  4. What would change it: the receivables will be collected in the new year, but the shops’ next orders will need stock first. Shorter terms, a smaller holiday stock or a bank line of credit would release or provide cash.

Answer. Not now. The business earned $48,000 but its operations used $16,000 of cash and it ends the year with $11,000, less than the dividend. Pay a dividend after the holiday receivables are collected, or arrange financing first.

What it means. Net income is the wrong figure for a dividend decision: it says the business is profitable, not that it has cash. The indirect method shows exactly where the profit went, into $41,000 of customers’ debts and $38,000 of candles.

Explore

Start from Lantern’s first year, with the small current items grouped. Change one line at a time and watch which direction it moves operating cash flow; set a working-capital change negative to see a decrease reverse the sign.

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Sell a piece of equipment for more or less than its book value. However the sale is split between the gain or loss and the book value, operating cash flow is unchanged and the investing inflow is the cash received.

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Common mistakes

  • “Depreciation is a source of cash.”

    Depreciation is added back because it reduced net income without using cash this period; the add-back undoes the expense and creates no cash. The cash left when the asset was bought, as an investing outflow. Recording more depreciation can’t raise operating cash flow, apart from any effect on the tax bill.

  • “Receivables went up, so add the increase.”

    An increase in a current asset is subtracted: revenue was recorded but the cash hasn’t arrived. When a sign is in doubt, use the identity ΔCash=ΔLiabilities+ΔEquity−ΔNoncash assets\Delta\text{Cash} = \Delta\text{Liabilities} + \Delta\text{Equity} - \Delta\text{Noncash assets}: assets other than cash enter with a minus sign, liabilities with a plus.

  • “The current portion of long-term debt is a current liability, so it belongs in the working-capital adjustments.”

    It is debt, and borrowing and repaying are financing; moving an instalment from noncurrent to current involves no cash at all. Dividends payable and short-term bank loans are financing items too. Lantern’s $5,000 current portion is left out of its reconciliation.

  • “Keep the gain in net income and show the proceeds in investing as well.”

    That counts the gain twice. Subtract the gain (or add back a loss) in the operating section and show the full proceeds in investing. Blackthorn subtracts its $2,500 gain and reports $11,500 of proceeds.

  • “Add back bad debt expense and the inventory write-down too.”

    Not when, as in Lantern’s reconciliation, receivables are taken net of the allowance and inventory after the write-down: both charges are already inside those changes, and adding them back counts them twice. If you start from gross receivables instead, the matching adjustment is the increase in the allowance (bad debt expense less write-offs, 1,404−820=5841{,}404 - 820 = 584), not the whole expense; if inventory is measured before a write-down, add the write-down back.

  • “The changes are the closing balances.”

    Only when every opening balance is zero, as in Lantern’s first year. Blackthorn’s receivables rose from $19,800 to $24,600, so the adjustment is −$4,800, not −$24,600.

Guided practice

Work through these with hints when you need them. Every hint and every worked solution is there to be used.

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On your own

No hints this time. Answer, check, and read the feedback; the solution appears once you have answered or if you ask for it. Your first answers count toward mastery.

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In practice

Explaining a fall in cash. Blackthorn’s owner asks why cash fell by $1,450 in 2027 when the business earned $23,250. The controller answers from the statement in the challenging example. Operations generated $38,050, more than net income because depreciation is a large noncash expense for a printer. The new press used $30,000 of cash, offset by $11,500 from selling the old one, the bank took $10,000 and dividends $11,000. The business is not losing money; it is investing and repaying debt slightly faster than operations replace the cash.

Forecasting next year. The same structure turns a profit forecast into a cash forecast. For 2028 the controller expects net income of about $26,000 and depreciation of $24,000, and expects receivables to grow by $5,000 with sales, so forecast operating cash flow is about 26,000+24,000−5,000=45,00026{,}000 + 24{,}000 - 5{,}000 = 45{,}000. Against it stand the $12,000 of debt due in 2028 (the current portion), $15,000 of planned equipment and the dividends. Holding dividends at $12,000 leaves 45,000−12,000−15,000−12,000=6,00045{,}000 - 12{,}000 - 15{,}000 - 12{,}000 = 6{,}000 to rebuild cash; raising them to $20,000 would mean another fall. The controller recommends keeping the dividend at $12,000 for another year.

Reading someone else’s reconciliation. Lenders and analysts read the indirect method for what it reveals about earnings. Working-capital adjustments that keep going the same way, such as receivables rising faster than sales year after year, suggest that profit is not turning into cash. A large operating cash flow that comes from stretching payables will reverse when suppliers insist on being paid, while one that comes from depreciation on a stable asset base is more likely to recur. The ratios that measure these patterns belong to F03; the reconciliation is where the evidence sits.

Knowledge check

Six questions, one attempt each, no hints. Score 80% or more to complete the lesson; you can take it again at any time.

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Summary

  • The indirect method starts from net income and adds or subtracts the items that make it differ from operating cash: noncash expenses, gains and losses on investing and financing transactions, and changes in operating working capital.
  • The signs follow from ΔCash = ΔLiabilities + ΔEquity − ΔNoncash assets: subtract increases in operating current assets, add increases in operating current liabilities, and the reverse for decreases.
  • Lantern’s first year: $27,387 of net income, $4,800 of depreciation and $7,753 of net working-capital changes give $39,940; opening balances were zero, so each change is the closing balance.
  • The direct and indirect methods are the same arithmetic grouped differently; both give Lantern $39,940, and US GAAP requires the reconciliation whichever is presented.
  • Leave financing and investing items out of the working-capital adjustments: the current portion of long-term debt, dividends payable, short-term loans and investments.
  • In a later year, roll each noncurrent account forward to find purchases, disposals, borrowing, repayments and dividends; subtract a gain, add back a loss, and report the full proceeds in investing.
  • Depreciation is not a source of cash, and profit is not cash: a growing business can be profitable and still run short of cash.

Key formulas

Terms introduced

Noncash expense
An expense that reduces net income without any cash payment in the period, such as depreciation, amortisation or an impairment loss. The indirect method adds it back.
Add-back
An amount added to net income in the indirect method because it reduced net income without reducing cash in the period, such as depreciation or a loss on the sale of equipment.
Operating working capital
The current assets other than cash and the current liabilities that arise from day-to-day operations: receivables, inventory, prepayments, accounts payable, accrued expenses, unearned revenue and income taxes payable. Current items that belong to investing or financing, such as short-term investments, the current portion of long-term debt and dividends payable, are excluded.

Sources

  1. Franklin, M., Graybeal, P. & Cooper, D. (2019). Principles of Accounting, Volume 1: Financial Accounting, section 16.1, “Explain the Purpose of the Statement of Cash Flows”. OpenStax. openstax.org/books/principles-financial-accounting/pages/16-…
  2. Franklin, M., Graybeal, P. & Cooper, D. (2019). Principles of Accounting, Volume 1: Financial Accounting, section 16.3, “Prepare the Statement of Cash Flows Using the Indirect Method”. OpenStax. openstax.org/books/principles-financial-accounting/pages/16-…
  3. Franklin, M., Graybeal, P. & Cooper, D. (2019). Principles of Accounting, Volume 1: Financial Accounting, section 16.6, “Appendix: Prepare a Completed Statement of Cash Flows Using the Direct Method”. OpenStax. openstax.org/books/principles-financial-accounting/pages/16-…
  4. Deloitte. Roadmap: Statement of Cash Flows, section 3.1, “Form and Content of the Statement of Cash Flows” (ASC 230-10-45-28 to 45-32 and 50-2). DART. dart.deloitte.com/USDART/home/codification/presentation/asc2…
  5. KPMG LLP (2026). Statement of cash flows: Handbook, US GAAP (March 2026), including ASC 230-10-45-13(c) on debt incurred to the seller and 45-15(b) on repayments. kpmg.com/kpmg-us/content/dam/kpmg/frv/pdf/2026/statement-cas…
  6. Boissou, V. & Ahuja, K. (2026). “IFRS 18 changes the statement of cash flows”. KPMG IFRS Institute, 1 June 2026. kpmg.com/us/en/articles/2026/ifrs-18-changes-statement-cash-…