Statement of Cash Flows: The Indirect Method
Online Solutions’ statement of cash flows for the year ended December 31, 2010, is
shown in Exhibit 8. The operating activities section is shown in summary form with
net cash flows from operating activities of $47,120. In this appendix, we illustrate how
to prepare the operating activities section of the statement of cash flows using the in-
direct method. This method is used by over 90% of publicly held companies.
The use of the indirect method only affects net cash flows from operating activi-
ties. The other method of preparing the net cash flows from operating activities sec-
tion is called the direct method. The direct method analyzes each transaction and its
effect on cash flows.^8 In contrast, the indirect method analyzes only the changes in
accounts. However, regardless of whether the direct or indirect method is used, the net
cash flows from operating activities is the same. In other words, use of the direct or in-
direct method affects the method of calculating and reporting cash flows from operating
activities but not the amount of net cash flows from operating activities.
A major reason that the indirect method is so popular is that it is normally less
costly to prepare. However, regardless of whether the indirect or direct method is used,
the reporting of net cash flows from investing and financing activities is not affected.
The indirect method reconciles net income with net cash flows from operating ac-
tivities. Net income is adjusted for the effects of accruals and deferrals that affected the
net income but did not result in the receipt or payment of cash. The resulting amount
is the net cash flows from operating activities.
The indirect method converts net income determined under the accrual basis of ac-
counting to what it would have been under the cash basis of accounting. In other
words, net cash flows from operating activities is equivalent to net income using the
cash basis of accounting.
To illustrate, assume that accounts receivable increases during the period by
$10,000. This increase is included in the period’s revenue and thus increases net in-
come. However, cash was not collected. Thus, an increase in accounts receivable must
be deducted from net income under the indirect method. Likewise, depreciation ex-
pense is deducted in arriving at net income, but does not involve any cash payments.
Therefore, depreciation expense is added to net income under the indirect method.234 Chapter 5 Accounting for Merchandise Operations
JCPenney Saks Incorporated
Fiscal Years’ Ending 2004 2003 2002 2004
Net sales $18,424 $17,786 $17,633 $6,437
Cost of merchandise sold 11,285 11,166 11,299 3,999
Gross profit $ 7,139 $ 6,620 $ 6,334 $2,438
Operating expense 6,119 6,074 5,919 2,243
Operating income $ 1,020 $ 546 $ 415 $ 195Gross profit as a percent of
net sales 38.7% 37.2% 35.9% 37.9%
Operating income as a percent
of net sales 5.5% 3.1% 2.4% 3.0%Exhibit 13
Operating Ratios—
JCPenney and Saks
IncorporatedAPPENDIX
8 We used the direct method to prepare the statement of cash flows in Chapters 2 and 3 and in the appen-
dix to Chapter 4.