Financial Accounting: An Integrated Statements Approach, 2nd Edition

STATEMENT OF CASH FLOWS—THE INDIRECT

METHOD

The indirect method of reporting cash flows from operating activities is normally less

costly and more efficient than the direct method. In addition, when the direct method

is used, the indirect method must also be used in preparing a supplemental reconcili-

ation of net income with cash flows from operations. The 2004 edition of Accounting

Trends & Techniquesreported that 593 out of 600 surveyed companies used the indirect

method. For these reasons, we will discuss first the indirect method of preparing the

statement of cash flows.

To collect the data for the statement of cash flows, all the cash receipts and cash pay-

ments for a period could be analyzed. However, this procedure is expensive and time-

consuming. A more efficient approach is to analyze the changes in the noncash balance

sheet accounts. The logic of this approach is that a change in any balance sheet account

(including cash) can be analyzed in terms of changes in the other balance sheet accounts.

To illustrate, the accounting equation is rewritten below to focus on the cash account:

Assets Liabilities Stockholders’ Equity

Cash Noncash Assets Liabilities Stockholders’ Equity

Cash Liabilities Stockholders’ Equity Noncash Assets

Any change in the cash account results in a change in one or more noncash bal-

ance sheet accounts. That is, if the cash account changes, then a liability, stockholders’

equity, or noncash asset account must also change.

Additional data are also obtained by analyzing the income statement accounts and

supporting records. For example, since the net income or net loss for the period is

closed to Retained Earnings, a change in the retained earnings account can be partially

explained by the net income or net loss reported on the income statement.

There is no order in which the noncash balance sheet accounts must be analyzed.

However, it is usually more efficient to analyze the accounts in the reverse order in

which they appear on the balance sheet. Thus, the analysis of retained earnings pro-

vides the starting point for determining the cash flows from operating activities, which

is the first section of the statement of cash flows.

The comparative balance sheet for Rundell Inc. on December 31, 2007 and 2006, is

used to illustrate the indirect method. This balance sheet is shown in Exhibit 3. Selected

ledger accounts and other data are presented as needed.

Retained Earnings

The comparative balance sheet for Rundell Inc. shows that retained earnings increased

$80,000 during the year. Analyzing the entries posted to the retained earnings account

indicates how this change occurred. The retained earnings account for Rundell Inc. is

shown below.

The retained earnings account must be carefully analyzed because some of the

entries to retained earnings may not affect cash. For example, a decrease in retained

584 Chapter 13 Statement of Cash Flows

Prepare a statement of

cash flows, using the

indirect method.

2

RETAINED EARNINGS

Dec. 31 Cash dividends 28,000 Jan. 1 Balance 202,300

Dec. 31 Net income 108,000

310,300

Dec. 31 Balance 282,300