Explain the indirect method for preparing the statement of cash flows.

• A. Start with net income, adjust for non-cash items and changes in working capital to derive cash from operating activities; then list investing and financing activities.
• B. Begin with cash receipts and payments for operating activities directly.
• C. Begin with net income but omit adjustments for non-cash items; report only operating activities.
• D. Present all activities in a single section without separate operating, investing, and financing sections.

Answer: (A)

The indirect method reconciles net income to cash provided by operating activities by adjusting for items that affected net income but did not involve cash, and for changes in working capital. Net income is the starting point because it comes from the accrual-based income statement, and the goal is to convert that accrual measure into cash flow.

First, add back non-cash expenses such as depreciation and amortization because these reduce net income without using cash in the period. Next, remove the effects of gains or losses from investing activities; gains increase net income but cash came from a different activity, so you subtract the gain (and add back a loss) to keep operating cash flow accurate. Then adjust for changes in working capital—accounts like accounts receivable, inventory, and prepaid expenses (current assets) typically reduce cash when they rise, while accounts payable and other current liabilities typically increase cash when they rise. Conversely, decreases in current assets or increases in current liabilities raise cash, and increases in current assets or decreases in current liabilities use cash.

After arriving at cash from operating activities, the statement presents investing and financing activities in their own sections. This structure shows how accrual accounting flows into cash, and how investing and financing decisions affect cash separately. The indirect method is common because it connects directly to the income statement and balance sheet, and it can be prepared from existing records with fewer detailed disclosures than the direct method.