Statement of Cash Flows Indirect Method

Statement of Cash Flows Indirect Method

The income statement contains noncash expenses and accruals. Because of this , net income is not an accurate measure of cash inflow. In fact, this is part of the reason for requiring a Statement of Cash Flows Indirect Method.

Noncash Items

Certain items in the income statement are called noncash items. These are items for which the cash flow connected with the expense occurs at a point in time outside of the reporting period. GAAP require the allocation of all or part of the expense to a time period other than the one in which the cash flow occurs. Depreciation is the most significant such item. When a company purchases certain assets, such as plant and equipment, the use of the asset is over a prolonged period that spans many income statement periods. On this basis, GAAP require that the total expense for the asset be spread over some extended number of income periods, such as 5, 10 or even 30 years.

The only thing at issue here is timing. The claim of expense for accounting purposes is separated in time from when the cash flow actually occurs. The cash flow for the item occurs at the time of purchase. The expense charged against income occurs in stages over several income statement periods. Therefore, noncash items make the company's net income figure very different from its cash inflow. Deferred and accrued taxes are two other examples of noncash items.

Accruals 

The revenues and expenses on the income statement include items for which no cash has yet been received. For example, a sale of merchandise that has been agreed to and perhaps even delivered, but that the customer has not yet paid for, can be included. Also, a sale for which some cash has already been received may not be included, because it has not met certain GAAP requirements. Despite this, the revenues shown over a long time represent a good estimate of the actual revenue that will ultimately be collected. However, within a limited time period of, say, one or two years, because of accruals the revenue shown on the income statement can be significantly different from the cash revenue that actually came into the company.

Estimating Cash Flow

Cash flow is often estimated by adding back noncash items to the net income, as in the first two lines of the operating activities part of the statement of cash. This is because the distortion from accruals is typically relatively small. We will use such an estimate in connection with long term investment decisions, called capital budgeting decisions, which are covered in next coming posts.

Accounting Income Versus Economic Income

Economic income is the total return on an investment, made up of the cash inflow plus the change in the market value of the assets and liabilities. As we have just discussed, however, net income is not cash flow and GAAP changes in the company's assets and liabilities do not reflect changes in market values. Thus the Net Income figure shown on the income statement can be quite different from the company's actual economic income. As with the balance sheet, however, some items on the income statement are more or less likely than others to be good estimates of economic reality.

Operating Income

Operating income can be a good estimate of the true economic operating income, provided that (1) the company has made no changes in its accounting procedures, such as switching inventory accounting from a "last in first out" (LIFO) to a "first in first out" (FIFO) basis and (2) the accounting period is sufficiently long. With respect to changes in accounting procedures, certain changes make the amounts reported in that period larger or smaller and can therefore distort the amounts reported. With respect to the length of the accounting period, several years is preferable. Good or poor performance may not be revealed in income statements of one or two years. However, over time, significant changes in performance are likely to be revealed in any extended series of income statements.

Extraordinary Income

Interpreting the economic meaning of extraordinary income requires that we understand its nature and origin. Without such an understanding, it can be impossible to determine the implications of extraordinary income for the company's future.

For example, consider an extraordinary item that is the sale of some land that was worth much more than its current book value. Suppose this difference between book and market values was widely known. In such a case, the extraordinary income that is recognized by the land sale is probably only a matter of bookkeeping. Managers and stockholders will have already taken the higher value into account.

In general, extraordinary items occur only once. In fact, this is part of the reason for requiring a Statement of Cash Flows Indirect Method. They do not reflect the company's sustainable net income. We therefore recommend that you use net income before extraordinary items when doing calculations that involve net income.