The Indirect Method, Step by Step
Chapter Fifty-Five
Syllabus topic 5, "Methods of Preparing Cash Flow Statement ( Indirect Method Only)"
Pages 152 to 155 of 162
In one line
The indirect method starts from net profit and adjusts it for non-cash items, for items whose cash effect belongs elsewhere, and for the changes in working capital.
What AS 3 says: paragraph 20
Under the indirect method, the net cash flow from operating activities is determined by adjusting net profit or loss for the effects of: (a) changes during the period in inventories and operating receivables and payables; (b) non-cash items such as depreciation, provisions, deferred taxes, and unrealised foreign exchange gains and losses; and (c) all other items for which the cash effects are investing or financing cash flows.
Three kinds of adjustment, lettered by the Standard, and the working order reverses them: do (b) and (c) first, then (a).
The four steps
Step one: start from net profit before tax and extraordinary items
Not profit after tax. The tax actually paid is deducted at the end of the operating section, so the starting figure must be before tax.
Where the question gives you the profit after tax, work back.
| Rs | |
|---|---|
| Profit after tax | x |
| Add: provision for taxation charged this year | x |
| Add: transfer to general reserve | x |
| Add: dividends declared during the year | x |
| Net profit before tax | x |
Where the question gives only the two balance sheets, the profit is derived from the movement in the profit and loss balance plus everything appropriated out of it.
| Rs | |
|---|---|
| Closing balance of profit and loss account | x |
| Less: opening balance | (x) |
| Add: transfer to reserves | x |
| Add: dividends paid or proposed during the year | x |
| Add: provision for taxation for the year | x |
| Net profit before tax | x |
This working note is worth three marks on its own and is where most students lose the question before it starts.
Step two: add back non-cash charges, deduct non-cash credits
Paragraph 20(b).
| Add back, because it reduced profit and took no cash | Deduct, because it raised profit and brought no cash |
|---|---|
| Depreciation and amortisation | Profit on the sale of a fixed asset |
| Goodwill, patents or preliminary expenses written off | Profit on the sale of an investment |
| Provision for doubtful debts, where it is created | Provision for doubtful debts written back |
| Loss on the sale of a fixed asset or investment | Unrealised gain on foreign exchange |
| Unrealised loss on foreign exchange | |
| Transfer to any reserve, if it was deducted |
Step three: remove items whose cash effect is investing or financing
Paragraph 20(c), and this is the step most often forgotten.
| Add back | Because |
|---|---|
| Interest paid | It is a financing outflow and will be shown in section C |
| Loss on sale of assets, again if not covered above | The whole proceeds go to section B |
| Deduct | Because |
|---|---|
| Interest received | It is an investing inflow and will be shown in section B |
| Dividend received | The same |
| Rent received on a property held as an investment | The same |
The rest of this chapter
Module one is free. The rest of this chapter comes with the B.Com. (Accountancy) Semester 3 notes.
You are reading a chapter from a later module. Everything in module one of every subject stays free, and so does the syllabus.
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Free either way: the syllabus, and module one of every subject.
The rest of this subject
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