Why the indirect method adds back depreciation and subtracts receivables

What the indirect method is for

Net income is an accrual measure. It records revenue when it is earned and expenses when they are incurred, whether or not cash moved in the same period. Profit is not cash shows how far apart the two can drift. The statement of cash flows reports cash in three sections, operating, investing and financing, and the indirect method is the way many companies arrive at the first one.

It works by starting from net income and removing everything in it that did not move operating cash during the period. Under US GAAP, ASC 230-10-45-28 describes it as a reconciliation that removes two kinds of items. Grant's video on this topic splits the second kind in two, which gives three kinds of adjustment:

1. Non-cash items. Expenses that reduced net income but paid no cash in the period, such as depreciation and amortization.
2. Operating timing differences. Changes in operating assets and liabilities, such as receivables and payables, where the revenue or expense is in net income but the cash has not moved yet, or the cash moved in an earlier period.
3. Items whose cash belongs in another section. Amounts in net income whose cash is reported in investing or financing, such as a gain or loss on selling equipment.

Nothing is invented on the way. Each adjustment either cancels part of net income that was not operating cash, or adds operating cash that net income did not include.

A worked example

This example is hypothetical. Its figures follow the example in Grant's video. Clearpane, a window cleaning business, has this year:

• Revenue of $400,000 for jobs completed. Customers paid $385,000 of it during the year. The other $15,000 is still owed, so accounts receivable rose by $15,000.
• Wages of $160,000, all paid in cash.
• Utilities of $10,000 a month, or $120,000 for the year. Clearpane paid eleven months, $110,000. December's $10,000 bill is unpaid at year end, so accounts payable rose by $10,000.
• Depreciation of $20,000 on its equipment and vans, which it bought in earlier years.

Net income is $400,000 − $160,000 − $120,000 − $20,000 = $100,000. Is cash from operations also $100,000? No. Here is the reconciliation, one line at a time.

1. Net income$100,000
2. Add back depreciation+$20,000

   Reduced net income. Paid no cash this year.

3. Subtract the increase in accounts receivable−$15,000

   Revenue in net income that customers have not paid yet.

4. Add the increase in accounts payable+$10,000

   Utilities expense in net income that Clearpane has not paid yet.

5. Cash from operating activities$115,000

Grey bars are totals. Green bars with a plus sign add; clay bars with a minus sign subtract. The thin line marks zero.

Ties to the cash receipts and payments: $385,000 collected − $110,000 utilities paid − $160,000 wages paid = $115,000.

Depreciation, +$20,000. Depreciation spreads the cost of equipment bought in earlier years over the years it is used. The cash left when the equipment was bought, and that payment was reported then, in investing activities. This year's $20,000 charge reduced net income and paid nothing, so it is added back. The add-back cancels a deduction; it is not a receipt of cash.

Accounts receivable, −$15,000. Clearpane earned revenue when it finished each job, so net income includes all $400,000. But $15,000 of that is a promise to pay, not cash, and some customers may never pay. Subtracting the increase leaves only the revenue that was collected.

Accounts payable, +$10,000. December's utilities are in net income as an expense, because Clearpane used the power. It has not paid the bill. Net income was reduced by $10,000 that has not left the bank, so the increase in payables is added back.

1. Net income$100,000
2. +Depreciation$20,000
3. −Increase in accounts receivable$15,000
4. +Increase in accounts payable$10,000
5. =Cash from operating activities$115,000

Net cash provided by operating activities for the period, in dollars.

Non-cash expenses

Expenses in net income that paid no cash in the period, such as depreciation and amortization.

Operating assets and liabilities

Balances that come from day-to-day operations, such as receivables, inventory, prepaid expenses, payables and accrued expenses. A decrease reverses the sign: a fall in receivables is added, a fall in payables is subtracted.

Gains and losses on investing items

Gains or losses in net income on, for example, selling equipment. The cash from the sale is reported in investing activities, so the gain or loss is removed from the operating section.

The result can be checked without the indirect method at all, by counting the operating cash that actually came in and went out:

Both routes reach $115,000. Counting receipts and payments by type is the direct method. ASC 230 encourages it, but many companies use the indirect method, and under ASC 230-10-45-29 the reconciliation from net income must be shown either way.

Where the signs come from

The rule "subtract an increase in an operating asset, add an increase in a liability" can look like something to memorize. It is the accounting equation, solved for cash.

Assets equal liabilities plus equity. Split the assets into cash and everything else:

Cash + other assets = liabilities + equity, so cash = liabilities + equity − other assets.

That holds at the start of the year and at the end, so it also holds for the change over the year:

Change in cash = change in liabilities + change in equity − change in other assets.

If there are no owner contributions or distributions, as at Clearpane, the change in equity is net income. So:

• An increase in a non-cash asset is subtracted. Cash went into receivables, inventory or prepaid costs instead of the bank, or revenue was booked before it was collected.
• An increase in a liability is added. An expense was booked, or cash was received, without cash leaving.
• Depreciation lowers the carrying amount of equipment, which is a non-cash asset. A decrease in an asset is added, which is the add-back.
• Decreases reverse the signs. If receivables fall, customers paid more than this year's revenue, so the fall is added. If payables fall, Clearpane paid off more than it incurred, so the fall is subtracted.

Clearpane's balance sheet shows it:

Change in cash = $10,000 (payables) + $100,000 (equity) − $15,000 (receivables) − (−$20,000) (equipment) = $115,000. It matches the bridge and the cash count. In a real year, buying equipment, borrowing and paying dividends also change these balances. Those changes go to the investing and financing sections. The indirect method adjusts only for the operating ones.

When cash belongs in another section

Now add one event. Clearpane sells a used van for $20,000 cash. The van's carrying amount, its cost less the depreciation recorded so far, was $15,000, so Clearpane records a $5,000 gain.

Account	Debit	Credit
Cash	$20,000
Equipment, net of accumulated depreciation		$15,000
Gain on sale of equipment		$5,000
Totals	$20,000	$20,000

Simplified: the carrying amount is removed as one line. In practice the cost and the accumulated depreciation are removed separately.

The gain raises net income to $105,000. The $20,000 of cash came from selling a long-lived asset, and under ASC 230 that cash is reported in investing activities. ASC 230-10-45-28 names gains and losses on sales of property, plant and equipment as items to remove from net income because their cash effects relate to investing. So the gain is subtracted in the operating section:

1. Net income, now including the $5,000 gain$105,000
2. Add back depreciation+$20,000
3. Subtract the increase in accounts receivable−$15,000
4. Add the increase in accounts payable+$10,000
5. Subtract the gain on sale of equipment−$5,000

   The $20,000 of cash from the sale is reported in investing activities.

6. Cash from operating activities$115,000

Grey bars are totals. Green bars with a plus sign add; clay bars with a minus sign subtract. The thin line marks zero.

Operating cash is still $115,000, as it should be: selling a van is not cleaning windows. The $20,000 appears once, in investing, and total cash rises by $135,000. A loss on a sale works the other way. It reduced net income without any operating cash leaving, so it is added back.

A common misconception

The most common one is that depreciation is a source of cash, because it is added on the statement of cash flows. In the example, which has no income tax, take the $20,000 depreciation charge away and net income rises by $20,000 while the add-back disappears. Operating cash is $115,000 either way. The add-back only cancels a deduction that never used cash. It produces nothing.

A second is that the indirect method finds cash that profit missed. It finds no cash. Every line in the bridge is a change in a balance on the balance sheet, or an amount already inside net income. The cash count and the balance sheet give the same $115,000.

Where this stops

The example has no inventory, interest or income taxes. Each would add a line under the same rule: inventory is an operating asset, and unpaid interest or taxes are liabilities. Classifying interest, dividends and taxes has rules of its own in ASC 230, which this page does not cover.

ASC 230-10-45-29 requires the reconciliation to report, at a minimum, the changes in operating receivables, inventory and operating payables separately. A real statement of cash flows therefore shows more lines than this one, but each follows the same logic.

This page follows US GAAP. IFRS also requires a statement of cash flows; it is not quoted here. Tax computations sometimes add back depreciation too, for a different reason, under tax rules this page does not cover.