 In this discussion, we will discuss the discussion question of Explain how the cash flows from operating activities section is created using the indirect method If we see a discussion question or essay question like this and we don't know exactly where to start Support accounting instruction by clicking the link below giving you a free month membership to all of the content on our website Broken out by category further broken out by course each course then organized in a logical reasonable fashion Making it much more easy to find what you need than can be done on a YouTube page We also include added resources such as Excel practice problems PDF files and more like QuickBooks backup files when applicable So once again click the link below for a free month membership to our website and all the content on it We might first think well I'm on a section here that's focusing in on the statement of cash flows So even if we don't know what the indirect method is We could probably say hmm it probably has something to do with the statement of cash flows And start discussing well what is the statement of cash flows and how do we put the statement of cash flows together And then of course try to get into this indirect method we should have an idea of what the indirect method is So the statement of cash flows is going to be one of our major financial statements We have the balance sheet income statements statement of equities statement of cash flows And the statement of cash flows is going to be reporting the cash flows that happened over time So the change in cash we're going to be reporting those in the statement of cash flows breaking them out into three major categories Operating investing financing So the operating activities even if we don't know what the indirect method is We might have probably have an idea of what operating activities are The cash flows from operations are going to be the major cash flows that happened They're going to be the detail that happened and they're similar to like the income statement So the income statement represents activity over time whereas the balance sheet represents something as of a point in time The cash flow statement is an activity statement So it's trying to represent things that are happening over time telling a story So it's similar to the income statement in that format However the income statement is on a cruel basis And we're working with a cash basis cash flow type statement So the cash flows from operations then is similar to the income statement It's going to show those activities and get to the bottom line Which on net income is on the income statement is net income On the statement of cash flows we're going to get cash provided by operations And that's going to be kind of like net income on a cash basis Now there's two methods to do that And notice again this operating activities is going to be the major of the three It's probably where the most detail is then Most line items, most activity happening on the operating as opposed to investing and financing When we think about the indirect versus direct method we're only focusing on the operating activity The financing and investing activities will remain the same whether using the indirect Or the other method that we can compare and contrast to the only other really acceptable method would be the direct method So those two methods only change the operating activities They have no effect on financing or investing activities So therefore if we look at the indirect method we can kind of compare and contrast it to the direct method The indirect method is going to get to basically net income on a cash basis Which is cash flows from operations but it's not going to kind of try to reconstruct the income statement Which would make sense that makes intuitive sense to most people Makes intuitive sense to me to say well what are we going to do if we're going to make this on a cash basis Let's just take revenue and expenses and convert all those to a cash basis for cash revenue and cash expenses And then we get basically to net income if we subtract the two out on a cash basis That would be more of a direct method The indirect method doesn't do that and it's actually preferred in some way or required oftentimes even if we use the direct method And the reason is not because it's more intuitive People can explain the direct method probably easier to investors than the indirect method But it's also kind of a reconciliation meaning it's reconciling net income on an accrual basis to a cash basis And the way it does that is it's going to start the thing, we're going to start where we ended We're start with what we did, we got net income That's going to be the first line item on the operating activities And then what we're going to do is we're going to kind of back out all activities that were accrual accounts Accrual activity, non-cash items So that we get to net income that's going to be more on a cash basis which is going to be operating cash flows from operations So in this way we're reconciling then, we're looking at the difference, we're looking at all the changes The things that are different between cash flows on a net income on an accrual basis Versus cash flows on a cash flow basis Sorry, net income We're looking at net income, the difference between net income basically on an accrual versus net income on a cash flow basis We're looking at those changes, how do we reconcile the two And that's one reason that the indirect method is often required even if we use the direct method We still have to do this reconciliation often times So the way we're going to do that then is we're going to start with net income And we're going to try to reverse out everything that's an accrual thing so that we can get to basically cash on a cash flow basis Net income on a cash flow basis, cash flows from operations The way we do that is we look at the change in all balance sheet accounts typically And so the change in current assets, the change in current liabilities for example And we know that the change has something to do with cash And the reason we know that is if you look at the journal entry for any type of current asset or current liabilities Typically it'll involve an income statement account, that's how we know it's going to be dealing with operations from operating activities So for example, a accounts receivable, the major journal entry is to debit accounts receivable and credit revenue And that deals with revenue, revenue is going to be an income statement account In other words, revenue is included in net income And if we have an increase in accounts receivable, we can see that we recorded something in net income for which we did not get cash And therefore an increase in the accounts receivable account would mean that we would have to decrease net income in order to get to a cash basis net income So anything that deals with the income statement then we can take a look at and try to use that same logic to reverse out anything that's an accrual type of activity to get to net income basically on a cash basis That'll be the approach we're using We can see some things that'll be directly on the income statement like if we think of depreciation expense That's going to be something that we know got on the income statement but has no cash involved, we debit depreciation expense and we credit accumulated depreciation No cash is involved there, and therefore we've got to take it out of net income So that's going to be something that will reverse out of net income Now again, we can see that on our worksheet, that should be equivalent to the change in accumulated depreciation Because that change is recorded as a debit to depreciation expense, a credit to accumulated depreciation However, there may be other things involved as well because we may have sold equipment or we may have sold or disposed of equipment So in any case, our goal there is to go to net income and go through and look at the changes typically in the balance sheet accounts With the help of using income statement to look at things like depreciation and some other resources that we have to along the way To reverse out anything that's on a cruel basis to get to a cash basis net income which would be cash flows from operating activities