Reporting Operating Activities: Direct and Indirect Method (Ind AS 7)

Understand Reporting Operating Activities: Direct and Indirect Method

Key rules to remember

Indirect method: operating profit before working capital changes

Net profit before tax + Depreciation and amortisation + Finance costs + Impairment/provisions (non-cash) + Loss on sale of assets − Interest and dividend income − Profit on sale of assets ± Other non-cash items

Add back expenses that are non-cash or belong to investing/financing. Deduct income that belongs to investing/financing.

Working capital adjustments

Increase in current assets → deduct; Decrease in current assets → add; Increase in current liabilities → add; Decrease in current liabilities → deduct

Use operating items only: inventories, trade receivables, trade payables, other operating assets and liabilities.

Net cash from operating activities (indirect)

Cash generated from operations − Income taxes paid

Income tax paid is shown under operating activities unless it can be specifically identified with investing or financing.

Direct method: cash receipts from customers

Revenue from operations − Increase in trade receivables (or + decrease)

Adjust for opening and closing receivables. Ignore bad debts if given as written off, and adjust separately if relevant.

Direct method: cash paid to suppliers

Purchases − Increase in trade payables (or + decrease)

Purchases = Cost of goods sold + Closing inventory − Opening inventory.

Reconciliation check

Net cash from operating activities (direct) = Net cash from operating activities (indirect)

Use this to check your answer when both can be computed.

How to solve Reporting Operating Activities: Direct and Indirect Method questions

1. 1Read what is asked: the method (direct or indirect), and whether the answer needs only operating activities or the full statement.
2. 2List the balance sheet movements: opening and closing figures of each operating asset and liability, and compute increase or decrease.
3. 3Identify non-operating items in the profit statement: interest, dividend income, gain or loss on disposal, finance costs. These move out of operating activities.
4. 4Indirect method: start with profit before tax, add back non-cash and non-operating expenses, deduct non-operating income, then apply working capital changes to reach cash generated from operations.
5. 5Direct method: compute cash received from customers and cash paid to suppliers, employees and other expenses, from the revenue and expense figures adjusted for working capital changes.
6. 6Deduct income tax paid (opening tax liability + tax expense − closing tax liability, or as given) to reach net cash from operating activities.
7. 7Check the sign of every adjustment and state any assumption you made, for example classification of interest paid.

Quickest way: Indirect method in six lines

Common mistakes in Reporting Operating Activities: Direct and Indirect Method

• Adding depreciation but forgetting to add back finance cost or to deduct interest income

  Students treat only depreciation as a non-cash adjustment.

  Fix: Scan every item in the profit statement and ask: is it non-cash, investing or financing? If yes, adjust it.

• Wrong sign on working capital changes

  Students memorise 'increase means add' without thinking about cash.

  Fix: Think cash: more receivables means customers have not paid, so cash is lower. More payables means you have kept cash, so cash is higher.

• Starting from profit after tax and also deducting tax paid

  Confusion over whether tax has already been charged.

  Fix: Start from PBT, then deduct tax actually paid. If you start from PAT, add back the tax expense first.

• Taking tax expense instead of tax paid

  Students use the figure shown in the profit statement.

  Fix: Tax paid = opening tax payable + tax expense − closing tax payable. Adjust for advance tax or refunds if given.

• Including sale proceeds of an asset in operating activities

  Students adjust the gain but then also keep the proceeds in operating cash.

  Fix: Remove the gain or loss from operating activities and show the full sale proceeds under investing activities.

• Ignoring non-cash items such as provisions or unrealised foreign exchange differences

  They are tucked away in notes or extra data.

  Fix: Reread all additional information. Adjust any non-cash item that has been charged or credited to profit.

Worked examples