Start from net income; add back amortization; remove the gain, add back the loss

Why “indirect”

The operating section can be built two ways. The direct method lists the cash flows themselves — cash collected from customers, cash paid to suppliers — and is the more readable statement. The indirect method starts from net income and adjusts it until it becomes cash from operations. Both arrive at the same operating total; they differ only in how the section is presented, and the investing and financing sections are identical under either. The indirect method is what nearly every private company files and what the 191 paper asks for, because it can be built from the income statement and two balance sheets alone.

The idea: net income is the accrual measure of the year. Every difference between it and operating cash is either an expense that never used cash, a gain or loss whose cash belongs somewhere else, or a timing difference in working capital (next lesson). Undo each one and net income becomes cash.

Add back amortization

Haliburton’s income statement charges amortization of 34,000. Look at the entry that put it there:

Amortization Expense                       34,000
    Accumulated Amortization – Equipment            34,000

The credit went to a contra-asset, not to Cash. The expense reduced net income by 34,000 without a dollar leaving the company — the cash left years ago, when the equipment was bought, and was reported as investing then. So it is added back: net income 72,000 + 34,000 = 106,000. The same logic applies to any non-cash expense — amortization of an intangible, an impairment loss, bad debts expense (though the last is usually handled through the change in receivables).

Add back the year’s expense, 34,000 — never the accumulated balance of 118,000. The balance is every year’s expense since the equipment was bought; only this year’s reduced this year’s net income.

Remove the gain, add back the loss

During the year Haliburton sold equipment that cost 40,000 with accumulated amortization of 12,000 — carrying amount 28,000 — for 26,000 cash. The entry:

Cash                                       26,000
Accumulated Amortization – Equipment       12,000
Loss on Disposal                            2,000
    Equipment                                       40,000

The only cash in that entry is the 26,000, and all of it is an investing inflow — selling a long-lived asset. The loss of 2,000 is the difference between two book figures; it reduced net income but moved no cash. Left in, it would make operating cash 2,000 too low while investing already reports the full 26,000. So the loss is added back: 106,000 + 2,000 = 108,000 before working-capital changes.

The counter-case makes the rule clear. Had the same equipment sold for 31,000, the entry would carry a gain of 3,000 (31,000 − 28,000). The gain raised net income by 3,000, but the cash — all 31,000 — is investing. To avoid counting 3,000 of it twice, the gain is subtracted from net income, and investing reports proceeds of 31,000.

$$\text{Cash before working capital}=\text{NI}+\text{amortization}+\text{losses}-\text{gains}$$

A loss is added, a gain is subtracted, and the proceeds go to investing whatever the sign. Subtracting a loss “because losses reduce cash” is the sign error markers see most often; a loss on disposal never reduced cash — the asset simply fetched less than its book value.