Why is indirect cash flow (starting from net income) used, and how are taxes and interest reflected?

• A. It directly shows cash receipts; taxes and interest are ignored.
• B. It avoids non-cash items.
• C. It reconciles net income to cash by adjusting non-cash items and working capital; taxes and interest are shown according to the framework and timing of cash payments.
• D. It is only used for tax planning.

Answer: (C)

The indirect method converts net income into cash flow from operations by reconciling accrual accounting to actual cash movements. It does this by starting with net income, adding back non-cash charges (like depreciation and amortization), removing non-cash gains or losses (which affected net income but not cash), and adjusting for changes in working capital (accounts receivable, inventory, accounts payable, and other current assets and liabilities).

Taxes and interest are shown according to when cash actually moves. The tax expense recorded in net income is adjusted to reflect the cash paid for taxes (often shown as a separate line or via changes in tax payable), and interest paid is reported as a cash outflow in the operating activities section under the prevailing accounting framework.

This approach is preferred because it clearly links the income statement to the cash flow statement and can be prepared from existing records without reconstructing every cash receipt and payment.