Statement of Cash Flows: Indirect Method for the CPA FAR Exam

Overview of the Statement of Cash Flows

The statement of cash flows reports the cash inflows and outflows of an entity during a reporting period, classified into operating, investing, and financing activities. ASC 230 governs the preparation of this statement. The indirect method of presenting operating activities is the most commonly used approach in practice and is heavily tested on the CPA FAR exam.

Classification of Activities

Operating Activities

Operating activities include transactions that enter into the determination of net income. Under the indirect method, the presentation begins with net income and adjusts for noncash items and changes in operating assets and liabilities. Operating activities capture the cash effects of revenue, expenses, gains, and losses not classified as investing or financing.

Investing Activities

Investing activities involve the acquisition and disposal of long-term assets and other investments not classified as cash equivalents. Common investing cash flows include purchases and sales of property, plant, and equipment; purchases and sales of investment securities; and loans made to others and collections of those loans.

Financing Activities

Financing activities involve transactions with the entity's owners and creditors that affect the entity's capital structure. Common financing cash flows include proceeds from issuing stock, payments to repurchase stock (treasury stock), proceeds from borrowing, repayments of borrowing, and dividend payments.

The Indirect Method: Operating Section

The indirect method starts with net income and adjusts for three categories of items:

1. Noncash Expenses and Revenues

Add back expenses that did not use cash and subtract revenues that did not generate cash:

• Add: Depreciation, amortization, depletion, bad debt expense, stock-based compensation expense
• Subtract: Amortization of bond premium (reduces interest expense below cash paid)
• Add: Amortization of bond discount (increases interest expense above cash paid)

2. Gains and Losses on Investing and Financing Activities

These items are removed from operating activities because their cash effects are reported in the investing or financing sections:

• Subtract: Gains on sale of equipment, investments, or other assets (cash is in investing)
• Add: Losses on sale of equipment, investments, or other assets (cash is in investing)
• Subtract: Gains on early extinguishment of debt (cash is in financing)
• Add: Losses on early extinguishment of debt (cash is in financing)

3. Changes in Operating Assets and Liabilities

Adjustments for changes in current assets and current liabilities related to operations:

• Increase in a current asset (other than cash): subtract (cash was used to increase the asset)
• Decrease in a current asset: add (cash was received as the asset decreased)
• Increase in a current liability: add (cash was saved or received)
• Decrease in a current liability: subtract (cash was used to reduce the liability)

A common mnemonic is that changes in current assets move opposite to their balance sheet direction, while changes in current liabilities move in the same direction as their balance sheet change.

Investing and Financing Sections

Both the investing and financing sections report gross cash inflows and outflows (not netted), with limited exceptions for items that turn over quickly. The total of all three sections equals the net change in cash and cash equivalents for the period.

Noncash Investing and Financing Activities

Significant noncash transactions that involve investing and financing activities are not reported on the face of the cash flow statement but must be disclosed separately. Examples include converting debt to equity, acquiring assets through capital leases, exchanging noncash assets, and issuing stock for assets. This disclosure ensures users understand all significant economic events, even those without cash flow effects.

Interest and Dividends

Under US GAAP, interest paid and interest received are classified as operating activities. Dividends received are also operating activities. Dividends paid to shareholders are classified as financing activities. This contrasts with IFRS, which allows more flexibility in classification.

Income Taxes

Income taxes paid are generally classified as operating activities. However, when it is practicable to determine the tax effect of a specific transaction classified as investing or financing, that tax amount may be classified accordingly. In practice, most entities report all income taxes paid as operating.

Exam Preparation Tips

• Know the three sections cold: operating, investing, and financing. Practice classifying transactions.
• Master the indirect method adjustments: start with net income, adjust for noncash items, remove gains and losses, and account for changes in working capital.
• Remember that gains are subtracted and losses are added back in the operating section when their cash effects appear elsewhere.
• Noncash investing and financing activities are disclosed separately, not on the statement itself.
• Interest paid is operating under GAAP; dividends paid is financing. Know this distinction.