Statement of Cash Flows

The statement of cash flows reports all cash inflows and outflows during a period, classified into three categories: operating, investing, and financing activities. It reconciles the beginning and ending cash balances and answers: Where did cash come from, and where did it go? :::info Key Concept

The statement of cash flows bridges the accrual-basis income statement to actual cash movements. An entity can report strong net income but still face a cash crisis — or vice versa.

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Cash and Cash Equivalents

Cash includes currency on hand and demand deposits. Cash equivalents are short-term, highly liquid investments that are:

• Readily convertible to known amounts of cash
• So near maturity that they present insignificant risk of value changes
• Original maturity of three months or less from the date of purchase :::tip Exam Tip — Three-Month Rule A 6-month Treasury bill purchased with 2 months remaining is not a cash equivalent (original maturity > 3 months). A 90-day certificate of deposit is a cash equivalent. :::

  Cash Equivalent?	Instrument	Reason
  ✅	60-day T-bill	Original maturity ≤ 3 months
  ✅	Money market fund	Readily convertible, negligible risk
  ❌	6-month CD	Original maturity > 3 months
  ❌	Equity securities	Not "near maturity" — subject to price risk

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Three Sections of the Statement

Operating Activities (CFO)

Cash flows from the entity's principal revenue-producing activities. These generally involve income statement items and changes in current assets and current liabilities. Cash inflows:

• Cash received from customers
• Interest and dividends received
• Insurance proceeds from operations Cash outflows:
• Cash paid to suppliers and employees
• Cash paid for interest
• Cash paid for income taxes
• Cash paid for operating expenses :::warning Important Classifications Under U.S. GAAP:
• Interest paid → Operating (even though it relates to financing)
• Interest received → Operating
• Dividends received → Operating
• Dividends paid → Financing (not operating!)
• Income taxes paid → Operating (unless directly attributable to investing/financing) :::

Investing Activities (CFI)

Cash flows from acquiring and disposing of long-term assets and other investments not classified as cash equivalents. Cash inflows:

• Sale of PP&E
• Sale of investments (debt and equity securities)
• Collection of loan principal (notes receivable)
• Sale of a business unit Cash outflows:
• Purchase of PP&E
• Purchase of investments
• Making loans to other entities (notes receivable)
• Acquisition of a business

Financing Activities (CFF)

Cash flows from transactions with owners and creditors that affect long-term capital structure. Cash inflows:

• Issuance of common or preferred stock
• Issuance of bonds or long-term notes payable
• Borrowings from banks (long-term) Cash outflows:
• Repurchase of treasury stock
• Payment of cash dividends
• Repayment of long-term debt principal
• Payment of finance lease principal

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Indirect Method (Most Common)

The indirect method starts with net income and adjusts for noncash items and changes in operating assets and liabilities. This is the method most commonly used in practice and most commonly tested.

The CLAD Framework

:::tip CLAD Mnemonic

Use CLAD to remember the adjustments from net income to cash from operations:

Letter	Adjustment	Direction
C	Current asset/liability changes	See rules below
L	Losses add back / Gains subtract	Reverse direction
A	Amortization, depreciation, depletion	Add back
D	Deferred items (deferred tax, deferred revenue changes)	Adjust accordingly

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Current Asset and Liability Changes

Change	Effect on Cash from Operations
Current asset increases (e.g., AR goes up)	Subtract (used cash)
Current asset decreases (e.g., inventory goes down)	Add (freed up cash)
Current liability increases (e.g., AP goes up)	Add (conserved cash)
Current liability decreases (e.g., wages payable goes down)	Subtract (used cash)

:::tip Exam Tip

Think of it this way: If a current asset increased, the company spent cash to build up that asset — so subtract. If a current liability increased, the company held onto cash by not paying — so add.

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Losses and Gains

Gains and losses from investing/financing activities (e.g., gain on sale of equipment) are removed from operating activities because the total cash from the transaction is classified elsewhere.

• Add back losses (they reduced net income but didn't use operating cash)
• Subtract gains (they increased net income but the cash is in investing)

Depreciation, Amortization, Depletion

These are noncash expenses that reduced net income. Add them back to convert from accrual to cash basis.

Indirect Method Example

Bear Co. reports the following for the year ended December 31:

Item	Amount
Net income	$180,000
Depreciation expense	45,000
Amortization of patent	5,000
Gain on sale of equipment	(12,000)
Loss on sale of investment	8,000
Increase in accounts receivable	(25,000)
Decrease in inventory	15,000
Increase in accounts payable	10,000
Decrease in wages payable	(3,000)
Increase in deferred tax liability	7,000
Cash flows from operating activities — Indirect method:
Bear Co. — Operating Activities	Amount
---	---:
Net income	$180,000
Adjustments:
Depreciation expense	45,000
Amortization of patent	5,000
Gain on sale of equipment	(12,000)
Loss on sale of investment	8,000
Increase in accounts receivable	(25,000)
Decrease in inventory	15,000
Increase in accounts payable	10,000
Decrease in wages payable	(3,000)
Increase in deferred tax liability	7,000
Net cash provided by operating activities	$230,000

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Direct Method

The direct method reports actual cash receipts and payments from operating activities. It provides more detailed information but is rarely used in practice.

Bear Co. — Operating Activities (Direct Method)	Amount
Cash received from customers	$975,000
Cash paid to suppliers	(580,000)
Cash paid to employees	(210,000)
Cash paid for interest	(25,000)
Cash paid for income taxes	(55,000)
Net cash provided by operating activities	$105,000

Converting Accrual to Cash (Direct Method Formulas)

$$\text{Cash from Customers} = \text{Revenue} - \Delta\text{AR} + \Delta\text{Unearned Revenue}$$ $$\text{Cash to Suppliers} = \text{COGS} + \Delta\text{Inventory} - \Delta\text{AP}$$ $$\text{Cash for Operating Expenses} = \text{OpEx} + \Delta\text{Prepaids} - \Delta\text{Accrued Liabilities}$$

note

If the direct method is used, a reconciliation of net income to cash from operations (essentially the indirect method) must be presented in a supplemental schedule.

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Complete Statement Example

Gies Co. — Statement of Cash Flows (Year Ended December 31)

	Amount
Cash flows from operating activities:
Net income	$250,000
Depreciation expense	60,000
Loss on sale of equipment	5,000
Increase in accounts receivable	(30,000)
Decrease in prepaid expenses	4,000
Increase in accounts payable	18,000
Decrease in income tax payable	(6,000)
Net cash from operating activities	$301,000
Cash flows from investing activities:
Purchase of equipment	(120,000)
Proceeds from sale of equipment	15,000
Purchase of AFS securities	(50,000)
Net cash used in investing activities	($155,000)
Cash flows from financing activities:
Proceeds from issuance of common stock	75,000
Repayment of long-term note payable	(40,000)
Payment of cash dividends	(60,000)
Purchase of treasury stock	(25,000)
Net cash used in financing activities	($50,000)
Net increase in cash and cash equivalents	$96,000
Cash and cash equivalents, beginning of year	84,000
Cash and cash equivalents, end of year	$180,000

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Supplemental Disclosures

Even when using the indirect method, certain items must be separately disclosed:

Required Supplemental Information

Disclosure	Reason
Cash paid for interest	Interest is in operating, but users want the actual amount
Cash paid for income taxes	Same — actual cash flow matters for analysis

Noncash Investing and Financing Activities

Significant noncash transactions must be disclosed either in a supplemental schedule or in the notes. These transactions are excluded from the statement of cash flows because no cash changed hands. Common examples:

• Conversion of bonds to common stock
• Acquisition of assets through capital (finance) lease
• Issuance of stock for land or other assets
• Exchange of noncash assets Example — MAS Inc. acquires land by issuing stock:

Debit

Credit

Land

$200,000

Common stock

$10,000

APIC

190,000

This transaction would appear as a noncash investing/financing disclosure:

Supplemental schedule of noncash investing and financing activities: The Company acquired land valued at $200,000 by issuing 10,000 shares of common stock.

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Classification of Specific Items

:::warning Frequently Tested Classifications

Transaction	Section
Cash received from customers	Operating
Interest paid	Operating
Interest received	Operating
Dividends received	Operating
Income taxes paid	Operating
Dividends paid	Financing
Purchase of PP&E	Investing
Sale of investment	Investing
Proceeds from issuing stock	Financing
Repayment of debt principal	Financing
Purchase of treasury stock	Financing
Payment of finance lease principal	Financing
Payment of operating lease principal	Operating
Insurance proceeds (operating claim)	Operating
Insurance proceeds (from PP&E destruction)	Investing

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Journal Entry Connections

Understanding journal entries helps classify cash flows correctly. Example — BIF Partners purchases equipment for cash:

Debit

Credit

Equipment

$80,000

Cash

$80,000

→ Investing activity — cash outflow of $80,000 Example — BIF Partners issues bonds:

Debit

Credit

Cash

$500,000

Bonds payable

$500,000

→ Financing activity — cash inflow of $500,000 Example — BIF Partners pays dividends:

Debit

Credit

Dividends payable

$30,000

Cash

$30,000

→ Financing activity — cash outflow of $30,000 Example — BIF Partners collects on notes receivable:

Debit

Credit

Cash

$25,000

Notes receivable

$25,000

→ Investing activity — cash inflow of $25,000 (principal collection)

Summary

:::danger Common Exam Pitfalls

1. Classifying dividends paid as operating — they are financing.
2. Classifying interest paid as financing — it is operating under U.S. GAAP.
3. Forgetting to remove gains from operating activities (the cash is already in investing).
4. Including noncash transactions in the statement — they go in supplemental disclosures.
5. Confusing the direction of current asset/liability changes — increases in assets subtract; increases in liabilities add.
6. Treating depreciation as a cash inflow — it is merely an add-back of a noncash expense. :::

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Practice Problem

Illini Entertainment provides the following data for the year:

• Net income: $320,000
• Depreciation: $75,000
• Gain on sale of building: $40,000
• Proceeds from sale of building: $190,000
• Purchase of equipment: $250,000
• Issuance of common stock: $100,000
• Repayment of bonds payable: $150,000
• Dividends paid: $80,000
• Increase in accounts receivable: $35,000
• Decrease in accounts payable: $20,000
• Conversion of preferred stock to common stock: $50,000 Required: Prepare the statement of cash flows using the indirect method.

Solution

Illini Entertainment — Statement of Cash Flows	Amount
Operating activities:
Net income	$320,000
Depreciation	75,000
Gain on sale of building	(40,000)
Increase in accounts receivable	(35,000)
Decrease in accounts payable	(20,000)
Net cash from operating	$300,000
Investing activities:
Proceeds from sale of building	190,000
Purchase of equipment	(250,000)
Net cash used in investing	($60,000)
Financing activities:
Issuance of common stock	100,000
Repayment of bonds payable	(150,000)
Dividends paid	(80,000)
Net cash used in financing	($130,000)
Net increase in cash	$110,000
Noncash disclosure: Conversion of $50,000 preferred stock to common stock.