The statement of cash flows

In depth

Classifying cash flows under US GAAP

ASC 230 defines investing and financing activities and makes operating activities the remainder. Investing covers acquiring and disposing of long-term productive assets and investments, and making and collecting loans. Financing covers dealings with owners and creditors as providers of capital: issuing stock, borrowing, repaying amounts borrowed and paying owners a return. Every receipt and payment that is neither is operating; in practice these are the cash effects of the transactions that make up net income. The table gives the paragraphs that decide the common cases.

Paragraph references are to ASC 230-10-45; for example, 16(b) is ASC 230-10-45-16(b).

Proceeds from selling equipment or other long-term assets, and collections of loans made to others, are investing inflows. Two rows surprise most students. Interest paid is operating although the loan itself is financing: interest is an expense in net income, and ASC 230 keeps the cash effects of net income together, so only the repayment of principal is financing. Dividends paid are financing although dividends received are operating, for the same reason seen from the other side: a dividend paid distributes profit to owners and is not an expense, while a dividend received is income. Customer deposits are operating receipts even though the revenue isn’t earned yet, because they are cash from customers for goods or services.

Paying for an asset over time needs care. Only the down payment and amounts paid at the purchase, or soon before or after it, are investing outflows; if the buyer instead takes on debt directly to the seller, that is a financing transaction, and its later principal payments are financing outflows (ASC 230-10-45-13(c)). Lantern paid $4,000 for its espresso equipment on 3 March and the other $8,000 on 2 April, on the supplier’s ordinary 30-day terms: trade credit paid soon after the purchase, not financing, so all $12,000 is an investing outflow for the year. F01’s March statement disclosed the $8,000 as a noncash item only because it was still unpaid at 31 March.

The van was different. Lantern paid $10,000 in cash, an investing outflow, and signed a $20,000 note with the dealer’s finance company. The note brought in no cash, so it is not in the statement at all; the principal Lantern repays from 2027 will be a financing outflow and the interest an operating one.

Lantern’s year by the direct method

The statement below is Lantern’s first annual statement of cash flows, built from the cash lines of the year’s entries. Its operating section uses the direct method: it lists operating receipts and payments by type, as F01’s March statement did.

Cash received from customers of $191,220 combines catering deposits ($4,040) and collections ($51,720), workshop fees ($22,500) and the online shop’s card receipts ($113,985), less refunds paid back to customers’ cards ($1,025). Cash paid to suppliers of $103,330 covers the beans from Kilnworth Roasting, catering supplies, rent, utilities, advertising, insurance, shipping, fuel, card fees and small costs; employees were paid $41,500, interest $450 and estimated income tax $6,000. Investing shows the equipment and the van’s down payment, and financing shows Ana’s $20,000, Coastline’s $10,000 and the two dividends of $300 and $4,700. The closing figure, $42,940, is the cash on the balance sheet at 31 December.

From the accrual records to the direct-method lines

Few businesses code every bank payment by type as it happens, so preparers usually derive the direct-method lines from the income statement and the balance sheet. The logic is the same for every line: start from the accrual amount and adjust it by the change in the balance sheet account that sits between the accrual and the cash. Revenue becomes cash collected after removing the increase in receivables (sold, not yet collected) and the receivables written off (sold, never collected), and adding the increase in unearned revenue (collected, not yet earned). An expense becomes cash paid after adding the increase in a related asset such as inventory or a prepayment (paid for, not yet an expense) and removing the increase in a related liability such as payables (an expense, not yet paid).

Fictional figures. Opening balances were zero, so each change is the 31 December balance.

• Customers: net revenue of $193,320, less the increase in receivables ($7,380) and the receivable written off ($820), plus the increase in unearned revenue ($6,100).
• Suppliers: cost of goods sold, supplies used and the other cash expenses ($105,800), plus the increases in inventory ($5,800), supplies ($640) and prepaid insurance ($300), less the increase in accounts payable ($9,210).
• Employees: event wages in cost of services and wages expense ($43,600), less the increase in wages payable ($2,100).
• Interest and income taxes: each expense less the increase in the related payable ($750 and $3,129).

Two expenses never reach the direct method: depreciation of $4,800 and bad debt expense of $1,404 used no cash. The $820 receivable written off appears instead, in the customers line, because it is a sale that will never be collected. Lantern’s opening balances were all zero, so each change equals the ending balance; in any later year you would use the difference between the opening and closing balances.

Noncash investing and financing activities

Some investing and financing transactions involve no cash, or only part of it. They are left out of the statement, but because they change the business’s assets and liabilities they must be disclosed, either on the same page or in a note the statement refers to (ASC 230-10-50-3 to 50-6; IAS 7, paragraph 43, has the same rule). When a transaction is part cash and part noncash, only the cash part goes in the statement (ASC 230-10-50-5). Converting debt into stock is the classic example (ASC 230-10-50-4); in small businesses the commonest is buying an asset by signing a note.

Lantern’s van is a part-cash purchase: the $10,000 paid is an investing outflow, and the disclosure beneath the statement relates the cash and noncash parts, as ASC 230-10-50-3 requires: “Van costing $30,000 acquired for $10,000 in cash (shown in investing activities) and $20,000 through a note payable.” A reader who saw only the $10,000 would underestimate both what Lantern invested and what it owes; the disclosure closes that gap. Moving the $5,000 instalment due on 1 June 2027 into current liabilities (adjustment e8) is not a noncash investing or financing activity at all, because no transaction with anyone took place.

Interest, dividends and income taxes under IFRS

IAS 7 agrees with ASC 230 on the three activities but, until the IFRS 18 amendments, gives companies choices that US GAAP does not. A company may classify interest paid as operating or financing, interest and dividends received as operating or investing, and dividends paid as financing or operating, provided it applies its choice consistently from period to period (IAS 7, paragraphs 31, 33 and 34). Taxes on income are operating unless they can be specifically identified with investing or financing activities (paragraph 35).

IFRS 18 Presentation and Disclosure in Financial Statements amends IAS 7 to remove those choices, with effect from the same date as IFRS 18 itself: annual reporting periods beginning on or after 1 January 2027. A company whose main business is not investing in assets or providing finance to customers must classify interest paid as financing and interest and dividends received as investing (new paragraph 34A), and every company must classify dividends paid as financing (paragraph 33A). Banks, investment companies and others with those main business activities classify interest paid and interest and dividends received to match where the related expense and income appear in their income statement (paragraph 34B). The amendments also make operating profit, rather than profit, the starting point of the indirect method.

“Most companies” means those whose main business is not investing in assets or providing finance to customers (IAS 7, paragraphs 33A and 34A as amended).

Direct or indirect: what the standards say and what companies do

ASC 230-10-45-25 encourages the direct method and lists the minimum classes of operating receipts and payments that a company using it must show separately: cash collected from customers; interest and dividends received; other operating receipts; cash paid to employees and other suppliers of goods or services; interest paid; income taxes paid; and other operating payments. IAS 7 also encourages the direct method (paragraph 19). Lantern’s statement shows the classes it has, with suppliers and employees on separate lines.

The encouragement has had little effect: most companies use the indirect method. Three reasons explain the gap. First, US GAAP asks a company that uses the direct method to provide the reconciliation of net income to operating cash flow as well, in a separate schedule (ASC 230-10-45-30), so the direct method means preparing both; IAS 7 asks for the reconciliation only from companies that use the indirect method. Second, accounting systems record revenue and expenses rather than receipts and payments by type, so the direct-method lines must be derived, as you did above, which is laborious in a large organisation. Third, users are familiar with the indirect format, and its starting point ties the statement to the income statement and the balance sheet.

The case for the direct method is plain from Lantern’s statement: a reader sees how much cash came in from customers and went out to suppliers and staff, figures that are useful for forecasting and that the indirect method never shows. This course teaches both, because Lantern’s accountant presents the direct method and must still provide the reconciliation, which is the subject of the next lesson.