CFA Program Level I

Cash flow statement, direct vs indirect method: CFA Level I

The statement of cash flows splits the period's cash flows into operating, investing and financing activities. The direct method lists gross operating cash receipts and payments; the indirect method starts from profit and adjusts it. Both methods give the same net operating cash flow.

Operating, investing and financing

Operating activities are the entity's main revenue-producing activities and anything that is not investing or financing. Investing activities are buying and selling long-term assets and other investments that are not cash equivalents. Financing activities change the size and make-up of the entity's equity and borrowings.

Under US GAAP (FASB Statement No. 95), interest paid to lenders is an operating outflow, and interest and dividends received are operating inflows. Dividends paid to owners and repayments of borrowing are financing outflows. Proceeds from selling property, plant and equipment are investing inflows.

Investing and financing transactions that use no cash, such as buying land by issuing a note to the seller, are left out of the statement and disclosed separately (IAS 7). The IFRS Foundation notes that IAS 7 has been amended alongside IFRS 18 with new requirements for classifying interest and dividend cash flows, so check which version a question assumes.

The indirect method, worked

The indirect method starts with net income and removes three kinds of item: non-cash expenses such as depreciation, gains and losses whose cash belongs to investing or financing, and changes in operating working capital.

Example (USD thousands): net income 1,000; depreciation 150; gain on sale of equipment 60; accounts receivable up 90; inventory down 40; accounts payable up 30.

Operating cash flow = 1,000 + 150 - 60 - 90 + 40 + 30 = 1,070. Depreciation is added back because no cash left. The gain is deducted because the whole sale proceeds go in investing. An increase in an operating asset is deducted, a decrease is added. An increase in an operating liability is added, a decrease is deducted.

The direct method, worked

The direct method reports major classes of gross receipts and payments, such as cash collected from customers, cash paid to suppliers and employees, interest paid and income taxes paid. US GAAP encourages it; a company that uses it must still provide a reconciliation of net income to operating cash flow in a separate schedule.

Each line can be derived from accrual figures. Example (USD thousands): cost of sales 2,000; inventory up 100; accounts payable up 40. Purchases = 2,000 + 100 = 2,100. Cash paid to suppliers = 2,100 - 40 = 2,060, because 40 of the purchases are still owed.

Depreciation never appears in a direct-method operating section, because it is not a cash payment.

Where the exam catches people

Believing a gain on selling equipment adds to operating cash flow: it is deducted in the indirect method, and the full proceeds are shown in investing.
Believing an increase in receivables adds to cash: sales were booked but not collected, so the increase is deducted.
Believing interest paid on a loan used for a buyback is a financing flow under US GAAP: FAS 95 puts interest paid in operating activities whatever the loan funded.
Believing the direct and indirect methods give different operating cash flows: they differ only in presentation and reach the same total.
Believing a non-cash purchase of land shows as an investing outflow: non-cash investing and financing transactions are disclosed separately, not in the statement.

Written from CFA Institute's documentation

Try 3 questions on this

Pick an answer to see why each option is right or wrong.

Ostrava Tools Inc. reports under US GAAP and presents operating cash flow using the indirect method. For the year (USD thousands): net income, 500; depreciation, 80; gain on the sale of a machine, 40; increase in accounts receivable, 30. The net cash flow from operating activities is closest to:
Right. In the game that’s Renown for your Financial Statement Analysis building.
Not that one: A is right. In the game your Financial Statement Analysis building would lose a little Renown, and this question would come back later.
The answerA.USD510,000The indirect method adjusts net income to remove items that do not affect operating cash (add back depreciation), items whose cash effects belong to investing activities (deduct the gain on sale of equipment), and accruals such as the change in receivables (deduct the increase).Your answerB.USD570,000This figure adds the increase in receivables: 500 + 80 - 40 + 30 = 570. Revenue booked but not yet collected raised receivables, so the increase is deducted from net income.Your answerC.USD590,000This figure adds the gain: 500 + 80 + 40 - 30 = 590. The gain on the machine is included in net income but relates to investing activities, so it is removed by deducting it: 500 + 80 - 40 - 30 = 510.
Show the full explanation and doc quotes
Operating cash flow = 500 + 80 - 40 - 30 = USD510,000.
Written from storage.fasb.org/aop_fas95.pdf
Corlan Distributors Inc. reports under US GAAP and presents operating cash flows by the direct method. For the year (USD thousands): cost of sales, 1,800; inventory, 420 at the start of the year and 500 at year end; accounts payable to suppliers, 260 at the start and 310 at year end. All inventory is bought on credit. Cash paid to suppliers for the year is closest to:
Right. In the game that’s Renown for your Financial Statement Analysis building.
Not that one: B is right. In the game your Financial Statement Analysis building would lose a little Renown, and this question would come back later.
Your answerA.USD1,750,000This figure skips the inventory step: 1,800 - 50 = 1,750. Cost of sales counts only the goods sold; the company also bought the 80 of goods that were added to inventory, so purchases were 1,880 before the payables adjustment.The answerB.USD1,830,000Cash paid to suppliers is found by adjusting cost of sales for the change in inventory and the change in payables. Inventory rose by 80, so purchases were 1,800 + 80 = 1,880.Your answerC.USD1,930,000This figure treats the rise in payables as extra cash paid: 1,800 + 80 + 50 = 1,930. A higher payables balance means more purchases were left unpaid at year end, so the increase is deducted: 1,880 - 50 = 1,830.
Show the full explanation and doc quotes
Payables rose by 50, so 50 of those purchases were still unpaid: 1,880 - 50 = 1,830, or USD1,830,000.
Written from storage.fasb.org/aop_fas95.pdf
Brisco Inc. reports under US GAAP. During the year it pays USD6 million of interest on a bank loan it took out to buy back its own shares, and none of the interest is capitalized. In Brisco's statement of cash flows, the interest payment is most likely classified within:
Right. In the game that’s Renown for your Financial Statement Analysis building.
Not that one: B is right. In the game your Financial Statement Analysis building would lose a little Renown, and this question would come back later.
Your answerA.Investing activitiesInvesting activities are about acquiring and disposing of productive assets and investments. Interest paid on a bank loan is a cost of borrowing, and US GAAP places it with operating cash flows.The answerB.Operating activitiesFASB Statement No. 95 (paragraph 23(d)) includes interest paid to lenders and other creditors in the cash outflows for operating activities.Your answerC.Financing activitiesIt is tempting to keep the interest next to the loan and the buyback, and some respondents argued for exactly that when Statement 95 was drafted. The Board kept interest paid in operating activities instead, requiring the amount paid to be disclosed so that users can reclassify it themselves.
Show the full explanation and doc quotes
The purpose of the loan does not change that: the share buyback and the loan principal are financing flows, but the USD6 million of interest paid is an operating outflow under US GAAP.
Written from storage.fasb.org/aop_fas95.pdf