The Statement of Cash Flows on the CPA Exam

By Kenneth W. Boyd

The financial accounting and reporting (FAR) section of the CPA exam covers basic financial statements including the statement of cash flows. After preparing the balance sheet and income statement, an accountant typically moves on to statement of cash flows.

The statement of cash flows documents a firm’s sources and uses of cash for a particular period of time, such as a month or year. The statement separates cash flows into three activities.

Activities on the Statement of Cash Flows
Type of Activity Description Example Inflow Example Outflow
Operating activities Operating activities represent the cash inflows and outflows
from your day-to-day business activities. Most of your cash
transactions will be operating activities.
Cash receipts from customers Paying for inventory and company payroll
Financing activities Raising money to run your business — and paying it back
— are considered financing activities.
Cash received from issuing stock or debt Paying stockholders a dividend
Investing activities Buying and selling assets are considered investing
activities.
Writing a check for a new company truck Selling a piece of equipment

The process described here is the direct method of the statement of cash flows. You can visualize the process of preparing the statement of cash flows by thinking about your company checkbook. You prepare the statement by grouping your deposits, checks, and debits into operating, financing, and investing activities.

When you’re going through your company checkbook, pick out the transactions that relate to financing and investing activities first. There will be fewer of those transactions. After you finish that process, all the remaining cash flows relate to operations. This trick makes the process go quickly, because you’re pulling out the smaller set of cash transactions first.

You finish the statement of cash flows by adding the net change in cash for each of the three activities. Say that the net change in cash for the year is a $5,000 increase. You add your beginning balance in cash to the net change, and you have your ending balance in cash for the period. If your beginning balance in cash is $30,000, your ending balance in cash should be $30,000 beginning balance + $5,000 net increase in cash = $35,000 ending cash balance.

To wrap up this process, verify that the ending balance in cash ($35,000) agrees with the ending balance in the balance sheet for the last day of the period. If you’re preparing a statement of cash flows for May, the $35,000 cash balance should agree with the cash balance in the May 31 balance sheet. If the two numbers don’t agree, review your statement of cash flows for errors.

Accountants typically prepare the balance sheet and income statement before the statement of cash flows, so if the two cash balances don’t agree, the error is likely in the cash flow statement.

The indirect method of cash flows deals with cash flows for operating expenses slightly differently. This method relates to the accrual basis of accounting. The accrual basis posts revenue when it’s earned and posts expenses when they’re incurred, regardless of when cash moves. The accrual method generates entries to accounts receivable (for revenue) and accounts payable (for expenses).

With the indirect method, the cash flows for operating activities start with net income at the top. You can assume that the company uses the accrual method (unless otherwise stated). So the top line in the operating activities section is net income using the accrual method. You then reconcile from net income to cash flow from operating activities.

To reconcile from net income to cash, you remove the non-cash income statement activity. In other words, you remove the income-statement impact of using the accrual method. Here are two examples:

  • The balance in prepaid insurance declines in March. The journal entry to decrease prepaid insurance is a debit (increase) to insurance expense and a credit (decrease) to prepaid insurance. In March, insurance expense is greater than cash paid for insurance expense.

    Keep in mind that the cash basis wouldn’t post insurance expense unless cash was paid during the period. In this case, the insurance expense was posted due to a prepaid balance. To reconcile from net income to cash, you add the decrease in the prepaid balance to the net income.

  • Depreciation expense and amortization expenses are non-cash items. These entries reduce net income but don’t involve a decrease in cash. To reconcile from net income to cash flow for operations, these expenses are added back. The cash method doesn’t account for either of these expenses, because nothing happens to cash.

After you go through your checkbook, you’ll have the net change in cash flows for operations. That amount is your check figure for the indirect cash flow method. When you finish reconciling from net income to cash, the cash total should agree to the change in cash flows for operating activities. If the reconciliation doesn’t agree to the change in cash, check your work for errors.