The statement of cash flows is derived from the balance sheet and income statement, and at some small clients the audit team builds it after the audit adjustments are posted. That is a place where errors can hide: a capital expenditure accrued in accounts payable shown as cash paid, a noncash lease addition shown as a purchase, a gain counted twice.
This guide covers how ASC 230, Statement of Cash Flows, works, how to prepare the statement with the indirect method, the classification questions that come up most, and how auditors test it. It paraphrases the Codification.
Purpose and structure
The statement of cash flows reports the cash receipts and cash payments of an entity during a period, classified into operating, investing and financing activities. It reconciles the beginning and ending totals of cash, cash equivalents and restricted cash.
Cash, cash equivalents and restricted cash
Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and so near maturity that they present insignificant risk of changes in value. Generally, only investments with original maturities of three months or less to the entity qualify. The entity sets a policy for which items it treats as cash equivalents and discloses it.
Since ASU 2016-18, restricted cash and restricted cash equivalents are included with cash and cash equivalents when reconciling beginning and ending amounts. Transfers between unrestricted and restricted accounts are not cash flows. When restricted cash is presented in a separate line on the balance sheet, the entity provides a reconciliation of those lines to the total in the cash flow statement.
The three categories
- Operating activities: transactions that enter into the determination of net income, and other activities not defined as investing or financing. Collections from customers, payments to suppliers and employees, interest paid and income taxes paid are operating.
- Investing activities: making and collecting loans, acquiring and disposing of debt and equity instruments, and acquiring and disposing of property, plant and equipment and other productive assets.
- Financing activities: obtaining resources from owners and providing them a return of and on their investment, borrowing and repaying amounts borrowed, and other long-term credit arrangements.
Direct vs indirect method
ASC 230 encourages the direct method, which reports major classes of gross operating cash receipts and payments. But an entity that uses the direct method must also present a reconciliation of net income to net cash from operating activities, which is effectively the indirect method. In practice, the indirect method is the common choice for private companies.
The choice affects only the operating section. Investing and financing activities are presented the same way under both methods.
Preparing the statement with the indirect method
Step 1: Start with net income
Begin with net income, including the portion attributable to any noncontrolling interest.
Step 2: Remove noncash items
Add back or deduct items that affected net income but not cash:
- depreciation, amortization and depletion
- amortization of debt issuance costs and debt discounts
- noncash lease cost under ASC 842 (amortization of operating lease right-of-use assets)
- share-based compensation expense
- deferred income taxes
- provision for credit losses, if not presented as part of the change in receivables
- impairment losses
- equity method earnings, net of distributions that are returns on investment
Step 3: Remove gains and losses on investing and financing transactions
A gain on the sale of equipment is deducted from net income, because the full proceeds are shown in investing activities. Similarly, a loss on extinguishment of debt is added back. Missing this step double counts the gain.
Step 4: Adjust for changes in operating assets and liabilities
Increases in operating assets (receivables, inventory, prepaid expenses) reduce cash from operations; decreases increase it. Increases in operating liabilities (accounts payable, accrued expenses, deferred revenue) increase cash; decreases reduce it.
Use the changes in operating balances only. Payables for capital expenditures, accrued interest capitalized into a construction project, and receivables from the sale of a building are not operating items and must be separated.
Step 5: Build investing and financing from the rollforwards
Rather than taking the net change in a balance sheet line, use the rollforward of each account:
- the fixed asset rollforward for purchases, disposals and proceeds; see the fixed asset rollforward template
- the debt rollforward for borrowings and repayments, presented gross
- the equity rollforward for contributions, distributions and repurchases
Step 6: Reconcile and disclose
The net change in cash, cash equivalents and restricted cash must agree to the change on the balance sheet. Then add the required supplemental disclosures.
Noncash investing and financing activities
Investing and financing activities that affect recognized assets or liabilities but do not result in cash receipts or payments are excluded from the statement and disclosed separately. Common examples:
- acquiring equipment with a note payable or seller financing
- right-of-use assets obtained in exchange for new lease liabilities
- converting debt to equity
- capital expenditures included in accounts payable at year end
- distributions declared but unpaid
If a transaction is part cash and part noncash, only the cash portion appears in the statement, and the noncash portion is disclosed.
Gross vs net reporting
ASC 230 generally requires cash receipts and payments to be reported gross. A company that draws on and repays a term loan reports the borrowing and the repayment separately, not the net change.
Net reporting is permitted in limited cases:
- items for which the turnover is quick, the amounts are large and the maturities are short (generally three months or less), such as certain revolving lines of credit
- cash receipts and payments on behalf of customers when the entity is substantively holding or disbursing cash for them, such as certain demand deposits for banks
A revolving line with daily draws and sweeps may qualify for net presentation. A term loan does not.
Classification issues worth knowing
ASU 2016-15 addressed eight specific cash flow classification issues. The ones that come up in private company audits:
- Debt prepayment or extinguishment costs: financing outflows.
- Contingent consideration payments after a business combination: payments made soon after the acquisition date (the ASU describes a period of about three months) are investing; later payments are financing up to the acquisition-date fair value of the liability, with any excess classified as operating.
- Proceeds from the settlement of insurance claims: classified on the basis of the nature of the loss, so proceeds for a destroyed building are investing and proceeds for business interruption are operating.
- Proceeds from corporate-owned life insurance: investing; premiums paid may be investing, operating or a combination.
- Distributions from equity method investees: classified using either the cumulative earnings approach or the nature of the distribution approach, as an accounting policy election.
Other recurring questions:
- Finance lease payments: the principal portion is financing; the interest portion follows the entity's classification of interest paid, which is operating.
- Operating lease payments: operating activities.
- Book overdrafts: changes are commonly presented as financing activities when the overdraft represents short-term financing; the presentation follows the entity's accounting policy and the terms of the bank arrangement.
- Interest paid: operating, except the capitalized portion, which is an investing outflow. Interest paid and income taxes paid must be disclosed. Under ASU 2023-09, the income taxes paid disclosure in ASC 740 is further disaggregated by jurisdiction, effective for private companies for annual periods beginning after December 15, 2025. See ASC 740 income taxes.
Auditing the statement of cash flows
The cash flow statement is part of the financial statements on which the auditor opines, so it is subject to the same risk assessment under AU-C 315 and the same materiality. Typical procedures:
- Tie out. Agree net income, beginning and ending cash, and each noncash add-back to the audited income statement and balance sheet and the supporting workpapers.
- Recompute from audited balances. Recalculate the change in each operating working capital account after audit adjustments, not from the unadjusted trial balance.
- Scrutinize investing and financing lines. Agree capital expenditures, disposals, borrowings and repayments to the fixed asset and debt rollforwards and to bank activity.
- Search for noncash transactions. Review new leases, financing agreements, board minutes and year-end AP for capital items.
- Check classification against ASC 230 and the client's policies, including the ASU 2016-15 items.
- Review disclosures: interest and taxes paid, noncash activities, restricted cash reconciliation and the cash equivalents policy. A GAAP disclosure checklist helps.
When the audit team prepares the statement for the client, document the nonattest service and management's review and approval, as the AICPA independence rules require.
Common errors
- Capital expenditures in year-end accounts payable reported as cash paid.
- Gains on asset sales not deducted from net income.
- Borrowings and repayments of term debt netted.
- ROU assets from new leases shown as investing outflows.
- Working capital changes computed from pre-adjustment balances.
- Restricted cash transfers shown as cash flows.
Frequently asked questions
What is the indirect method of preparing a statement of cash flows?
The indirect method starts with net income and adjusts it for noncash items, gains and losses on investing and financing transactions, and changes in operating assets and liabilities to arrive at net cash from operating activities.
Is the direct method required under ASC 230?
No. ASC 230 encourages the direct method, but the indirect method is permitted. An entity using the direct method must also present a reconciliation of net income to net cash from operating activities.
How are noncash investing and financing activities reported?
They are excluded from the body of the statement and disclosed separately, either in narrative form or in a schedule. Examples include equipment acquired with a note and right-of-use assets obtained for new lease liabilities.
Can cash flows be reported net?
Only in limited cases. ASC 230 generally requires gross reporting, but net reporting is allowed for items with quick turnover, large amounts and short maturities, generally three months or less.
Is restricted cash included in the statement of cash flows?
Yes. Since ASU 2016-18, restricted cash and restricted cash equivalents are included with cash and cash equivalents in the beginning and ending totals, and transfers between them are not reported as cash flows.
Sources
- FASB ASC 230, Statement of Cash Flows (230-10-45 classification; 230-10-50 disclosures)
- FASB ASU 2016-15, Classification of Certain Cash Receipts and Cash Payments (eight classification issues)
- FASB ASU 2016-18, Restricted Cash
- FASB ASU 2023-09, Improvements to Income Tax Disclosures (income taxes paid disaggregation; annual periods beginning after December 15, 2025 for entities other than public business entities)
- FASB ASC 842-20-45, Lease classification of cash flows
- AICPA, AU-C Section 315 and AU-C Section 320
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