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17.3 Cash Flows from Operating Activities: The Instraight Method

Learning Objectives

At the finish of this section, students have to have the ability to fulfill the complying with objectives:

Explain the distinction in the start of the operating activities section of the statement of cash flows once the indirect technique is offered fairly than the direct method. Demonstrate the removal of both noncash items and nonoperating gains and losses in the application of the instraight technique. Determine the impact caused by the adjust in the assorted connector accounts once the indirect approach is offered to current cash flows from operating activities. Identify the reporting classification for interest revenues, dividfinish revenues, and interemainder cost in creating a statement of cash flows and also explain the dispute that resulted from this managing.

The Steps Followed in Applying the Indirect Method

Question: As mentioned, the majority of establishments execute not pick to existing their operating task cash flows utilizing the straight technique despite the choice of FASB. Instead, this information is virtually universally displayed within a statement of cash flows by implies of the indirect method. How does the instraight strategy of reporting operating task cash flows differ from the straight method?


Answer: The indirect strategy actually follows the exact same set of steps as the straight strategy except that it begins through net income rather than the business’s whole revenue statement. After that, the exact same three actions demonstrated formerly to determine the net cash flows from operating activities are adhered to although the mechanical application here is various.

You are watching: Net cash flows from operating activities under the indirect method is determined by eliminating:

Noncash items are rerelocated. Nonoperational gains and also losses are removed. Adjustments are made, based on the financial readjust developing throughout the duration in the assorted balance sheet connector accounts, to switch all continuing to be revenues and also expenses from accrual accounting to cash accounting.

Rerelocating Noncash and Nonoperating Items—The Instraight Method

Question: In the revenue statement presented in Figure 17.4 "Liberto Company Income Statement Year Ended December 31, Year One" for the Liberto Company kind of, net revenue was reported as $100,000. This figure included depreciation price (a noncash item) of $80,000 and also a acquire on the sale of equipment (an investing activity rather than an operating activity) of $40,000. In using the instraight approach, exactly how are noncash items and nonoperating gains and also losses removed from net income?


Answer: First, all noncash items within net income are eliminated. Depreciation is the instance contained here. As an cost, it is an unfavorable component uncovered within net income. To remove an adverse, it is counter by a positive. Therefore, including ago $80,000 serves to remove the affect of depreciation from the reporting company’s net income.

2nd, all nonoperating items within net income are eliminated. Liberto’s obtain on sale of equipment is reported within reported revenue. As a get, it is a positive figure; it assisted rise earnings this period. To remove this gain, $40,000 need to be subtracted from net earnings. The cash flows resulting from this transaction came from an investing activity and not an operating task.

In applying the indirect approach, as presented in Figure 17.7 "Operating Activity Cash Flows, Indirect Method—Elimicountry of Noncash and also Nonoperating Balances", an unfavorable is rerelocated by addition; a positive is removed by subtractivity.

Figure 17.7 Operating Activity Cash Flows, Indirect Method—Elimination of Noncash and Nonoperating Balances


In the straight approach, these two income statement quantities were sindicate omitted in arriving at the individual cash flows from operating activities. In the indirect strategy, they are both physically removed from revenue by reversing their effect.

The affect is the exact same in the indirect method as in the straight method; the balances are rerelocated.

Converting Accrual Accounting Figures to Cash Balances—The Indirect Method

Question: After all noncash and also nonoperating items are removed from net revenue, just the transforms in the balance sheet connector accounts should be utilized to complete the convariation to cash. For Liberto, those balances were presented previously.

Accounts receivable: up $19,000 Inventory: down $12,000 Prepaid rent: up $4,000 Accounts payable: up $9,000 Salary payable: dvery own $5,000

Each of these increases and also decreases was supplied in the direct method to turn accrual accounting numbers into cash balances. That same procedure is adhered to in the instraight strategy. In determining cash flows from operating tasks, just how are alters in an entity’s connector accounts reflected in the application of the instraight method?


Answer: Although the steps appear to be different, the very same logic is applied in the instraight technique as in the direct approach. The adjust in each of the previous connector accounts discloses the difference in the accrual accounting quantities recognized in the income statement and the actual transforms in cash. Here, though, the effect is measured on net earnings overall quite than on the individual revenue and price accounts.

Accounts receivable enhanced by $19,000. This increase in the receivable balance shows that less money was collected than the sales made by Liberto in the time of the period. Receivables go up because customers are slow-moving to pay. This readjust outcomes in a lower cash balance. Hence, the $19,000 is subtracted in showing up at the cash circulation amount produced by operating activities. The cash received was actually less than the figure reported for sales that appears within the company’s net earnings. Subtract $19,000.

Inventory decreased by $12,000. A drop in the amount of inventory on hand shows that much less merchandise was purchased throughout the duration. Buying less requires a smaller sized amount of cash to be paid. That leaves the cash balance higher. The $12,000 is included in arriving at the operating task readjust in cash. Add $12,000.

Prepassist rent boosted by $4,000. An boost in any type of prephelp price shows that more of the asset was acquired throughout the year than was consumed. This extra purchase requires the usage of cash; hence, the resulting cash balance is reduced. The increase in prepaid rent necessitates a $4,000 subtraction in the operating activity cash flow computation. Subtract $4,000.

Accounts payable boosted by $9,000. Any jump in a licapacity implies that Liberto paid much less cash throughout the period than the debts that were incurred. Postponing licapability payments is a widespread strategy for conserving cash to store the reported balance high. In determining cash flows from operating tasks, the $9,000 liability rise is added. Add $9,000.

Salary payable lessened by $5,000. Licapacity balances fall once additional payments are made. Such cash transactions are reflected in applying the indirect strategy by a $5,000 subtraction from net revenue. Subtract $5,000.

Thus, if Liberto Company type of uses the indirect method to report its cash flows from operating tasks, the indevelopment will be presented to decision devices as presented in Figure 17.8 "Liberto Company Statement of Cash Flows for Year One, Operating Activities Reported by Indirect Method".

Figure 17.8 Liberto Company type of Statement of Cash Flows for Year One, Operating Activities Reported by Instraight Method


As with the direct strategy (Figure 17.6 "Liberto Company Statement of Cash Flows for Year One, Operating Activities Reported by Direct Method"), the complete right here shows a net cash incirculation of $133,000 from the operating activities of this agency. In both situations, the starting spot was net revenue (either as the whole earnings statement or as the single number). Then, all noncash items were rerelocated and nonoperating gains and also losses. Finally, the impact of alters in the miscellaneous connector accounts that bridge the time duration in between accrual accounting acknowledgment and the cash exchange are included so that only the cash flows from operating tasks remain.

In reporting operating activity cash flows by implies of the instraight approach (Figure 17.8 "Liberto Company type of Statement of Cash Flows for Year One, Operating Activities Reported by Instraight Method"), the complying with pattern can be seen.

A change in a connector account that is an asset is reflected on the statement in the oppowebsite fashion. As displayed previously, increases in both accounts receivable and also prepaid rent are subtracted while a decrease in inventory is added. A change in a connector account that is a liability is contained on the statement in an the same readjust. An increase in accounts payable is included whereas a decrease in salary payable is subtracted.

A quick visual comparison of the direct strategy (Figure 17.6 "Liberto Company kind of Statement of Cash Flows for Year One, Operating Activities Reported by Direct Method") and also the instraight technique (Figure 17.8 "Liberto Company type of Statement of Cash Flows for Year One, Operating Activities Reported by Indirect Method") makes the two show up almost totally unrelated. However, once analyzed even more closely, the same series of actions have the right to be seen in each. They both begin through the income for the period. Noncash items and also nonoperating gains and also losses are removed. Changes in the connector accounts for the duration are factored in so that only the cash from operating activities remains.

Test Yourself


The Hemingmethod Company kind of reported net income last year of $354,000. Within that figure, depreciation expense of $37,000 was contained. In enhancement, accounts receivable raised by $11,000 in the time of the duration. What amount of cash did this agency generate from its operating activities?

$306,000 $328,000 $380,000 $402,000


The correct answer is alternative c: $380,000.


Depreciation is a noncash price that appears within net revenue as an unfavorable. To remove it, the $37,000 number is included. Addition counterbalances the original negative effect. The rise in accounts receivable means that customers were slow-moving to pay this year. Credit sales were better than the amount of cash got. The $11,000 is subtracted from net inconcerned arrive at the lower cash figure. Thus, cash inflow from operating tasks is $380,000 ($354,000 + $37,000 − $11,000).

Test Yourself


The Faulkner Corporation reported net income in Year One of $437,000. Accounts receivable at the begin of the duration totaled $26,000 however flourished to $41,000 by the end of Year One. Beginning insurance payable was $7,000 but dropped to an ending balance of $4,000. What amount of cash did Faulkner collect as a result of its operating activities?

$419,000 $425,000 $449,000 $455,000


The correct answer is choice a: $419,000.


Accounts receivable went from $26,000 to $41,000. The $15,000 increase suggests that crmodify sales were better than cash built up. The $15,000 is subtracted from net revenue. Insurance payable fell by $3,000 ($7,000 to $4,000); hence, the amount passist was higher than the price recognized. Cash was invested to alleviate the liability. The $3,000 is also subtracted in getting here at the cash adjust. The cash inflow from operating activities is $419,000 ($437,000 net income − $15,000 and also $3,000).

The Reporting of Dividends and Interemainder on the Statement of Cash Flows

Question: When listing cash flows from operating activities for the year finished December 31, 2010, EMC Corporation (a technology company) had an inflow of practically $103 million labeled as “dividends and also interest received” and an outcirculation of over $76 million presented as “interemainder passist.”

Unmuch less a firm is a financial institution or financing institution, dividfinish and interest earnings carry out not show up to relate to its main operating function. For the majority of businesses, these cash inflows are basically various from the normal sale of products and solutions. Monetary amounts gathered as dividends and also interemainder resemble investing task cash inflows because they are regularly generated from nonpresent assets. Similarly, interest cost payments are normally associated with noncurrent liabilities rather than resulting from day-to-day operations. Interemainder expenditures could absolutely be regarded as a financing activity cash outflow.

Dividfinish distributions are not in question right here. They are labeled as financing activity cash outflows bereason they are made directly to stockholders. The problem is the classification of dividend and also interemainder revenue collections and also interemainder expense payments. Why is cash received as dividends and interest and cash phelp as interemainder price reported within operating tasks on a statement of cash flows quite than as investing tasks and also financing activities?


Answer: Authoritative pronouncements that create UNITED STATE GAAP are the subject of years of intense research, discussion, and conflict. In this process, controversies frequently aclimb. When FASB issued its official typical on cash flows in 1987, 3 of the salso board members voted against passage. Their opposition, at leastern in component, came from the handling of interest and dividends. On page ten of Statement 95, Statement of Cash Flows, these three argue “that interest and also dividends received are returns on investments in debt and equity securities that have to be classified as cash inflows from investing activities. They believe that interest paid is a expense of obtaining financial resources that should be classified as a cash outflow for financing tasks.”

The other board members were not persuaded. Thus, inclusion of dividends accumulated, interest gathered, and interemainder paid within an entity’s operating activity cash flows ended up being a necessity of UNITED STATE GAAP. Such arguments arise typically in the development of official accounting rules.

The majority of the board supposedly felt that—because these transactions occur on a consistent recurring basis—a better portrait of the organization’s cash flows is provided by inclusion within operating tasks. At every juncture of financial accountancy, multiple possibilities for reporting exist. Radepend is complete consensus ever accomplished regarding the many appropriate technique of presenting financial information.

Talking With an Independent Auditor about International Financial Reporting Standards

Following is the conclusion of our intercheck out with Robert A. Vallejo, partner via the accountancy firm PricewaterhouseCoopers.


Question: Any company that complies with UNITED STATE GAAP and also concerns an revenue statement have to also current a statement of cash flows. Cash flows are classified as resulting from operating tasks, investing activities, or financing activities. Are IFRS rules the same for the statement of cash flows as those uncovered in UNITED STATE GAAP?

Rob Vallejo: Differences do exist in between the 2 framefunctions for the presentation of the statement of cash flows, but they are relatively minor. Probably the a lot of evident concern entails the reporting of interemainder and dividends that are received and phelp. Under IFRS, interemainder and dividfinish collections might be classified as either operating or investing cash flows whereas, in U.S. GAAP, they are both forced to be presented within operating activities. A comparable distinction exists for interemainder and also dividfinish payments. These cash outflows can be classified as either operating or financing tasks according to IFRS. For UNITED STATE GAAP, interemainder payments are regarded as operating tasks whereas dividfinish payments are thought about financing tasks.

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Key Takeaway

Most reporting entities use the instraight method to report net cash flows from operating activities. This presentation starts with net income and also then eliminates any type of noncash items (such as depreciation expense) and nonoperating gains and losses. Their impact on net earnings is reversed to create this removal. In addition, transforms in each balance sheet connector account (such as accounts receivables, inventory, accounts payable, and salary payable) should likewise be used in converting from accrual accounting to cash. Changes in ascollection connectors are reversed in arriving at cash flows from operating tasks whereas transforms in licapability connectors have the same affect (increases are included and also decreases are subtracted). Cash transactions that result from interest revenue, dividend revenue, and interest expense are all reported within operating activities because they happen on a consistent continuous basis. However, some argue that interemainder and dividend collections are really acquired from investing activities and also interest payments relate to financing activities.