Three activity buckets
Every cash flow gets classified as operating, investing, or financing. Misclassification is one of the most heavily tested FAR errors.
| Activity | Typical items |
|---|---|
| Operating | Cash from customers, cash to suppliers/employees, interest paid/received, dividends received, income taxes paid |
| Investing | Purchase/sale of PP&E, purchase/sale of investment securities, lending and collecting on loans |
| Financing | Issuing/repurchasing stock, borrowing and repaying debt principal, paying dividends |
IMPORTANT (US GAAP specific): Interest paid, interest received, and dividends received are all operating activities under US GAAP. Only dividends paid are financing. This differs from IFRS, which allows more flexibility — know the US GAAP answer for the exam.
Indirect method (the one you'll build most often)
Start with net income, then reverse out non-cash items and working-capital changes:
- Add back: depreciation, amortization, losses on sale, stock compensation expense
- Subtract: gains on sale
- Increase in a current asset → subtract from net income; decrease → add
- Increase in a current liability → add to net income; decrease → subtract
EXAM TIP: Think of it as "cash follows the opposite direction of assets, and the same direction as liabilities." An increase in accounts receivable means less cash was collected than sales recorded, so it reduces the indirect-method adjustment.
Direct method
Shows actual cash received from customers and cash paid to suppliers/employees, computed by adjusting each income statement line for the related balance-sheet change. Less commonly tested numerically, but the exam expects you to know it requires a reconciliation to net income as a supplementary disclosure either way.