CPA FAR Cash Flows: Direct vs Indirect Method (2027 Prep)

Tessa calculates $42,000 of operating cash flow twice. One calculation starts with customer collections and cash payments, while the other starts with $38,000 of net income. Both use the same original fictional accounts.

The totals should agree. The direct method presents operating cash receipts and payments, and the indirect method reconciles accrual net income to that operating cash total. Switching methods does not create extra cash or change the underlying transactions.

Follow one dataset through both. We will trace a retailer's receivables, inventory and payables, then reconcile investing, financing and ending cash. A separate noncash equipment purchase will show why a correct ending balance cannot prove every classification is correct.

Keep the assumptions beside the source accounts

Our original example covers one year for a fictional US business corporation using simplified US GAAP cash-flow classifications, with no restricted cash, foreign exchange effects, acquisitions, receivable write-offs, deferred taxes, capitalized interest or lease transactions. Only the stated transactions affect these balances.

Use dollars throughout. Sales are $240,000, cost of goods sold is $132,000, salaries expense is $42,000 and insurance expense is $12,000. Separate depreciation expense is $9,000, interest expense is $2,000 and income tax expense is $8,000.

An equipment sale contributes a $3,000 gain. Subtracting the listed expenses and adding that gain produces $38,000 of net income. No depreciation is embedded in cost of goods sold, and inventory contains only purchased merchandise.

The original source accounts (CSV) file includes beginning and ending balances, the income statement and transaction details. These facts belong to our illustration. They are supplied so you can test every conversion without borrowing unstated assumptions from another example.

Convert sales into customer collections

Accounts receivable rises from $18,000 to $24,000. The $6,000 increase means this simplified year's sales exceed collections by $6,000, giving cash received of $234,000.

Check the account itself. Beginning receivables of $18,000 plus sales of $240,000 leave $258,000 to collect. Subtract the $24,000 still receivable at year-end and customer collections are $234,000.

That calculation assumes no other receivable movements. A write-off, acquisition or foreign currency adjustment would require additional facts before you could treat the entire balance change as collection timing. Our dataset excludes those movements explicitly.

OpenStax's direct-method explanation explains converting accrual revenue and expenses using related operating accounts. We use original figures here, with the account bridge visible so a remembered sign can be checked against the actual balance.

Separate inventory purchases from supplier payments

Inventory falls from $26,000 to $22,000. With $132,000 of cost of goods sold, purchases equal $132,000 plus $22,000 ending inventory minus $26,000 beginning inventory, or $128,000.

Purchases are not yet payments. Accounts payable relates only to merchandise suppliers in this example, and it increases from $18,500 to $21,000. Cash paid to suppliers is therefore $18,500 plus $128,000 minus $21,000, giving $125,500.

Trace both accounts. Inventory reconciles as $26,000 plus $128,000 purchases minus $132,000 sold, leaving $22,000. Supplier payables reconcile as $18,500 plus $128,000 purchases minus $125,500 paid, leaving $21,000.

Keep the two adjustments separate. Using only the payable change would miss the merchandise already on hand at the start of the year. Treating every payable as a supplier balance would also fail if it included equipment creditors or other unrelated obligations.

Finish the remaining operating payments

Salaries payable decreases from $4,000 to $3,000. Cash paid to employees is $42,000 expense plus $4,000 beginning payable minus $3,000 ending payable, or $43,000. The company pays more than this year's salary expense.

Prepaid insurance moves the other way. It rises from $1,000 to $3,000, so $12,000 insurance expense corresponds to $14,000 of cash paid. The extra $2,000 remains prepaid rather than becoming this year's expense.

Interest expense equals cash interest here. There is no interest payable change, discount amortization or capitalized interest to reconcile, so the payment is $2,000. Income taxes payable rise from $1,500 to $2,000, making cash taxes $7,500 against $8,000 of current tax expense.

Now total the direct section. Subtract the five payment amounts below from $234,000 collected, obtaining $42,000 of net operating cash. Payment rows show positive magnitudes, and the calculation subtracts them once.

Reach the same operating total from net income

Start the indirect method at $38,000. Add back $9,000 depreciation and subtract the $3,000 equipment-sale gain, reaching $44,000 before the operating balance adjustments. Depreciation reduced income without being a current cash payment.

Remove only the gain here. The full $14,000 equipment-sale proceeds belong in investing, while the $3,000 gain included in income must be reversed from the operating reconciliation. Subtracting $14,000 from net income would remove more than the income statement included.

Next adjust the operating balances. Subtract the $6,000 receivable increase, add the $4,000 inventory decrease and add the $2,500 supplier-payable increase. Then subtract the $1,000 salaries-payable decrease and $2,000 prepaid-insurance increase, and add the $500 income-taxes-payable increase.

Those balance adjustments total minus $2,000. Add that to $44,000 and indirect operating cash is $42,000, agreeing with the direct calculation. OpenStax's indirect-method explanation describes the net-income reconciliation and removal of long-term asset disposal gains.

Do not adjust cash itself. The operating reconciliation explains cash from other accounts, so including the change in cash would count the answer as another input. Current debt principal also needs its financing classification instead of an automatic current-liability sign rule.

Use the transaction details for investing and financing

The sold equipment has a $20,000 original cost and $9,000 accumulated depreciation, giving $11,000 carrying value. Cash proceeds of $14,000 therefore produce the stated $3,000 gain. A separate equipment purchase uses $36,000 cash.

Investing cash is minus $22,000. It combines the $14,000 sale receipt and $36,000 purchase payment, with neither amount replaced by the gain or the equipment account's net change. OpenStax's cash-flow classification explanation explains the operating, investing and financing categories used here.

Financing has three cash transactions. Borrowing brings in $18,000, principal repayment uses $5,000 and dividends paid use $7,000. Net financing cash is $6,000 for the year.

Keep interest separate from principal. This simplified US GAAP example classifies its ordinary $2,000 interest payment in operating and its $5,000 debt principal repayment in financing. Do not carry that classification across a different reporting framework or unusual transaction without checking the applicable requirements.

Leave the note-financed machine out of cash totals

The retailer also acquires a $22,000 machine by issuing a $22,000 note directly to the seller, with no cash changing hands at acquisition. Disclose that transaction separately. It is a noncash investing and financing activity.

It still changes the accounts. Equipment increases, and debt increases, even though neither cash section includes that $22,000. The original transaction record lets you separate it from the $36,000 equipment purchase that actually used cash.

An offsetting error can hide. If Tessa incorrectly adds $22,000 to financing inflows and $22,000 to investing outflows, the net change in cash stays the same. Both sections would still be wrong.

Check the gross movements too. Correct ending cash is one reconciliation check, not a substitute for identifying whether each transaction moved cash. The noncash disclosure keeps the machine visible without inventing a receipt and payment.

Reconcile all sections to the cash balance

Combine $42,000 operating, minus $22,000 investing and $6,000 financing to obtain a $26,000 cash increase. Add the $19,000 beginning cash balance and ending cash is $45,000 under either method.

The records agree beyond that total. Opening notes payable of $40,000 plus $18,000 borrowed minus $5,000 repaid plus the $22,000 seller note produce $75,000 ending debt. Only the first two changes involve cash.

Check the equipment balance as well. Original cost rises from $100,000 to $138,000 after removing the $20,000 asset sold and adding both equipment acquisitions. Accumulated depreciation ends at $40,000 after removing $9,000 on the disposal and recording $9,000 expense.

The downloadable balance sheet balances. Assets rise from $124,000 to $192,000, while liabilities and equity rise by the same amount. Retained earnings increase from $20,000 to $51,000 through $38,000 income less $7,000 dividends, with common stock unchanged at $40,000.

Diagnose a disagreement before changing the total

Suppose Tessa adds the $6,000 receivable increase in the indirect calculation instead of subtracting it. Operating cash becomes $54,000, which is $12,000 above the correct result because changing minus $6,000 to plus $6,000 creates a double-sized difference.

Return to the receivable bridge. The ending balance shows that some recorded sales remain uncollected, and the direct collection calculation still gives $234,000. Correct the sign and recompute before carrying the number into ending cash.

Avoid a balancing plug. A difference between methods points to an input, account relationship or classification that needs checking. Record the first disagreement and its correction so the next study session starts with an explanation you can reconstruct.

Keep a reusable record for the next example

Download the worked cash-flow reconciliation (CSV) for both operating methods, cash sections, noncash disclosure and ending-cash check. Use the blank cash-flow reconciliation (CSV) to record another example's source amount, balance changes, signed cash effect and reason.

Label the framework first. Then identify which balances belong to each revenue or expense and separate cash transactions from noncash movements. A sign rule becomes useful when you can explain what the account change represents.

For another study topic, the CPA FAR Online Center offers original FAR practice and feedback. Its feedback supports preparation and does not reproduce official exam scoring or predict a licensing result.

Consult the AICPA exam-content page for the blueprint effective on your testing date before assigning study priority. This original comparison illustrates accounting mechanics and makes no claim about which method appears more often on the exam.

Choose one payment to reconstruct tomorrow. Cover the answer, rebuild its beginning-balance-plus-activity-minus-ending-balance calculation and compare it with the record. Keep any missing assumption beside the calculation instead of silently supplying it.

2027 preparation edition. Sources checked October 11, 2026. Tessa, the retailer, accounts and records are original fictional teaching material with simplified US GAAP classifications. No restricted cash, exchange effects, acquisitions, receivable write-offs, deferred tax, capitalized interest or leases. Supplier payables concern merchandise only. Depreciation is separate from cost of goods sold. This is study instruction, not an official exam item, reporting recommendation or score prediction. Cover is conceptual art.