A profitable company can run out of cash, and a money-losing company can fund payroll. The income statement explains profit; the statement of cash flows explains where the money actually went.
The income statement uses accrual accounting (revenue when earned, expense when incurred), so net income can diverge from cash for an entire year. A company can record 4 million still in receivables and only $1 million in the bank. ASC 230 forces that gap into the open by reconciling the period's cash movement to the bank statement, classified into three buckets so users can tell whether cash came from running the business, selling assets, or borrowing.
ASC 230 partitions every cash receipt and payment into exactly one of three categories. Misclassification is the single most-tested error on this LO.
TRAP: Under GAAP, interest paid is operating, not financing. Interest received and dividends received are operating. Only dividends paid are financing. IFRS allows more flexibility, but the exam follows GAAP unless told otherwise.
Common mistakes
- Subtracting the gain in Operating but also netting it against proceeds in Investing. Equipment with $50,000 book value sold for $80,000. The $30,000 gain is subtracted in Operating. Investing shows the full $80,000 proceeds, not $80,000 - $30,000 = $50,000. Trap answer: $50,000 in Investing, which double-counts the gain by understating proceeds.
- Reversing the working capital direction. AR increased $20,000. Net income $100,000 plus depreciation $10,000. The wrong answer adds the $20,000 to get $130,000 Operating; the correct answer subtracts it to get $90,000.
- Classifying interest paid as Financing. Interest paid is Operating under GAAP. Moving $25,000 of interest paid out of Operating and into Financing overstates Operating by $25,000 and understates Financing by the same.
Bottom line
- ASC 230 requires three sections: Operating, Investing, Financing; every cash receipt or payment lands in exactly one
- Indirect method starts with net income, adds back non-cash expenses, removes investing gains/losses, adjusts for working capital
- Working capital rule: current asset up = subtract; current liability up = add. Opposite directions, always.
- Equipment sale: gain is subtracted in operating; full cash proceeds appear in investing, never split, never double-count
Exam shortcut
When you see a gain or loss on sale in the income statement, immediately mark TWO actions: reverse it in Operating, then put the FULL CASH PROCEEDS in Investing. Trap answers always net the gain into the proceeds. That's the most common wrong answer pattern on this LO. For working capital, write "ASSET UP, CASH DOWN" at the top of your scratch paper.
The full lesson (about 3,291 words, 22 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- I.A5
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