Statement of cash flows presents inflows and outflows of cash and cash equivalents and is dealt with in IAS 7. The statement of cash flows is required to be presented by all entities for each period for which financial statements are presented.
Cash and cash equivalents
Definition of cash and cash equivalents
Cash is defined by IAS 7 as cash on hand and demand deposits.
Cash equivalents are investments that are (IAS 7.6-9):
- held for meeting short-term cash commitments rather than for investment or other purposes,
- highly liquid,
- readily convertible to known amounts of cash and
- subject to an insignificant risk of changes in value.
IAS 7.7 specifies that an investment will ‘normally’ have a maturity of maximum 3 months from the date of acquisition in order to meet the short-term criterion. Although the 3-month period is not set as a strict requirement in IAS 7, it became to be generally accepted as a valid benchmark. The classification at initial recognition remains unchanged when the investment approaches its maturity date. If a deposit has a maturity that is longer than 3 months, but there is no penalty (e.g. interest loss) for early withdrawal, it is possible to treat it as a cash equivalent, provided that it is held for meeting short-term cash commitments rather than for investment or other purposes.
Debt instruments and money market funds
It is possible for certain debt instruments, such as government bonds or high-quality corporate bonds, to meet the criteria of cash equivalents (see the discussion for money market funds below).
Some companies use money market funds (or liquidity funds etc.) in their cash management process. Money market funds are equity instruments (see below), but it is possible to consider them to be cash equivalents if the above-mentioned criteria are met. This issue was on the agenda on IFRIC (IFRIC update from July 2009): ‘The IFRIC noted that the amount of cash that will be received must be known at the time of the initial investment, i.e. the units cannot be considered cash equivalents simply because they can be converted to cash at any time at the then market price in an active market. The IFRIC also noted that an entity would have to satisfy itself that any investment was subject to an insignificant risk of changes in value for it to be classified as a cash equivalent.’ In order to satisfy themselves that there is only insignificant risk of changes in value , entities can choose a fund that invests only in debt instruments with highest ratings and maturity of no more than 3 months, with a portfolio that is highly diversified in order to limit credit risk.
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For example, see this disclosure by Vodafone:
Equity instruments cannot be, in principle, considered to be cash equivalents because they are not readily convertible to known amounts of cash and usually they are subject to more than insignificant risk of changes in value. An exception to this rule relates to equity instruments that are in substance cash equivalents. IAS 7 gives an example of preferred shares acquired within a short period of their maturity and with a specified redemption date.
Intragroup cash pooling arrangements
Some groups have central pooling of all cash and cash equivalents which effectively leave subsidiaries with cash deposited with a parent company or other group company. Such balances need to be assessed against the criteria of IAS 7, but it is entirely possible to classify them as cash equivalents. The factors to be taken into account include terms and conditions of the intragroup arrangement, credit rating of the group, its liquidity and access to external financial resources.
Restrictions of use
The IFRIC considered a scenario where an entity can freely access a deposit, but has a contractual obligation with a third party to keep a specified amount of cash in that separate demand deposit and to use the cash only for specified purposes. If the entity were to use the amounts held in the demand deposit for purposes other than those agreed with the third party, the entity would be in breach of its contractual obligation. The Committee concluded that such restrictions on the use of a demand deposit do not result in the deposit no longer being cash as long as the entity can access those amounts on demand.
Gold and cryptocurrencies
Gold or cryptocurrencies cannot be classified as cash equivalents as they are not readily convertible to known amounts of cash.
Reconciliation to the statement of financial position
Cash and cash equivalents that are reported in the statement of cash flows may not necessarily equal the cash and cash equivalents line in the statement of financial position. Some entities present cash balance in the statement of cash flows net of any on-demand bank overdrafts (instead of treating it as financing cash flows), whereas in the statement of financial position a negative balance is presented as a liability (IAS 7.8). Another common difference relates to cash and cash equivalents of a subsidiary that are classified as assets held for sale under IFRS 5. If such a difference between the statement of cash flows and the statement of financial position exists, entities are required to provide a reconciliation between the amounts presented in those two statements (IAS 7.45).
Entities are required to disclose the policy for determining the composition of cash and cash equivalents and the components comprising the overall balance (IAS 7.45-46). If there is a significant judgement in determining whether a particular asset should be classified as cash equivalent, entities should also make relevant disclosures based on IAS 1.122.
Restricted cash is a commonly used term when referring to cash and cash equivalent balances with some restrictions on their use. IAS 7 gives an example of cash and cash equivalent balances held by a subsidiary that are not available for use by the group due to exchange controls or other legal restrictions, which should be disclosed (IAS 7.48-49). Although not specifically required, it is common practice to disclose other kinds of restrictions relating to cash and cash equivalents (e.g. cash from a government grant that can be used only for a specific expenditure).
Restricted cash balances should also be carefully examined against the definition of cash and cash equivalents. It may turn out that instead of a mere disclosure, they should be reclassified to other assets.
Example: Restricted cash
Entity A received an investment loan from a bank of $100 million. This amount is made available on a dedicated bank account, but in order to make a bank transfer from this account, Entity A needs to obtain an approval of a bank employee, who verifies whether the expenditure in question is in line with budget and schedule that was attached to the loan agreement.
In this example, it is unlikely that the $100 million will be presented as cash and cash equivalents as Entity A cannot use it without prior approval of a third party (a bank). In the example, the $100 million would be best kept off-balance sheet. When actual transfers take place, Entity A reports inflows from financing activities and, at the same time, outflows in investing activities.
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Operating activities are the core revenue-producing activities of the entity. All other activities that do not fit into definitions of investing or financing activities are also classified as operating activities. In general, a cash flow that results from the transaction or other event that has a direct impact on P/L will be presented under operating activities, with a notable exception of disposal of long-term assets (IAS 7.6,13-15). It is possible that a particular type of transaction may be classified both as operating and investing activity depending on the business model of an entity.
Examples of cash flows from operating activities are:
- cash receipts from the sale of goods, the rendering of services and from other revenue streams,
- cash payments to suppliers for purchased goods and services or to, and on behalf of, employees,
- cash receipts and payments from contracts held for dealing or trading purpose,
- cash receipts and payments relating to loans and deposits in a financial institution,
- cash payments or refunds of income taxes unless they can be specifically identified with financing or investing activities,
- cash payments for/receipts from hedge contracts when the hedged item is classified as operating activity.
Cash flows from operating activities may be reported using either direct method on indirect method (IAS 7.18-20).
Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents. Investing cash flows must result in a recognised asset in the statement of financial position (IAS 7.6,16) – this is a very important point to note. Items that by their nature relate to investing activities, but do not result in a recognised asset, cannot be included in investing activities. For example, internal development expenditures are classified as operating activities if they are expensed and as investing activities if they are capitalised. Other notable examples relate to transaction expenses for business combinations which under IFRS 3 must be expensed and therefore are classified as operating cash payments.
Examples of cash flows from investing activities are:
- cash payments to acquire property, plant and equipment, intangibles and other long-term assets,
- cash payments relating to internally generated property, plant and equipment, intangibles and other long-term assets,
- cash receipts from sales of property, plant and equipment, intangibles and other long-term assets,
- cash payments to acquire/cash receipts from sale of equity or debt instruments (other than instruments considered to be cash equivalents or those held for dealing or trading purposes),
- cash receipts and payments relating to loans made to other parties in a non-financial institution,
- cash payments for/receipts from derivative contracts except when these contracts are held for dealing or trading purposes, or the payments/receipts are classified as financing activities,
- cash payments for/receipts from hedge contracts when the hedged item is classified as investing activity.
Financing activities are activities that result in changes in the size and composition of the contributed equity and borrowings of the entity (IAS 7.6,17). Examples of such activities are:
- cash proceeds from issuing shares or other equity instruments,
- cash payments to owners to acquire or redeem the entity’s shares,
- cash proceeds from issuing (and repayments of) loans, bonds and other borrowings,
- repayments of a lease liability.
Operating/ investing/ financing activities – practical issues
A number of practical specific issues relating to the classification of cash flows is discussed below.
Interest and dividends
There is a separate section of IAS 7 (IAS 7.31-34) devoted to interest and dividends as there is no consensus on their classification as operating, investing or financing activities. The table below summarises which category they are allowed to be included in:
The approach to presenting interest paid/received and dividends received within operating activities follows the logic that these items are included in profit or loss of the entity. Dividends paid can be included in operating activities to show the sustainability of dividend payments from operating activities (though they are most often classified within financing activities). The alternative approach classifies these items according to their ‘nature’, e.g. interest paid on debt in classified within financing activities.
However, in the course of the Primary Financial Statements project, IASB proposes to remove options for presentation of interest and dividends in the statement of cash flows. For most entities, interest and dividends paid would be presented within financing activities, whereas interest and dividends received within investing activities.
For zero-coupon and similar instruments, the payment at maturity should be split between interest and principal amount. Consider the following example:
Example: Interest on zero-coupon instruments in cash flow statement
Entity A is a manufacturing company, as an accounting policy choice it presents interest received under operating activities in the statement of cash flows. On 1 January 20X1 Entity A buys a 2-year zero-coupon government bond with a face value of $10 million. Entity A pays $9 million for this bond.
In 20X1, Entity A reports an outflow of $9 million under investing activities in the statement of cash flows. In 20X1 and 20X2 entity accrues interest on the bond and presents it as interest income, but no cash flow occurs with respect to interest in those years. In 20X3 the bond is redeemed by the government and Entity A receives $10 million.
The cash inflow of $10 million is split into repayment of originally invested funds ($9 million in investing activities) and interest earned on those funds ($1 million in operating activities).
Factoring of trade receivables
Factoring of trade receivables is not specifically addressed in IAS 7. In my opinion, the presentation in the statement of cash flows depends on whether trade receivables subject to factoring are derecognised. If they are, it means that in substance they have been paid and a cash inflow from operating activities should be reported.
If trade receivables are not derecognised, factoring is in substance a borrowing with trade receivables treated as a collateral, hence a financial liability and cash receipt in financing activities. When a payment from a customer is received, a trade receivable is derecognised with an inflow in operating activities and a financial liability effectively repaid with a cash outflow in financing activities. This approach applies also to situations where the customer pays directly to the financial institution (the factor), in this case entities can say that the payment was collected on behalf of the entity.
It is true that in the last example the payment by the customer to the financial institution may be treated as a non-cash transaction and no operating cash flow would be reported in effect by the entity. It is however least preferable approach in my opinion, as entity would never report cash flow from its principal activities even after the customer has paid.
Supplier finance arrangements
Supplier finance arrangements pose similar presentation difficulties as factoring of trade receivables covered above. Again, the key question is whether the derecognition criteria set out in IFRS 9 are met.
The discussion here on presentation in the cash flow statement mirrors the one presented above. See more discussion here.
Purchases with extended credit terms
If the payment date to a supplier exceeds normal credit terms, the acquisition of an asset (or service) and assumption of a related liability should be treated as non-cash transaction, with subsequent repayment of a liability treated as financing cash outflows.
Acquisition by assumption of long-term payables
It may be the case that an entity purchases, for example, a piece of equipment on credit with repayments spread over many years. A question arises in such a case – should repayments of such a liability be presented within investing or financing activities? There is no definite answer to this question based on IAS 7. Some argue that when payments are due significantly later than the acquisition, such a liability constitutes financing with repayments presented within financing activities, similarly to leases. Others argue that such liabilities do not constitute borrowings unless a counterparty is normally involved in providing financing. Additionally, as an analogy, there may be instances where an entity significantly extends credit to its customers (trade receivables with significant financing component under IFRS 15) and this would be also counter-intuitive to treat these receivables as loans for non-financial entities.
In my opinion, both approaches are acceptable. It is simply important to make a conscious decision. It should also be noted that this matter is explicitly addressed in US GAAP which say that only payments to suppliers at the time of (or soon before or after) the purchase can be presented in investing activities. On the other hand, the assumption of directly related long-term payable to the seller is a financing transaction and subsequent payments of principal on that payable are financing cash outflows (ASC Topic 230, 230-10-45-13 to 15).
Income tax payments are usually classified as operating activities, although IAS 7 permits otherwise if they can be specifically identified with financing and investing activities (IAS 7.35-36). Classification other than within operating activities is rare.
VAT is not covered in IAS 7 and there are two approaches adopted in practice. VAT payments can be shown together with receipt/payment of the related receivable/ payable, or separately.
Changes in ownership interests in subsidiaries and other businesses
Paragraphs IAS 7.39-42B cover changes in ownership interests in subsidiaries and other businesses. They include certain disclosure and classification requirements.
Transaction costs relating to business combinations should be reported in operating activities as they are not capitalised and therefore cannot be included in investing activities. It gets more complicated with contingent consideration recognised at acquisition date at fair value with corresponding debit entry allocated to acquired assets or goodwill. The amount of such a contingent consideration can change as a result of events that occurred after the acquisition date (e.g. achieving a specified revenue target) and, when paid, it should be split between operating and investing activities, i.e. the amount recognised at acquisition date should be reported under investing activities (unless it was financing…) and the remaining amount under operating activities.
Reporting cash flows on a gross vs. net basis
As a rule, cash flows are reported on a gross basis, i.e. cash receipts and cash payments are presented separately (IAS 7.21). This of course does not concern presenting cash flows from operating activities using indirect method. However, in certain cases, cash flows may be reported on a net basis (IAS 7.22-24).
When cash receipts and payments are on behalf of third parties, i.e. when the reporting entity acts only as an agent, entities use net cash flow presentation (IAS 7.23).
Cash receipts and payments for items in which the turnover is quick, the amounts are large, and the maturities are short are also presented on a net basis (IAS 7.23A). This is most often the case with short-term borrowings such as revolving credit lines.
Foreign currency cash flows
As a rule, foreign currency cash flows should be translated using the exchange rate at the date of the cash flow. This also includes translating cash flows of a foreign subsidiary in the consolidated financial statements. As a practical expedient, IAS 7 permits to use, as IAS 21 does, average exchange rate for the period when translating cash flows of a foreign subsidiary (IAS 7.25-27).
The effect of exchange rate changes on cash and cash equivalents held in a foreign currency is shown in cash flow statement in order to reconcile opening and closing balances of cash and cash equivalents. It is however excluded from any of the three major activities and presented as a reconciling item at the end of the cash flow statement (IAS 7.28).
Investing and financing transactions that do not have a direct impact on current cash flows are excluded from the statement of cash flows. However, they need to be disclosed elsewhere in the financial statements (IAS 7.43-44). Examples of such transactions are acquisitions of assets by assuming liabilities or through leases, or simply by exchanging assets for other assets.
Non-cash transactions are included in cash flow statement under operating activities in indirect method as adjustments to profit or loss.
Changes in liabilities arising from financing activities
Paragraphs IAS 7.44A-E require a reconciliation between the opening and closing balances in the statement of financial position for liabilities arising from financing activities. This requirement applies also to changes in financial assets (such as hedging derivatives) if cash flows from those financial assets were, or future cash flows will be, included in cash flows from financing activities. This reconciliation should include both cash and non-cash changes, such as accrued interest, changes in foreign exchange rates or changes in fair values.
It may be useful to expand such a disclosure and combine it with the reconciliation of opening and closing balance of net debt (if reported by the entity). But still such an expanded reconciliation should clearly label changes in liabilities arising from financing activities.
Paragraphs IAS 7.50-51 suggest voluntary disclosures relating to undrawn borrowing facilities, cash flows of each reportable segment or distinguishing cash flows representing increases in operating capacity from those required to maintain operating capacity. The last disclosure mentioned is rarely made in practice, especially because IAS 7 gives no further information on how to make such a distinction.