The statement of cash flows is a primary financial statement that all entities must present, irrespective of the nature of their business. IAS 7 requires cash flows to be classified as operating, investing or financing activities in the manner most appropriate to the entity’s business (IAS 7.10-11). As a result, the same type of transaction may be classified as operating by one entity and investing by another, depending on the entity’s business model. The categories used in the statement of cash flows do not correspond directly to those used in the statement of profit or loss.
The statement of cash flows shows how an entity generates and uses cash and cash equivalents through its operating and investing activities, how it obtains funding through borrowings and how it services its debt. It also provides insight into distributions of cash to owners.
Let’s dive in.
Operating activities
Operating activities are the principal revenue-producing activities of an entity. They are also the default classification for cash flows that do not meet the definitions of investing or financing activities.
As a general rule, cash flows arising from transactions or events that affect P/L are classified as operating activities. A notable exception is the disposal of long-term assets (IAS 7.6 and 13-15).
Examples of cash flows from operating activities include:
- cash receipts from the sale of goods, the rendering of services and other revenue-generating activities;
- cash payments to suppliers for goods and services and payments to, and on behalf of, employees;
- cash payments under contracts held for dealing or trading purposes;
- cash receipts and payments relating to loans and deposits reported by financial institutions;
- cash payments or refunds of income taxes, unless they can be specifically identified with financing or investing activities; and
- cash payments under hedging contracts when the hedged item is classified as an operating activity.
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Presentation method
An entity must report cash flows from operating activities using either of the following methods (IAS 7.18):
- the direct method, which discloses major classes of gross cash receipts and gross cash payments; or
- the indirect method, which adjusts profit or loss for non-cash transactions, deferrals or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing cash flows.
Direct method
IAS 7 encourages entities to report cash flows from operating activities using the direct method. Under this method, information about major classes of gross cash receipts and gross cash payments may be obtained in one of two ways (IAS 7.19):
- directly from the entity’s financial systems or accounting records; or
- by adjusting sales, cost of sales and other items in profit or loss for movements in working capital, non-cash items and items for which the cash effects relate to investing or financing activities.
Entities using the second approach are not required to present a reconciliation of the adjustments made between items in the statement of profit or loss and the corresponding cash receipts or payments.
The direct method is most commonly used in the financial sector. However, Telefónica SA is a notable example of a non-financial company that uses the direct method to report its cash flows:
Indirect method
Under the indirect method, net cash flow from operating activities is calculated by adjusting profit or loss for:
- changes in working capital;
- non-cash items recognised in profit or loss, such as depreciation; and
- items for which the cash effects relate to investing or financing activities.
IAS 7.20 requires profit or loss to be used as the starting point when operating cash flows are reported using the indirect method. Nevertheless, entities often start with another subtotal, such as operating profit. Strictly speaking, this does not comply with IAS 7.20 because such subtotals exclude certain items of income and expense.
Once IFRS 18 applies, it will replace IAS 1 and amend IAS 7 by requiring operating profit or loss to be used as the starting point for the indirect method.
Investing activities
Investing activities involve the acquisition and disposal of long-term assets and other investments that are not classified as cash equivalents. For a cash flow to be classified as an investing activity, it must result in the recognition of an asset in the statement of financial position (IAS 7.6 and 16).
Consequently, expenditure that relates broadly to investing activities but does not result in a recognised asset is classified as an operating activity. For example, expenditure on internal development is classified as operating when it is expensed and as investing when it is capitalised. Transaction costs associated with a business combination are another example of operating cash flows because IFRS 3 requires them to be expensed.
Examples of cash flows from investing activities include:
- cash payments to acquire property, plant and equipment and intangible assets;
- cash payments relating to internally generated assets;
- cash receipts from the sale of long-term assets;
- cash payments and receipts relating to the acquisition and disposal of equity or debt instruments, excluding cash equivalents and instruments held for dealing or trading purposes;
- cash payments relating to loans made to other parties by non-financial institutions;
- cash payments under derivative contracts, except when the contracts are held for dealing or trading purposes or the payments are classified as financing activities; and
- cash payments under hedging contracts when the hedged item is classified as an investing activity.
Financing activities
Cash flows from financing activities must result in changes in the size or composition of the entity’s contributed equity or borrowings (IAS 7.6 and 17). Examples include:
- cash proceeds from the issue of shares or other equity instruments;
- cash payments to owners to acquire or redeem the entity’s own shares;
- cash payments to acquire non-controlling interests;
- cash proceeds from, and repayments of, loans, bonds and other borrowings; and
- repayments of lease liabilities.
Reporting cash flows on a gross or net basis
Cash flows are generally reported on a gross basis, with cash receipts and cash payments presented separately (IAS 7.21). This requirement does not, of course, apply to operating cash flows presented using the indirect method.
In specified circumstances, cash flows may be reported on a net basis. This includes situations in which an entity acts as an agent by receiving and paying cash on behalf of third parties.
Cash receipts and payments may also be reported on a net basis when they relate to items with quick turnover, large amounts and short maturities. This commonly applies to short-term borrowings such as revolving credit facilities (IAS 7.22-24).
Foreign currency cash flows
Cash flows denominated in a foreign currency are generally translated using the exchange rate applicable on the date of the cash flow. The same principle applies to the cash flows of a foreign subsidiary included in consolidated financial statements.
As a practical expedient, IAS 7, like IAS 21, permits the use of an average exchange rate for the period when translating the cash flows of a foreign subsidiary (IAS 7.25-27).
The effect of changes in exchange rates on cash and cash equivalents held in a foreign currency is presented in the statement of cash flows to reconcile the opening and closing balances of cash and cash equivalents. However, it is not classified within operating, investing or financing activities. Instead, it is presented as a separate reconciling item at the end of the statement of cash flows (IAS 7.28).
Interest and dividends
Paragraphs IAS 7.31-34 set out accounting policy choices for the classification of interest and dividends, as summarised in the following table:
A few comments:
- The classification of interest paid, interest received and dividends received as operating activities reflects the fact that these items affect profit or loss.
- Presenting dividends paid as operating activities may seem counterintuitive. The rationale is that the payments must be funded from cash generated through operating activities.
- An alternative approach classifies the items according to their nature. Under that approach, for example, interest paid on borrowings and dividends paid to owners are classified as financing activities.
However, IFRS 18 largely removes these options. Once it applies, most entities will present interest and dividends paid within financing activities and interest and dividends received within investing activities:
Zero-coupon instruments
For zero-coupon and similar instruments, the payment made at maturity should be divided between the interest element and the principal amount. Consider the following example: Entity A is a manufacturing company that classifies interest received as an operating activity in its statement of cash flows. On 1 January 20X1, it purchases a two-year zero-coupon government bond with a face value of $10 million for $9 million.
In 20X1, Entity A reports an investing cash outflow of $9 million. Although interest on the bond accrues and is recognised as interest income in P/L for 20X1 and 20X2, no cash is received before the bond matures.
On redemption in 20X3, Entity A receives $10 million. This amount is divided between the repayment of the funds originally invested, with $9 million classified as an investing cash inflow, and the interest earned, with $1 million classified as an operating cash inflow.
Factoring of trade receivables
IAS 7 does not specifically address the factoring of trade receivables. Presentation in the statement of cash flows depends on whether the receivables subject to factoring are derecognised.
If the receivables are derecognised, they have, in substance, been settled, resulting in a cash inflow from operating activities.
If the receivables are not derecognised, the factoring arrangement is, in substance, a borrowing secured against the receivables. The entity therefore recognises a financial liability and presents the initial receipt of cash as a financing cash inflow.
A subsequent payment by the customer results in the derecognition of the trade receivable, giving rise to an operating cash inflow, and the effective repayment of the financial liability, giving rise to a financing cash outflow. This applies even when the customer pays the financial institution, or factor, directly, because the payment is regarded as being collected on behalf of the entity.
It might be argued that the customer’s payment to the financial institution should be treated as a non-cash transaction, resulting in no cash flow being reported by the entity. In my opinion, this is the least preferable approach because it would mean that the entity never reports a cash flow from its principal activities, even after the customer has paid.
Supplier finance arrangements
Paragraphs IAS 7.44F-44H require an entity to disclose sufficient information about its supplier finance arrangements to enable users of the financial statements to assess their effects on the entity’s liabilities, cash flows and exposure to liquidity risk.
Such arrangements involve one or more finance providers paying amounts owed to suppliers, with the entity paying the finance provider at a later date. The arrangements may give the entity extended payment terms or allow suppliers to receive payment earlier than under the original invoice terms.
These arrangements are also described as supply chain finance, payables finance or reverse factoring. However, they exclude arrangements that provide only credit enhancement, such as financial guarantees or letters of credit used as guarantees, and payment instruments used to settle amounts owed to suppliers directly, such as credit cards.
The disclosures must be provided in aggregate, except where arrangements have dissimilar terms and conditions, and must include:
- the key terms and conditions, including extended payment periods and any security or guarantees provided;
- the carrying amounts and line items in the statement of financial position relating to liabilities included in the arrangements, including the amounts for which finance providers have already paid the suppliers;
- the range of payment due dates for those liabilities and for comparable trade payables that are not included in the arrangements, together with further explanation or breakdown where the ranges are wide; and
- the nature and effect of non-cash changes in the relevant liabilities, including changes arising from business combinations, foreign exchange differences and other non-cash transactions.
Read more about supplier finance arrangements in PwC’s Bringing transparency on supplier finance publication.
Taxes
Payments of income tax are generally classified as operating activities. However, IAS 7 requires them to be classified differently when they can be specifically identified with financing or investing activities (IAS 7.35-36). In practice, classifications outside operating activities are uncommon.
IAS 7 does not specify how payments of VAT should be classified. Two approaches are commonly applied in practice:
- VAT cash flows are combined with the receipt or payment relating to the associated receivable or payable, or
- they are presented separately.
Non-cash transactions
Investing and financing transactions that do not directly affect current cash flows are excluded from the statement of cash flows. However, they must be disclosed in the notes to the financial statements (IAS 7.43-44).
Examples include the acquisition of assets by assuming directly related liabilities, the acquisition of assets through leases, and the exchange of one asset for another. Some non-cash items are also reflected as adjustments to profit or loss in the reconciliation presented under the indirect method, although they are not themselves presented as cash flows.
The following extract from Severn Trent’s annual report illustrates the disclosure of non-cash transactions:
Acquisition by assumption of long-term payables
In some circumstances, an entity may acquire an asset, such as equipment, on credit, with the payments spread over several years. This raises the question of whether the subsequent payments should be classified as investing or financing activities.
IAS 7 does not provide a clear answer. One view is that when payment is deferred significantly beyond the acquisition date, the resulting liability is equivalent to financing. Repayments are therefore presented as financing activities, in a similar manner to repayments of lease liabilities.
Another view is that such liabilities do not constitute borrowings unless the counterparty is normally engaged in providing finance. By analogy, an entity that provides its customers with a significant period of credit and recognises a significant financing component in its contracts with customers would not normally classify the resulting receivables as loans.
In my opinion, both approaches are justifiable. It’s worth noting, however, that US GAAP addresses the issue explicitly and permits only payments made to suppliers at or around the time of purchase to be presented as investing activities. The assumption of a directly related long-term payable to the seller is treated as a financing transaction, with subsequent repayments classified as financing cash outflows (ASC Topic 230, 230-10-45-13 to 15).
Changes in ownership interests in subsidiaries and other businesses
Paragraphs IAS 7.39-42B contain classification and disclosure requirements relating to changes in ownership interests in subsidiaries and other businesses.
Transaction costs associated with business combinations should be classified as operating activities. Because these costs are expensed rather than capitalised, they cannot be presented as investing activities.
The treatment of contingent consideration is more complex. Contingent consideration is recognised at fair value at the acquisition date, with a corresponding amount included in the acquired assets or goodwill. Its value may subsequently change because of post-acquisition events, such as the achievement of a specified revenue target. In applying the general requirements, a payment of contingent consideration is allocated between operating and investing activities. The amount recognised at the acquisition date is classified as an investing activity, while any remaining amount is classified as an operating activity.
Changes in liabilities arising from financing activities
IAS 7.44A-E require an entity to reconcile the opening and closing balances in the statement of financial position for liabilities arising from financing activities. This requirement also applies to changes in financial assets, such as hedging derivatives, when cash flows relating to those assets have been, or will be, classified as financing activities.
The reconciliation should include both cash and non-cash changes, including accrued interest, movements in foreign exchange rates and changes in fair value. Some companies broaden this disclosure by combining it with a reconciliation of the opening and closing balances of net debt, where net debt is disclosed. However, such a broader reconciliation must separately identify changes in liabilities arising from financing activities to satisfy the requirements of IAS 7.
Voluntary disclosure
IAS 7.50-51 encourage entities to provide voluntary disclosures relating to undrawn borrowing facilities and the cash flows of each reportable segment. They also encourage entities to distinguish cash flows that represent increases in operating capacity from those required to maintain operating capacity.
The latter disclosure is rarely provided in practice, particularly because IAS 7 does not contain further guidance on how such cash flows should be distinguished.