IAS 7 Statement of Cash Flows

Ignoring an accrual principle??? What?! No way! That’s the basic accounting rule we should all follow!

Yes, of course, you’re right. BUT: There IS an exception.

The statement of cash flows.

Preparing the statement of cash flows might become the biggest accountant’s nightmare. Why is that?

Because the statement of cash flows is THE ONLY statement ignoring an accrual basis and based on a CASH basis.

All other financial statements follow an accrual principle and it means that we have lots of non-cash transactions in our financial statements that we need to eliminate for cash flows.

Exactly the process of eliminating non-cash transactions and showing pure cash movements may give you headaches because the numbers sometimes do not balance.

But before I’ll show you perfectly clean starting point for your cash flow preparations, let’s dive a bit deeper into the standard IAS 7 Statement of cash flows and see how IFRS want us to present cash.

Why IAS 7?

The statement of cash flows shows the ability of any company to generate cash. It is really simple as that.

Some accountants look to the statement of cash flows as to some unnecessary and annoying issue and they prepare it because they MUST.

But in reality, many investors explore the statement of cash flows right after looking to profit figure, because they sometimes feel that the profit could be manipulated by some non-cash transactions, such as various provisions, fair value adjustments, etc.

However, cash is cash and the statement of cash flows not only shows you HOW MUCH CASH the company generated over the year, but also WHERE the cash was generated:

• Did the company increase their sales and generated cash by operating activities?
• Did the company sell some of its property and generated cash by investing activities?
• Or did the company take new loans and generated cash by financing activities?

So, looking to where the cash was generated and spent is as important as assessing the liquidity ratio, profitability ratio, and other financial indicators.

What is the objective of IAS 7?

The objective of IAS 7 Statement of cash flows is to require the information about the historical changes in cash and cash equivalents of an entity.

This information shall be provided in the statement of cash flows which classifies cash flows during the period from operating, investing and financing activities.

What comprises cash and cash equivalents?

The statement of cash flows shows you the movements in cash and cash equivalents.

Cash comprises cash on hand (e.g. petty cash) and demand deposits (e.g. bank accounts).

Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.

Here, the investment with short maturity (up to 3 months) would qualify for cash equivalent – for example, state treasury note. However, most shares and other equity instruments are excluded from cash equivalents.

Please note that the movements between cash and cash equivalents is a part of cash management and are not shown in the operating, financing or investing part of the statement of cash flows. So if your company buys the state treasury bill with short maturity date, then this movement is not shown (it appears as the cash and cash equivalents have not moved at all).

How the statement of cash flows shall be presented?

IAS 7 says that the statement of cash flows shall report cash flows during the period classified by operating, investing and financing activities.

Before we’ll take a look at each part, let me also add that the statement of cash flows should also contain the final reconciliation in which you summarize the overall movement in cash and cash equivalents (corresponding with your balance sheet) as shown in this picture:

In the notes to the financial statements, an entity shall disclose the components of cash and cash equivalents.

Operating activities

Operating activities are the principal revenue-producing activities of the entity and other activities that are not investing or financing activities.

This part is probably the most important, because it shows the ability of the company to generate cash by its own activities, rather than by external financing or making investments.

Cash flows from operating activities result from the primary revenue-generating activities of each company and therefore, there might be differences between different entities.

For example, manufacturing company would report advance given for the acquisition of PPE as investing activity, but the bank would report similar advance as an operating activity based on its specific purpose.

However, operating activities generally result from profit making activities and the examples are:

• Cash receipts from the sale of goods and the rendering of services;
• Cash receipts from royalties, fees, commissions and other revenue;
• Cash payments to suppliers for goods and services;
• Cash payments to and on behalf of employees;
• Cash receipts and cash payments of an insurance entity for premiums and claims, annuities and other policy benefits;
• Cash payments or refunds of income taxes unless they can be specifically identified with financing and investing activities; and
• cash receipts and payments from contracts held for dealing or trading purposes.

Direct and indirect method

A company may select from 2 methods of reporting cash flows from operating activities:

1. Direct method: here, you need to disclose major classes of gross cash receipts and gross cash payments; or
2. Indirect method: here, you start with the profit or loss before tax and then you adjust it for the effect of:
   • Working capital changes over the period (inventories, operating receivables, payables);
   • Non-cash items (depreciation, unrealized foreign exchange gains or losses, etc.);
   • Items associated with investing or financing activities.

Direct method provides more understandable information not disclosed under indirect method. However, in reality, indirect method is far more preferred because it’s easier to get the information based on your accounting records. (in most cases).

You can read the article about preparation of the statement of cash flows here.

Investing activities

Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents.

Examples of cash flows classified in investing activities are:

• Cash payments to acquire property, plant and equipment, intangibles and other long-term assets (including capitalized development costs and self-constructed PPE);
• Cash receipts from sales of PPE, intangibles and other long-term assets;
• Cash payments to acquire and cash receipts from sales of equity or debt instruments of other entities and interests in joint ventures (but not for trading or dealing purposes);
• Cash advances and loans made to other parties, and cash receipts from their repayment (other than advances and loans made by a financial institution – these would go to operating part);
• Cash payments for and cash receipts from various derivative contracts except when the contracts are held for dealing or trading purposes, or the payments are classified as financing activities.

Financing activities

Financing activities are activities that result in changes in the size and composition of the contributed equity and borrowings of the entity.

Examples of cash flows arising from financing 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 debentures, loans, notes, bonds, mortgages and other short-term or long-term borrowings;
• Cash repayments of amounts borrowed; and
• Cash payments by a lessee for the reduction of the outstanding liability relating to a finance lease.

Reporting cash flows from investing and financing activities

Cash flows from investing and financing activities shall always be reported GROSS, so no netting off.

It means that you cannot present the cash paid to acquire some vehicle and cash received from sale of some other vehicle in 1 line – instead, you must present these cash flows separately in 2 lines.

• Cash receipts and payments on behalf of customers when the cash flows reflect the activities of the customer rather than those of the entity.For example, some real estate company can collect rents from tenants and pay them over to the property owners.
• Cash receipts and payments for items in which the turnover is quick, the amounts are large, and the maturities are short.For example, changes in principal amounts relating to credit card customers.

Also, financial institutions can report certain transactions on the net basis.

Other issues

Foreign currency

When there are foreign currency cash flows, then you need to translate them to your functional currency by applying the exchange rate at the date of the cash flow.

However, be careful at the closing, because unrealized year-end foreign exchange gains or losses are NOT cash flows. If they relate to your cash or cash equivalents, then you should present these amounts in the separate line in the final reconciliation.

Interest and dividends

Cash flows from interest and dividends received and paid shall be presented separately and consistently from period to period.

In fact, you have a choice here for each of these items:

• Interest and dividends paid can be classified either as operating cash flow, or financing cash flow.
• Interest and dividends received can be classified either as operating cash flow, or investing cash flow.

Either way you choose, it’s OK, but do it consistently in each reporting period.

Taxes on income

Basically, cash flows arising from income taxes are classified as cash flows from operating activities.

But if you can specifically identify these taxes with financing or investing activities, then you should report your cash flows from taxes in these parts.

Investments

When you hold some investments in subsidiaries, associates and joint venture, then reporting cash flows to and from these investments really depends on the accounting method you use.

When you apply equity or cost method, then you should include only the cash flows between yourself and the investee into the cash flow statement (dividends or advances).

Please watch the following video with the summary of IAS 7 here:

Have you ever had any issues or troubles when preparing the statement of cash flows? Please comment below this video and don’t forget to share it with your friends by clicking HERE. Thank you!