3.4 IAS 7 Statement of Cash Flows

3.4 IAS 7 Statement of Cash Flows

The Statement of Cash Flows provides information about how an entity generates and uses cash and cash equivalents. Under IAS 7, cash flow reporting assists investors, lenders, and analysts in evaluating an entity's solvency, liquidity, financial flexibility, and ability to generate future net cash inflows. Because accrual accounting permits management discretion over revenue timing, depreciation methods, and provisioning, cash flow data acts as the ultimate reality check against reported accounting profits.

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Definition of Cash and Cash Equivalents

Under IAS 7.6, the core units of liquidity are defined as:

• Cash: Comprises cash on hand and demand deposits (e.g., bank checking accounts accessible immediately without penalty).
• Cash Equivalents: 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.

The Three-Month Maturity Rule (IAS 7.7)

An investment normally qualifies as a cash equivalent only when it has a short maturity of, say, three months or less from the date of acquisition (e.g., 60-day commercial paper, 90-day Treasury bills).

Crucial Distinction: A five-year government bond acquired four years and ten months after issuance (with two months remaining to maturity) does qualify as a cash equivalent. However, a five-year bond purchased at issuance does not become a cash equivalent when its remaining maturity drops below three months, because it was not acquired as a short-term cash management investment.

Bank Overdrafts (IAS 7.8)

Bank borrowings are generally considered to be financing activities. However, where bank overdrafts are repayable on demand and form an integral part of an entity's cash management (characterized by the bank balance fluctuating frequently from positive to overdrawn), overdrafts are included as a negative component of cash and cash equivalents.

Equity Investments Exclusion

Equity investments are excluded from cash equivalents because they are exposed to significant market price risk, unless they are in substance cash equivalents (e.g., preferred shares acquired three months before their mandatory redemption date).

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The Three Activity Classifications

IAS 7 categorizes all cash inflows and outflows into three mutually exclusive operational activities:

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Operating Cash Flows: Direct Method vs Indirect Method

IAS 7.18 allows entities to report cash flows from operating activities using either the direct method or the indirect method.

1. The Direct Method (IAS 7.18(a))

Under the direct method, major classes of gross cash receipts and gross cash payments are disclosed. IAS 7 encourages entities to report operating cash flows using the direct method because it provides information that is useful in estimating future cash flows and is not available under the indirect method.

$$\text{Cash Received from Customers} = \text{Sales Revenue} - \Delta\text{Trade Receivables} + \Delta\text{Contract Liabilities}$$ $$\text{Cash Paid to Suppliers} = \text{Cost of Sales} + \Delta\text{Inventories} - \Delta\text{Trade Payables}$$ $$\text{Cash Paid to Employees} = \text{Wages Expense} - \Delta\text{Wages Payable}$$

2. The Indirect Method (IAS 7.18(b))

Under the indirect method, profit or loss (or profit before tax) is adjusted for:

• The effects of transactions of a non-cash nature (depreciation, amortisation, impairment losses, unrealized foreign exchange gains/losses, movement in provisions);
• Any deferrals or accruals of past or future operating cash receipts or payments (changes in inventory, trade receivables, and trade payables);
• Items of income or expense associated with investing or financing cash flows (gain/loss on disposal of PPE, finance costs, dividend income).

Profit before tax                                            $X,XXX
Adjustments for:
  Depreciation and amortisation                                 XXX
  Impairment losses                                             XXX
  Gain on disposal of property, plant and equipment            (XXX)
  Finance costs                                                 XXX
  Dividend income                                              (XXX)
Operating cash flows before working capital changes          $X,XXX
Adjustments for working capital:
  (Increase) / decrease in trade and other receivables        (XXX)
  (Increase) / decrease in inventories                        (XXX)
  Increase / (decrease) in trade and other payables             XXX
Cash generated from operations                               $X,XXX
Interest paid                                                  (XXX)
Income taxes paid                                              (XXX)
Net cash from operating activities                           $X,XXX

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Specific Accounting Policy Choices: Interest & Dividends

IAS 7.31–34 permits an entity to establish an accounting policy for the classification of interest and dividends, provided it is applied consistently from period to period:

Taxes on Income (IAS 7.35–36)

Cash flows arising from taxes on income must be separately disclosed and classified as cash flows from operating activities, unless they can be specifically identified with financing or investing activities (e.g., capital gains tax paid on the direct disposal of an investment property is classified as an investing cash outflow).

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Non-Cash Transactions & Financing Liabilities Reconciliation

1. Exclusion of Non-Cash Transactions (IAS 7.43–44)

Investing and financing transactions that do not require the use of cash or cash equivalents are strictly excluded from the Statement of Cash Flows itself. Such transactions must be disclosed elsewhere in the financial statements (in the notes) to provide all relevant information about these investing and financing activities.

Examples of Non-Cash Transactions:

• Acquiring assets by assuming directly related liabilities or by means of a lease (IFRS 16);
• Acquiring an entity by means of an issue of equity shares (IFRS 3);
• Converting debt to equity (e.g., convertible note conversions).

2. Reconciliation of Liabilities from Financing Activities (IAS 7.44A–44E)

Entities must disclose a reconciliation between the opening and closing balances of liabilities arising from financing activities, distinguishing:

• Cash changes (drawdowns, repayments, lease principal repayments);
• Non-cash changes (acquisition of new leases, foreign exchange rate changes, fair value changes, amortization of borrowing costs).

IAS 7.44F–44H (2023 amendments, effective 1 January 2024) also require disclosure of supplier finance arrangements, including their terms, the carrying amount of the related liabilities and the ranges of payment due dates.

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Worked Example: Statement of Cash Flows Preparation

Scenario

Pacific Logistics Ltd is preparing its Statement of Cash Flows for the year ended 31 December 20X5. The financial statements disclose the following information:

Profit or Loss Statement Information for 20X5

• Sales Revenue: $6,200,000
• Cost of Sales: ($3,800,000)
• Gross Profit: $2,400,000
• Wages and employee benefits: ($1,100,000)
• Depreciation expense (PPE): ($320,000)
• Other operating expenses: ($350,000)
• Gain on disposal of equipment: $40,000
• Finance costs: ($80,000)
• Dividend income: $25,000
• Profit before income tax: $615,000
• Income tax expense: ($180,000)
• Profit for the year: $435,000

Comparative Statement of Financial Position Balances

• Cash and cash equivalents: 20X4: $210,000; 20X5: $295,000 (Increase $85,000)
• Trade receivables: 20X4: $420,000; 20X5: $560,000 (Increase $140,000)
• Contract liabilities (deferred revenue): 20X4: $60,000; 20X5: $90,000 (Increase $30,000)
• Inventories: 20X4: $510,000; 20X5: $590,000 (Increase $80,000)
• Trade payables: 20X4: $380,000; 20X5: $440,000 (Increase $60,000)
• Current tax liability: 20X4: $45,000; 20X5: $55,000 (Increase $10,000)
• Bank borrowings: 20X4: $800,000; 20X5: $1,100,000 (Increase $300,000)
• Lease liabilities: 20X4: $350,000; 20X5: $710,000 (Increase $360,000)

Additional Transaction Data

1. Equipment with an original cost of $200,000 and accumulated depreciation of $130,000 (carrying value $70,000) was sold for $110,000 cash, generating the $40,000 gain on disposal.
2. Additions to PPE during the year totaled $1,100,000. Of this, $450,000 was acquired through new lease contracts recognized under IFRS 16 (non-cash addition), and $650,000 was paid in cash.
3. Lease principal repayments during the year totaled $90,000.
4. Dividends paid to shareholders totaled $180,000 (classified as financing).
5. Pacific Logistics classifies interest paid as operating, and dividends received as investing.

Technical Solution: Direct vs Indirect Method

1. Derivation of Operating Cash Flows (Direct Method)

• Cash Received from Customers:

$$\text{Revenue (\$6,200,000)} - \text{Increase in Receivables (\$140,000)} + \text{Increase in Contract Liabilities (\$30,000)} = \mathbf{\$6,090,000}$$

• Cash Paid to Suppliers:

$$\text{Cost of Sales (\$3,800,000)} + \text{Increase in Inventory (\$80,000)} - \text{Increase in Trade Payables (\$60,000)} = (\mathbf{\$3,820,000})$$

• Cash Paid to Employees: ($1,100,000)
• Cash Paid for Other Operating Expenses: ($350,000)
• Cash Generated from Operations: $6,090,000 - $3,820,000 - $1,100,000 - $350,000 = $820,000
• Interest Paid: ($80,000)
• Income Taxes Paid:

$$\text{Current Tax Expense (\$180,000)} - \text{Increase in Tax Liability (\$10,000)} = (\mathbf{\$170,000})$$

• Net Cash from Operating Activities: $820,000 - $80,000 - $170,000 = $570,000

2. Derivation of Operating Cash Flows (Indirect Method Reconciliation)

• Profit before tax: $615,000
• Adjustments for non-cash and non-operating items:
  • Add Depreciation: +$320,000
  • Deduct Gain on disposal of equipment: ($40,000)
  • Add Finance costs: +$80,000
  • Deduct Dividend income: ($25,000)
• Operating cash flows before working capital changes: $950,000
• Changes in working capital:
  • Increase in trade receivables: ($140,000)
  • Increase in contract liabilities: +$30,000
  • Increase in inventories: ($80,000)
  • Increase in trade payables: +$60,000
• Cash generated from operations: $820,000
• Interest paid: ($80,000)
• Income taxes paid: ($170,000)
• Net Cash from Operating Activities: $570,000

3. Investing Activities

• Cash paid to acquire PPE: ($650,000)
• Cash proceeds from sale of equipment: $110,000
• Dividend received: $25,000
• Net Cash used in Investing Activities: ($515,000)

4. Financing Activities

• Proceeds from bank borrowings: $300,000
• Repayment of lease liabilities (principal): ($90,000)
• Dividends paid to shareholders: ($180,000)
• Net Cash from Financing Activities: $30,000

5. Net Increase in Cash and Cash Equivalents

• Net increase: $570,000 (Operating) - $515,000 (Investing) + $30,000 (Financing) = $85,000
• Cash and cash equivalents at 1 Jan 20X5: $210,000
• Cash and cash equivalents at 31 Dec 20X5: $295,000

6. Required Note Disclosures

• Non-Cash Transaction: During 20X5, Pacific Logistics acquired $450,000 of transport equipment via new lease liabilities under IFRS 16. This transaction is excluded from the Statement of Cash Flows.
• Reconciliation of Financing Liabilities (IAS 7.44A):
  • Bank Borrowings: $800,000 (Opening) + $300,000 (Cash proceeds) = $1,100,000 (Closing)
  • Lease Liabilities: $350,000 (Opening) - $90,000 (Cash principal repayment) + $450,000 (Non-cash lease additions) = $710,000 (Closing)