IAS 7 – Statement of Cash Flows

Overview

This content provides IAS 7 requirements to prepare cash flow statements along with examples and practical illustrations.

Cash flows are needed by companies and individuals to assess the cash flow structure of a company and to analyse its liquidity status. This information is also used by other users of the financial statements to make informed decisions with regards to their dealings with the company.

IAS 7 provides detailed guidance on how to prepare cash flow statements so that uniformity and consistency are ensured across the industries to make comparisons easier between different financial statements of different companies.

Scope

All entities are required to prepare cash flow statements as part of their financial statements. The cash flow statement will be prepared in accordance with the requirements of IAS 7 which will be discussed in detail here.

Important Definitions (simplified)

Cash: Means cash in hand and those deposits in the bank which can be withdrawn on demand i.e. bank balances

Cash Equivalents: These represent short term investments that can be converted easily into cash and do not bear a significant risk of change in value (This will be explained in detail in a later section)

Operating Activities: These are activities that lead to revenue generation by an entity and do not include financing and investing activities. For example, cash from sales and trade receivables, cash payments for inventory purchases and settlement of creditors for inventory etc.

Investing Activities: These are activities that refer to investments by the company e.g., investments in fixed assets. This also includes long term investments that are not included in the definition of cash equivalents above for example investments in shares and bonds.

Financing Activities: These are activities that pertain to the equity of the Entity. Equity includes both share capital and debt. So, all cash flows arising from financing activities will be classified in this section. For example, repayment of the loan, injection of additional share capital, payment of dividends etc.

Cash and Cash Equivalents

Cash and cash equivalents mean short term investments whose purpose is to meet short-term cash requirements and they are not meant for long term investments. The standard attributes two properties for an investment that can be treated as a cash equivalent under this standard:

1. It can be converted easily into cash flow and the amount of cash flow can be determined
2. It is not subject to significant changes in its value.

Example:

Short investment in bank balance for a period of 1 month. It carries an insignificant interest rate. We can easily determine the cash flows when this investment will mature i.e. principal plus accrued interest. Also, there will not be a significant change in its fair value after one month.

As per standard, for an investment to qualify as a cash equivalent it should have a short-term maturity not exceeding three months. Investments in shares and other equity investments are generally excluded from cash equivalents.

Bank borrowings are not considered as part of cash equivalents. For bank overdrafts, if these balances generally fluctuate from positive to negative (i.e. overdrawn) and are repayable on demand, these will be considered as part of cash and cash equivalents. However, if they tend to be long term and represent more of a long-term loan, they will not be treated as part of cash and cash equivalents.

In the statement of cash flows, there is no need to show movements within cash and cash equivalents. For example, an additional amount transferred to a bank balance or short term investment will not be shown separately in the cash flow as such activities represent the management of cash and cash equivalents itself and do not represent any investing, financing or operating activities of the core business.

Presentation of a Statement of Cash Flows

The statement of cash flows will be distinctly divided into three parts:

1. Operating activities
2. Investing activities
3. Financing activities

A single transaction may have one or two cash flows that can be classified separately into two different activities. For example, for borrowings, there are two payments, principal and interest. Payment of principal amount will form part of financing activities; however, interest portion can be classified in the operating activities section. This is because the interest represents the cost of running a business on a day to day basis and falls with the purview of operating activities.

Operating Activities

The definition of operating activities highlights “principal revenue-generating activities of the Company”. For example, if a company is involved in the sale of toys, its principal revenue-generating activities would include sales of toys, handling of trad receivables, cost of sales (i.e. purchase cost of toys), employees involved in making sales and purchases and other ancillary activities. Such transactions generally result in the determination of profit or loss for the entity, or more specifically operating profit or loss for the company. Interest, however, can be included in operating activities as discussed above. But cash flow from the sale of a fixed asset cannot be represented in operating activities although it may form part of profit or loss i.e. profit or loss on sale of fixed assets.

Examples are:

• Cash flows arising from the sales (i.e. cash sales and receipts from debtors)
• Cash flows from other revenue streams of the entity (for example royalties, fees, commission, and other income)
• Payments made to suppliers
• Remuneration and other payments to employees (e.g. payment of salaries and other benefits, commission etc.)
• For an insurance entity, payments of premiums and claims and other policy benefits
• Income tax payments or refunds (sometimes income tax payments might be categorized in financing or investing activities)
• Cash transactions against contracts held for trading purposes (e.g. advance received on a construction project (for a construction company) not yet started will be shown in operating activities)
• Cash payments to acquire or construct assets that will be held for rental to others and subsequently held for sale (for example in the case of a company dealing in scaffolding materials which are given on rental to the customer and subsequently sold. In such case, these costs will be shown in the cost of sales and their cash flows will form part of investing activities e.g. rent and cash received on sale of such assets)
• For entities that deal in holding securities and loans for trading purposes, cash flows from such loans and securities will be classified as operating activities because such activities will constitute the operating activities of these companies.
• For banking companies and other financial institutions, cash advances and loans provided to customers and loans obtained from borrowers constitute operating activities. Accordingly, such cash flows will fall into operating activities (for example, advances received, interest received and paid etc.)

Investing Activities

Cash flows from investing activities include:

• Cash payments to purchase fixed assets (property, plant and equipment, intangibles, and other long-term assets).
• Cash receipts from the sale of fixed assets
• Cash payments to acquire equity or debt investments (for banking and investment companies, these will be included in operating activities as discussed above)
• Cash receipts from the sale of equity or debt investments
• Cash advances and loans (for financial institutions these will be classified in investing activities)
• Cash repayments against advances and loans (principal amount of loan provided to an employee will be classified in investment activities)
• Cash payments for derivative contracts except when such contracts are classified in operating or financing activities based on the nature of the entity holding them and the purpose they are held for.
• Cash receipts from above futures, forwards, and other such contracts.

Financing Activities

Cash flows from financing activities include:

• Cash flows from the issue of share capital or other equity instruments (for example cash received from the issuance of the share capital at a premium)
• Cash payments made to shareholders for redemption or repayment of share capital
• Cash flows from loans, debentures, notes, and other debt instruments
• Cash repayments of loans and other debt instruments
• Cash payment made by a lessee against the lease liability (interest amount on lease liability may be classified in operating activities however principal repayment will be shown in financing activities)

Preparing Cash Flows under Operating Activities

Cash flows statement is prepared by two methods (both of these are acceptable under IAS 7; however, the standard prefers the use of direct method)

1. Direct method
2. Indirect method

However, the difference in the two methods are limited to the “operating activities” section of the cash flows only, and the other two sections (investing activities and financing activities) remain the same under both methods.

1. Direct method

Under the direct method, receipts and payments are shown directly against each major class for example cash received from customers, cash paid to suppliers, cash paid/received from employees etc.

1. Indirect method

Under the indirect method, profit before tax is shown as the starting point and then all non-cash items are added back and the impact of increase or decrease in the working capital is shown to reach cash profit generated from operations.

A simple format of cash flow prepared under the indirect method is as follows.

	Current year	Prior year
Operating activities
PBT (Profit before tax)	XX	XX
Adjustments for non-cash and other items:
Depreciation – property, plant and equipment	XXX	XX
Amortization of right of use assets (IFRS 16)	XXX	XX
Amortization of intangibles	XXX	XX
Employee benefits provisions	XXX	XX
Gain on sale of fixed assets	XXX	XX
Other provisions and non-cash items (please specify)	XXX	XX
Finance income (Note 1)	XXX	XX
Finance cost (Note 1)	XXX	XX
Provision for taxes	XXX	XX
Changes in working capital and other balances:
–                 Inventories	XXX	XX
–                 Trade and other receivables	XXX	XX
–                 Related party balances	XXX	XX
–                 Advances received from customers	XXX	XX
–                 Trade and other payables	XXX	XX
Cash used in operations	XXX	XX
Tax payment	XX	XX
Interest payment	XX	XX
Employees’ long-term benefits paid	XX	XX
Net cash used in operating activities	XX	XX

Note 1: Finance income and expenses may not necessarily be non-cash items, however, the standard requires these to be shown separately. Hence, they are added back to profit or loss and then their payments or receipts are shown separately.

Note 2: All non-cash items are removed from the profit before tax including provisions of all types, depreciation, profit, or loss on sale of assets etc. to reach at a cash profit.

Reporting Cash Flows from Investing and Financing Activities

Gross receipts and payments arising from investing or financing activities will be shown separately in cash flows statement.

However, some cash flows may be reported on a net basis. These include:

• Cash receipts and payments from customers that represent the activity of a customer rather than that of the Entity (for example advance payment made by a customer and then requesting a refund from that payment, these two transactions do not need to be shown separately as advance received from customer and advance refunded to the customer, instead it can be shown as net advance received etc.)
• Cash receipts and payments for items in which turnover is quick and maturities are short (for example credit card payments, purchase, and sale of investments etc.)
• For a financial institution, cash payment and receipts against a deposit with a fixed maturity date can be shown as a net. Similarly, deposits placed and withdrawn from other financial institutions can be shown as net deposits. Advances and loans made to customers and their repayments can also be shown as the net.

Foreign Currency Cash Flows

Cash flow transactions arising from a foreign currency will be converted into the functional currency at an exchange rate prevailing at the date of cash flow i.e. the date of transaction. A weighted average rate can also be used as a practical expedient, for example, foreign sales of a company for a month occurring throughout the month can be converted at a weighted average monthly exchange rate.

The cash flows of a foreign subsidiary shall be translated at the rate prevailing at the dates of the cash flows i.e. the date of the transaction when these cash flows occurred and not at the end of the reporting period on which cash flow is prepared.

Example:

Company X has part of its operations in a foreign jurisdiction. The cash flows received against these sales for the month of March 2021 amounted to FY 1300.  These sales are evenly distributed throughout the month. FY is the foreign currency while Company X’s functional currency is AED. The weighted average exchange rate for the month of March is 1 FY = 5 AED. The exchange rate prevailing at year-end is 1 FY = 7 AED. The company wants to include this transaction in its cash flows.

Analysis

The cash flow should be converted at the date of the transaction itself or a weighted average rate appropriate to the period. In this case, since sales are evenly distributed across the month, a weighted average rate can also be used. However, the closing rate cannot be used. Because as per IAS 21, transactions are converted at a rate prevailing at the date of transaction.

So, in the cash flows statement, receipts from customers against sales will be shown as AED 6,500 (1300*5).

Unrealized Gains and Losses

Unrealized gains and losses arising from changes in exchange rates are not considered as cash flows.

Example:

Company X has a balance receivable from a customer denominated in a foreign currency. This represented receivables against sales dated 4 January 2021 amounted to FY 5,000. FY is the foreign currency while the functional currency of the company is AED. The exchange rate was 1 FY = 5 AED at the date of this transaction. At year-end, the amount is not yet received and the exchange rate at year-end closing i.e. 31 December 2021 is 1 FY = 7 AED. We need to see how this transaction will be recorded and how unrealized gain or loss will appear. Further how this loss will be treated in cash flows.

Analysis

At the date of transaction, the company will record sales and trade receivables by converting FY 5,000 at the rate prevailing on the date of this transaction i.e. 4 January 2021.

Dr. Trade receivables                            25,000 (5000*5)

Cr.  Sales                                              25,000

At year-end, since the receivables are not yet received, hence the company will translate the receivables at the exchange rate prevailing at year-end.

Dr. Trade receivables                            10,000 ((5000*(7-5)) as the exchange rate increased by 2 at YE

Cr. Exchange gain                                10,000

Treatment in cash flow:

Since this exchange gain is not realized yet, it will not be shown in the cash flow statement. But if we are preparing cash flow on the indirect method, we start with profit before tax which will include this exchange gain as well. Hence, we subtract this from the non-cash items and the other impact is taken into trade receivables in the “working capital changes section” as shown below.

	Current year	Prior year
Cash flows from operating activities
Profit or loss for the year before tax	XXX	XXX
Adjustments for:
Unrealized exchange gain	(10,000)	XXX
Provision for income tax	XXX	XXX
Changes in:	XXX	XXX
–                 Trade and other receivables	10,000	XXX
Cash used in operations	XXX	XXX

However, for practical purposes, since both impacts take place in the operating cash flows, companies normally show these items.

Unrealized Gains and Losses on Cash and Cash Equivalents

Unrealized gains and losses occurring on cash and cash equivalents should ideally follow the same treatment as is the case with other unrealized gains or losses. However, since we reconcile cash flows with the closing balance of cash and cash equivalents, we need to show somewhere these gains and losses, otherwise, reconciliation with closing cash and cash equivalents cannot be done.

Standard requires to present this amount separately from operating, investing, and financing activities. It is shown at the bottom of the cash flow statement after all these sections as shown in the below cash flow extract.

CASH FLOWS FROM INVESTING ACTIVITIES	XXX	XXX
CASH FLOWS FROM INVESTING ACTIVITIES	XXX	XXX
CASH FLOWS FROM FINANCING ACTIVITIES	XXX	XXX
NET INCREASE IN CASH AND CASH EQUIVALENTS	XXX	XXX
Impact of unrealized foreign exchange gain on cash and cash equivalents	XXX	XXX
Cash and cash equivalents as of 1 January	XXX	XXX
CASH AND CASH EQUIVALENTS AT 31 DECEMBER	XXX	XXX

Interest and Dividends

Cash flows from interest and dividends shall be shown separately as either operating, investing, or financing activities depending on their nature. The classification shall be consistent over the years.

In case if a portion of interest is capitalized in accordance with IAS 23 Borrowing Costs, it will not affect the cash flow and the full amount of interest paid (either capitalized or expensed) should be shown in the cash flows.

Payment of interest and receipt of dividends are usually classified as operating cash flow for a financial institution because it represents their principal revenue-generating activities i.e. providing loans and advances to customers and investing in shares and bonds which give rise to interest and dividends.

However, for other entities, there is no specification as to which one to classify as operating and which to classify as financing.  An entity may show interest payments in operating activity as it leads to the determination of profit and is considered part of operating activities however, another logic can be that this forms part of financing activities as it is originated from a financing loan.

Accordingly, the standard approves the use of both mechanisms used for showing interest and dividends as either operating or financing cash flows, however, whatever method chosen needs to be consistent over the years.

Taxes on Income

Cash flows relating to taxes on income should be shown separately as operating activities.

However, taxes also arise on items that are financing or investing in nature for example tax on interest income (on loans) or tax on the sale of fixed assets. If it is practicable to identify such taxes separately, they will be classified in either investing or financing activity to which they pertain.

Investment in Subsidiaries, Associates, and Joint Ventures

When accounting for investment in an associate or a joint venture or a subsidiary accounted for by using the equity or cost method, cash flows are restricted between the investor and the investee i.e., dividends received from associate or joint venture or subsidiary and advance received or paid to them.

Changes in Ownership Interest in Subsidiaries and Other Businesses

When a subsidiary is purchased or it ceases to exist i.e. control of the subsidiary is obtained or lost, certain cash flows will appear in the books that need to be accounted for in cash flow statements.

Such cash flows include cash paid for acquiring the subsidiary, cash received on disposing of the subsidiary, internal cash and bank balances appearing in the books of a subsidiary and other payments e.g., commission etc.

The standard requires to classify these cash flows under investing activities and to disclose the following items:

• Consideration paid or received on gaining control or losing control of a subsidiary or other business
• Portion of consideration consisting of cash and cash equivalents
• The amount of cash and cash equivalents in such subsidiaries and other businesses
• The assets and liabilities other than cash or cash equivalents along with their amounts in such subsidiaries and other businesses and summarized by major classes.

However, some of these items are not shown in cash flows e.g. the last item (asset and liabilities) and these can be disclosed separately somewhere else in the notes relating to disposal or acquisition of subsidiaries or other businesses. The purpose is to help users assess which cash flows and assets are contributed by the subsidiary acquired or vice versa.

In case of disposal and acquisition of various subsidiaries during the year, their cash flows will not be netted off and the impact of disposals will be shown separately from the effect of acquisition.

The cash consideration paid or received as a result of acquiring or disposing of a subsidiary will be shown in cash flows net of cash flows acquired or lost in the books of such subsidiary. For example, if a subsidiary is acquired for a cash consideration of AED 50,000 and there are cash and cash equivalents in the books of the subsidiary amounting to AED 3,000, then, consideration will be shown as AED 47,000 in the cash flows (i.e. net of cash existing in the books of the subsidiary).

Cash flow effects of the transaction in which a change in ownership interest in a subsidiary takes place but control is not lost, are shown in financing activities except for the case of investment entities whose primary business involves such transaction and it will amount to investment activities for such entities.

For example, Entity A has 70% investment in a subsidiary B as of the start of the year. During the year, Entity A sold 10% interest in the subsidiary for cash of AED 50,000. Since the Entity still has the control (60%), this transaction will be accounted for within equity and the cash consideration received will be shown in the financing section of the cash flows.

Non-cash Transactions

There exist many non-cash transactions in the books of a company e.g. depreciation, provisions. We have discussed earlier that such non-cash transactions that exist in the operating section of cash flows are adjusted to remove the impact of such non-cash items.

However, non-cash items may exist in investing and financing activities. For example, purchase of fixed assets by setting off receivable balance of a supplier, waiver off a loan by a shareholder etc.

Since there is no separate section in cash flows to explicitly disclose removing the effect of such cash flows, these need to be disclosed elsewhere to inform users of these non-cash transactions.

Components of Cash and Cash Equivalents

A breakup of the cash and cash equivalents will be shown in the financial statements. Also, a reconciliation of cash and cash equivalents is required to be disclosed that equates the balance of cash and cash equivalents shown in the statement of financial position with that shown in the statement of cash flows.

A simple reconciliation pattern is shown below.

Note XX. Cash and cash equivalents
	CY	PY
Cash in hand	XXX	XXX
Cash at bank	XXX	XXX
Total cash and cash equivalent as per the statement of financial position	XXX	XXX
Overdrafts	XXX	XXX
Short term investments	XXX	XXX
Cash and cash equivalents as per the statement of cash flow	XXX	XXX

Example: Preparation of a cash flow

RSQ has prepared its balance sheet and profit and loss account (see below). With the help of these along with other information given below, we are required to prepare a cash flows statement.

RSQ Limited
Statement of Financial Position
As at 31 December 2020
	2020	2019
ASSETS	AED	AED
NON-CURRENT ASSETS
Property and equipment	17,938	7,807
Right of use assets	6,827	6,616
Intangibles	6,791	9,151
Total non-current assets	31,556	23,574
CURRENT ASSETS
Inventories	7,825	7,907
Trade and other receivables	34,306	18,477
Receivables from related parties	7,182	7,126
Investments	5,600	4,500
Cash and cash equivalents	7,912	8,070
Total current assets	62,825	46,080
TOTAL ASSETS	94,381	69,654
Equity
Share capital	5,000	5,000
Retained earnings	39,336	8,370
Total equity	44,336	13,370
CURRENT LIABILITIES
Bank loan	12,787	21,001
Trade and other payables	12,572	8,811
Intercompany payables	7,731	7,725
Advances received from customer	7,919	8,122
Tax payable	6,180	6,395
Lease liability	2,856	4,230
Total current liabilities	50,045	56,284
TOTAL EQUITY AND LIABILITIES	94,381	69,654

 

RSQ Limited
Profit and loss statement
Year ended 31 December 2020
	2020	2019
Sale of goods	45,700	38,604
Cost of sales	(9,140)	(7,720)
Gross profit	36,560	30,884
Other income	320	405
General and admin expenses	(2,600)	(3,670)
Profit from operations	34,280	27,619
Finance income	765	3,450
Finance expense	(639)	(550)
Profit before tax	34,406	30,519
Tax expense	(3,440)	(3,052)
Profit after tax	30,966	27,467

Other data:

• Movement in fixed assets is shown below:

Particulars	Depreciation	Addition	Disposal	Gain on disposal
Property and equipment	(2,349)	12,480	–	–
Right of use assets	(311)	522	–	–
Intangibles	(1,248)	–	(1,112)	430

• Investments represent short term but do not meet the definition of cash and cash equivalents
• No dividends have been paid during the year and movement in retained earnings is due to the impact of profit for the year
• Addition in right of use asset represent a cash payment of 522 for a settlement and this will be treated as cash addition.
• Finance income and expense represents all amount received and paid respectively during the year and there are no accrued amounts.
• In the absence of any information for lease liability, assume the difference as payment of lease liability.

Analysis and Preparation of Cash Flows Statement

Generally, cash flows are prepared from the balance sheet, income statement and relevant notes along with other information for example movement in some accounts to depict cash movements as well as non-cash items.

We first start by taking profit before tax and then look for notes and other information to find out all non-cash items. These non-cash items are added back / subtracted from profit before tax to arrive at cash profits.

Then we take the impact of working capital balances (trade receivables and payables, inventory, other payables and receivable except for long term payables and receivables that fall with investing and financing activities)

RSQ Limited
Cash flows statement
For the year ended 31 December 2020
	2020
Operating activities
PBT (profit before tax)	34,406
Adjustments for non-cash and other items:
Depreciation on property and equipment	2,349
Amortization of right of use assets	311
Amortization of intangible assets	1,248
Gain on disposals of intangibles	(430)
Finance cost	639
Finance income	(765)
	37,758
Changes in working capital and other balances:
inventory stock (7,907 -7825)	82
Trade debtors and other receivables	(15,829)
Related party balances	(56)
Intercompany payables	6
Advances from customers	(203)
Investments	(1,100)
Trade creditors and other payables	3,761
Cash generated from operations	24,419
Payment of Income tax	(3,655)
Net cash generated	20,764
INVESTING ACTIVITIES
Purchase of property and equipment	(12,480)
Acquisition of intangible assets	(522)
Cash received on disposal of intangibles (1,112+430)	1,542
Finance income received	765
Net cash used	(10,695)
FINANCING ACTIVITIES
Repayment against lease liabilities	(1,374)
Repayment of loan balance	(8,214)
Finance cost paid	(639)
Net cash used	(10,227)
Net decrease	(158)
Opening cash and cash equivalents	8,070
Closing cash and cash equivalents	7,912

Note: In the working capital section, subtract opening balance of assets from closing balance and for liabilities do the vice versa.