Cash flows must be classified and reported according to the activity which gave rise to them. There are three standard activities:

• Operating activities
• Investing activities; and
• Financing activities.

The elements of the cash receipts and payments should be listed under each of the above three standard headings, which together make up the cash and cash equivalents movement for the period. This net movement is normally added to the balance that is brought forward at the beginning of the period, to give the balance of cash and cash equivalents at the period end, as shown in the illustrative examples in IAS 7.

Another entity acting on behalf of the reporting entity Question: Does a reporting entity present cash flows relating to operating, investing and financing transactions where another entity makes payments and receipts on the entity’s behalf? Answer: Non-cash activities are not generally reflected in the cash flow statement. However, when an entity is in substance directing another entity to act as its agent to collect receivables and settle liabilities on its behalf, it might be appropriate for a reporting entity to present cash inflows and outflows from such activities in the cash flow statement, as the reporting entity has the right to the cash inflows or the obligation to settle the liability and is the principal in the underlying transaction from which the cash flows arise. Judgement is required to determine whether that other entity is acting as an agent and making and receiving payments on the entity’s behalf. Processes that are established for convenience only and mean a reporting entity is not directly involved in a cash flow might suggest that the other entity is acting as an agent and processing cash flows on behalf of the reporting entity. A lack of direct involvement in a cash flow such that the reporting entity is purposely excluded from the cash exchange might suggest that the other entity is not acting as an agent for the reporting entity. For example, a group might maintain a central treasury function (an external financial institution or a group entity) that makes all cash payments and receipts on behalf of the reporting entity and the reporting entity does not have a bank account. The reporting entity presents these cash flows in the cash flow statement and classifies them as operating, investing or financing, in accordance with the nature of the underlying transaction. This is different to a situation in which another entity is a principal in the underlying transactions and incurs liabilities or recognizes assets that relate to the reporting entity’s operations. The reporting entity should not account for these transactions.

Cash deposited in a group treasury function Question: Is it appropriate for a subsidiary with cash deposited in a group treasury function to present these deposits as cash and cash equivalents? Answer: Only if these balances meet the definition of ‘cash equivalents. We expect that balances within a group treasury function would qualify as ‘cash and cash equivalents’ only in limited circumstances. ‘Cash equivalents’ must be ‘subject to an insignificant risk of changes in value’. Banking institutions are subject to capital requirements, regulatory oversight, third party liquidity management, and are generally independent of deposit makers. However, there are no regulatory restrictions on group treasury functions within companies to maintain a cash or capital balance sufficient to meet the demand obligation that attaches to inter-company balances. The creditworthiness of the group treasury function can fluctuate depending on decisions it (or the group) might make. Also, unlike a financial institution whose liabilities are backed by a diverse portfolio of income yielding assets, liabilities of a treasury subsidiary might be backed principally by receivables from other group subsidiaries, and hence the creditworthiness of the group treasury function is highly dependent on the commercial performance of these businesses. Factors that could indicate that balances within a group treasury function are subject to an insignificant risk of changes in value include the following: the group treasury function maintains sufficient cash and liquid resources, along with access to credit lines, to meet all intercompany obligations simultaneously; adequate controls and procedures of the group treasury function, For example, similar to those that a regulated financial institution would be subject to; demonstration that the group treasury function is continuously monitored and managed to maintain the liquidity position of the group as a whole; review of the group treasury controls and procedures by the board of directors, including but not limited to review of the group’s credit risk, continuous maintenance of a specified cash coverage ratio and the parent’s liquidity position; and monitoring the liquidity exposure of the group respective to the credit risk of various subsidiaries with open receivable positions. If the above factors are met, the company might be able to demonstrate that these balances within a group treasury function are subject to an insignificant risk of changes in value, thereby meeting the definition of ‘cash equivalents. This might be considered a significant accounting judgement, the nature of which should be disclosed. Entities should also consider the requirements for related party disclosures and financial risk management as it pertains to the group treasury function.

Cash flows are classified under the three standard headings of operating, investing, and financing activities, and a definition is provided for each. Each category includes cash flow examples that would be expected to be classified under these headings; however, cash flows are to be presented in the manner that is most appropriate to the business.

Ordering of the cash flow statement Question: Does an entity have to present the cash flow statement in a specific order? Answer: No, IAS 7 does not specify a required sequence for the three cash flow categories. An entity should report its cash flows in a manner deemed most appropriate to its business. In practice, most entities reporting under IFRS keep to the order of operating, investing and financing activities. The classification of cash flows by activity provides useful analysis about the relative importance of each of these activities and the inter-relationship between them. It should also provide useful information for comparison purposes across reporting entities.

Classification of cash flows in a manner appropriate to the business Question: What does “the manner appropriate to its business” mean? Answer: The nature of an entity’s business influences the appropriate classification of its cash flows. For example, dividends received by a venture capital entity are likely to be operating activities, because its business is to receive a return on investments; whilst a manufacturing entity would classify such dividends received under investing activities. For this reason, the examples given in IAS 7 for cash flow classification are not a rigid set of rules, but ones that would normally be expected to be included under each heading. Inevitably, some items will call for judgement when determining their classification. Decisions should be made according to the individual reporting entity’s circumstances and the transaction’s substance. There should be consistency of treatment between the cash flow statement and the other primary statements, and consistency of classification from period to period. For example, the receipt of a government grant should be classified according to its substance: Grants given as a contribution towards the purchase of fixed assets should be classified as an investing activity, irrespective of their treatment in the balance sheet. (Grant monies received should be disclosed separately from the cash outflows for a related investing or financing activity, unless the impact is immaterial.) Grants given as a contribution towards expenditures used to generate period revenues should be classified as cash flows from operating activities, to match their treatment in the income statement. Similarly, the level of aggregation or disaggregation within each category of cash flows should be appropriate to the entity’s business and the needs of financial statement users. An entity can sub-divide the elements of cash receipts and payments that are listed as examples, to give a full description of the entity’s activities. For example, proceeds from the issue of a debenture might be shown separately from the proceeds of other long-term borrowings, or cash receipts from dividends received might be further subdivided between dividends received from associated entities and other dividends received. Disclosures should enable the user to understand the relationship between the entity’s different activities and the way in which they generate and expend cash.

A single transaction entered into by an entity might result in several cash flows that could be classified differently. These should be split out, and presented under their respective headings, according to their nature.

Leases and other amortizing loans Question: How are payments for leases or other amortizing loans classified in the cash flow statement? Answer: Lease payments should be split into their component parts of principal and interest payments. This also applies to payments for amortizing loans, where each payment includes both an amount in respect of interest and an amount for the repayment of principal. The cash payment for the principal element is classified under financing activities. The cash payment for the interest element is treated in the same manner as other interest payable (operating or financing, consistent with the entity’s policy on classification of interest payable). Payments made before the commencement of a lease are classified as investing cash flows, as these are cash payments for the acquisition of the right-of-use asset. The substance of payments made at the commencement of lease should be considered to determine its classification in the cash flow statement. For example, a one-off upfront payment of all the lease payments on commencement would be presented as an investing cash flow; while the payment at commencement of the first periodic payment might be classified as a financing cash flow consistent with the ongoing periodic payments of the principal element. Payments in connection with leases accounted for using the short-term or low-value exemptions under IFRS 16, and variable lease payments that are not part of the lease liability, are classified under operating activities in the cash flow statement.

Gross or net cash flows

Where there is a material cash flow for any constituent element described above, the standard requires that ‘major classes’ of gross receipts and payments should be presented separately on the face of the cash flow statement.

Gross cash flows give users more detailed information on the effects of the entity’s activities on the cash flows, and so they provide more relevant information than net cash flows. However, there are certain situations where the standard specifically permits the reporting of net cash flows.

Cash receipts and payments on behalf of customers, where these reflect the customer’s activities, can be reported net. Cash receipts and payments can also be reported net for items arising in operating, investing, or financing activities where the turnover is quick, the amounts are large and the maturities are short.

Gross or net cash flows Question: What are some examples of cash receipts and cash payments that can be presented net? Answer: There are two general categories of activities where cash flows can be shown net. The first is where cash receipts and payments are on behalf of customers and reflect the customer’s activities (For example, where the entity is acting as an agent). IAS 7 gives further examples of this, as follows: the acceptance and repayment of demand deposits of a bank; funds held for customers by an investment entity; and rents collected on behalf of, and paid over to, the owners of properties. The second category is for items where the turnover is quick, the amounts are large and the maturities are short. Some examples of these items are: advances and repayments of credit card principal amounts; the purchase and sale of investments; other short-term borrowings (For example, those which have a maturity period of three months or less); and the issuance and redemption of numerous short-term commercial programmers during the year (where the maturities are less than three months, the turnover is quick and the volume is large). Not all purchases and sales of investments will qualify for net presentation on the cash flow statement, only those that meet the above conditions. In practice, the reporting of cash flows on a net basis for investments will usually only arise in a bank or similar financial institution. Therefore, for a non-bank (or similar) entity, the purchases and sales of investments should normally be shown gross. An exception might be where amounts are placed on deposit and continually rolled over. Netting of these cash flows is permitted, but not required, and therefore it is an accounting policy choice as to whether to present the cash flows on a net (that is, only reflect the commissions received) or a gross basis. When the gross basis is used, the cash flows should both be shown under the same heading in the cash flow statement.

The following cash flows can be reported net for financial institutions:

• cash receipts and payments for the acceptance and repayment of deposits with a fixed maturity date;

• the placement of deposits with, and withdrawal of deposits from, other financial institutions; and

• cash advances and loans made to customers, and the repayment of those advances and loans.

Gross or net cash flows: consolidated financial statements that include financial institutions Question: IAS 7 permits financial institutions to present the cash flows of certain activities on a net basis. Is this presentation permitted in the consolidated financial statements of a group that includes a financial institution? Answer: Net presentation of the financial institution’s cash flows relating to these activities is appropriate in the consolidated cash flow statement of a group that includes the subsidiary financial institution, even though gross cash flows would be reported for the group’s other operations.

The reporting of gross cash flows does not apply to operating activities where the indirect method is followed.

Cash flows from operating activities

IAS 7 defines operating activities as “the principal revenue-producing activities of the entity and other activities that are not investing or financing activities”. The separate disclosure of operating activity cash flows allows users to assess the extent to which the operating activities generate cash flows to maintain the entity’s operating capability and support the cash flows for financing and investing activities.

Cash flows from operating activities represent the cash effects of transactions and other events relating to the entity’s principal revenue-producing activities.

Generally, cash flows from operating activities will represent the movements in cash and cash equivalents resulting from the operations shown in the income statement in arriving at profit or loss. Some transactions giving rise to amounts included in profit or loss will not be classified as operating cash flows;

For example, the cash flow relating to a gain on the sale of a fixed asset will normally be reported under investing activities. In contrast, cash payments to manufacture or acquire assets that are held for rental to others, and are routinely held for sale when they cease to be rented, are cash flows from operating activities; this is because they arise from the entity’s principal revenue-producing activities.

Similarly, the cash receipts from rentals and subsequent sales of such assets are also cash flows from operating activities.

Classification of cash flows in a manner appropriate to the business Question: What does “the manner appropriate to its business” mean? Answer: The nature of an entity’s business influences the appropriate classification of its cash flows. For example, dividends received by a venture capital entity are likely to be operating activities, because its business is to receive a return on investments; whilst a manufacturing entity would classify such dividends received under investing activities. For this reason, the examples given in IAS 7 for cash flow classification are not a rigid set of rules, but ones that would normally be expected to be included under each heading. Inevitably, some items will call for judgement when determining their classification. Decisions should be made according to the individual reporting entity’s circumstances and the transaction’s substance. There should be consistency of treatment between the cash flow statement and the other primary statements, and consistency of classification from period to period. For example, the receipt of a government grant should be classified according to its substance: Grants given as a contribution towards the purchase of fixed assets should be classified as an investing activity, irrespective of their treatment in the balance sheet. (Grant monies received should be disclosed separately from the cash outflows for a related investing or financing activity, unless the impact is immaterial.) Grants given as a contribution towards expenditures used to generate period revenues should be classified as cash flows from operating activities, to match their treatment in the income statement. Similarly, the level of aggregation or disaggregation within each category of cash flows should be appropriate to the entity’s business and the needs of financial statement users. An entity can sub-divide the elements of cash receipts and payments that are listed as examples, to give a full description of the entity’s activities. For example, proceeds from the issue of a debenture might be shown separately from the proceeds of other long-term borrowings, or cash receipts from dividends received might be further sub-divided between dividends received from associated entities and other dividends received. Disclosures should enable the user to understand the relationship between the entity’s different activities and the way in which they generate and expend cash.

Leases and other amortizing loans Question: How are payments for leases or other amortizing loans classified in the cash flow statement? Answer: Lease payments should be split into their component parts of principal and interest payments. This also applies to payments for amortizing loans, where each payment includes both an amount in respect of interest and an amount for the repayment of principal. The cash payment for the principal element is classified under financing activities. The cash payment for the interest element is treated in the same manner as other interest payable (operating or financing, consistent with the entity’s policy on classification of interest payable). Payments made before the commencement of a lease are classified as investing cash flows, as these are cash payments for the acquisition of the right-of-use asset. The substance of payments made at the commencement of lease should be considered to determine its classification in the cash flow statement. For example, a one-off upfront payment of all the lease payments on commencement would be presented as an investing cash flow; while the payment at commencement of the first periodic payment might be classified as a financing cash flow consistent with the ongoing periodic payments of the principal element. Payments in connection with leases accounted for using the short-term or low-value exemptions under IFRS 16, and variable lease payments that are not part of the lease liability, are classified under operating activities in the cash flow statement.

Purchase of land and buildings by a property developer Question: How should the cash flows in respect of the purchase of land and buildings be classified by a property developer that purchases land and buildings to redevelop and sell? Answer: The property developer should classify the cash outflows in respect of the purchase of land and buildings as operating cash flows. Property purchased by a developer is analogous to inventory acquired by a manufacturer.

Purchase of land and buildings by a property investment entity Question: How should the cash flows in respect of the purchase of land and buildings be classified by a property investment entity that purchases land and buildings for the purposes of earning rental income from the properties and, subsequently, routinely earns revenue from the sale of property? Answer: Cash outflows in respect of the purchase of the land and buildings are classified as operating activities where such assets are routinely sold and the sales proceeds are treated as revenue. Normally, cash outflows in respect of the purchase of long-term assets (including property, plant and equipment and investment property) are classified as investing activities. However, cash payments to manufacture or acquire assets held for rental to others that are subsequently routinely held for sale are cash flows from operating activities. The cash receipts from rentals and subsequent sales of such assets are also cash flows from operating activities.

Factoring arrangements Question: How should the cash flows in respect of a factoring arrangement be classified in the cash flow statement? Answer: It is common for an entity to enter into a factoring arrangement that transfers to a third party (the ‘factor’) its rights to cash to be collected from receivables in exchange for an immediate cash payment. In a factoring arrangement where an entity de-recognizes the factored receivables and receives cash from the factor, the cash receipt is classified as an operating cash inflow. This is because the entity has received cash in exchange for receivables that arose from its operating activities. Where the entity continues to recognize the receivables and the amount received from the factor is recorded as a liability, the cash received is classified as a financing cash inflow. The substance of the factoring arrangement is financing, in which the entity retains substantially all of the risk and rewards of the factored receivables. When the cash is collected by the factor, the liability and the receivables are de-recognized. It is acceptable for this to be disclosed as a non-cash transaction, because the settlement of the liability and the factored receivables does not result in cash flows. The net impact of these transactions on the cash flow statement is to present a cash inflow from financing, but there is no operating cash flow from the original sale to the entity’s customers. It might also be acceptable to present cash flows of a factoring arrangement in the cash flow statement, even if there is no actual cash flow. Management should consider the substance of the arrangement when evaluating whether this type of presentation is acceptable. For example, an entity that continues to recognize the receivables in a factoring arrangement might present the de-recognition of the liability as a financing cash outflow and the settlement of the receivables as an operating cash inflow. This presentation is acceptable, because the substance of the transaction is that the factor collects the receivables on the entity’s behalf and retains the cash in settlement of the separate financing transaction. A similar presentation might be acceptable for a reverse factoring arrangement, where the obligation to settle, payables is transferred to a financial institution. The entity might present an operating outflow and a financing inflow to reflect the borrowing and the settlement of payables for inventory purchases.

Insurance proceeds Question: How should the cash flows in respect of insurance proceeds be classified in the cash flow statement? Answer: Insurance proceeds are classified within the cash flow statement based on the nature of the insured item, rather than on how management plans to utilize the proceeds. Insurance proceeds that relate to an investing activity (such as destroyed fixed assets) are an investing cash inflow. Insurance proceeds that relate to an operating activity (such as inventory losses or business interruption) are an operating cash inflow. There will often be a mismatch between when the loss was incurred and the recognition and receipt of the insurance reimbursement.

Costs to obtain or fulfil a revenue contract Question: How should the cash outflows in respect of the costs to obtain or fulfil a revenue contract be classified? Answer: Entities should generally present cash payments for revenue contract costs as cash from operations in the cash flow statement because cash payments for contract costs relate to the entity’s ordinary revenue generating activities. Such costs are amortized by reference to the transfer of goods or services to the customer, an operating activity for the entity. Capitalization of contract costs is also analogous with capitalization of inventory on certain customer contracts.

Where an entity deals or trades in securities, this is equivalent to inventory in a retail entity, and this activity will be treated as an operating activity. Similarly, financial institutions will classify cash flows about loan advances to customers within operating activities.

IAS 7 gives the following examples of cash flows that are expected to be classified as operating activities:

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

Operating cash flows could be reported using either the direct method or the indirect method. The standard encourages, but does not require, reporting entities to use the direct method.

The direct method reports the major classes of gross operating cash receipts (For example, cash collected from customers) and gross operating cash payments (For example, cash paid to suppliers and employees).

These gross operating cash flows are aggregated to produce the entity’s net operating cash flow. This presentation is consistent with that of investing and financing activities.

There are two ways in which gross operating cash receipts and payments could be derived under the direct method. They could be captured directly from a separate cash-based accounting system that records amounts paid or received in any transaction.

Alternatively, they could be determined by adjusting operating income statement items for non-cash items, changes in working capital, and other items that relate to investing and financing cash flows.

Direct method: gross operating cash receipts and payments Question: How are gross operating cash receipts and payments determined indirectly for presentation using the direct method? Answer: Many entities do not collect information that will allow them to determine gross cash receipts and payments directly from the accounting system. The information required for use of the direct method can be obtained by making appropriate adjustments to the profit and loss account item. For example, cash collected from customers might be derived by adjusting sales for the changes in amounts receivable from customers during the period. Similarly, cash paid to suppliers, for goods used in manufacture or resale, might be determined indirectly by adjusting cost of sales for changes in inventory and amounts due to suppliers during the period. It might be complex to determine detailed categories of operating cash receipts and payments. Therefore, while the direct method produces a cash flow statement in its purest form (with information that is not otherwise available from the income statement and the balance sheet), this approach might require incremental work to be performed in comparison to that required when using the indirect method, because in most cases, the sub ledger accounts are not set up to provide the level of information needed to report on direct cash flows.

Direct method: foreign exchange differences related to operating activities Question: Where the direct method is used to present the cash flows from operating activities, how are foreign exchange differences relating to settled and unsettled transactions reflected in the cash flow statement? Answer: The cash receipt and/or payment itself is presented, and so no exchange differences should arise in preparing the cash flow statement.

The same total cash flows from operating activities are reported under the indirect method as under the direct method. The figure is produced by adjusting the profit or loss to remove the effects of non-cash items (such as depreciation and provisions), changes in working capital (such as accruals and pre-payments, and changes in receivables and payables in the period), and items that relate to investing and financing activities. This will reconcile the profit or loss to the cash flow from operating activities.

An alternative permitted presentation under the indirect method is to show the revenues and expenses disclosed in the income statement (or if present, the separate income statement) and the adjustments for changes in working capital and non-cash movements in the period to give the cash flows.

Application of the indirect method Question: What is the starting point for using the indirect method for reporting operating cash flows? Answer: It is widely accepted in practice that the reconciliation for operating cash flows can begin from either profit after taxation or profit before taxation. The words used in IAS 7 are “profit or loss”, which are generally taken to mean the same as profit after taxation; however, the illustrative example in IAS 7 begins the reconciliation with profit before taxation. Some entities begin the reconciliation using another sub-total appearing in their income statement (For example, profit before taxation and finance costs, or operating profit) where the differences between these measures and profit before (or after) taxation are clearly identified and reconciled in the income statement. The starting point should not be misleading, and the outcome should properly reflect the cash flows from operating activities. For example, it would not be appropriate to use an undefined measure as the starting point for the reconciliation or to exclude non-controlling interests from the measure. Regulators in some jurisdictions apply a narrower interpretation of this issue, considering it acceptable to start the reconciliation only at profit after taxation, profit before taxation or profit from continuing operations. Illustrative example A, which accompanies IAS 7, shows an alternative to reconciling profit and loss to present operating cash flows using an indirect method. This presentation method is rarely used in practice.

Indirect method: reconciliation of profit and loss Question: What items are included in the reconciliation of profit and loss to operating items under the indirect method? Answer: The reconciliation of profit or loss to net cash flows from operating activities will generally disclose movements in inventory, debtors and creditors related to operating activities and other non-cash items (For example, depreciation, provisions, gain or loss on sale of assets, share of profits of associates, and charges relating to share-based payment). It will also include other items that are required to be disclosed separately, such as interest and taxes. Gains and losses that do not give rise to any cash flows are excluded from the cash flow statement. Gains and losses included in profit or loss are adjusted (gains deducted, losses added) in the reconciliation to arrive at the net cash flow from operating activities where the indirect method is used. For example, a gain on the sale of plant and machinery is excluded from cash flow from operating activities. The gain is not a cash flow, but it forms part of the proceeds from the sale that are presented under investing activities. The same treatment applies to gains and losses on investments (other than cash equivalents). Where investments are used for trading activities (For example, by a bank or similar financial institution), cash flows related to purchases and sales of investments are included in operating activities. In this situation, one approach is to adjust profit or loss for the movement in investments, without any further adjustment for changes in fair value or other gains and losses recognized in profit or loss, to arrive at the net cash flow from operating activities. Other approaches might be acceptable. Management should analyze the movements in opening and closing debtors and creditors, to eliminate those movements that relate to items reported in financing or investing activities. For example, an entity might purchase a fixed asset on credit prior to the year-end. The closing creditors’ balance would need to be adjusted to eliminate the amount owing for the fixed asset purchase, before working out the balance sheet movements for operating creditors. When the creditors’ balance is paid, the cash outflow would be presented as an investing cash flow, and the movement in the balance sheet adjusted to reflect the payment does not relate to operating cash flows. Similarly, the entity should eliminate balance sheet movements related to items such as acquisitions and disposals of subsidiaries during the year, exchange differences on foreign subsidiaries’ working capital, and other non-cash adjustments for opening and closing accruals for no operating items. This means that movements in working capital would not necessarily be the same as the difference between the opening and closing balance sheet amounts. A question arises as to whether the eliminated items within each balance sheet movement of working capital need to be reported separately, so that the overall movement between the opening and closing balance sheet amounts is readily understandable. For example, an entity could identify the total balance sheet movement in creditors and then separately itemize the operating element and the other movements. IAS 7 is silent on this point and, in practice, this is rarely done; only the operating movement is reported. Some entities monitor working capital movements on ‘controllable’ items (such as trade debtors, creditors and inventory) separately from other ‘less controllable’ items (such as provisions), because this is a key performance measure for management. Such movements are often presented in the cash flow reconciliation in a separate line entitled ‘net working capital movement’. IAS 7 does not specifically define ‘net working capital’. Therefore, we consider this to be an acceptable presentation, provided that the presentation is consistent year on year. The reconciliation could be presented on the face of the cash flow statement or in a note.

Indirect method: foreign exchange differences arising from settled transactions that relate to operating activities Question: Under the indirect method, how are foreign exchange differences arising from settled transactions that relate to operating activities reflected in the cash flow statement? Answer: Any exchange gain or loss on a settled transaction that relates to operating activities is already included in arriving at profit. Consequently, no adjustment for such an exchange gain or loss is necessary in the reconciliation of profit to operating cash flows when the transaction is settled. Consider a UK entity (which has a functional currency of CU) that was set up in January 20X6. It purchased goods for resale from France in February 20X6 for FCU200,000 when the exchange rate was CU1 = FCU1.50. It entered the purchase in its inventory records as: FCU200,000 @ 1.50 = CU133,333. The entity settled the debt under the contract’s terms in October 20X6 when the exchange rate was CU1 = FCU1.60. The amount paid in settlement was: FCU200,000 @ 1.60 = CU125,000. The entity would therefore recognize an exchange gain of CU133,333 − CU125,000 = CU8,333 in arriving at profit for the year. Assuming that there are no other transactions during the year and the inventory remained unsold at the balance sheet date on 31 December 20X6, a simplified cash flow statement is given below: CU CU Cash flows from operating activities 8,333 Profit Adjustment for: (133,333) Increase in Inventories Net cash flow used in operating activities (125,000)

Indirect method: foreign exchange differences arising from settled transactions that relate to investing or financing activities Question: Under the indirect method, how are foreign exchange differences arising from settled transactions that relate to investing or financing activities reflected in the cash flow statement? Answer: The exchange gain or loss is removed in the reconciliation required under the indirect method, where a settled transaction does not relate to operating activities, and the exchange gain or loss is included in profit or loss. This is because it is included as part of the cash flows arising from the settlement classified under investing or financing activities. For example, the functional currency equivalent of foreign cash received from a foreign investment would be shown under investing activities as dividends received, and it would reflect any exchange gain or loss that arises at the time of receipt and is reported in the income statement.

Indirect method: foreign exchange differences arising from unsettled transactions that relate to operating activities Question: Under the indirect method, how are foreign exchange differences arising from unsettled transactions that relate to operating activities reflected in the cash flow statement? Answer: Where the indirect method is used, the exchange differences that arise on translation at the balance sheet date, for monetary items that form part of operating activities, will require no adjustment in the reconciliation of profit to net cash flow from operating activities, even though they do not involve any cash flows. This is because increases or decreases in monetary items that form part of operating activities will include the exchange differences on their translation at the balance sheet date, which would be offset against their equivalent exchange gain or loss included in profit for the year. The effect is that the net cash flow from operating activities will not be distorted by such translation differences. Consider a UK entity (which has a functional currency of CU) that was set up in January 20X6. It purchased goods for resale from France in February 20X6 for FCU200,000 when the exchange rate was CU1 = FCU1.50. It entered the purchase in its inventory records as: FCU200,000 @ 1.50 = CU133,333. At the UK entity’s year end of 31 December 20X6, the account had not been settled. At 31 December 20X6, the exchange rate was CU1 = FCU1.55, so that the original creditor for CU133,333 would be translated at FCU200,000 @ 1.55 = CU129,032. The gain on exchange of CU133,333 − CU129,032 = CU4,301 would be reported as part of the profit for the year. The cash flow statement would be as follows: CU CU Cash flows from operating activities Profit 4,301 Adjustment for: Increase in Inventories (133,333) Increase in Creditors 129,032 Net cash flow used in operating activities nil The exchange differences included in profit and in the year end creditor balance offset each other. Therefore, cash flow from operating activities is not affected and no adjustment is required in the reconciliation. Alternatively, an entity could split the movement on the receivables/payables into cash, foreign exchange, acquisitions and other movements, including only the movement in cash in the reconciliation. The exchange gain or loss included in arriving at profit will not be offset by the total movement in receivables or payables, and so it is adjusted for the reconciliation to balance. The method used is an accounting policy choice for the entity and is applied consistently from one period to the next.

Indirect method: foreign exchange differences arising from unsettled transactions that relate to investing or financing activities Question: Under the indirect method, how are foreign exchange differences arising from unsettled transactions that relate to investing or financing activities reflected in the cash flow statement? Answer: Exchange differences on monetary items that form part of investing or financing activities (such as long-term loans) will normally be reported as part of the profit or loss for the financial year. They are eliminated in arriving at the net cash flows from operating activities when performing the reconciliation for the indirect method. This is because the actual movement on long-term monetary items that includes the relevant exchange difference is not reported in the reconciliation of profit to operating cash flow, since they are not operating activity items. Consider the opening balance sheet at 1 October 20X6 of a UK entity (which has a functional currency of C) which consists of cash of C100,000 and share capital of C100,000. The entity takes out a long-term loan on 31 March 20X7 of FC270,000 when the rate of exchange is C1 = FC1.40. The proceeds are immediately converted to C (that is, C192,857). There are no other transactions during the year. The exchange rate at the balance sheet date of 30 September 20X7 is C1 = FC1.60. The summarized balance sheet at 30 September 20X7 would be as follows: C’000 C’000 Assets  Cash 293 293 Equity and liabilities  Capital and reserves  Share capital 100 Reserves 24 124 Non-current liabilities  Long-term loan 169 Total equity and liabilities 293 The foreign currency loan, having been translated at the rate ruling at the receipt date to C192,857 (FC270,000 @ 1.40), is translated at the balance sheet date to C168,750 (FC270,000 @ 1.60). The exchange gain of C24,107 is recognized in profit for the year. The cash is made up of C100,000 (received from the share issue) and C192,857 (received on converting the currency loan immediately to C). Cash flow statement C’000 C’000 Cash flows from operating activities  Profit 24 Adjustment for: Foreign exchange gain (24) Net cash flow from operating activities Nil Cash flows from financing activities  Receipts of foreign currency loan 193 Net cash flow from financing activities 193 Net increase in cash and cash equivalents 193 Cash and cash equivalents at beginning of period 100 Cash and cash equivalents at end of period* 293 * Represents year-end cash balances. The above illustration shows that the exchange gain of C24,107 does not have any cash flow effect and is related to financing activities. Therefore, it needs to be eliminated from profit. A similar adjustment would be necessary if the loan remains outstanding at 30 September 20X8.

Cash flow from investing activities

IAS 7 defines ‘investing activities’ as “the acquisition and disposal of long-term assets and other investments not included in cash equivalents”. So, cash flows from investing activities generally include the cash effects of transactions relating to the acquisition and disposal of any long-term asset or current asset investment (other than those regarded as cash equivalents).

This includes cash flows relating to the acquisition or disposal of equity interests in other entities (including obtaining or losing control of subsidiaries, and investments in or disposals of associates and joint ventures) or business units.

The disclosure of cash flows from investing activities provides users with information on the extent of expenditure that has been incurred to generate future cash flows and profits for the business. Only expenditures that result in a recognized asset in the balance sheet are eligible for classification as cash flows from investing activities.

Classification of cash flows in a manner appropriate to the business Question: What does “the manner appropriate to its business” mean?  Answer: The nature of an entity’s business influences the appropriate classification of its cash flows. For example, dividends received by a venture capital entity are likely to be operating activities, because its business is to receive a return on investments; whilst a manufacturing entity would classify such dividends received under investing activities. For this reason, the examples given in IAS 7 for cash flow classification are not a rigid set of rules, but ones that would normally be expected to be included under each heading. Inevitably, some items will call for judgement when determining their classification. Decisions should be made according to the individual reporting entity’s circumstances and the transaction’s substance. There should be consistency of treatment between the cash flow statement and the other primary statements, and consistency of classification from period to period. For example, the receipt of a government grant should be classified according to its substance: Grants given as a contribution towards the purchase of fixed assets should be classified as an investing activity, irrespective of their treatment in the balance sheet. (Grant monies received should be disclosed separately from the cash outflows for a related investing or financing activity, unless the impact is immaterial.) Grants given as a contribution towards expenditures used to generate period revenues should be classified as cash flows from operating activities, to match their treatment in the income statement. Similarly, the level of aggregation or disaggregation within each category of cash flows should be appropriate to the entity’s business and the needs of financial statement users. An entity can sub-divide the elements of cash receipts and payments that are listed as examples, to give a full description of the entity’s activities. For example, proceeds from the issue of a debenture might be shown separately from the proceeds of other long-term borrowings, or cash receipts from dividends received might be further subdivided between dividends received from associated entities and other dividends received. Disclosures should enable the user to understand the relationship between the entity’s different activities and the way in which they generate and expend cash.

Exploration or internal research activities Question: Can cash flows relating to exploration activities or internal research activities be classified as investing cash flows? Answer: Exploration activities that are expensed in the income statement cannot be classified as investing activities, because they do not result in a recognized asset. Similarly, internal research activities that are expensed cannot be classified as investing activities.

Development costs for long-term assets Question: Are development costs for long-term assets classified as investing cash flows? Answer: Cash payments made for the acquisition of long-term assets will include any capitalized development costs and costs incurred in the construction of an asset by the entity for its own use.

Acquisition costs for a business combination Question: Are acquisition costs for a business combination classified as investing cash flows? Answer: No. Transaction costs in a business combination are expensed as incurred under IFRS 3 and do not result in a recognized asset. They are classified within operating activities in the cash flow statement.

Non-cash elements of investing activities Question: Is it necessary to adjust for non-cash elements of investing activities? Answer: Yes. The amount paid in respect of fixed assets and right-of-use assets during the year might not be the same as the amount of additions shown in the ‘fixed asset’ note and ‘right-of-use assets’ note. Examples of differences that might require adjustment include: Fixed assets purchased on short term credit – the amounts for additions should be adjusted for the outstanding payable, to arrive at the cash paid in the period for the asset. This adjustment also requires a corresponding adjustment to operating cash flows, to arrive at the movement in creditors for fixed asset acquisitions, where the indirect method is used. Fixed assets acquired in foreign currencies – the functional currency equivalent of the foreign currency amount paid in cash that is reported in the cash flow statement is not necessarily the same as the functional currency equivalent of the cost recorded at the transaction date and included in the balance sheet, because of changes in exchange rates during the period that the credit is outstanding. Right-of-use assets under IFRS 16 are non-cash investing activities (acquisition of an asset) and non-cash financing activities (incurring a long-term liability); therefore, entities should exclude right-of-use assets additions from investing cash flows. An exception relates to payments made before the commencement of the lease or any initial direct costs capitalized, because these are cash payments for the acquisition of the right-of-use asset, which are classified as investing activities.

Acquiring equity instruments from non-controlling interests Question: Are cash payments to acquire equity instruments from non-controlling interests classified as an investing activity? Answer: No. In consolidated financial statements, cash flows arising from changes in ownership interests in a subsidiary that do not result in a loss of control (For example, purchase or sale of a subsidiary’s equity instruments) are not classified as investing activities; instead, they are classified as cash flows from financing activities.

Cash flows from sale and leaseback transactions Question: How would the cash proceeds from a sale and leaseback transaction be presented in the cash flow statement of the seller-lessee? Answer: If the transfer of a fixed asset by the seller-lessee satisfies the requirements of IFRS 15 to be accounted for as a sale of the asset, we believe that there are two acceptable approaches to presenting the cash received from the purchaser-lessor in the cash flow statement. The first approach is to allocate the cash received from the purchaser lessor between: i. the proceeds attributable to the proportion of the rights transferred to the buyer-lessor (interest in the value of the underlying asset sold in the sale and leaseback) that would be classified in the cash flow statement as investing activities; and ii. The remaining balance related to the proportion of the right of use being retained that would be classified in the cash flow statement as a cash flow from financing activities. For example, consider an entity that sold an asset for CU 1 million, which is the fair value of the asset. The entity concludes that the transfer of the asset qualifies as a sale in accordance with IFRS 15. The entity leases the asset back in exchange for fixed lease payments, resulting in 40% of the right of use over the underlying asset being retained. In this example, CU600,000 (60% of CU1 million) of the cash inflow would be presented as investing activities, because it relates to the proportion of the rights transferred; and CU400,000 as financing cash flows, because it reflects the financing obtained for the right of use retained. The second approach is to present the cash received from the purchaser lessor, up to the fair value of the underlying asset, as investing activities in the cash flow statement, because it relates to proceeds for the sale of fixed assets. The lease payments to the purchaser-lessor in the future would be presented in the cash flow statement following the general guidance on lease payments. If the cash received by the seller-lessee for the sale of the asset is lower than its fair value, a portion of the consideration received is non-cash and is not reflected in the cash flow statement. It is, in substance, a non-cash prepayment of the lease payments. Conversely, if the sale price is above fair value, the excess is identified as financing in accordance with IFRS 16 and is presented as financing activities in the cash flow statement. If the transfer of an asset by the seller-lessee does not satisfy the requirements of IFRS 15 to be accounted for as a sale of the asset, the cash proceeds are classified as financing activity in the cash flow statement. This is because the substance of this transaction is that the lessor is providing finance to the lessee, with the asset as security.

IAS 7 gives the following examples of cash flows expected to be classified as investing activities:

• Payments to acquire long-term assets (including property, plant and equipment, intangibles, and payments relating to capitalized development costs and self-constructed property, plant, and equipment).
• Receipts from sales of long-term assets. Payments to acquire equity or debt instruments of other entities and interests in joint ventures (other than payments for those instruments considered to be cash equivalents or those held for dealing or trading purposes).
• Receipts from the sale of equity or debt instruments of other entities and interests in joint ventures (other than payments for those instruments considered to be cash equivalents or those held for dealing or trading purposes).
• Advances and loans made to other parties (other than those made by a financial institution).
• Receipts from the repayment of advances and loans made to other parties (other than those received by a financial institution).
• Payments for futures, forwards, options, and swaps, except where the contracts are held for dealing or trading purposes or the payments are classified as financing activities.
• Receipts from futures, forwards, options, and swaps, except where the contracts are held for dealing or trading purposes or the receipts are classified as financing activities.

Where a derivative contract is accounted for as a hedge of an identifiable position, the cash flows about that contract should be classified in the same manner as the cash flows of the position being hedged.

Cash flows from hedging transactions: general Question: How are cash flows for hedging instruments that are formally designated as hedging instruments presented in the cash flow statement? Answer: Cash flows attributable to a designated hedging instrument are classified in the same manner as the transactions that are the subject of a hedge. For example, a reporting entity might purchase a futures contract, in order to reduce its exposure to increases in the price of planned inventory purchases. Cash flows in relation to the futures contract would be classified as an operating activity cash flow, which is consistent with the treatment of the inventory purchase. A reporting entity might, however, hedge a net investment in a foreign subsidiary with a borrowing that is denominated in the same currency as the net investment being hedged. The hedge accounting does not change the fact that it is still a borrowing. The foreign subsidiary might have contributed to group cash flows reported under each of the standard headings. The cash flows from the borrowing can only be classified in the cash flow statement under financing in the consolidated financial statements, since the cash flows from the borrowings cannot be identified with any specific cash flows from that subsidiary.

Cash flows from hedging transactions: economic hedges Question: How are cash flows for hedging instruments that are not formally designated as hedging instruments presented in the cash flow statement? Answer: An entity might enter into derivatives that do not meet the criteria for hedge accounting in IFRS 9, but that are regarded by management as acting as hedges and reducing risk exposure. These derivatives are sometimes referred to as ‘economic hedges. An example of an economic hedge might be an airline’s use of fuel derivatives to mitigate exposure to movements in jet fuel prices, even if the airline has elected not to apply hedge accounting for such derivatives. Therefore, the cash flows relating to derivatives held as economic hedges are presented in the most appropriate manner for the business. For example, an airline would normally present cash flows for the purchase of fuel derivatives as operating activities, provided that they are directly related to fuel purchases.

Where any of the above items are held for dealing or trading purposes, their cash flows will be reported under operating rather than investing activities.

Cash flow from financing activities

IAS 7 defines ‘financing activities’ as “activities that result in changes in the size and composition of the contributed equity and borrowings of the entity”. Therefore, cash flows from financing activities generally comprise receipts or payments about the obtaining, servicing, and repayment or redemption of debt and equity sources of finance.

Except for bank overdrafts and where borrowings are classified as cash equivalents, cash flows from all forms of borrowings (including short-term borrowings of three months or less) are reported within financing activities.

Separate disclosure of the cash flows from financing activities is useful to users of the financial statements when determining how operating and investing activities are being financed and in predicting claims on future cash flows by providers of capital to the entity.

Classification of cash flows in a manner appropriate to the business Question: What does “the manner appropriate to its business” mean? Answer: The nature of an entity’s business influences the appropriate classification of its cash flows. For example, dividends received by a venture capital entity are likely to be operating activities, because its business is to receive a return on investments; whilst a manufacturing entity would classify such dividends received under investing activities. For this reason, the examples given in IAS 7 for cash flow classification are not a rigid set of rules, but ones that would normally be expected to be included under each heading. Inevitably, some items will call for judgement when determining their classification. Decisions should be made according to the individual reporting entity’s circumstances and the transaction’s substance. There should be consistency of treatment between the cash flow statement and the other primary statements, and consistency of classification from period to period. For example, the receipt of a government grant should be classified according to its substance: Grants given as a contribution towards the purchase of fixed assets should be classified as an investing activity, irrespective of their treatment in the balance sheet. (Grant monies received should be disclosed separately from the cash outflows for a related investing or financing activity, unless the impact is immaterial.) Grants given as a contribution towards expenditures used to generate period revenues should be classified as cash flows from operating activities, to match their treatment in the income statement. Similarly, the level of aggregation or disaggregation within each category of cash flows should be appropriate to the entity’s business and the needs of financial statement users. An entity can sub-divide the elements of cash receipts and payments that are listed as examples, to give a full description of the entity’s activities. For example, proceeds from the issue of a debenture might be shown separately from the proceeds of other long-term borrowings, or cash receipts from dividends received might be further subdivided between dividends received from associated entities and other dividends received. Disclosures should enable the user to understand the relationship between the entity’s different activities and the way in which they generate and expend cash.

Acquiring equity instruments from non-controlling interests

 Question: Are cash payments to acquire equity instruments from non-controlling interests classified as an investing activity?

Answer: No. In consolidated financial statements, cash flows arising from changes in ownership interests in a subsidiary that do not result in a loss of control (For example, the purchase or sale of a subsidiary’s equity instruments) are not classified as investing activities; instead, they are classified as cash flows from financing activities.

The standard gives the following examples of the cash flows expected to be classified as arising from financing activities:

• receipts from the issue of shares or other equity instruments; payments to acquire or redeem the entity’s shares;

• receipts from the issue of debentures, loans, notes, bonds, mortgages, and other short- or long-term borrowings;

• repayments of amounts borrowed;
• capital element of lease payments (under IAS 17, finance lease payments); and

• cash flows from derivatives used for financing activities.

Transaction costs relating to debt or equity financing Question: How are transaction costs relating to debt or equity financing classified in the cash flow statement? Answer: Transaction costs arising on obtaining debt financing, such as fees paid to banks or lawyers on arrangement, are a form of finance cost and are accounted for using the effective interest method. These costs would therefore be classified in the same way as any interest payable on debt finance, and they would be classified as financing or operating activity cash flows. Transaction costs relating to equity financing are classified as a financing activity (consistent with the recognition of incremental, directly attributable transaction costs) as a deduction from equity, in accordance with IAS 32. In our view, material transaction costs of an equity transaction are disclosed separately from the proceeds of the equity instrument under financing activity. This is consistent with the principle that, in general, cash inflows and outflows are reported gross. This is particularly relevant where transaction costs relate to the issue of a compound instrument that contains both a liability and an equity element.

Redemption of deep discounted bonds Question: How are the cash flows relating to the redemption of deep discounted bonds, or premiums payable on the redemption of debt securities, classified? Answer: IAS 7 does not deal specifically with the treatment of cash flows on redemption of a deep discounted bond or the premium payable on the redemption of a debt security. Financial liabilities or financial assets are measured at amortized cost using the effective interest rate method. Any difference between the initial measurement at cost (being the fair value of the consideration received less transaction costs) and the maturity value of the liability, such as a discount or a redemption premium, is amortized to the income statement as a finance cost. Such finance costs are similar to interest costs for the liability, and so the cash flow effects of these items are reported in the cash flow statement when the instruments are redeemed in a manner consistent with interest costs. Where a bond is issued at a deep discount, there are no cash flows over the instrument’s life. The discount is in the nature of ‘interest’, which is part of finance costs in the income statement. Consequently, on maturity the discount is classified in the same manner as interest, and it is disclosed as the premium paid on the bond’s redemption. The balance is classified in financing activities as repayment of the bond. Similarly, where debt instruments are redeemed at a premium, it is necessary to separate the principal and the interest element of the amounts paid on redemption. For example, where supplemental interest is paid on convertible bonds that are redeemed rather than converted, the whole amount of the supplemental interest accrued over the bond’s life and paid at redemption is classified in the same manner as interest. Similar arguments would apply to preference shares that are redeemed at a premium. Consider an entity that issues a 10-year zero coupon bond with a face value of C100,000 at a discount of C61,446. Its issue price is C38,554 and the effective yield is 10%. At the issue date, the proceeds of C38,554 would be shown as a cash inflow in financing activity cash flows. The discount of C61,446 represents a rolled-up interest charge, which would be amortized to the income statement as a finance cost over the bond’s life while the bond remains outstanding. However, there would be no cash flow in these periods because no cash has been paid. On maturity, the discount of C61,446 is classified in the same manner as interest and disclosed as the premium paid on the bond’s redemption. The balance of C38,554 is classified in financing activities as repayment of the bond. A similar treatment would apply to the investor. The investor classifies the payment for the bond of C38,554 as part of cash outflow in investing activities. On maturity, the receipt of C100,000 is split, classifying the C61,446 in the same manner as interest and the C38,554 as an investing activity cash flow.

Gain or loss on early settlement of a debt security Question: How should the gain or loss on the early settlement of a debt security be classified in the cash flow statement? Answer: Consider an entity that issues a 10-year zero coupon bond with a face value of C100,000 at a discount of C61,446. Its issue price is C38,554 and the effective yield is 10%. Assume that the entity has decided to redeem the bond early, at the beginning of year 4, for C55,000. The bond’s carrying value, in the balance sheet at the end of year 3, is calculated as follows: C’000 C’000 Proceeds at the beginning of year 1 38,554 Interest accrued in year 1 10% on C38,554 3,855 Interest accrued in year 2 10% on C42,408 4,241 Interest accrued in year 3 10% on C46,649 4,665 12,761 Carrying value (capital value of bond C100,000 less unamortized discount of C61,446 – C12,761 = C48,685) 51,315 Loss on redemption: 55,000 Redemption proceeds 51,315 Less carrying value 3,685 The loss is allocated to finance costs, such that C16,446 (C12,761 + C3,685) is classified in the same manner as interest paid, and C38,554 is classified as a capital repayment under financing activity cash flows. This is because the total cash cost of the finance is then reflected in the cash flow statement. This is also consistent with the treatment of finance costs under IFRS. The difference between the net proceeds of an instrument (in this example, C38,554) and the total amount of the payments made (C55,000) is amortized to the income statement as finance cost (C16,446).

In consolidated financial statements, cash flows arising from changes in ownership interests in a subsidiary that do not result in a loss of control (For example, purchase or sale by a parent of a subsidiary’s equity instruments) are classified as cash flows from financing activities, unless the subsidiary is held by an investment entity and is measured at fair value through profit and loss.

Interest and dividend cash flows

The cash flows arising from dividends and interest receipts and payments should be classified in the cash flow statement under the activity appropriate to their nature.

Classification should be consistent from period to period. Dividends and interest received and paid are required to be disclosed. For total interest paid, the standard requires disclosure in the cash flow statement, regardless of whether the interest has been expensed or capitalized.

Interest cash flows: capitalized borrowing costs Question: How are capitalized borrowing costs presented in the cash flow statement? Answer: IAS 7 allows for interest payments to be classified as cash flows from operating or financing activities. But it does not specify whether interest payments that are capitalized as part of the cost of an asset can be classified as cash flows from investing activities. The general principle, that cash flows are classified in the manner most appropriate to the business would indicate that interest payments that are capitalized as part of the cost of property, plant and equipment can be classified as part of an entity’s investing activities. Interest payments that are capitalized as part of the cost of inventories can be classified as part of an entity’s operating activities. This view is consistent with the IFRS IC’s 2011 recommendation to resolve this inconsistency through an annual improvement, although no such amendment has been finalized. An entity should clearly disclose the classification of interest payments in the cash flow statement, if material.

Interest cash flows: disclosure Question: Are interest payments required to be disclosed separately on the face of the cash flow statement? Answer: IAS 7 requires total interest paid to be disclosed in the cash flow statement, regardless of whether the interest has been expensed or capitalized. In our view, the disclosure should be made in or underneath the cash flow statement, as opposed to separate disclosure in the notes to the financial statements. Capitalized interest paid during the period could be included in the cash flow statement within a separately disclosed total of interest paid during the period. Capitalized interest paid could also be separately disclosed on the face of the cash flow statement as cash flows from investing activities, with separate disclosure of other interest paid, in order to show total interest paid for the period.

Interest cash flows: negative interest Question: How should negative interest be presented in the cash flow statement? Answer: Negative interest can be presented as a separate line item on the face of the income statement, either within ‘net finance costs’ (being finance income, finance costs and negative interest) or as another expense category. Negative interest should be classified in the cash flow statement under the activity appropriate to its nature, consistent with how it is presented in the income statement.

IAS 7 does not dictate how dividends and interest cash flows should be classified, but rather allows an entity to determine the classification appropriate to its business. It is generally accepted that dividends received and interest paid or received in respect of a financial institution’s cash flows will be classified as operating activities, but the classification is not so clear-cut for other entity types.

The standard allows the following presentation for interest and dividends received and paid, provided that the presentation selected is applied consistently from period to period:

• Interest and dividends received in operating or investing activities.
• Interest and dividends paid in operating or financing activities.

Dividends paid to non-controlling interests Question: Should dividends paid to non-controlling interests be classified as operating or financing cash flows? Answer: IAS 7 permits entities to show dividends paid as operating or financing activities. Dividends paid could be considered as operating activities because this allows users to determine the entity’s ability to pay dividends out of operating cash flows. More commonly, entities categories dividends paid to owners of the parent and to non-controlling shareholders of subsidiaries as financing activities because dividends are discretionary, and payments might vary according to the amount legally available for distribution, the cash available and the entity’s dividend policy. The choice should be applied consistently to dividends to parent shareholders and to non-controlling interests.

Dividends paid on instruments classified as liabilities Question: How are dividends on shares that are classified as liabilities presented in the cash flow statement? Answer: In some circumstances, a subsidiary’s shares or other financial instruments (or a component of these) are shown as liabilities in consolidated financial statements in accordance with IAS 32, and the dividends paid on those instruments are shown as part of the interest charge in the income statement. It follows that, in the consolidated cash flow statement, the dividends paid are shown as interest paid and classified consistently with other interest payable.

Taxation cash flows

Cash flows about taxation on income should be classified and separately disclosed under operating activities in the cash flow statement, unless they can be specifically attributed to financing or investing activities. Where taxation cash flows are disclosed under different activities, the standard requires that the total amount of tax paid on income is disclosed.

Allocation of taxation cash flows Question: Should taxation cash flows be allocated between operating, financing and investing activities? Answer: In general, an entity would report a single tax cash flow in the cash flow statement under operating activities. It might be inappropriate, and rather misleading, to allocate tax cash flows between the three economic activities, even though such cash flows can be specifically attributed to financing or investing activities. A payment of income or corporation tax usually involves only one cash flow, that is arrived at by applying the rate of tax to the entity’s total income. The total income is the result of aggregation of taxable income arising from all sources, including taxable gains arising on the disposal of assets. The taxation rules under which taxable total income is calculated often do not easily lend themselves to subdivision between operating, investing and financing activities, and any allocation might result in the reporting of hypothetical figures in the cash flow statement. Apportioning the taxation cash flows would not necessarily report them along with the transactions that gave rise to them. This is because the taxation cash flows generally arise from activities in an earlier period. For example, in many tax regimes the tax effects of investing activities (For example, tax deductions arising on the acquisition of plant and machinery) are offset against profits arising from operating activities (trading profits). The reporting of a theoretical tax refund, due to tax deductions on the acquisition of plant and equipment under investing activities, will require grossing up the actual tax paid on operating activities. A similar situation arises where the tax effects of trading losses are offset against taxable gains arising on the disposal of assets.

Reporting sales taxes Question: How are sales taxes reported in the cash flow statement? Answer: Sales taxes are not a tax on income and are not covered by the guidance in IAS 7 on taxes on income. However, the cash flows of an entity include sales tax. The IFRS IC was asked to consider the accounting for sales taxes (VAT) but did not add the issue to its agenda, and suggested the issue should be considered as part of the wider financial statement presentation project. Given there is no guidance in this area, an entity may either present sales tax receipts and payments separately in the statement of cash flows or as part of the cash inflows and outflows for the item purchased or sold. An entity should consider whether to disclose the policy applied to sales taxes. If sales tax receipts and payments are presented separately, an entity will need to consider where the cash flows are classified. A pragmatic approach is to allocate the net change on the sales taxes payable to, or receivable from, the tax authorities to cash flows from operating activities, unless it is more appropriate to allocate it to another heading. Generally, the majority of the sales tax transactions would relate to operating activities. However, it might be appropriate to include the cash flows relating to the payment or receipt of sales taxes under another heading where a significant proportion of the sales tax paid or received relates to investing or financing activities. Including the net movement on the sales taxes account in operating cash flows means that there is no need to adjust for any sales taxes included in opening and closing debtors or creditors in the reconciliation between profit and net cash flow from operating activities under the indirect method. Where the direct method is used, customer payments received inclusive of sales taxes may be shown gross, with any sales tax payments made presented separately. Where sales tax incurred by the entity is irrecoverable (For example, the entity might operate in a territory where local law does not provide for the recovery of sales taxes incurred by the entity), the cash flows should be classified consistent with their presentation in the balance sheet and income statement – For example, where irrecoverable sales tax is incurred as part of the purchase price to a capital asset in accordance with IAS 16 and the cash flow would be presented as an investing cash flow. Similarly, irrecoverable sales taxes incurred on the purchase of inventory items in accordance with IAS 2 would be presented in operating cash flows. Irrecoverable sales taxes levied on a lessee’s lease payments could be presented as investing cash flows (if they are capitalized to the right-of-use asset) or operating cash flows (if the amounts are recognized as an expensed).

Taxes other than income tax or sales tax Question: How are taxes other than sales taxes or income taxes reported in the cash flow statement? Answer: Taxation cash flows, excluding those in respect of tax on income and sales taxes, are included in the cash flow statement under the same standard headings as the cash flow that gave rise to the taxation cash flows. This presentation is consistent with the manner in which transactions are presented in the income statement and balance sheet. For example, employers’ social security contributions, and amounts paid in respect of employees’ tax on earnings collected by the entity and paid over to the tax authorities, are included in operating activities. Where the direct method is followed, they are included in the amounts shown as paid to or on behalf of employees. Similarly, capital taxes incurred in an acquisition of a property would be included in investing activities.

Investments accounted for under the equity or cost method

Where a group has investments in associates or joint ventures that are included in financial statements using the equity method, the cash flow statement should include only the cash flows between the group and those investees and not the cash flows of those entities. This means that the following cash flows should be included:

• cash flows from sales or purchases between the group and the associates or joint ventures; and
• cash flows from investments in, and dividends from, the associates or joint ventures.

This also applies to a parent’s investments in subsidiaries, associates, and joint ventures accounted for using the cost or equity method in the parent’s separate financial statements.

Investments accounted for under the equity method Question: How are cash flows related to equity–accounted-for investments classified in the cash flow statement? Answer: Dividends received from equity-accounted-for investees are classified under operating or investing activities, consistent with the group’s policy for dividends received. Where an entity prepares its cash flow statement under the direct method, only the cash dividends received from associates and joint ventures are shown under operating or investing activities (in line with the group’s policy for dividends received). Under the indirect method, the starting point is profit or loss, which will include the group’s share of profits from associates and joint ventures. The share of profits does not give rise to any cash flow, unless it is received in the form of dividends, in which case it is deducted as a non-cash adjustment in the reconciliation of profit or loss to operating cash flows. Only the dividends received are reflected in the cash flow statement. Cash flows relating to acquisitions and disposals of equity-accounted-for investments are classified as investing activities.

Cash flows of joint operations Question: How are cash flows related to joint operations classified in the cash flow statement? Answer: Joint operators account for their rights and obligations by recognizing their share of the joint operation’s assets, liabilities, revenue and expenses, including any held or incurred jointly. These accounting entries are recorded in each joint operator’s own financial statements. Therefore, the relevant cash flows are included in the joint operator’s individual entity cash flows, as well as in the group’s cash flows, classified in accordance with their nature.