Cash flow statements (2024)

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Classification of cash flows

IAS 7, Statement of Cash Flows requires an entity to present a statement of cash flows as an integral part of its primary financial statements. A statement of cash flow classifies and presents cash flows under three headings:

(i) Operating activities
(ii) Investing activities and
(iii) Financing activities

Operating activities can be presented in two different ways. The first is the direct method which shows the actual cash flows from operating activities – for example, the receipts from customers and the payments to suppliers and staff. The second is the indirect method which reconciles profit before tax to cash generated from operating profit. Under both of these methods the interest paid and taxation paid are then presented as cash outflows deducted from the cash generated from operations.

Investing activity cash flows are those that relate to non-current assets including investments . Examples of investing cash flows include the cash outflow on buying property plant and equipment, the sale proceeds on the disposal of non-current assets and any cash returns received arising from investments.

Financing activity cash flows relate to cash flows arising from the way the entity is financed. Entities are financed by a mixture of cash from borrowings from third parties (debt) and by the shareholders (equity). Examples of financing cash flows include the cash received from new borrowings or the cash repayment of debt as well as the cash flows with shareholders in the form of cash receipts following a new share issue or the cash paid to them in the form of dividends.

This topic is examined in much more depth in the FR examination than it is at FA. For example, in FA, an extract, or the whole statement of cash flow might be required in the multi-task questions but it could also be constructed as an OT question. FR, however, is more likely to ask for an extract from the statement of cash flows using more complex transactions (for example, the purchase of PPE using right-of-use asset leases). However, that does not mean that FR will never require the preparation of a complete statement of cash flows so be prepared.

Operating activities – the indirect method and direct method

There are two different ways of starting the cash flow statement, as IAS 7,Statement of Cash Flowspermits using either the 'direct' or 'indirect' method for operating activities.

The direct method is intuitive as it means the statement of cash flow starts with the source of operating cash flows. This is the cash receipts from customers. The operating cash out flows are payments for wages, to suppliers and for other operating expenses which are deducted. Finally the payments for interest and tax are deducted.

Alternatively, the indirect method starts with profit before tax rather than a cash receipt. The profit before tax is then reconciled to the cash that it has generated. This means that the figures at the start of the cash flow statement are not cash flows at all. In that initial reconciliation the profit before tax is adjusted for expenses that have been charged against profit that are not cash out flows; for example depreciation and losses on disposal of non-current assets, have to be added back, and non-cash income; for example, investment income and profits on disposal of non-current assets are deducted. The changes in inventory, trade receivables and trade payables (working capital) do not impact on the measurement profit but these changes will have impacted on cash and so further adjustments are made. For example, an increase in the levels of inventory and receivables will have not impacted on profit before tax but will have had an adverse impact on the cash flow of the business. Thus, in the reconciliation process, the increases in inventory and trade receivables are deducted from profit before tax. Conversely, decreases in inventory and trade receivables are added back to the profit before tax. The opposite is applicable for trade payables. Finally, the payments for interest and tax are presented – usually as a further deduction.

The following exercise illustrates both the direct and indirect methods operating activities section.

Exercise: The direct and indirect method

Extracts from the financial statements are as follows