This article was first published in the January 2013 International edition of Accounting and Business magazine.
IAS 7, Statement of Cashflows, requires the reporting of movements of cash and cash equivalents, which are classified as arising from three main activities: operating, investing and financing. No specific format is prescribed by the standard but cashflows must be presented under these three main headings. In practice, most entities follow this disclosure format.
In April 2009 IAS 7 was amended so that only expenditure resulting in a recognised asset in the statement of financial position is eligible for classification as an investing activity. Financing cashflows include cashflows relating to obtaining, servicing and redeeming sources of finance. Operating cashflows comprise all cashflows during the period that do not qualify as investing or financing.
Operating cashflows may be presented using the direct method, which shows the gross cash receipts or payments from operations. Alternatively, the entity can calculate the cashflows indirectly by adjusting net profit or loss for non-operating and non-cash transactions and for changes in working capital. Entities are encouraged to report cashflows using the direct method because it is said to be more useful. However, most entities use the indirect method. This raises the question as to which profit or loss figure should be used.
The illustration in IAS 7 starts with profit before tax. There are alternatives that start with operating profit, which is not defined in International Financial Reporting Standards (IFRS) and so requires judgment, or start with the final profit or loss figure at the foot of the income statement.
The profit before tax figure relates only to continuing operations and so needs to be adjusted for relevant operating cashflows relating to any discontinued operation if it is used as the starting point in the statement of cashflows. The net cashflows relating to discontinued operations should be disclosed as well as significant non-cash transactions such as depreciation, amortisation, and income statement charges for provisions.
Classification in practice
The actual classification of cashflows must reflect the nature of the activities of the entity and so some cashflows, which may look similar, may be classified differently by different entities because the nature and purpose of their business is different. For example, dividends received by an investment company are likely to be classified as operating cashflows but a manufacturing entity is more likely to classify them as investing cashflows.
An individual transaction may include cashflows that are classified differently. For example, when a loan repayment includes both interest and capital, the interest element may be classified as an operating cashflow while the capital element is classified as a financing cashflow.
The resulting cashflow total is the movement in the balance of cash and cash equivalents from the start of the period to the end.
Cash equivalents are defined as ‘short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value’. IAS 7 does not define ‘short-term’ but does state that ‘an investment normally qualifies as a cash equivalent only when it has a short maturity of, say, three months or less from the date of acquisition’.
The three-month time limit is a little arbitrary but consistent with the concept of insignificant risk of changes in value and the purpose of meeting short-term cash commitments. Any investment or term deposit with an initial maturity of more than three months does not become a cash equivalent when the remaining maturity period reduces to under three months. However, in limited circumstances, a longer-term deposit with an early withdrawal penalty may be treated as a cash equivalent. With an investment in a money market fund, it is not sufficient that the investment can readily be realised in cash as the investment must be readily convertible to cash that is subject to an insignificant risk of change.
Bank overdrafts are generally classified as borrowings but IAS 7 notes that if a bank overdraft is repayable on demand and forms an integral part of an entity’s cash management then it is a component of cash and cash equivalents. Restricted cash balances should be disclosed in a note, including a narrative explanation of any restriction.
It is often impracticable to identify tax cashflows with individual transactions and tax cashflows often arise in a different period from the cashflows of the underlying transactions. As a result, taxes paid should generally be classified as operating cashflows. However, where specific cashflows can be identified with either investing activities or financing activities, then it is appropriate to classify that element of the tax cashflows as investing or financing respectively.
The cashflows arising from dividends, and interest receipts and payments, should be classified in the cashflow statement in a consistent manner from period to period and under the activity appropriate to their nature. These items must be disclosed separately on the face of the cashflow statement. IAS 7 does not dictate how dividends and interest cashflows should be classified but allows an entity to determine the classification appropriate to its business.
In May 2012, the International Accounting Standards Board (IASB) issued an exposure draft proposing that payments relating to interest capitalised under IAS 23 should be classified in accordance with the classification of the underlying asset on which those payments were capitalised. This would mean, for example, that payments of interest capitalised as part of the cost of property, plant and equipment would be classified as investing activities, and payments of interest capitalised as part of the cost of inventories would be classified as operating activities.
Generally cashflows should be shown gross. There are exceptions such as when cash receipts and payments are made on behalf of a customer and therefore represent the customer’s transactions rather than those of the reporting entity. Additionally, the calculation of operating cashflows using the indirect method also results in some netting of cashflows.
In consolidated financial statements, cashflows arising from changes in the ownership of a subsidiary that does not result in a loss of control are classified as cashflows from financing activities. Also, consideration paid in a business combination is treated as an investing activity. However, in more complex scenarios the guidance in IAS 7 is not always clear.
In the case of deferred consideration, the acquiring entity will record the fair value of the deferred consideration as a liability at the acquisition date in accordance with IFRS 3, Business Combinations. This liability will increase as the discount unwinds and is reflected as a finance charge in profit or loss. When the liability is settled at a later date, the payment will reflect both the amount initially recognised as consideration plus the interest element.
IAS 7 does not deal directly with how this payment should be classified and so it can be classified as an investing cashflow or as a financing cashflow. Alternatively it can be disaggregated into the amount initially recognised as consideration (investing or financing) and the interest element resulting from the unwinding of the discount, which should be treated as a financing or operating cashflow according to the entity’s policy.
When a subsidiary joins or leaves the group, its cashflows should be included in the consolidated statement of cashflows for the same period as the results are reported in the consolidated statement of profit or loss and other comprehensive income. The aggregate cashflow includes any cash consideration paid or received and the amount of cash and cash equivalents in the subsidiary over which control is gained or lost. The net of these latter amounts is included in investing activities. The net assets excluding cash and cash equivalents of the subsidiary at the acquisition or disposal date need to be eliminated from other cashflow headings to avoid double counting as the related amounts are already included.
Foreign currency movements on cash and cash equivalents should be reported separately in the cashflow statement to allow the reconciliation of the opening and closing balances of cash and cash equivalents. Cashflows that result from derivative transactions undertaken to hedge another transaction should be classified under the same activity as cashflows from the subject of the hedge.
When the reporting entity holds foreign currency cash and cash equivalents, these are monetary items that will be retranslated at the reporting date in accordance with IAS 21. Any exchange differences arising on this retranslation will have increased or decreased these cash and cash equivalent balances.
As these exchange differences do not give rise to any cashflows, they should not be reported as any part of the cashflow activities presented in the statement of cashflows. Their net impact should be disclosed as a reconciling item between opening and closing balances of cash and cash equivalents.
A weakness of statements of cashflow is that they do not distinguish between discretionary and mandatory cashflow. By disclosing the mandatory cashflow, users can see the available free cashflow. Additionally, the nature of the definition of cash equivalents can make comparison of the cashflows difficult. Further comparison of cashflows can be made even more difficult by the fact that entities can show cashflows using the direct method or indirect method. The results of these two methods give different operating cashflow reports.
Graham Holt is an examiner for ACCA, and associate dean and head of the accounting, finance and economics department at Manchester Metropolitan University Business School