Relevant from September 2025
This article considers the statement of cash flows, including how to calculate cash flows and where those cash flows are classified and presented in the statement of cash flows. Both the direct and indirect methods of preparing a statement of cash flows will be addressed in this article.
Computing cash flows
Cash flows are either receipts (ie cash inflows) and so are represented as a positive number in a statement of cash flows, or payments (ie cash outflows) and so are represented as a negative number in a statement of cash flows.
Cash flows are usually calculated as a ‘balancing’ figure. For example, when the opening balance of an asset, liability or equity item is reconciled to its closing balance using non-cash information from the statement of profit or loss and/or additional notes, the balancing figure is usually the cash flow.
Common cash flow calculations include income taxes paid (an operating activity cash outflow), the payment to buy property, plant and equipment (PPE) (an investing activity cash outflow) and dividends paid (a financing activity cash outflow). The following examples illustrate all three of these cases.
EXAMPLE 1 – Calculating income taxes paid
Crombie Co had income taxes payable of $500 at 1 January 20X1. The income taxes payable at 31 December 20X1 is $900 and the tax charged in the statement of profit or loss was $1,000.
Required: Calculate the tax paid by Crombie Co for the year ended 31 December 20X1.
Solution
It is necessary to reconcile the opening balance to the closing balance to reveal the cash flow (ie the tax paid) as the balancing figure.
Income taxes payable | $ | Explanation |
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|---|---|---|---|---|
Opening balance at 1 January 20X1 | 500 | Credit balance |
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Tax charge for the year 20X1 | 1,000 | The tax charged in the statement of profit or loss means that the entity now owes more tax. The debit charged as the expense in profit or loss is posted and a credit to income taxes payable reflects the increase in the current tax liability |
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Sub-total | 1,500 | This sub-total represents the liability at the reporting date in the event that no tax had been paid |
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Cash flow – the payment of tax | (600) | This is the last figure written in the reconciliation. It is the balancing figure and explains why the actual year-end income taxes payable balance is smaller than the sub-total |
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Closing balance at 31 December 20X1 | 900 | This is the closing income taxes payable balance |
This simple technique of taking the opening balance of an item and adding (or subtracting) the non-cash transactions that have caused it to change, to then reveal the actual cash flow as the balancing figure, has wide application.
EXAMPLE 2 – Calculating the payments to buy PPE
At 1 January 20X1, Crombie Co had PPE with a carrying amount of $10,000. The carrying amount of PPE at 31 December 20X1 is $30,000. During the year, depreciation charged was $2,000, a revaluation surplus of $6,000 was recorded and PPE with a carrying amount of $1,500 was sold for $2,000.
Required: Calculate the cash paid by Crombie Co to buy new PPE during the year ended 31 December 20X1.
Solution
Here we can take the opening balance of PPE and reconcile it to the closing balance by adjusting it for the changes that have arisen in the period that are not cash flows. The balancing figure is the cash paid to buy new PPE.
PPE | $ | Explanation |
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|---|---|---|---|---|
Opening balance at 1 January 20X1 | 100,000 | Debit balance |
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Deprecation | (2,000) | Deprecation reduces the carrying amount of the PPE without being a cash flow. The double entry for depreciation is a debit to profit or loss to reflect the expense and a credit to the asset to reflect its consumption. |
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Revaluation surplus | 6,000 | The revaluation gain increases PPE without being a cash flow. The double entry is a credit to the revaluation surplus to reflect the gain and a debit to the asset to reflect its increase |
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Disposal | (1,500) | The carrying amount of the PPE that has been disposed of reduces the PPE thus a credit to the asset account which is then posted as a debit in the disposals account |
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| _____ |
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Sub-total | 12,500 | This sub-total represents the balance of the PPE if no PPE had been bought for cash |
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Cash flow – the payment to buy PPE | 17,500 | This is the last figure written in the reconciliation. This balancing figure explains why the actual PPE at the reporting date is greater than the sub-total |
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| _____ |
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Closing balance at 31 December 20X1 | 30,000 |
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| _____ |
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Note that the cash proceeds from the disposal of PPE ($2,000) would be shown separately as a positive cash inflow under investing activities. The profit on disposal of PPE of $500 ($2,000 - $1,500) would be adjusted for as a non-cash item under the operating activities section of the statement of cash flows (see later).
EXAMPLE 3 – Calculating the dividend paid
At 1 January 20X1, Crombie Co had retained earnings of $5,000. Profit for the year was $4,500 and retained earnings at 31 December 20X1 are $7,000.
Required: Calculate the dividend paid by Crombie Co during the year ended 31 December 20X1.
Solution
As before, to work out the cash flow – in this case dividends paid – we can reconcile an opening to closing balance – in this case retained earnings. This working is in effect an extract from the statement of changes in equity.
Retained earnings | $ | Explanation |
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|---|---|---|---|---|
Opening balance at 1 January 20X1 | 5,000 | Credit balance |
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Profit for the year 20X1 | 4,500 | The profit for the year is a credit and increases the retained earnings |
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| _____ |
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| 9,500 | This sub-total represents the balance on retained earnings if no dividends have been paid |
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Cash flow – the dividends paid | (2,500) | This is the last figure written in the reconciliation. This balancing figure of dividends paid explains why the actual year-end retained earnings is $7,000 rather than $9,500 |
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| _____ |
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Closing balance at 31 December 20X1 | 7,000 |
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| _____ |
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Classification of cash flows
IAS 7 Statement of Cash Flows requires an entity to present a statement of cash flows, presenting 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 employees. The second is the indirect method which reconciles operating profit to cash from operating activities before income taxes. Under both of these methods, the income taxes paid are then presented as a cash outflow from operating activities and deducted from the cash from operating activities before income taxes to give a total net cash from (or used in) operating activities.
Investing activities cash flows are those that relate to non-current assets, including investments. Examples of cash flows from investing activities include the cash outflow on buying PPE, the cash inflow from sale proceeds on the disposal of PPE and any cash inflows arising from investments (ie dividends received and interest received).
Financing activities cash flows relate to the way the entity is financed – debt or equity. Entities are financed by a mixture of cash from borrowings (debt) and cash from shareholders (equity). Examples of cash flows from financing activities include the cash received from new borrowings or the cash repayment of debt, including any interest paid. It also includes the cash flows related to shareholders in the form of cash receipts following a new share issue or the cash paid to them in the form of dividends.
Operating activities – the direct method and indirect method
As noted above, IAS 7 permits two different ways of reporting cash flows from operating activities – the direct method and the indirect method.
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 outflows are payments for wages, to suppliers and for other operating expenses which are deducted. Finally, the income taxes paid are deducted.
Alternatively, the indirect method starts with operating profit rather than a cash receipt. The operating profit is then reconciled to the cash that it has generated. This means that the figures at the start of the statement of cash flows are not cash flows at all. In that initial reconciliation, the operating profit is adjusted for income and expenses that have been recorded in the statement of profit or loss but are not cash inflows or outflows. For example, depreciation and losses on disposal of PPE have to be added back, and non-cash income such as gains on disposal of PPE need to be deducted.
The changes in working capital (ie inventories, trade receivables and trade payables) will have impacted cash and must be adjusted for as well. For example, an increase in the levels of inventories and trade receivables will have had an adverse impact on the cash flow of the business. Therefore, in the reconciliation process, the increases in inventories and trade receivables are deducted from operating profit. Conversely, decreases in inventories and trade receivables are added back to operating profit. The opposite is applicable for trade payables.
For each movement in working capital, you must consider whether it has had a favourable or unfavourable cash flow impact on the business. If the impact is favourable, then the movement in the year should be added on to operating profit as part of the reconciliation. If the impact is unfavourable, then it should be deducted.
Finally, income taxes paid are presented.
The following example illustrates both the direct and indirect methods.
EXAMPLE 4 – The direct and indirect methods
Extracts from the financial statements are as follows
| $ | |
|---|---|
Operating profit | 80,000 |
Investment income | 12,000 |
Profit before tax and income taxes | 92,000 |
Interest expenses on borrowings | (10,000) |
Profit before income taxes | 82,000 |
| Income tax expense | (32,000) |
| PROFIT | |
Other comprehensive income |
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Gains on property revaluation | 40,000 |
Total comprehensive income | 90,000 |
| Closing balance $ | Opening balance $ |
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Current assets |
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Inventories | 30,000 | 25,000 |
Trade receivables | 20,000 | 26,000 |
Current liabilities |
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Trade payables | 14,000 | 11,000 |
Additional information:
- During the year, depreciation of $50,000 and amortisation of $40,000 were charged to the statement of profit or loss.
- ‘Cash receipts from customers’ were $800,000. ‘Cash paid to suppliers and employees’ was $626,000.
- Income taxes paid was $13,000.
Required:
(a) Prepare the operating activities section of the statement of cash flows using the direct method.
(b) Prepare the operating activities section of the statement of cash flows using the indirect method.
Solution (a) direct method
The direct method is relatively straightforward in that all the data are cash flows and so it is a case of listing the receipts as positive and the payments as negative.
Cash flows from operating activities – Direct method | $ |
|---|---|
Cash receipts from customers | 800,000 |
Cash paid to suppliers and employees | (626,000) |
Cash from operating activities before income taxes | 174,000 |
Income taxes paid | (13,000) |
| Net cash from operating activities | 161,000 |
Note that the additional information in this example stated figures related to cash receipts from customers and cash paid to suppliers and employees. You may need to determine these for yourself by using the figures in the financial statements and the additional information provided in the question.
You should refer to material from your learning provider to learn more about these calculations.
Solution (b) indirect method
As we start with operating profit in the indirect method, we have to add back all the non-cash expenses charged, deduct the non-cash income and adjust for the changes in working capital. Only then is the actual cash flow of tax paid presented. Having a good understanding of the format of the statement of cash flows is key to a successful attempt at these questions.
Cash flows from operating activities – Indirect method | $ |
|---|---|
Operating activities |
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Operating profit | 80,000 |
Depreciation charge | 50,000 |
Amortisation charge | 40,000 |
Increase in inventories | (5,000) |
Decrease in trade receivables | 6,000 |
Increase in trade payables | 3,000 |
Cash from operating activities before income taxes | 174,000 |
Income taxes paid | (13,000) |
| Net cash from operating activities | 161,000 |
Note that, whichever method is used, the same figure is presented as the cash from operating activities before income taxes and the net cash from operating activities.
Written by a member of the FA/FFA examining team
