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Cash is the heart of any businesses and cash flows statement is the statement that telling the condition of the heart. Hence, it is obviously crucial for an entity to monitor its cash flows on timely basis. Cash flows statement explains the entity’s cash inflow and outflow movements. Such statement helps entities to monitor its cash flows position. This is important as cash are needed in every aspect of businesses.
This article elaborates more on cash flows statement. Specifically, it covers the key principles that an entity considers when preparing the cash flows statement. IAS 7 Statement of Cash Flows stipulates the principles of the preparation of cash flows.
Take note that cash flows statement is one of the primary statements that make up a complete set of financial statements. You may be interested to read more on a complete set of financial statements in Components of the General Purpose Financial Statements.
Despite some people may argue that cash flows statement provides a historical information, it is still an important statement. Mainly because it helps to provide an indicator of the amount, timing and certainty of future cash flows.
Let’s now go into the details.
Cash and cash equivalents for the purpose of cash flows statement
IAS 7 uses the term cash and cash equivalents in the preparation of cash flows statement. What is cash? And what is cash equivalents? Cash makes up of cash on hand and demand deposits.
On the other hand, cash equivalents are short-term, highly liquid investments that are readily convertible to known amount of cash. As such, they are subject to an insignificant risk of changes in value.
Entities hold cash equivalent to meet their short-term cash commitments instead for investment. As such, an investment qualifies as a cash equivalent only if it has short term maturity. For this, IAS 7 considers investments with maturity of three months or less from the date of acquisition as cash equivalents.
The components of cash and cash equivalents in cash flows statement may not necessarily be the same as cash and cash equivalents in the statement of financial position. As such, IAS 7 requires a reconciliation between these two amounts.
Sometimes, there are restrictions imposed on the usage of cash and cash equivalents. For this, IAS 7 requires entities to disclose the amount of significant cash and cash balances held that are not available for use by the group.
The classification of cash flows in the cash flows statement
In the cash flows statement, IAS 7 divides cash flows into three main classifications by activity. They are cash flows from operating, investing and financing activity.
Why do we need to differentiate into these activities? This is because each type of activity represents different cash flows derivation and utilisation. Entities need to be able to differentiate these three types of cash flows activities.
Cash flows from operating activities are derived from the principal revenue-producing activities of the entity. It shows the ability of the entity to generate sufficient cash flows to repay loans, pay dividends and maintaining the operating capability of the entity. In addition, it also tells readers the ability of the entity to make new investment without the external source of financing. As such, cash flows from operating activities result from the transactions that enter into the determination of profit or loss. Examples are:
- Cash receipts from sales of goods and rendering of services.
- Cash derived from royalties, fees, commissions and other revenue.
- Payment of cash to suppliers for goods and services.
Cash flows from investing activities reflect the extent to which expenditures have been made for resources intended to generate future income and cash flows. Only expenditures that result in a recognised asset are eligible for classification as investing activities. Examples are:
- Cash payments to buy property, plant and equipment, intangibles and other long-term assets.
- Cash receipts from sales of property, plant and equipment, intangibles and other long-term assets.
- Payment of cash to buy equity or debt instruments of other entities and interests in joint ventures.
- Cash receipts from the repayment of advances and loans made to other parties, except to financial institutions.
Cash flows from financing activities are crucial in predicting claims on future cash flows by the capital providers. Examples of cash flows are:
- Cash proceeds from issuing shares or other equity instruments.
- Payment of cash to owners to buy or redeem the entity’s shares.
- Cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other borrowings.
- Cash repayments of amounts borrowed.
Other considerations for reporting of cash flows statement
In addition to the above, IAS 7 also requires:
1. Reporting of cash flows from operating activities
For this, entities can choose whether to present using either the direct or indirect method. The direct method requires the disclosure of major classes of gross cash receipts and payments.
In contrast, the indirect method requires adjustments to the profit or loss for the effects:
- Firstly, a non-cash nature,
- Secondly, for any deferrals or accruals of past or future operating cash receipts or payments, and
- Thirdly, items of income or expense associated with investing or financing cash flows.
Nevertheless, IAS 7 encourages to use the direct method. This is because the method provides useful information to estimate future cash flows, which is not available under the indirect method.
2. Reporting of cash flows from investing and financing activities
Entities report separately major classes of gross cash receipts and payments from investing and financing activities. An exception applies if they are reported on a net basis as explained below.
3. Reporting of cash flows on a net basis
Entities report the cash flows from operating, investing and financing activities on a net basis when:
- Firstly, cash receipts and payments on behalf of customers when the cash flows reflect the activities of the customer.
- Secondly, cash receipts and payments for items in which the turnover is quick, the amounts are large and the maturities are short.
In addition, IAS 7 states that the following cash flows of a financial institution may be reported on a net basis:
- Firstly, for cash receipts and payments for the acceptance and repayment of deposits with a fixed maturity date.
- Secondly, for the placement of deposits with and withdrawal of deposits from other financial institutions.
- Lastly, for cash advances and loans made to customers and the repayment of those advances and loans.
4. Foreign currency cash flows
IAS 7 requires an entity to record cash flows from foreign currency transactions by translating them to the entity’s functional currency at the date of the cash flow. Similarly, an entity also translates the cash flows of a foreign subsidiary at the dates of the cash flows.
If you need a recap on reporting the effect of foreign currency transactions, this is explained in Key Principles in Reporting the Effects Changes in Foreign Exchange Rates.
5. Interest and dividends
The standard is clear that entities disclose separately the cash flows from interest and dividends received and paid. Entities disclose such items as either operating, investing or financing activities consistently from period to period. Regardless whether entities capitalise or expense it off, IAS 7 requires a disclosure on the total amount of interest paid in the cash flows statement.
6. Taxes on income
Entities disclose separately the cash flows arising from taxes on income and classify them as operating activities. Nevertheless, classification as investing or financing activities are possible if they can be specifically identified to those activities.
7. Non-cash transactions
All investing and financing transactions that do not involved the use of cash or cash equivalents are excluded from cash flows statement. Instead, entities disclose them on the other parts of the financial statements.
8. Changes in liabilities from financing activities
Entities must also disclose information relating to changes in liabilities arising from financing activities and it should include cash and non-cash changes.
To sum up, the above are the key principles in the preparation of the cash flows statement. It is our hope that it helps you to understand the different components of the cash flows statement.
We will continue our discussion on other financial reporting requirements in our future articles. Meantime, enjoy other articles in the Financial Accounting Section.