It is appropriate to undertake a fresh reconsideration of the relevance of the current structure of the statement of cash flows to meet investors’ needs that have evolved over the years. These needs are further highlighted considering the change in the structure of the statement of profit or loss in accordance with IFRS 18. The model we propose creates full coherence between the statement of cash flows and the new statement of profit or loss. The core of the proposed reform focuses on the operating category, which will be prepared using the direct method and will include two sections: the first represents the cash flows from operating activities as it is today (excluding taxes). The second section includes cash flows for investments in operating assets, that is, payments for the purchase/investment in assets used in operating activities, as well as receipts from their disposal. Additionally, we recommend requiring a disclosure that will enable investors to distinguish between those two sections, as viewed by management.
Although the statement of cash flows currently carries significant weight for many users in the analysis of companies, its structure is far from optimal in terms of its relevance to investors. The problems with the existing structure of the statement of cash flows are intensified considering the change in the structure of the statement of profit or loss in accordance with IFRS 18, which will become mandatory at the beginning of 2027.
Even before IFRS 18, two main difficulties exist regarding the statement of cash flows from a financial statement analysis perspective. The first relates to the manner of presentation of cash flows from operating activities, and the second concerns the classification of investments in operating assets. Regarding the first difficulty, global accounting standards, including IAS 7, have allowed companies over the years to choose to present these cash flows using the indirect method, that is, adjusting accrual-based profit. Although the relief arose from implementation issues that are no longer relevant in today’s information technology environment, almost all companies worldwide use this relief, which causes an absence of transparency and clear information for investors.
The problem lies not only in the amounts reflected in the statement itself, but also the resulting quality of management’s explanations for changes in cash flows within the management discussion and analysis and in earnings calls. When the indirect method is used, it is easy to avoid clear explanations as to why there was, for example, a decrease in customer receipts during the period by using superficial explanations, such as a simplistic description of the change as a consequential effect of changes in accounts receivable and inventory. In contrast, it is much more difficult to avoid a clear explanation for the change, such as a decrease in customer demand, entry of competitors accompanied by price declines or a change in customer credit terms, when this decrease is presented directly to investors in accordance with the direct method.
The second difficulty from investors’ perspective relates to the fact that under the current guidance, investments in operating assets such as property, plant and equipment and intangible assets are classified as cash flows from investing activities, rather than operating activities. However, investors expect that cash flows from operating activities will provide them with a cash flow benchmark for the results reported in the statement of profit or loss. Therefore, investors typically adjust the cash flows from operating activities for investments in operating assets, which ultimately leads to a calculation of Free Cash Flow metric (FCF).
To illustrate the inherent gap between operating profit and cash flows from operating activities, assume that a company purchases a machine whose useful life is ten years. For simplicity, assume also that the aggregate operating profit for the entire decade (after deducting depreciation expense) is zero. In this case there is an inherent gap, since the aggregate cash flows from operating activities for the decade will necessarily be positive and equal to the cash flows used to purchase the machine (the aggregate depreciation expenses over the decade). However, after offsetting the cash used to purchase the machine, it is clear that the activity resulting from the purchase of the machine did not generate net economic benefits. In other words, an annual cash investment that is evenly distributed over the years in a company that is not growing will be equivalent to the annual depreciation expenses but is classified in different categories in the statement of profit or loss (operating profit) and in the statement of cash flows (investing activity).
The coming into effect of IFRS 18 at the beginning of 2027, which revolutionizes the structure of the statement of profit or loss, is expected to highlight these difficulties for investors. While the new statement of profit or loss in accordance with IFRS 18 establishes a uniform language for profitability, the statement of cash flows remains behind. Furthermore, although the classification categories in the new statement of profit or loss will now be similar to the traditional breakdown of the statement of cash flows, there are material gaps between the two statements, particularly where IFRS 18 requires classifying revenue and expenses in different categories compared to the classification under IAS 7. It is important to emphasize that those gaps create a clear disconnect that disrupts the ability of financial statement users to bridge operating profit and cash flows from operating activities. IFRS 18 even intensifies the second difficulty mentioned above, since companies with certain main business activities (investment entities and credit institutions) have a broader scope of operating assets. The new requirement of IFRS 18 to present operating profit as a subtotal in the statement of profit or loss draws even more attention to the gap.
It should be noted that IFRS 18 includes an amendment to IAS 7 to require classification of interest and dividend payments and receipts within financing and investing activities, respectively, but this is obviously only a partial solution.
The IASB’s New Project
Over the past year and a half, an important new project of the IASB has been underway for the improvement of the statement of cash flows and related matters. One of the central issues being examined is the transparency of cash flow measures that are not defined under IFRS (primarily FCF). In fact, this is a proposal for improvement that is a direct result of one of the most significant changes that IFRS 18 brought with it, management-defined performance measures (MPMs). IFRS 18 requires presenting MPMs in the financial statements, but left cash flow data outside its scope, since the measure must be a subtotal of income and expenses. In practice, particularly in the investment world, cash flow metrics (primarily FCF) are the bread and butter of analysts, boards of directors and compensation structures.
Although the project to improve the statement of cash flows constitutes an important building block, the difficulties from investors’ perspective are not only the issues discussed in the project, and we believe it is appropriate as part of the project to make a significant change to the structure of the statement of cash flows.
Proposed Model
According to the model we propose, the statement of cash flows and the new statement of profit or loss should be fully aligned, particularly in the operating category, which will be prepared using the direct method. It is worth noting that IAS 7 views the direct method as preferable but permits application of the indirect method for implementation issues. As mentioned above, in the current era of information technology, a question arises regarding the relevance of the claim that there is an implementation difficulty in using the direct method.
Under our proposed model, two separate sections will be included in the operating category:
- Cash flows from operating activities: Reflects the cash flows that exist today under IAS 7.
- Cash flows from investments in operating assets: Payments for the acquisition or construction of property, plant and equipment and intangible assets used in operating activities, as well as receipts from their disposal.
This proposed solution, which aligns with valuations that generally distinguish between operating assets and investment assets, will eliminate the lack of coherence between recording an operating cost in the statement of profit or loss and recording the same “investment” cost in the statement of cash flows. This incoherence arises because IFRS 18 justifiably requires presenting expenses attributed to asset use (depreciation, impairment and routine maintenance) in the operating section of the statement of profit or loss, since these are core costs of operating activities. In contrast, IAS 7 requires classification of cash flows for the acquisition of property, plant and equipment and intangible assets as part of investing activities.
Considering the operating activity concept of IFRS 18, this proposed new section of the operating category in the statement of cash flows will also include payments and receipts for investments relevant to operating activities in investment entities, e.g., the purchase of investment property in real estate companies.
Additionally, regarding tax cash flows, we believe that following IFRS 18’s clear requirement to present tax expenses as a separate category, it is similarly appropriate to classify tax cash flows as a separate category at the end of the statement of cash flows, contrary to the existing default today of presenting tax payments in operating activities.
Managerial Information Distinguishing Between the Two Types of CAPEX
The distinction between maintenance CAPEX (whose purpose is primarily maintaining the existing asset potential) and growth CAPEX is crucial for assessing the future capabilities and prospects of a company. Although IAS 7 recommends presenting disclosure separating the two types of CAPEX, in practice, just like the implementation of the direct method, this is a recommendation that is almost never implemented. Thus, it is extremely difficult for investors to understand whether the company is “burning” cash to maintain an existing level of activity or investing for growth. We believe this disclosure is critically important for investors, and if indeed MPMs will include cash flow data, some progress may be achieved in this context. However, if the solution ultimately does not come through MPM disclosure, we believe it would be appropriate to consider requiring this disclosure in the notes.
To illustrate the above, assume that a company incurred amount A that is recognised as an expense for the day-to-day maintenance of existing property, plant and equipment used in its operating activities, amount B for the replacement of parts of those existing assets that is capitalised as part of their cost, and amount C for the acquisition of new assets to expand its operations. In accordance with the existing IAS 7, amount A will be classified as cash flow from operating activities while amounts B+C will be classified as cash flows from investing activities. In contrast, under the proposed model, amount A will be presented in the first section of cash flows from operating activities while amounts B+C will be presented in the second section (the new section) of cash flows from operating activities. In this case, we believe it is appropriate to provide a separate disclosure of amount C.
It should be noted that according to IAS 7, only costs that result in a recognised asset are eligible for classification as investing activities. According to the model we propose, this requirement merely changes its location. Instead of marking the boundary between cash flows from operating activities and cash flows from investing activities, the same eligibility line marks the boundary between section A of the cash flows from operating activities and the other relevant categories – section B of the cash flows from operating activities and cash flows from investing activities.
Looking to the Future: Coherence among all Financial Statements
We believe that the proposed model will enable investors to better analyse cash flows and obtain a consistent measure of the quality of operating earnings over time. This, alongside the inclusion of cash flow MPMs as reflected in the IASB’s current project, will contribute to improving the relevance of the statement of cash flows while making certain management adjustments to the accounting data. We believe it is extremely important to include MPM metrics in relation to the statement of cash flows in the spirit of the IASB’s new project. However, this should be supplementary to the revision of the structure of the statement of cash flows rather than a substitute. In other words, the way management views its recurring cash flows, adjusting cash flows it considers exceptional, is important to investors, but it must first be based on an appropriate and relevant structure of the statement of cash flows.
The bottom line is that the time has come to align the operating profitability and operating cash flows, so that the statements speak the same language. The next step will also be alignment of both sides of the statement of financial position to the three categories. This will enable investors to easily calculate the return on net assets, both on an accrual and cash basis, from operating and investing activities separately. Additionally, this may contribute to investors’ ability to easily calculate the cost of financing the entity, both on an accrual and cash basis.
(*) Written by Shlomi Shuv and Shlomi Davidov, Deputy Chief Accountant at the Israel Securities Authority (ISA). It should be clarified that the article is an opinion piece by the authors and does not necessarily reflect the professional positions of the Israel Securities Authority staff. Additionally, all the disclosures and amendments that arose within the proposed model are a proposal for amendments to the standard itself and not a proposal/recommendation for disclosure guidelines outside of it.