IAS 7 – Statement of Cash Flows
What is the objective of the statement of cash flows and why is it required?
In accordance with the Conceptual Framework for Financial Reporting, the objective of financial statements is to provide users with information that is useful in making economic decisions. Business entities require cash to manage their ongoing operations, repay obligations they have undertaken, and provide returns to their investors. Information about cash flows provides financial statement users with a basis for assessing the reporting entity’s ability to generate future cash flows, including their timing and certainty, as well as a basis for evaluating the entity’s needs in utilising such cash flows. Consequently, accounting standard-setters worldwide have decided to require the inclusion of a statement of cash flows. This requirement is relatively recent, originating in the mid-1980s, and stems, among other factors, from pressures placed on accounting standard-setters by securities regulators, who considered the information in this statement to be essential both for equity investors and for bondholders.
How does the statement of cash flows differ from other financial statements?
By its very nature, the statement of cash flows is an exceptional report within the set of financial statements, as it is prepared on a cash basis rather than on an accrual basis like the other financial statements. The statement of cash flows does not include non-cash transactions or events, as they do not generate cash flows in the current period. However, disclosure is required in the financial statements regarding significant non-cash investing and financing transactions.
How does the statement of cash flows support analysis and forecasting?
Similar to the other financial statements, the statement of cash flows is based on historical data. Nevertheless, it enables forecasting of future cash flows of the reporting entity based on past cash flow information. Used together with the other financial statements, the statement of cash flows allows users to assess changes in the reporting entity’s net assets, its financial structure (including liquidity and solvency), and its ability to influence the amounts and timing of cash flows to adapt to changing circumstances and seize opportunities. Accordingly, the statement of cash flows can help identify entities experiencing liquidity difficulties and thus serve as an important tool in the early detection of potential bankruptcies.
How are cash flows classified under IAS 7?
To provide information that enables users to evaluate the impact of different activities on the entity’s financial position and cash flows, the Standard requires separate presentation of cash flows arising from the entity’s activities, as follows:
- Cash flows from (or used in) operating activities.
b. Cash flows from (or used in) investing activities.
c. Cash flows from (or used in) financing activities.
This classification provides users with insights into the relationships between these activities and their impact on the entity’s financial position. Although investing and financing cash flows are presented directly, the Standard permits the use of either the direct or the indirect method for presenting operating cash flows. Nevertheless, the Standard encourages the use of the direct method, on the grounds that it provides more detailed information about cash flows from operating activities and their various sources—information that is useful for forecasting future cash flows and is not provided under the indirect method.
Why is the statement of cash flows particularly important for financial analysis?
The statement of cash flows plays an important role in financial statement analysis, as it represents actual cash flows, unlike the statement of comprehensive income which is heavily influenced by management estimates and accounting policy choices. In other words, it presents facts (cash movements) and leaves little room for “accounting games” (accounting treatments, estimates, etc.). As a result, the statement of cash flows enables comparisons of operating performance among different reporting entities, eliminating the effect of differing accounting policies.
Furthermore, analysts sometimes assess the quality of an entity’s financial reporting by examining the ratio between operating cash flows and accounting profit. A ratio consistently below 1 overtime may, in some circumstances, indicate poor reporting quality, e.g., earnings management through expense deferral.
Information on operating cash flows can reveal much about a reporting entity’s business activities. For example, positive operating cash flows alongside recurring accounting losses may characterise asset-intensive industries, such as investment property, where depreciation charges are substantial and exceed rental income (assuming the reporting entity applies the cost model). This may also describe an entity in decline or one liquidating its assets. For instance, a company engaging in massive clearance sales of inventory at low prices and collecting receivables through significant discounts would present accounting losses but positive operating cash flows. Conversely, negative operating cash flows alongside accounting profits over time may characterise a growing entity expanding its operations, requiring substantial funding to extend credit to new customers and to increase its inventory base. In addition, reporting negative operating cash flows over several reporting periods constitutes one of the warning signs that reporting entities and their auditors must consider when assessing whether the entity can meet its obligations, and in certain cases, may indicate a “going concern” issue.
What does IAS 7 require regarding scope and cash equivalents?
IAS 7 requires all reporting entities, without exception and regardless of the nature of their operations, to present a statement of cash flows and prescribes the principles for its preparation. Based on the view that, in assessing an entity’s ability to generate future cash flows, there is no substantive difference between cash on hand and cash equivalents, with highly liquid financial assets readily convertible into cash, immediately and without significant risk—the Standard requires the statement of cash flows to also explain changes in cash equivalents. That is, cash equivalents form part of the entity’s cash management, rather than part of operating, investing, or financing activities.