3.2.1 Demand deposits and short-term investments

In defining ‘cash’, IAS 7 does not explain what is meant by ‘demand deposits’, perhaps because the term is commonly understood as amounts that can be withdrawn on demand, without prior notice being required or a penalty being charged (for example, by an additional fee or forfeiture of interest). In any event, the distinction is largely irrelevant because amounts not classified as demand deposits may still qualify as cash equivalents and end up being treated in the same way. Thus, whether or not an amount meets the definition of a cash equivalent may become the more important determination.

Cash equivalents are held for the purpose of meeting short-term cash commitments rather than for investment or other purposes. For an investment to qualify as a cash equivalent it must be readily convertible to a known amount of cash and be subject to an insignificant risk of changes in value. Normally only an investment with a short maturity of, say, three months or less from the date of acquisition qualifies as a cash equivalent. Equity investments are excluded unless they are cash equivalents in substance. IAS 7 provides an example of such an instrument, being redeemable preference shares acquired within a short period of their maturity and with a specified redemption date. [IAS 7.7]. The Interpretations Committee considered, in July 2009,¹ what the standard means when it refers to a ‘known amount of cash’ and confirmed that the amount of cash that will be received must be known at the time of the initial investment. Accordingly, traded commodities, such as gold bullion, would not be eligible for inclusion in cash equivalents because the proceeds to be realised from such an investment is determined at the date of disposal rather than being known or determinable when the investment is made.

Cash held in a foreign currency or investments acquired in a currency other than the functional currency of the entity (‘foreign currency’) are not excluded from qualifying as cash and cash equivalents merely because they are denominated in a foreign currency, provided they meet the other criteria discussed above. [IAS 7.28].

3.2.2 Money market funds

Entities commonly invest in money market-type funds such as an open-ended mutual fund that invests in money market instruments like certificates of deposit, commercial paper, treasury bills, bankers' acceptances and repurchase agreements Although there are different types of money market funds, they generally aim to provide investors with low-risk, low-return investment while preserving the value of the assets and maintaining a high level of liquidity. The question then arises as to whether investments in such funds can be classified as cash equivalents. As discussed below, entities may consider the underlying investments of the fund when assessing the significance of the risk of changes in value, however when determining whether classification as a cash equivalent is appropriate, the unit of account is the investment in the money market fund itself.

To meet the definition of a cash equivalent, an investment must be short term; highly liquid; readily convertible to a known amount of cash; and subject to insignificant risk of changes in value. IAS 7 considers a maturity date of three months or less from the date of acquisition to be short-term in the context of maturity, however money market funds generally do not have a legal maturity date. Instead, if the investments are puttable and can be sold back to the fund at any time, they may meet the short-term criterion.

Typically, investments in money market funds are redeemed directly with the fund, therefore in assessing liquidity of the investment, focus should be on the liquidity of the fund itself. In making this assessment, entities should consider the nature of any redemption restrictions in place as these may prevent the redemption of the investment in the short term. Alternatively, if a money market fund investment is quoted in an active market, it might be regarded as highly liquid on that basis.

The short-term and highly liquid investment must also be readily convertible into known amounts of cash which are subject to an insignificant risk of changes in value. [IAS 7.6]. As discussed in 3.2.1 above this means that the amount of cash that will be received must be known at the time of the initial investment. Accordingly, investments in shares or units of money market funds cannot be considered as cash equivalents simply because they are convertible at any time at the then market price in an active market.

The Interpretations Committee also confirmed that an entity would have to satisfy itself that any investment was subject to an insignificant risk of change in value for it to be classified as a cash equivalent.² In assessing whether the change in value of an investment in a money market fund can be regarded as insignificant, an entity must conclude that the range of possible returns is very small. This evaluation is first made at the time of acquiring the investment and reassessment is required if the facts and circumstances change. The evaluation will involve consideration of factors such as the maturity of the underlying investments of the fund; the credit rating of the fund; the nature of the investments held by the fund (i.e. not subject to volatility); the extent of diversification in the portfolio (which is expected to be very high); the investment policy of the fund; and any mechanisms by the fund to guarantee returns (for example by reference to short-term money market interest rates).

Investments are often held for purposes other than to act as a ready store of value that can be quickly converted into cash when needed to meet short-term cash commitments. It is therefore important, even where the criteria above are met, to understand why the entity has invested in a particular money market fund. Where an investment otherwise satisfies the criteria in paragraph 6 of IAS 7, but is not held by the entity to satisfy short-term cash commitments, it should not be classified as a cash equivalent.

Substantial judgement may be required in assessing whether an investment in money market funds can be classified as a cash equivalent. Therefore, appropriate disclosure is essential. As discussed at 3.1 above, entities are required to disclose the policies adopted in determining the composition of cash equivalents and, where relevant, this should include the policy applied and significant judgements made in classifying investments in money market funds.

3.2.3 Investments with maturities greater than three months

The longer the term of the investment, the greater the risk that a change in market conditions (such as interest rates) can significantly affect its value. For this reason, IAS 7 excludes most equity investments from cash equivalents and restricts the inclusion of other investments to those with a short maturity of, say, three months or less from the date of their acquisition by the entity. [IAS 7.7].

Similarly, an investment with a term on acquisition of, say, nine months is not reclassified as a cash equivalent from the date on which there is less than three months remaining to its maturity. If such reclassifications were permitted, the statement of cash flows would have to reflect movements between investments and cash equivalents. This would be misleading because no actual cash flows would have occurred.

The criteria explained above are guidelines, not rules, and a degree of common sense should be used in their application. In the final analysis, cash equivalents are held to meet short-term cash commitments and amounts should be included in cash equivalents only if they can be regarded as being nearly as accessible as cash and essentially as free from exposure to changes in value as cash.

For example, an entity might justify including in cash equivalents a fixed deposit with an original term longer than three months if it effectively functions like a demand deposit. Typically, a fixed deposit will carry a penalty charge for withdrawal prior to maturity. A penalty will usually indicate that the investment is held for investment purposes rather than the purpose of meeting short-term cash needs. However, some fixed deposits still offer interest at a prevailing demand deposit rate in the event of early withdrawal, with any penalty limited to the entity being required to forego the incremental higher interest that it would have received if the deposit were held to maturity. In this case, it may be arguable that there is effectively no significant penalty for early withdrawal, as the entity receives at least the same return that it otherwise would have in a demand deposit arrangement. Where an entity does assert that this type of investment is held for meeting short-term cash needs and classifies the investment as a cash equivalent, the calculation of the effective interest rate (EIR) in accordance with IFRS 9 – Financial Instruments – should be on a consistent basis. IFRS 9 requires that, when calculating the EIR, all contractual terms of the financial instrument, for example prepayments, call and similar options, should be considered. See Chapter 50 at 3.4. [IFRS 9 Appendix A]. In this example, the entity is asserting that it is likely to withdraw the deposit should the need arise and, as a consequence, will only receive interest at the (lower) demand deposit rate. Therefore, the EIR should reflect this intention.

3.2.4 Bank overdrafts

Although bank borrowings are generally considered to be financing activities, there are circumstances in which bank overdrafts repayable on demand are included as a component of cash and cash equivalents. This is in cases where the use of short-term overdrafts forms an integral part of an entity's cash management practices. Evidence supporting such an assertion would be that the bank balance often fluctuates from being positive to overdrawn. [IAS 7.8].

The Interpretations Committee confirmed that where overdrafts do not often fluctuate from being negative to positive, this is an indicator that the arrangement does not form part of an entity's cash management and, instead, represents a form of financing.³

3.2.5 Cryptocurrencies

The Interpretations Committee confirmed in its June 2019 meeting that a holding of cryptocurrency is not cash because cryptocurrencies do not currently have the characteristics of cash.⁴ In particular, the Committee noted that, although some cryptocurrencies can be used in exchange for particular goods or services, the Committee is not aware of any cryptocurrency that is used as a medium of exchange or as the monetary unit in pricing goods or services to such an extent that it would be the basis on which all transactions are measured and recognised in financial statements.⁵

Cryptocurrencies are discussed in more detail in Chapter 17 at 11.5.

3.2.6 Client money

Some financial institutions and other entities hold money on behalf of clients. The terms on which such money is held can vary widely. This is discussed in more detail in Chapter 52 at 3.7.

There are numerous types of arrangements that result in an entity holding client money so it is impossible to generalise as to the appropriate treatment. However, as explained in Chapter 52 at 3.7, where an entity enjoys sufficient use of the client money such that it is exposed to the credit risk associated with the cash and is entitled to all income accruing, the entity would include the client money as part of its cash balance and recognise a corresponding liability. Any restrictions on the use of the cash should be considered and disclosed as explained in 3.4 below.

4.1.1 The direct method

Under the direct method, major classes of gross cash receipts and gross cash payments are disclosed. [IAS 7.18]. IAS 7 encourages entities to use the direct method, because it provides information which may be useful in estimating future cash flows and which is not available under the indirect method. [IAS 7.19].

Under the direct method, information about major classes of gross cash receipts and payments may be obtained either:

1. from the accounting records of the entity (essentially based on an analysis of the cash book); or
2. by adjusting sales, cost of sales (interest and similar income and interest expenses and similar charges for a financial institution) and other items in the statement of comprehensive income for:
   1. changes during the period in inventories and operating receivables and payables;
   2. other non-cash items; and
   3. other items for which the cash effects are investing or financing cash flows. [IAS 7.19].

A statement of cash flows prepared under the direct method should include the same disclosures of gross cash receipts and gross cash payments irrespective of which approach has been used to determine their value. There is no requirement for entities using the approach described in (b) above to present a reconciliation showing the adjustments made between, for example, revenue in the statement of comprehensive income and cash receipts from customers.

African Rainbow Minerals Limited is an example of an entity using the direct method for presenting its cash flows from operating activities, as illustrated in Extract 40.7 below.

4.1.2 The indirect method

The indirect method arrives at the same value for net cash flows from operating activities, but does so by working back from amounts reported in the statement of comprehensive income. There are two approaches for presenting the net cash flows from operating activities when using the indirect method. The most common approach adjusts reported profit or loss for the effects of:

1. changes in inventories and operating receivables and payables during the period;
2. non-cash items such as depreciation, provisions, deferred taxes, unrealised foreign currency gains and losses, and undistributed profits of associates; and
3. all other items for which the cash effects are investing or financing cash flows. [IAS 7.20].

Anheuser-Busch InBev has used this adjusted profit approach to present its indirect method statement of cash flows, as illustrated in Extract 40.8 below.

Alternatively, the indirect method of presentation can show separately revenues and expenses, adjusted for non-cash, investing or financing items, making up operating profit before working capital changes. [IAS 7.20]. An example of this rarely used alternative is given at the end of Appendix A to IAS 7.

When an entity adopts the adjusted profit approach to presenting net cash flows from operating activities under the indirect method, the reconciliation should start either with profit or loss before tax (as in Extract 40.6 above) or profit or loss after tax (as in Extract 40.8 above). Any other basis, such as EBITDA, EBIT, or profit or loss excluding non-controlling interests, does not meet the requirement in IAS 7 for adjusting ‘profit or loss’, [IAS 7.20], which includes ‘all items of income and expense in a period’. [IAS 1.88].

To obtain the information on working capital movements for the indirect method, the figures in the statement of financial position must be analysed according to the three standard headings of the statement of cash flows. Thus, the reconciliation of profit or loss to cash flow from operating activities will include, not the increase or decrease in all receivables or payables, but only in respect of those elements thereof that relate to operating activities. For example, amounts owed in respect of the acquisition of property, plant and equipment (other than assets held for rental and subsequent sale), intangible assets, or non-operational investments will be excluded from the movement in payables included in this reconciliation. Although this may not present practical difficulties in the preparation of a single-entity statement of cash flows, it is important that sufficient information is collected from subsidiaries for preparing the group statement of cash flows.

Furthermore, when a group has acquired a subsidiary during the year, the change in working capital items will have to be split between the increase due to the acquisition (to the extent that the purchase consideration was settled in cash, this will be shown under investing activities) and the element related to post-acquisition operating activities which will be shown in the reconciliation. In a similar way, if a group has disposed of a subsidiary during the year, the changes in the working capital items in the reconciliation will exclude the movements relating to the working capital of the subsidiary that has left the group. Further additional considerations needed when preparing a statement of cash flows for a group are explained at 6 below.

4.4.1 Interest and dividends

An entity is required to disclose separately cash flows from interest and dividends received and paid, and their classification as either operating, investing or financing activities should be applied in a consistent manner from period to period. [IAS 7.31]. For a financial institution, interest paid and interest and dividends received are usually classified as operating cash flows. However, IAS 7 notes that there is no consensus on the classification of these cash flows for other entities and suggests that:

• interest paid may be classified under either operating or financing activities; and
• interest received and dividends received may be included in either operating or investing cash flows. [IAS 7.33].

The standard allows dividends paid to be classified as a financing cash flow (because they are a cost of obtaining financial resources) or as a component of cash flows from operating activities. [IAS 7.34].

In Extract 40.6 at 4 above, AstraZeneca has included interest paid under operating activities, interest received under investing activities and dividends paid under financing activities, as permitted by the standard. A different treatment is adopted by Anheuser‑Busch InBev in Extract 40.8 at 4.1.2 above, where interest paid, interest received and dividends received are all disclosed as operating cash flows.

All of these treatments are in compliance with the standard, however the most appropriate treatment will depend on the nature of the entity and its activities. For example, if an entity does not include interest received or dividends received within revenue it may be more appropriate to include the interest or dividend cash inflows as investing cash flows rather than operating cash flows. This is because cash flows from operating activities are primarily derived from the principal revenue-producing activities of the entity, [IAS 7.14], and the amount of cash flows arising from operating activities is intended to be a key indicator of the extent to which the operations of the entity have generated sufficient cash flows to repay loans, pay dividends and make new investments without recourse to external sources of financing. [IAS 7.13]. Similarly, an entity could treat interest and dividends paid as financing cash flows because they are a cost of obtaining financial resources. [IAS 7.34]. In addition, the standard requires the total amount of interest paid during the period to be disclosed in the statement of cash flows, whether it has been recognised as an expense or capitalised as part of the cost of an asset in accordance with IAS 23 – Borrowing Costs. [IAS 7.32]. A literal reading of this requirement might suggest that interest paid should be presented as a single figure under operating or financing activities. However, it would also seem appropriate to include the cash outflow relating to capitalised borrowing costs under investing activities, provided that when this is done, the total amount of interest paid is also disclosed, either on the face of the statement of cash flows or in the notes. This gives rise to an apparent inconsistency between paragraph 16 of IAS 7 and paragraphs 32 to 33 of IAS 7, but attempts to clarify the issue through an annual improvement⁹ received negative feedback from respondents and ultimately no amendment was made.¹⁰

Where an entity has issued shares that are classified as financial liabilities in accordance with IAS 32 – Financial Instruments: Presentation (see Chapter 47), the dividends paid on those shares should be presented in the statement of cash flows as either operating or investing, in line with the entity's presentation of other interest paid.

4.4.2 Taxes on income

Cash flows arising from taxes on income should be separately disclosed within operating cash flows unless they can be specifically identified with investing or financing activities. [IAS 7.35].

Whilst it is possible to match elements of tax expense to transactions for which the cash flows are classified under investing or financing activities; taxes paid are usually classified as cash flows from operating activities because it is often impracticable to match tax cash flows with specific elements of tax expense. Also, those tax cash flows may arise in a different period from the underlying transaction. [IAS 7.36]. This is the presentation adopted by Anheuser-Busch InBev in Extract 40.8 at 4.1.2 above. However, when it is practicable to make this determination, the tax cash flow is identified as an investing or financing activity in accordance with the individual transaction that gives rise to such cash flows. In cases where tax cash flows are allocated over more than one class of activity, the entity should disclose the total amount for taxes paid. [IAS 7.36].

4.4.3 Sales taxes and other non-income tax cash flows

Although it provides guidance on the treatment of taxes on income, IAS 7 does not specifically address the treatment of cash flows relating to other taxes, such as value added tax (VAT) or other sales taxes and duty. The Interpretations Committee has considered whether it should add the question about VAT to its agenda and decided that it was not appropriate to develop an interpretation. Instead, it suggested that the issue of cash flows relating to VAT be considered by the IASB in its review of IAS 7 as part of the project on Financial Statement Presentation.

In explaining why, it would not add this question to its agenda, the Interpretations Committee noted that ‘IAS 7 does not explicitly address the treatment of VAT’ and added that ‘while different practices may emerge, they are not expected to be widespread’.¹¹

Therefore, it seems that entities can choose to disclose VAT receipts and VAT payments separately in the statement of cash flows or as part of the related cash inflows and outflows. Given the availability of alternative treatments, the Interpretations Committee noted that it would be appropriate in complying with IAS 1 – Presentation of Financial Statements – for entities to disclose whether cash flows are presented inclusive or exclusive of related VAT.¹² We believe that the same principles should be applied for other non-income taxes.

4.4.4 Cash flows from factoring of trade receivables

Another question not explicitly addressed in the standard is the classification of cash receipts from the factoring of trade receivables.

In the case of debt factoring, an entity aims to provide cash flow from trade receivables more quickly than would arise from normal collection from customers, generally by transferring rights over those receivables to a financial institution. In our view, the classification of the cash receipt from the financial institution depends on whether the transfer results in derecognition of the trade receivables, or to the continued recognition of the trade receivables and the recognition of a financial liability for the funding received from the factoring entity. The characteristics determining which of these accounting treatments would be appropriate are discussed in Chapter 52 at 4.5 and 5.

Only to the extent that the factoring arrangement results in the derecognition of the original trade receivable would it be appropriate to regard the cash receipt in the same way as any other receipt from the sale of goods and rendering of services and classify it in operating activities. [IAS 7.14(a)]. In cases where the trade receivable is not derecognised and a liability is recorded, the nature of the arrangement is a borrowing secured against trade receivables and accordingly we believe that the cash receipt from factoring should be treated in the same way as any short-term borrowing and included in financing activities. [IAS 7.17(c)]. The later cash inflow from the customer for settlement of the trade receivable would be included in operating cash flows and the reduction in the liability to the financial institution would be a financing outflow. Following the principle in IFRS 9 for the disclosure of income and expenditure relating to a transferred asset that continues to be recognised, [IFRS 9.3.2.22], these two amounts would not be offset in the statement of cash flows. However, it would be acceptable for the entity to disclose the net borrowing receipts from, and repayments to, the financial institution, if it was determined that these relate to advances made for and the repayment of short-term borrowings such as those which have a maturity period of three months or less. [IAS 7.23A]. In some cases, the factoring arrangement requires customers to remit cash directly to the financial institution. When the transfer does not give rise to derecognition of the trade receivable by the reporting entity, we believe that entity can apply either of the following ways to depict the later settlement of the debt by the customer:

1. as a non-cash transaction. No cash flows would be reported at the time of the ultimate derecognition of the trade receivable and the related factoring liability; or
2. as a transaction in which the factoring entity collects the receivable as agent of the entity and then draws down amounts received in settlement of the entity's liability to the financial institution. In this case the entity would report an operating cash inflow from the customer and a financing cash outflow to the financial institution.

4.4.5 Cash flows from supply-chain financing (reverse factoring)

In the case of supply-chain financing or reverse factoring arrangements, typically a purchaser aims to defer cash flows through an arrangement with a financial intermediary, see Chapter 52 at 6.5 for further explanation. The primary accounting concerns with these types of arrangements are how the purchaser should present the liability it owes to the financial intermediary in its statement of financial position and how the cash outflows to settle this liability should be presented in the statement of cash flows. The presentation in the statement of financial position is dealt with in Chapter 52 at 6.5.

In relation to the cash outflows, an entity would need to consider the substance of the arrangement to determine whether these cash flows are operating or financing in nature based on the definitions of operating activities and financing activities discussed above at 4.1 and 4.3. The presentation of the amount owed to financial intermediary as either a trade payable or a financial liability should also inform this consideration so that the treatment in the statement of cash flows and the treatment in the statement of financial position is consistent i.e. where the amount owed has been presented as a financial liability the cash outflows would be shown as financing cash flows and if presented as a trade payable the cash outflows would be presented as part of operating activities.

In practice, the appropriate presentation of any such arrangement is likely to involve a high degree of judgement and we believe that, whatever the presentation adopted, additional disclosure will often be necessary to explain the nature of the arrangements, the financial reporting judgements made and the amounts involved.

4.4.6 Property, plant and equipment held for rental

Payments to acquire and receipts from the sale of, property, plant and equipment are usually included in investing cash flows; however, this is not always the case.

A number of entities routinely sell assets that were previously held for rental, for example, car rental companies that acquire vehicles with the intention of holding them as rental cars for a limited period and then selling them. IAS 16 – Property, Plant and Equipment – requires an entity, that, in its ordinary course of business, routinely sells items of property, plant and equipment that it has held for rental to others, to classify gains on the sale of such property, plant and equipment as revenue. [IAS 16.68A]. Accordingly, the proceeds from the sale of such assets are classified as cash flows from operating activities, as are cash payments to manufacture or acquire property, plant and equipment held for rental to others and routinely sold in the ordinary course of business. [IAS 7.14].

The requirement to classify payments for such property, plant and equipment held for rental under operating cash flows is intended to avoid initial expenditure on purchases of assets being classified as investing activities, while inflows from sales are recorded within operating activities. However, this means that management will need to determine, at the time of acquisition or manufacture, which of the assets that it intends to rent out will be ultimately held for sale in the ordinary course of business.

4.4.7 Cash flows for service concession arrangements

Because a cash flow is only classified in investing activities if it results in a recognised asset in the statement of financial position, a question arises regarding the classification of the cash inflows and outflows of the operator of a service concession arrangement that is within the scope of IFRIC 12 – Service Concession Arrangements.

IFRIC 12 features two possible accounting models – the intangible asset model or the financial asset model. Under both models, the service element relating to the construction of the infrastructure asset is accounted for in accordance with IFRS 15 – Revenue from Contracts with Customers – and the revenue recognised gives rise to an intangible or a financial asset, in the form of a receivable, respectively. It is unclear whether cash flows incurred in the construction or upgrade phase should always be regarded as operating cash flows because they relate to the provision of construction services; or whether they are more accurately classified as investing activities, as they reflect cash outflows that result in the recognition of an asset.

In the case of an arrangement under the intangible asset model, the cash flows incurred during construction or upgrading could be classified in investing activities as they relate to the acquisition of an intangible that will generate future income and cash flows. Once the operating phase is reached, the cash inflows received would be most appropriately classified in operating activities as most operating and maintenance costs are likely to be executory and will be accounted for as incurred.

On the other hand, when the financial asset model applies, cash outflows during the construction phase may considered to be deferred payments and therefore represent the provision of financing to the grantor. In a corollary of the discussion on deferred payments at 5.4 below, where the time value of money is significant to the transaction, the transaction may be tantamount to providing a loan. In this case the repayment of such an instrument during the operating phase could be considered an investing cash flow (or potentially split between investing and operating cash flows for the capital and interest components respectively, depending on the policy of the entity).

Since there is no specific guidance relating to the classification of cash flows for service concession arrangements, current practice is mixed. IFRIC 12 is discussed in more detail in Chapter 25.

4.4.8 Treasury shares

Treasury shares are an entity's own equity instruments that are acquired and held by the entity, a subsidiary, or other members of the consolidated group. The consideration paid or received for treasury shares is recognised directly in equity and not as a movement in investments. [IAS 32.33]. As such, it should be clear that payments and receipts to acquire or dispose of treasury shares should be classified within financing activities. [IAS 7.17]. Even where such treasury shares are acquired by the entity as part of an equity-settled share-based payment transaction, the cash outflow should be classified under financing activities. Whilst cash payments to and on behalf of employees are classified under operating activities, [IAS 7.14], the acquisition of treasury shares does not settle a transaction between the entity and its employees. An equity-settled share-based payment transaction is completed when the entity transfers its equity instruments to employees in consideration for the services received.

When a cash payment is made by a subsidiary to its parent or a trust that holds treasury shares as part of an equity-settled share-based payment arrangement, the payment should be accounted for as a deduction from equity in the separate financial statements of the subsidiary, on the grounds that the payment does not settle the transaction with the employees, but is effectively a distribution to the parent or the trust (see Chapter 34 at 12.4.3 and 12.5.3). Having regarded this as a distribution, it follows that the cash flow should be classified as either operating or financing, according to the entity's policy on dividends as discussed at 4.4.1 above.

4.4.9 Cash flows related to the costs of a share issue

Costs directly related to the issue of shares are required to be deducted from equity. [IAS 32.35]. As the costs reduce the amount of the proceeds received from the share issue, they should be classified as a financing cash flow. [IAS 7.17(a)]. However, where a proposed share issue is cancelled, there would be no proceeds from the issue to record and the related expenses would be included in profit and loss rather than equity. As such, the definition of a financing cash flow would not be met, and the transaction costs would be classified in operating cash flows.

4.4.10 Cash flows on derivative contracts

Payments and receipts relating to derivative contracts can be classified within operating, investing or financing in different circumstances. Where the contract is held for dealing or trading purposes, the cash flows are classified under operating activities. [IAS 7.14]. IAS 7 requires that payments for, and receipts from, futures contracts, forward contracts, option contracts and swap contracts are classified as cash flows from investing activities, except when the contracts are held for dealing or trading purposes, or the cash flows are classified as financing activities. [IAS 7.16].

The standard adds that when a contract is accounted for as a hedge of an identifiable position, the cash flows of the contract are classified under the same heading as the cash flows of the position being hedged. [IAS 7.16]. An example is an interest rate swap. An entity wishing to convert an existing fixed rate borrowing into a floating rate equivalent could enter into an interest rate swap under which it receives interest at fixed rates and pays at floating rates. All the cash flows under the swap should be reported under the same cash flow heading as interest paid (i.e. as financing activities or operating activities, in accordance with the entity's determined policy, as discussed at 4.4.1 above), because they are equivalent to interest or are hedges of interest payments.

The standard suggests that receipts and payments on contracts might be included in financing cash flows; but, except for the text on contracts accounted for as hedges of an identifiable position, gives no indication of the circumstances under which such a classification would be appropriate. [IAS 7.16].

So how should an entity classify the cash flows from a derivative contract that is considered by management as part of a hedging relationship, but for which the entity elects not to apply hedge accounting (taking all movements to profit or loss) or for which hedge accounting is not permitted under IFRS 9? Consider the following example.

This example highlights a current deficiency in IAS 7; its terminology was never updated or refined when the IASB issued guidance on hedge accounting. This deficiency is acknowledged by the IASB when it discusses, in the implementation guidance to IFRS 9, the classification of cash flows from hedging instruments. [IFRS 9.IG.G.2]. Therefore, in our opinion, since the IASB has not reflected the requirements of IFRS 9 in the text of IAS 7, it does not require the treatment of cash flows ‘when a contract is accounted for as a hedge of an identifiable position’, [IAS 7.16], to be restricted only to those hedging relationships that either are designated as hedges under IFRS 9, or would otherwise qualify for hedge accounting had they been so designated. Accordingly, in Example 35.1 above, entity A would include the payment on the forward contract in cash flows from operating activities.

4.4.11 Classification of cash flows – future developments

As part of their Better Communication in Financial Reporting project, the IASB is developing new presentation requirements for the statements of financial performance, including the statement of cash flows and at the time of writing aims to publish an Exposure Draft of amendments by the end of 2019.

5.3.1 Entities applying the direct method

When an entity enters into a transaction denominated in a foreign currency, there are no consequences for the statement of cash flows until payments are received or made. The receipts and payments will be recorded in the entity's accounting records at the exchange rate prevailing at the date of payment and these amounts should be reflected in the statement of cash flows. [IAS 7.25].

The consolidated statement of cash flows prepared under the direct method uses the foreign currency financial statements of each foreign subsidiary as the starting point. This means that cash flows are measured first in the functional currency of the subsidiary and then retranslated into the currency in which the consolidated financial statements are presented.

5.3.2 Entities applying the indirect method

Under the indirect method, profit or loss is adjusted for the effects of transactions of a non-cash nature, any deferrals of operating cash receipts or payments and income or expenses associated with investing or financing cash flows. [IAS 7.18]. Exchange differences will be included in profit or loss when the settled amount differs from the amount recorded at the date of the transaction. Likewise, if the transaction remains unsettled at the reporting date, exchange differences will also be taken to profit or loss on the retranslation of the unsettled monetary items at closing rates. Entities must therefore determine what adjustments should be made to ensure that foreign currency items are only included in the statement of cash flows to the extent that cash flows have occurred.

5.4.1 Asset purchases on deferred terms

The purchase of assets on deferred terms can be a complicated area because it may not be clear whether the associated cash flows should be classified under investing activities, as capital expenditure, or within financing activities, as the repayment of borrowings.

It could be argued that the payment of a deferred amount would not meet the definition of investing cash flows, because it does not result in recognition of an asset, but rather a reduction of a liability. However, as discussed above at 4, the Interpretations Committee and the IASB have affirmed in 2013 their position that in determining the classification of cash flows, the nature of the activity is still the primary principle to be considered.¹⁵ Accordingly, the classification of the payment comes down to a judgement as to whether its nature relates to the acquisition of an asset or the repayment of a liability.

In our view, in cases where financing is provided by the seller of the asset, the acquisition and financing should be treated as a non-cash transaction and disclosed accordingly. Subsequent payments to the seller are then included in financing cash flows. Nevertheless, if the period between acquisition and payment is not significant, the existence of credit terms should not be interpreted as changing the nature of the cash payment from investing to financing. The period between acquisition and payment would be regarded as significant if it gave rise to a significant financing component under IFRS 15 (see Chapter 29 at 2.5), [IFRS 15.60‑65]. Therefore, the settlement of a short-term payable for the purchase of an asset is an investing cash flow, whereas payments to reduce the liability relating to a lease or other finance provided by the seller for the purchase of an asset should be included in financing cash flows.

Where an entity acquires an asset under a lease, the acquisition of the asset is clearly a non-cash transaction, [IAS 7.44], and the payments to reduce the outstanding liability relating to a lease are clearly financing cash flows. [IAS 7.17].

5.4.2 Asset disposals on deferred terms

It follows that the derecognition of property, plant and equipment by the lessor under a lease or another arrangement determined to be the provision of finance by the vendor would be disclosed as a non-cash transaction. Receipts to reduce the receivable from the purchaser would be investing cash flows, but appropriately described, for example as the receipt of deferred consideration rather than the proceeds on sale of property, plant and equipment. [IAS 7.16].

5.4.3 Sale and leaseback transactions

A sale and leaseback transaction involves the transfer of an asset by an entity (the seller-lessee) to another entity (the buyer-lessor) and the leaseback of the same asset by the seller-lessee. Sale and leaseback transactions are discussed further in Chapter 23 at 8.

In terms of presentation in the statement of cash flows, IFRS 16 – Leases – refers only to leases, requiring the cash payments for the principal portion of the lease liability to be presented in financing activities and cash payments for the interest portion to be presented in accordance with IAS 7. [IFRS 16.50]. Nothing is included in IFRS 16 or IAS 7 with respect to cash flow presentation in the case of a sale and lease-back transaction.

Presentation of the cash flows relating to the sale and leaseback transaction for a seller-lessee will depend on how the transaction is accounted for under IFRS 16, specifically whether the transfer of the asset is accounted for as a sale of the asset in accordance with the requirements of IFRS 15. [IFRS 16.99].

If the transaction does satisfy the requirements of IFRS 15 to be accounted for as a sale, the cash received comprises an amount reflecting the fair value of the underlying asset plus the amount of any additional financing provided by the buyer-lessor to the seller-lessee. [IFRS 16.101]. This should be reflected in the statements of cash flows by splitting the proceeds between investing cash flows and financing cash flows. However, there are different approaches as to how this split could be determined. From an economic standpoint, the seller-lessee has sold only its interest in the value of the underlying asset at the end of the leaseback – it has retained its right to use the asset for the duration of the leaseback. [IFRS 16.BC266]. Therefore, in our view, the amount that should be shown as an investing cash inflow is the amount of the sale proceeds that reflects the proportion of the fair value of the underlying asset that is not retained by the seller-lessee. Any excess should be presented as part of cash flows from financing activities. This presentation in the statement of cash flows is consistent with the requirement in IFRS 16 to recognise only the amount of any gain or loss on the sale and leaseback relating to the rights that have been transferred to the buyer-lessor and also to measure the right-of-use asset as a proportion of the previous carrying amount of the underlying asset. [IFRS 16.100]. This can be seen in Example 40.2 below, which is based on Example 23.24 in Chapter 23.

If the transaction does not satisfy the requirements of IFRS 15 to be accounted for as a sale, the cash received is classified in the cash flow statement as a cash inflow from financing activities because the substance of the transaction is that the lessee has raised finance, with the asset provided as security. The resulting financial liability is accounted for under IFRS 9, [IFRS 16.103], and the seller-lessee splits the cash outflows between repayment of the principal and payment of interest. Repayments of the principal are classified as financing cash flows, whereas interest should be presented in a manner consistent with the presentation of other interest paid in statement of cash flows (see 4.4.1 above).

5.4.4 Revenue contracts with deferred payment terms

As discussed in Chapter 29 at 2.5, a contract with a customer that has a significant financing component would be separated into a revenue component (for the notional cash sales price) and a loan component (for the effect of the deferred or advance payment terms). In the case of deferred payment terms this gives rise to two cash flow components i.e. the revenue component cash flows should be classified as cash flows from operating activities, and the cash flows related to the significant financing component should be classified consistent with the entity's choice to present cash flows from interests received. If the customer pays in advance, however, the sum of the cash amount and the accrued interest represent revenue, and thus there is only one cash flow component which should be classified as cash flows from operating activities.

5.6.1 Cash flows to increase and maintain operating capacity

IAS 7 does not contain any guidance as to how to distinguish cash flows for expansion from cash flows for maintenance in relation to the voluntary disclosure referred to under (b) above. The standard merely states that this information is useful in helping the user to determine whether the entity is investing adequately in the maintenance of its operating capacity or whether it may be sacrificing future profitability for the sake of current liquidity and distributions to owners. [IAS 7.51].

Hongkong Land Holdings distinguishes renovations expenditure from developments capital expenditure in its analysis of investing cash flows.

5.6.2 Segment cash flow disclosures

Disclosure of segmental cash flows is encouraged because it reveals the availability and variability of cash flows in each segment and allows users to better understand the relationship between the cash flows of the business as a whole and those of its component parts. [IAS 7.52].

IAS 7 contains an example of the segmental disclosure advocated at 5.6 above. [IAS 7 Appendix A part D]. However, this example simply reports the operating, investing and financing cash flows of its two segments with no reconciliation of the total to the statement of cash flows. In practice it might be difficult to allocate financing cash flows across the entity's reportable segments, given that this is not how treasury functions tend to operate.

A.P. Møller – Mærsk provides an analysis of operating cash flows and capital expenditure (part of its investing cash flows) by reportable segment. The entity does not disclose financing cash flows by reportable segment (comparative information is provided in the financial statements but is not reproduced here).

6.3.1 Acquisition-related costs

IFRS 3 – Business Combinations – requires acquisition-related costs (other than those costs relating to the issue of equity or debt securities) to be recognised as an expense in the period in which the costs are incurred and the services are received. [IFRS 3.53]. As discussed at 4.2 above, the definition of investing activities in IAS 7, states that ‘only expenditures that result in a recognised asset in the statement of financial position’ give rise to investing cash flows. [IAS 7.16]. As a result, cash flows relating to acquisition costs recognised as an expense would have to be classified within operating activities.

6.3.2 Deferred and other non-cash consideration

Not all acquisitions or disposals of businesses are satisfied in full by the exchange of cash. Any non-cash consideration, such as shares issued by either party or amounts to be paid or received by the entity at a later date, is not included in the amount presented under investing activities. [IAS 7.43]. Instead, the non-cash element of the acquisition or disposal is disclosed. As explained in more detail at 5.4 above, the purchase of assets on deferred terms can be a complicated area because it may not be clear whether the associated cash flows should be classified under investing activities, as capital expenditure, or within financing activities, as the repayment of borrowings. Hence judgement is required when determining the appropriate classification of the deferred payment in the statement of cash flows. These same principals apply on the acquisition of a business involving deferred consideration.

6.3.3 Contingent consideration

6.3.4 Settlement of amounts owed by the acquired entity

A question that sometimes arises is how to treat a payment made by the acquirer to settle amounts owed by a new subsidiary, either to take over a loan that is owed to the vendor by that subsidiary or to extinguish an external borrowing.

Payments made to acquire debt instruments of other entities are normally included under investing activities. [IAS 7.16]. Therefore, a payment to the vendor to take over a loan that is owed to the vendor by the subsidiary is classified under the same cash flow heading irrespective of whether it is regarded as being part of the purchase consideration or the acquisition of a debt.

Payments made by the acquirer to the vendor before acquisition to extinguish an external borrowing of the subsidiary would similarly be classified as investing cash flows. This presentation can be contrasted with the repayment of an external borrowing by the new subsidiary after acquisition, using funds provided by the parent, which is a cash outflow from financing activities. [IAS 7.17].

6.3.5 Settlement of intra-group balances on a demerger

A similarly fine distinction might apply on the demerger of subsidiaries. These sometimes involve the repayment of intra-group indebtedness out of the proceeds from external finance raised by the demerged subsidiary. If the external funding is raised immediately prior to the subsidiary leaving the group, it is strictly a financing inflow in the consolidated statement of cash flows, being cash proceeds from issuing short or long-term borrowings. [IAS 7.17]. If the subsidiary both raises the external funding and repays the intra-group debt after the demerger, the inflow is shown in the consolidated statement of cash flows under investing activities, being a cash receipt from the repayment of advances and loans made to other parties. [IAS 7.16].

6.4.1 Investments in associates and joint ventures

Changes in cash and cash equivalents relating to associates or joint ventures accounted for under the equity or cost method will impact the entity's statement of cash flows only to the extent of the cash flows between the group and the investee. [IAS 7.37]. The same concept would apply to associates or joint ventures carried at fair value as allowed by IAS 28 – Investments in Associates and Joint Ventures (discussed in Chapter 11). Examples include cash dividends received and loans advanced or repaid. [IAS 7.37]. Cash flows in respect of an entity's investment in an equity accounted associate or joint venture would also be presented. [IAS 7.38].

Cash dividends received from equity accounted associates and joint ventures would be classified as operating or investing activities in accordance with the entity's determined policy for other dividends received (see 4.4.1 above). Where the net cash inflow from operating activities is determined using the indirect method, the group's share of profits or losses from equity-accounted investments will appear as a non-cash reconciling item in the cash flow statement (see 4.1.2 above).

The cash flows arising on the acquisition and disposal of an associate or joint venture would be classified as investing activities. In addition, the considerations set out at 6.3.2 and 6.3.3 above in respect of deferred and contingent consideration on acquisition and disposal of a subsidiary should also be applied when determining the appropriate classifications of cash flows relating to the acquisition and disposal of associates and joint ventures.

6.4.2 Cash flows of joint operations

IAS 7 does not specifically deal with the treatment of the cash flows of joint operations. However, following the guidance of IFRS 11 – Joint Arrangements – all transactions should be reflected in the accounts of the joint operator's financial results to the extent of its interests in those transactions. [IFRS 11.20]. Therefore, the cash flows of the joint arrangement are already included in the operator's financial statements and no additional adjustments are required to reflect the activities of the joint operation.

The treatment of cash flows for the acquisition and disposal of a joint operation is less clear as there is an argument for presentation either as a single net cash flow in investing activities (as is required for the cost of a business combination, discussed at 6.3 above); or as separate cash flows, classified according to the nature of the underlying assets and liabilities acquired. IFRS 11 requires an entity to determine whether the activity undertaken by a joint operation constitutes a business as defined in IFRS 3 and to apply business combination or asset acquisition accounting in accordance with that analysis. [IFRS 11.21A]. Therefore it would be appropriate to apply a similar approach to the presentation of the cash flows, with acquisitions and disposals of operations meeting the definition of a business giving rise to a single investing cash flow, and acquisitions and disposals of operations not regarded as a business giving rise to cash flows according to the nature of the assets and liabilities acquired or disposed.

6.4.3 Cash flows in investment entities

IAS 7 does not address the treatment of subsidiaries held at fair value in an investment entity. As these investments are accounted for at fair value through profit or loss in accordance with IFRS 9, the related cash flows would be treated consistently with cash flows from joint ventures and associates discussed at 6.4.1 above.

The disclosures required by an investment entity on the acquisition of subsidiaries are less than those required for other entities. Investment entities need only disclose the total consideration paid or received and the portion of the consideration consisting of cash and cash equivalents are required to be disclosed. [IAS 7.40‑40A].

6.5.1 Cash flows of subsidiaries, associates and joint ventures

IAS 7 addresses the treatment of cash flows of associates, joint ventures and subsidiaries accounted for by use of the cost method, restricting its reporting in the statement of cash flows to the cash flows between investor and the investee, for example, to dividends and advances as discussed in 6.4.1 above. [IAS 7.37]. This treatment would also be applied to associates, joint ventures and subsidiaries either held at fair value through profit or loss, or using the equity accounted method in the separate financial statements, as allowed by IAS 27 – Separate Financial Statements – and discussed in Chapter 8.

6.5.2 Group treasury arrangements

Some groups adopt treasury arrangements under which cash resources are held centrally, either by the parent company or by a designated subsidiary company. Any excess cash is transferred to the designated group entity. In some cases, a subsidiary might not even have its own bank account, with all receipts and payments being made directly from centrally controlled funds. Subsidiaries record an intercompany receivable when otherwise they would have held cash and bank deposits at each period end. A question that arises is whether or not a statement of cash flows should be presented when preparing the separate financial statements of such a subsidiary given that there is no cash or cash equivalents balance held at each period end and, for some entities, at any time during the year. In our view, the preparation of the statement of cash flows should be based upon the actual cash flows during the period regardless of cash and cash equivalents balance held directly by the entity.

Where no cash flows through an entity, but rather all transactions flow through another group company, the entity should still record receipts from debtors and payments to suppliers, albeit with an associated deposit to or withdrawal from a balance with another group company. Just as a bank processes payments and receipts as agent for the account holder, so the group treasury function acts as agent for the entity, and these transactions should be reflected in a statement of cash flows. This approach is consistent with the requirements in IAS 7 that all entities should prepare a statement of cash flows which forms an integral part of the financial statements. [IAS 7.1].

Where the subsidiary makes net deposits of funds to, or net withdrawals of funds from the designated group entity during the reporting period, a further question arises as to how movements should be presented in the subsidiary's statement of cash flows. Normally these transactions give rise to intercompany balances. Therefore, the deposits or withdrawals should be evaluated against the definitions of the categories of cash flows and presented as either operating activities or alternatively as investing or financing activities, as appropriate. Further consideration should be made as to whether these cash flows meet the criteria for net presentation as discussed in 5.2 above.

In extremely rare cases the intercompany balances may meet the definition of cash equivalents and be regarded as short-term highly liquid investments that are readily convertible into known amounts of cash and are subject to insignificant risk of changes in value. However, in most cases such funds are transferred to the designated group entity for an indeterminate term and the fact that both the subsidiary and designated group entity are controlled by the parent company makes it difficult to conclude that the subsidiary could demand repayment of amounts deposited independently of the wishes of the parent company.