IFRS suggests that for a set of financial statements to be complete, there should be five statements which are presented with equivalent importance. One of these 5 statements is the statement of cash flows. The success of an entity does not only depend on its profit but also by the ability to generate and receive cash flows.
To understand how an entity generates, uses or obtains cash and to determine its future cash flows, the statement of cash flow is a must.
IAS 7 deals with the statement of cash flows which presents inflows and outflows of cash.
The main objective of IAS 7 is to expect the presentation of historical changes in cash equivalents of any entity.
Cash flows are classified into operating, investing as well as financing activities. Here is some information that will help you in understanding this better.
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Cash and Cash Equivalents
Cash equivalents are held for meeting short term commitments. They are highly liquid, readily convertible to the recognized amounts of cash and are subject to an insignificant risk of changes in value. To meet the short term agreements, IAS 7 specifies that an investment has a maturity of three months maximum from the date of obtainment.
This time period is generally considered as a criterion and there is no hard and fast rule for this in the IAS 7. Initially, the classification is unchanged when any investment approaches its maturity date.
Also, if a deposit has a maturity that exceeds 3 months but there is no interest loss for its early withdrawal then it is probable to treat such cases as a cash equivalent.
However, it should be held for fulfilling short term cash commitments and not investments or other purposes. It is clear that cash equivalents cannot include equity investments. Plus, they are presented in the statement of the final position within cash and cash equivalents. The numbers of cash and cash equivalents in the statement of the final position may not always be the same for which the statements of cash flow has come up with reconciliation.
The Institutional money market funds association specifies that triple-A-rated money market funds can be recognised as cash equivalents. Debt instruments like government bonds or corporate bonds can meet the standards of cash equivalent by using market funds in their cash management procedure. Money market funds must uphold amounts of overnight and one week’s security which should not be less than the prescribed minimum.
It should neither exceed the maximum laden average maturity nor the maximum laden average life to mitigate liquidity risk. Moreover, IRFIC clearly states that the amount of cash that is obtained should be identified at the time of initial investment.
If a unit is converted into cash at a given time then it will not be considered as a cash equivalent. To ensure that there is an insignificant risk of changes in value, an entity can select a fund that invests in debt instruments with the highest level of rating and also has a maturity of only 3 months.
These statements were laid down because auditors evaluate every situation based on individual merits and there is no one statement which can clarify if a market fund is going to be considered as cash equivalent or not.
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Central Pooling Arrangements
Intergroup cash pooling of cash and cash equivalents which leave subsidiaries with cash deposited with other companies can be classified as cash equivalents. Factors like terms and conditions of the intergroup pooling arrangements, the credit rating of the group, liquidity as well as the access to external financial resources should be taken into consideration.
When it comes to gold and cryptocurrencies, they cannot be assessed as a cash equivalent since they can’t be converted to known amounts of cash.
In order to determine the cash and cash equivalent along with the elements that comprise the overall balance, it is a must for the entities to disclose the policy. When the cash and cash equivalent balance has some restrictions on its use, it is known as restricted cash. Generally, the restrictions are disclosed on cash and cash equivalents but it is not quite specific in the IAS 7.
A cash flow that impacts from a transaction or any other event that may have a direct effect on P/L comes under operating activities. These are the core profit-producing activities of a particular entity. From normal trading activities to provisions of services by an entity, everything comes under operating activities.
In simple words, all those activities that do not fall under-investing or financing activity classification are presented in operating activities. Such activities gain revenue and add to the profits of entities.
Be it cash receipts and payments from contractors held for trading purposes, related to loans and depositions or rendering of services, operating activities comprises all of them. Also, cash inflows and profits are not the same things. This is so because the entity may give long credit terms and the money will receive months or even years later.
Cash flow statement presentation from operating activities can be reported using direct or indirect methods.
All the activities that are undertaken by an entity for the investment of long term assets fall under investing activities. However, the investments are not a part of a cash equivalent.
According to IAS 7, cash flows that are investing should conclude in a recognised asset in the statement of financial position. Some elements may relate to investing activities but if they are not recognized assets then they cannot be included in this category.
For instance, development expenditures can be operating if they are expensed but will fall under investing activities if they are capitalized.
Cash payments to acquire long term assets like property and plants, payments related to internally generated property or loans made to other parties in a non-financial institution and cash receipts from sales of property are some examples of investing activities.
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Activities that relate to the changes in size, as well as the composition of the contributed equity and borrowing of the entity, are financing activities. Such activities enable you to see the financial structure of any entity, how much equity they have and also how much debt they are in.
This enables you to easily estimate the future necessities to either service this debt or deliver returns to the shareholders. Examples of financing activities include Cash outflows to pay dividends, cash inflows from the sale of equity and cash outflows from buying back equity.
Interest and Dividends
Cash flows from interests and dividends received and paid must be presented separately from time to time. Plus, interests and dividends paid can be categorized as operating or financing cash flow. It can be done either way but it has to be done consistently. To be more precise, interests paid are generally considered as a cash flow from operating activities.
On the other hand, dividends are usually financing activities as they are a source of gaining financial resources. Also, if you relate loans as to what interests they are for, it would be more suitable to categorize them in financing activities.
When it comes to dividends, only include those who have made a full payment during the year in the IAS 7 statement of cash flows. For instance, if any dividend has been submitted but not yet paid then do not include it in the statement of cash flow.
Direct and Indirect Method
For reporting cash flows, a company can choose either the direct method or the indirect method. In the direct method, information about major classes of gross receipts and gross cash payments are disclosed. This can be done from accounting records or by adjusting sales and other items in the statement. It provides you with more information that is understandable and is not disclosed under the indirect method.
Alongside, under the indirect method, the net cash flow from operating activities is speculated by modifying profit. Also, it can be presumed by changes during the period in inventories, undistributed profits of associates and also non-cash items such as depreciation and provisions.
Foreign Currency and Taxes
Foreign currency cash flows must be translated using the exchange rate at the date of cash flow. Whenever a foreign currency is involved, it has to be converted to the functional currency. The effect of exchange rate changes on cash as well as cash equivalents is indicated in the cash flow statement to reconcile opening and closing balances of cash and cash equivalents.
Also, unrealised year-end foreign exchange gains or losses cannot be included in the cash flows. These amounts have to be separately reconciled if they pertain to cash or cash equivalent. If you can individually identify taxes with investing or financing activities then those have to be reported too.
These were the highlights on the IAS 7 statement of cash flows. It defines how to present information in a statement of cash flow regarding cash and cash equivalent to an entity.
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