The cash flow statement (CFS) provides information about a company’s cash receipts and payments from operating activities, investing activities and financing activities. Accounting standards allow two presentation formats: (a) direct method, which shows specific operating cash inflows and outflows and (b) indirect method, which starts with net income and adjusts it for non-cash items, non-operating items, and changes in working capital to arrive at net cash flows from operating activities.
Operating, investing and financing activities
Operating activities include a company’s day-to-day activities aimed at selling goods and providing services. These depend on the nature of business of a company. An activity considered as investing or financing in nature for one entity may be operating in nature for others.
Investing activities include purchasing and selling long-term assets and other investments, such as PPE, intangible assets, debt and equity investments.
Financing activities include obtaining and repaying capital, such as stocks or bonds.
Reporting non-cash financing and investing activities
Non-cash transactions such as a purchase of PPE by issuing common stock do not appear as a cash flow but, if material, is required to be disclosed in the notes or as a supplementary schedule to CFS.
IFRS and US GAAP differences in preparation of statement of cash flows
IFRS allows some discretion in classifying interest and dividends. While for a financial institution, interest received and paid is definitely an operating activity, for other entities, interest received might be classified in investing activities and interest paid may be classified in financing activities. Similarly, dividends received may be classified either as operating or investing and dividends paid may be classified either as operating or financing. IFRS requires income taxes to be classified as an operating activity unless it can be identified with an investing or financing activity. IFRS clubs bank overdraft as part of cash and cash equivalents.
US GAAP does not allow such discretion. Under US GAAP, interest received, interest paid, and dividends received are classified in operating activities and dividends paid are classified in financing activities. Further, US GAAP classifies all income tax expenses as an operating activity. US GAAP shows bank overdrafts as financing activities.
Preparation methods: direct method vs indirect method
The direct method provides information about specific sources and uses of cash, but the indirect method shows only the net result. This is why both IFRS and US GAAP recommend the direct method.
The indirect method tells us about the reasons why operating cash flows differ from net income, and it mirrors the forecasting approach used by analysts, i.e. it allows an analyst to start from forecasted net income for a company. However, the indirect method is more popular possibly because it is easier to prepare and hence requires fewer resources.
Preparing statement of cash flows under the indirect method
Under IFRS, the important adjustments needed to reconcile net income to net cash from operating activities in the indirect method includes:
- Add back income tax expense and subtract income taxes paid.
- Exclude share of the company’s income because associated receipt of dividends would be included as a cash inflow under investing activities.
- Exclude net finance costs and report associate interest received (either as operating or investing) and interest paid (as either operating or financing).
- Add back depreciation, amortization and impairment expense.
- Adjust for changes in working capital.
Cash flows from investing activities and cash flows from financing activities are the same for a company regardless of whether the direct method or indirect method is used.
US GAAP also requires similar adjustments. However, if a company used the direct method, it is also required to show reconciliation between net income and cash flow from operations. Also, if a company used the indirect method, it is required to separately show interest paid and taxes paid.