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FRC areas of focus: IAS 7 & cash flow classification
Publication date: 23 Nov 2022
uk In brief 2022-66
What is the issue?
The FRC recently published their Annual Review of Corporate Reporting for 2021/2022, and the topic cash flow statements is top of the list of topics that arose most frequently in their correspondence with companies. The FRC stated that they were “disappointed” with the number and type of errors they found in the cash flow statements of companies they reviewed.
This is an area that the FRC has given guidance on previously in the form of a Cash Flow and Liquidity Disclosure thematic review in 2020.
The types of errors the FRC highlighted this year were very similar to the issues they raised in 2020; specifically issues around classification, incorrect inclusion of non-cash items in the cash flow statement, and inappropriate netting of cash flows.
This document highlights a few of the common errors noted by the FRC and gives guidance in these areas. This is not intended to be a complete guide to the cash flow statement, but rather should serve as a reminder on areas of frequent error.
Non-cash items
The cash flow statement identifies the cash effects of transactions with parties that are external to the reporting entity and their impact on the cash position. Only those transactions that involve a cash flow should be reported in the cash flow statement, transactions that do not have an impact on cash flows should not be included in the cash flow statement.
The FRC has noted examples of companies including additions to right-of-use assets in the investing cash flows, but as these are non-cash in nature they should not be included in the cash flow statement.
On the other hand, IAS 7 does require disclosure of material non-cash transactions in the notes to the accounts, and the FRC has found cases where this disclosure was missing or could be improved.
Classification in the cash flow statements
Cash flows are classified under the three standard headings of operating, investing and financing activities. The definitions of these headings as per IAS 7 are given below:
- Operating Activities - “the principal revenue-producing activities of the entity and other activities that are not investing or financing activities.”
- Investing Activities - “ the acquisition and disposal of long-term assets and other investments not included in cash equivalents.”
- Financing Activities - “activities that result in changes in the size and composition of the contributed equity and borrowings of the entity.”
- Cash flows should be presented in the manner which is most appropriate to the business, however there are examples of items which would be expected to be classified under specific headings.
Common classification errors
Transaction type
| Expected cash flow classification
| Comments
| ||
|---|---|---|---|---|
Operating
| Investing
| Financing
| ||
Interest paid
| x
| x
| IAS 7 does not dictate how interest cash flows should be classified, but rather allows an entity to determine the classification appropriate to its business. It is generally accepted that interest paid or received in respect of a financial institution’s cash flows will be classified as operating activities, but the classification is not so clear cut for other entity types. The standard allows interest received to be classified as operating or investing, and interest paid to be classified as operating or financing, provided that the presentation selected is applied on a consistent basis from period to period and across all transaction types. Accordingly, interest paid on leases under IFRS 16 needs to be treated consistently with all other interest paid.
| |
Interest received
| x
| x
| ||
Loans to and from other parties including JVs, associates, and related parties
| x
| Advances and loans made to other parties, including related parties and other group companies (other than those made by a financial institution), and receipts from the repayment of those advances and loans should be classified as investing cash flows.
Conversely, advances and loans received from other parties including related parties and other group companies and repayments of those advances and loans should be classified as financing cash flows.
| ||
Sale and leaseback - qualifies as a sale under IFRS 15
| x
| x
| We believe there are two acceptable approaches where the transaction qualifies as a sale under IFRS 15.
The first approach is to split the proceeds between those attributable to the proportion of the rights transferred to the buyer-lessor (interest in the value of the underlying asset sold in the sale and leaseback), which would be classified as investing cash flows, and the remaining balance related to the proportion of the right of use being retained, which would be classified as a financing cash flow.
The second approach is to present the cash received from the purchaser-lessor, up to the fair value of the underlying asset, as investing activities in the cash flow statement, because it relates to proceeds for the sale of fixed assets. If the cash received in the sale is greater than the fair value of the asset, the excess is classified as a financing activity.
| |
Sale and leaseback - does not qualify as a sale under IFRS 15
| x
| If the transfer of an asset by the seller-lessee does not satisfy the requirements of IFRS 15 to be accounted for as a sale of the asset, the cash proceeds are classified as financing activity in the cash flow statement. This is because the substance of this transaction is that the lessor is providing finance to the lessee, with the asset as security.
| ||
Business Combinations: Transaction costs
| x
| Acquisition related transaction costs should be classified as operating cash flows, they should not be classified as investing cash flows as they do not directly generate or dispose of a long term asset on the balance sheet.
| ||
Business Combinations: Deferred Consideration
| x
| (x)
| The subsequent payment of any deferred consideration recognised at the acquisition date will be classified as either an investing activity, consistent with the requirement for aggregate cash flows arising from a business combination to be presented separately and classified as investing activities, or as a financing activity where the arrangement is, in substance, a financing activity.
The arrangement would in substance be a financing activity where it represents the entity borrowing from the vendor to finance the acquisition. An entity may need to apply judgement in making this determination, and may consider the purpose and structure of the consideration, including the period of time before amounts are due and any implicit or explicit financing terms.
| |
Business Combinations: Contingent Consideration
| x
| x
| (x)
| The subsequent payment of any contingent consideration recognised as a liability at the acquisition date (and any adjustments that are IFRS 3 measurement period adjustments) should in most circumstances be measured as an investing activity, consistent with the requirement for aggregate cash flows arising from a business combination to be presented separately and classified as investing activities, or as a financing activity where the arrangement is, in substance, a financing activity. See comment on deferred consideration above regarding when the payment might be in substance a financing activity.
Payments for additional contingent consideration that arises outside of the measurement period and which exceeds the amount initially recognised as a liability would normally be classified as operating cash flows (or financing cash flows, if this reflects the substance).
If subsequent remeasurement of the liability reduces the total cash payable below the acquired assets recognised, this effectively caps the amount shown as investing cash flows. The reduced cash payment is shown as the investing cash outflow.
|
Gross or net cash flows
IAS 7 requires that ‘major classes’ of gross receipts and payments be presented separately on the face of the cash flow statement. Gross cash flows give users more detailed information on the effects of the entity’s activities on the cash flows, and so they provide more relevant information than net cash flows.
There are certain situations where the standard specifically permits the reporting of net cash flows. Cash receipts and payments on behalf of customers, where these reflect the customer’s activities, can be reported net. Cash receipts and payments can also be reported net for items arising in operating, investing or financing activities where the turnover is quick, the amounts are large and the maturities are short.
The following cash flows can also be reported net for financial institutions:
- cash receipts and payments for the acceptance and repayment of deposits with a fixed maturity date;
- the placement of deposits with, and withdrawal of deposits from, other financial institutions; and
- cash advances and loans made to customers, and the repayment of those advances and loans.
The FRC’s 2021/2022 Review of Corporate Reporting highlighted that in some instances companies are inappropriately netting cash flows within the cash flow statement, for example where parent companies were inappropriately offsetting intra-group borrowings with lending cash flows. Similarly offsetting external borrowing and lending cash flows (unless they meet the criteria listed above) would be inappropriate.
Where do I get more details?
PwC’s Manual of Accounting contains frequently asked questions on the cash flow treatment of a variety of common transactions.
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