Paragraph 10 of IAS 7 "Statement of Cash Flows" provides that the statement of cash flows shall report cash flows during the period classified into three activities: operating, investing and financing. The Standard permits cash flows from operating activities to be reported using either the direct method or the indirect method.
The Three Activities Used to Classify Cash Flows
The Standard defines each of the three activities as follows:
- Operating activities are the principal revenue-producing activities of the entity and other activities that are not investing or financing activities.
- Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents.
- Financing activities are activities that result in changes in the size and composition of the contributed equity and borrowings of the entity.
The Standard explains that this classification allows users of financial statements to assess the impact of these activities on the entity's financial position and on the amount of its cash and cash equivalents.
The Direct Method Versus the Indirect Method
For reporting cash flows from operating activities, the Standard provides that an entity shall report them using either of the following methods:
- The direct method: major classes of gross cash receipts and gross cash payments are disclosed.
- The indirect method: profit or loss is adjusted for the effects of transactions of a non-cash nature, any deferrals or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing cash flows.
The Standard encourages entities to report cash flows from operating activities using the direct method, because it provides information which, per the Standard's own text, may be useful in estimating future cash flows and is not available under the indirect method.
How Is the Reconciliation Built Under the Indirect Method?
The Standard provides that, under the indirect method, the net cash flow from operating activities is determined by adjusting profit or loss for the effects of changes during the period in inventories and operating receivables and payables, and other similar items. That is, the starting point is profit or loss itself, not gross receipts and payments as under the direct method.
Illustrative Example (with Assumed Figures)
To illustrate the reconciliation mechanics, suppose a hypothetical entity's profit before tax was 100,000 monetary units for the period, depreciation expense (a non-cash item) was 20,000 units, and trade receivables increased by 15,000 units during the period (a use of cash). The estimated net cash flow from operating activities under the indirect method would then be 100,000 + 20,000 − 15,000 = 105,000 monetary units. This example is purely illustrative, using assumed figures, and is not based on any figure in the Standard's text.
Why Does This Distinction Matter to Users of Financial Statements?
The three-way classification of cash flows, and the choice between the two reporting methods, helps users of financial statements assess the extent to which an entity can generate sufficient cash to meet its obligations and fund its investments without resorting to external financing. The choice between the direct and the indirect method does not change the final net operating cash flow figure; it only changes how its details are presented: the direct method shows gross cash receipts and payments item by item, while the indirect method starts from the accounting profit figure and adjusts it to arrive at the same result.
Legal References
- IAS 7 — Statement of Cash Flows (2024 edition; applies until IFRS 18 becomes effective on 1 January 2027; paragraph 37 was amended by Annual Improvements Volume 11 from 1 January 2026) — Paragraphs 6, 10, 18, 19 and 20.
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