Cash Flow Statements: common myths and mistakes
Cash Flow Statements: common myths and mistakes
- Only cash outflows that result in a recognised asset in the statement of financial position can be classified as cash flows from investing activities
- Cash flows that result in changes in the size and composition of the company’s equity or borrowings are classified as cash flows from financing activities
- Cash flows that are not from investing or financing activities are classified as cash flows from operating activities.
Classifying cash flows – common myths
‘Movement in inter-company balances are always cash flows from operating activities’
If a parent or a subsidiary presents its separate or individual statement of cash flows and has group balances, it is crucial to assess the nature of these balances to determine the appropriate classification of cash flows. Where cash flows relate to funding to / from subsidiaries (as opposed to trading or management cost recharges), the likely classification would be cash flows from investing / financing activities (respectively) rather than from operating activities. As such, movement in inter-company balances doesn’t always mean the cash flows are from operating activities.
‘Cash flows related to the acquisition and disposal of PPE are always cash flows from investing activities’
Although cash flows related to asset acquisitions are generally classified as cash flows from investing activities, cash payments for manufacturing or acquiring PPE held for rental to others that are subsequently held for sale (as inventory) in the ordinary course of business are classified as cash flows from operating activities. Additionally, rental income and subsequent sale of these assets are also classified as cash flows from operating activities.
‘All deferred considerations in a business combination are classified as investing activities’
Some business combinations may involve payment of a fixed amount of the purchase consideration at a future date. However, the cash paid may be more than the initial liability as the discount for the time value of money is unwound. This excess amount may be financing or operating cash flows as it is a form of imputed interest (see below). The payment of the initially recognised amount might also be a financing cash flow where the deferred consideration is, in substance, a loan granted by the vendor.
‘All interest payments are classified as cash flows from financing activities’
Entities may choose an accounting policy to classify interest payments on loans as cash flows from financing or operating activities. Further, where borrowing costs on qualifying assets are capitalised, an entity may choose to classify such payments as cash flows from investing activities (or cash flows from operating/ financing activities depending on its accounting policy choice).
‘All lease payments are classified as cash flows from financing activities’
a) Variable lease payments: Sometimes, a lease arrangement may require the lessee to pay lease payments as a percentage of its sales for using the leased asset. Such payments are not included in the lease liability / ‘Right of use’ (ROU) asset and thus are not classified as cash flows from financing activities / investing activities. As such, these variable lease payments are classified as cash flows from operating activities.
b) Short-term leases and low-value leases exemption: Where the lessee takes these exemptions, then it recognises the lease payments as an expense on straight-line basis over the lease term or another systematic basis of that is more representative of the pattern of lessee’s benefit. Accordingly, such payments are included in cash flows from operating activities since they are excluded from the measurement of the lease liability and ROU asset.
c) Prepaid lease: Where the lease payments have been paid in full on inception or commencement of the lease, they generally relate to the acquisition of long-term assets and are therefore classified as cash flows from investing activities.
Common mistakes when classifying cash flows
Understanding the common pitfalls around the classification of cash flows into operating, investing and financing activities will make sure you aren’t making the same mistakes.Costs incurred in acquiring investment in subsidiary
Under IFRS, acquisition-related costs are recognised in the consolidated profit or loss when incurred, and are hence classified as cash flows from operating activities in the consolidated financial statements. However, in the separate financial statements of a parent company, these costs are capitalised as part of the cost of investment in the subsidiary, so are classified as cash flows from investing activities.
A common mistake is to classify acquisition-related costs in separate financial statements as part of cash flows from operating activities instead of cash flows from investing activities.
Payment of contingent consideration in a business combination
Under IFRS, contingent consideration in a business combination is initially recognised at fair value. An increase (or decrease) in its carrying amount payable in cash or cash equivalents is recognised in profit or loss. As such, when cash is paid to settle the contingent consideration, an amount up to the initial recognition amount is presented as part of cash flows from investing activities, while any amount in excess of the initial recognition amount is presented as part of cash flows from operating activities.
A common error in IFRS is classifying excess cash flows above the initial recognition amount as part of cash flows from investing activities instead of cash flows from operating activities.
Factoring arrangements
When a receivable is factored with recourse, cash received from the factor is in sub stance a collateralised loan and accordingly recognised as a financial liability, rather than offset against the debtors. As such, cash collected from the factor should be presented as part of cash flows from financing activities.
A common error is to wrongly consider the cash received from factor as if it is collected from the debtors, and present it as part of cash flows from operating activities.
Change in ownership interest in a subsidiary when control is retained
Cash flows arising from changes in ownership interests in a subsidiary that do not result in a loss of control should be classified as cash flows from financing activities (unless held by an investment entity and measured at fair value through profit or loss).
A common mistake is to incorrectly classify cash inflows or outflows arising from changes in ownership interests as cash flows from investing activities in consolidated financial statements.
Bank overdrafts
Bank overdrafts that are repayable on demand and forming an integral part of entity’s cash management are included as a component of cash and cash equivalents for the purpose of statement of cash flows. However, these continue to be presented as a liability in the statement of financial position.
A common error is to incorrectly exclude bank overdrafts from cash equivalents for the statement of cash flows. Another common mistake is that some entities correctly classify bank overdrafts as cash equivalents for cash flow statement purpose, but incorrectly present them in the statement of financial position as part of cash and cash equivalents.
If you would like to discuss your business or cash flow statements, please contact Charles Ellis.