## **Learning Outcomes**

After reading this article, you will be able to explain the purpose of the statement of cash flows prepared under IAS 7, perform the indirect method reconciliation from profit before tax to cash generated from operations, identify key adjustments required (including non-cash and working capital movements), and apply this process accurately for single-entity published accounts or exam questions.

## **ACCA Financial Reporting (FR) Syllabus**

For ACCA Financial Reporting (FR), you are required to understand and apply the indirect method for preparing the operating section of the statement of cash flows. Focus your revision on:

- The role and structure of the statement of cash flows (IAS 7)
- Steps in reconciling profit before tax to cash generated from operations (indirect method)
- Identifying and adjusting for non-cash items
- Adjusting for changes in working capital
- Treatment of interest and tax paid in the cash flow
- Understanding common errors and exam pitfalls

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Which section of the statement of cash flows is reconciled from profit before tax using the indirect method under IAS 7?
   a) Investing activities  
   b) Financing activities  
   c) Operating activities  
   d) Cash and cash equivalents

2. True or false? Depreciation expense is added back to profit before tax when calculating cash generated from operations using the indirect method.

3. When trade receivables increase during the year, what is the effect on cash generated from operations?
   a) Increase cash
   b) Decrease cash
   c) No effect
   d) Depends on other factors

4. Briefly outline two examples of non-cash items typically adjusted for in the indirect reconciliation.

## **Introduction**

The statement of cash flows (SoCF) is a key component of published financial statements, required by IAS 7, presenting the cash inflows and outflows during a period, classified into operating, investing, and financing activities. Unlike the statement of profit or loss, which is prepared on an accruals basis, the SoCF focuses solely on actual cash movements. Most entities use the indirect method to reconcile profit before tax (PBT) to cash generated from operations. Understanding this process is critical for ACCA FR exam success.

> **Key Term: Statement of cash flows**
> A financial statement that summarizes the cash flows of an entity over a period, categorising them into operating, investing, and financing activities in accordance with IAS 7.

## **OPERATING ACTIVITIES AND THE INDIRECT METHOD**

Operating activities typically comprise the principal revenue-producing activities of the entity. IAS 7 allows two methods to determine cash flow from operating activities: the direct and the indirect method. The indirect method starts with profit before tax and adjusts for non-cash items, non-operating items, and changes in working capital.

> **Key Term: Indirect method**
> A technique for calculating cash flow from operating activities by starting with profit before tax and adjusting for non-cash transactions and movements in working capital.

### Step 1: Starting Point – Profit Before Tax

Begin the reconciliation with profit before tax as per the statement of profit or loss for the period.

### Step 2: Adjust for Non-Cash Items

Non-cash expenses and income are included in profit but do not represent cash movements. Common non-cash adjustments include:

- Depreciation and amortisation (add back)
- Impairment expenses (add back)
- Profit or loss on disposal of non-current assets (deduct profit, add loss)
- Provisions (increase/decrease charged to profit)

> **Key Term: Non-cash item**
> An amount included in profit or loss that does not entail a cash inflow or outflow in the current period.
>
> **Key Term: Working capital**
> The excess of an entity's current assets over current liabilities, primarily comprising inventory, trade receivables, and trade payables.

### Step 3: Adjust for Non-Operating Items

Remove any income or expenses included in profit before tax that relate to investing or financing activities, such as:

- Investment income (e.g., interest received, dividends received)
- Finance costs (interest expense)

These items are shown separately in other sections of the cash flow statement.

### Step 4: Adjust for Changes in Working Capital

Movements in key current asset and liability balances during the period affect operational cash flows:

- Increase in inventory: Deduct from cash (more cash used to purchase inventory)
- Increase in trade receivables: Deduct from cash (less cash collected from customers)
- Increase in trade payables: Add to cash (more goods/services acquired on credit, not yet paid)

These adjustments ensure only cash received or paid in respect of operating activities remains.

### Step 5: Arrive at Cash Generated from Operations

After making all the above adjustments, the result is “cash generated from operations.” This figure is used as the starting point for reporting cash flows from operating activities, before further deducting cash paid for interest and income taxes.

> **Key Term: Cash generated from operations**
> The cash inflow resulting from the entity's core trading activities, prior to interest and tax payments, calculated via the indirect method reconciliation.

### **Worked Example 1.1**

**Prepare the reconciliation from profit before tax to cash generated from operations:**

At year-end, Bubblegum Ltd reported the following:

- Profit before tax: \$120,000
- Depreciation expense: \$25,000
- Amortisation: \$5,000
- Loss on disposal of equipment: \$4,000
- Increase in inventory: \$18,000
- Decrease in trade receivables: \$6,000
- Increase in trade payables: \$9,000
- Investment income (interest received): \$3,000

Required: Using the indirect method, reconcile profit before tax to cash generated from operations.

> **Answer:**
> Start with profit before tax: \$120,000  
> Add: Depreciation (\$25,000)  
> Add: Amortisation (\$5,000)  
> Add: Loss on disposal (\$4,000)  
> Less: Investment income (as this is investing, not operating) (\$3,000)  
> Deduct: Increase in inventory (\$18,000)  
> Add: Decrease in receivables (\$6,000)  
> Add: Increase in payables (\$9,000)
> Calculation:  
> \$120,000  
> \+ \$25,000  
> \+ \$5,000  
> \+ \$4,000  
> – \$3,000  
> – \$18,000  
> \+ \$6,000  
> \+ \$9,000  
> = \$148,000  
> Therefore, cash generated from operations is \$148,000.

### **Exam Warning**

> A common exam error is to reverse the adjustment for working capital movements. For example, an increase in receivables should decrease cash (deducted), not added—receivables represent sales not yet collected in cash.

### **Revision Tip**

> Practise constructing the indirect reconciliation with different scenarios. Pay special attention to the signs (add vs deduct) for each adjusting item.

## **Summary**

The indirect method transforms accrual-based profit before tax into cash generated from operations by adjusting for all non-cash items, removing investing and financing items, and accounting for working capital movements. Correct identification and adjustment of these items are essential to ensure exam accuracy.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Define and explain the purpose of the statement of cash flows under IAS 7
- Outline the steps in the indirect method for reconciling profit before tax to cash generated from operations
- Identify and adjust for depreciation, amortisation, provisions, and other non-cash items
- Remove non-operating items such as investment income and finance costs
- Adjust for changes in working capital and their effect on cash flows
- Recognise and correct common errors in reconciling operating cash flows in exams

## **Key Terms and Concepts**

- Statement of cash flows
- Indirect method
- Non-cash item
- Working capital
- Cash generated from operations

Statement of cash flows (IAS 7) - Indirect method reconciliation