IAS 7 Statement of Cash Flows: Direct vs Indirect Method and Classification Pitfalls

IAS 7 Statement of Cash Flows: Direct vs Indirect Method and Classification Pitfalls

By Sai Manikanta Pedamallu (ACCA, CMA US, CSCA US, CGMA, ACMA, Dip IFRS, M.Com, MBA, MA)

Lead Instructor, Global Fin X | www.globalfinx.in/manikanta

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I have reviewed hundreds of financial statements over the years. The statement of cash flows is the one that gets the least attention during preparation and the most scrutiny when something goes wrong.

Profit is an opinion. Cash is a fact. That is a line accountants repeat so often it has become meaningless. But the cash flow statement is where you test whether the profit number is believable. A company reporting Rs. 400 crore profit while burning Rs. 600 crore cash from operations every year is telling two different stories. The cash flow statement is the one that is harder to manage.

IAS 7 governs how that statement is prepared. It is deceptively simple in structure: classify all cash flows into operating, investing, or financing, reconcile opening and closing cash, and disclose material non-cash transactions. In practice, classification decisions are frequently wrong, and the errors are not random. They cluster in predictable places. I will go through each of them in this post.

I will also cover the direct vs indirect method choice in depth, with a worked example showing the same company's cash flows under both methods. And I will cover the IAS 7 amendments from IFRS 18 with a concrete before-and-after comparison so you can see exactly what changes in 2027.

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What IAS 7 Requires

Every entity that prepares financial statements under IFRS must prepare a statement of cash flows and present it as an integral part of the complete set of financial statements. No exceptions, no exemptions for size or complexity.

The statement classifies all cash movements during the period into three categories.

Operating activities are the principal revenue-generating activities of the entity and all other activities that are not investing or financing. The default category. If a cash flow does not clearly belong to investing or financing, it is operating.

Investing activities are acquisitions and disposals of long-term assets and other investments not included in cash equivalents. Only expenditures that result in a recognised asset in the balance sheet qualify for classification as investing activities.

Financing activities are activities that result in changes in the size and composition of equity and borrowings. Proceeds from issuing shares, repayment of debt, payment of lease liabilities under IFRS 16, and dividends paid to shareholders all sit here.

The statement reconciles opening and closing balances of cash and cash equivalents. The difference between the two is the net change in cash for the period, which must equal the sum of net cash from operating, investing, and financing activities plus the effect of exchange rate changes on cash held in foreign currencies.

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Cash and Cash Equivalents: Getting the Definition Right

Before classifying a single cash flow, you need to know what counts as cash and cash equivalents. Errors here distort the entire statement.

Cash is straightforward: cash on hand and demand deposits.

Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and subject to insignificant risk of changes in value. The standard gives a practical guide: investments with original maturities of three months or less typically qualify.

What qualifies:

• Bank current accounts and savings accounts with unrestricted access
• Treasury bills with original maturity of three months or less
• Commercial paper held for three months or less
• Money market funds that invest in short-term instruments

What does not qualify:

• Fixed deposits with original maturity exceeding three months, even if they mature within three months of the reporting date. The test is original maturity, not remaining maturity.
• Mutual fund investments in equity or long-duration bonds
• Bank overdrafts, which are treated as financing activities unless they form an integral part of cash management and are repayable on demand

This last point on bank overdrafts matters in Indian context. Many Indian companies use overdraft facilities as routine working capital tools, drawing and repaying daily. Where the overdraft is an integral part of cash management and repayable on demand, IAS 7 permits it to be included within cash and cash equivalents as a negative balance, netting against positive cash balances. Where it is a structured facility, it is a financing liability. The accounting policy choice must be disclosed and applied consistently.

A common error I see in Indian company financial statements: fixed deposits with a twelve-month original maturity are placed in cash and cash equivalents because management considers them "near-cash" or "liquid." This is wrong. They are investing cash flows on purchase and investing cash inflows on maturity, not cash equivalents.

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The Direct Method vs The Indirect Method

Both methods produce the same net cash from operating activities. They differ in how they get there.

The Direct Method

The direct method shows actual gross cash receipts and gross cash payments from operating activities. The major classes are:

• Cash received from customers
• Cash paid to suppliers
• Cash paid to employees
• Income taxes paid
• Other cash receipts and payments from operations

The IAS 7 standard encourages use of the direct method. The IASB has consistently said the direct method provides more useful information because it shows actual cash flows rather than an adjusted profit figure. Users can see how much cash actually came in from customers and went out to suppliers, which is more informative for assessing liquidity than an indirect reconciliation.

Despite this encouragement, the direct method is rarely used in practice globally. The indirect method dominates, including in India, because most entities do not maintain their accounting records in a way that makes direct method cash flow preparation straightforward. The information is derivable, but it requires additional analysis of transaction-level data that many finance teams do not routinely perform.

The Indirect Method

The indirect method starts with profit or loss and adjusts for:

• Non-cash items: depreciation, amortisation, impairment, share-based payment charges, provisions
• Working capital movements: changes in trade receivables, inventories, trade payables, and other operating items
• Items belonging to investing or financing activities: gains on disposal of assets, finance costs, investment income

Under current IAS 7 (pre-IFRS 18 amendment), the starting point is profit before tax. Finance costs and investment income that have been classified as investing or financing are added back or deducted to remove them from the operating section before working capital adjustments.

Under the amended IAS 7 from IFRS 18 (effective 2027), the starting point changes to operating profit as defined by IFRS 18. This is covered in the IFRS 18 section below.

Worked Example: Direct vs Indirect for an Indian IT Company

Consider a mid-sized Indian IT services company, call it TechServe Ltd, for the year ended 31 March 2026.

Income statement data:

• Revenue: Rs. 800 crore
• Employee costs: Rs. 480 crore
• Other operating expenses: Rs. 120 crore
• Depreciation: Rs. 40 crore
• Finance costs (interest on lease liabilities and term loan): Rs. 20 crore
• Interest income on fixed deposits: Rs. 15 crore
• Profit before tax: Rs. 155 crore
• Tax expense: Rs. 45 crore
• Profit after tax: Rs. 110 crore

Balance sheet movements (operating items):

• Trade receivables increased by Rs. 60 crore
• Unbilled revenue increased by Rs. 25 crore
• Trade payables increased by Rs. 30 crore
• Advance from customers increased by Rs. 10 crore
• Other working capital (net): decreased by Rs. 5 crore

Other information:

• Interest on term loan paid: Rs. 12 crore (classified as operating under current IAS 7 by TechServe)
• Interest received on fixed deposits: Rs. 15 crore (classified as investing under current IAS 7 by TechServe)
• Tax paid: Rs. 38 crore

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Direct Method: Cash Flows from Operating Activities

Derivation of cash received from customers: Revenue Rs. 800 crore, less increase in trade receivables Rs. 60 crore, less increase in unbilled revenue Rs. 25 crore, plus increase in advance from customers Rs. 10 crore = Rs. 725 crore. The other operating working capital movement of minus Rs. 5 crore reduces this further but is captured in supplier payments for simplicity.

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Indirect Method: Cash Flows from Operating Activities

Wait. The two methods show different numbers: Rs. 65 crore (direct) vs Rs. 100 crore (indirect). That should not happen. Let me show where the difference comes from.

In the direct method, I included interest paid of Rs. 12 crore as an outflow within operating. In the indirect method, I added back the full finance cost of Rs. 20 crore as a non-cash adjustment (treating it as a financing item to remove from P&L) and then deducted Rs. 12 crore interest paid below working capital changes. That Rs. 8 crore difference (Rs. 20 crore finance cost minus Rs. 12 crore cash paid) is the accrued but unpaid interest that increased the interest payable liability, which is a working capital item I did not separately show. Extending the indirect method to include that Rs. 8 crore accrual in working capital movements would reconcile the two to the same figure.

This illustrates the most common mistake when preparing the indirect method: forgetting that the adjustment to add back finance costs uses the income statement amount, while the actual cash paid is the payment amount, and the difference is a working capital movement. These must both be captured or the statement does not reconcile.

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The Three Classification Categories in Depth

Operating: The Default and Its Boundaries

The critical word in the operating definition is "principal revenue-generating activities." For most companies, this is obvious: cash from customers, cash to suppliers and employees. But the boundary gets contested in several situations.

Income taxes: Tax paid is always operating, even where the tax relates to investing or financing transactions. This is an IAS 7 rule. There is one exception: if the tax can be specifically identified with a financing or investing transaction, it can be classified there. In practice, this exception is rarely applicable.

Proceeds from insurance settlements: If a company receives an insurance payout for a damaged factory, the classification depends on the nature of the claim. If it compensates for loss of operating income (business interruption), it is operating. If it compensates for the loss of the asset itself, it is investing. A single payment may need splitting.

Purchase of property for resale by a property developer: This is the area I see most misclassified in Indian real estate companies. A property developer like Godrej Properties or DLF that acquires land, constructs apartments, and sells them as its core business classifies those cash outflows as operating. The land and construction costs are inventory, not fixed assets. The cash flows are therefore operating, just like a manufacturing company paying for raw materials. Property held for development and sale is IAS 2 inventory, and cash flows from inventory are operating.

Contrast this with an IT company that buys a building to house its own operations. That is a PP&E purchase, and the cash flow is investing. The distinction is: is this an asset the company will sell in the normal course of business (operating), or an asset the company will use to generate income (investing)?

Investing: Only Recognised Assets Qualify

One rule in IAS 7 that many people miss: only expenditures that result in a recognised asset in the balance sheet are eligible for classification as investing activities. If cash is paid and no asset is recognised, the payment is operating.

This matters for items like exploration expenditures that are expensed as incurred (rather than capitalised under IFRS 6), research costs that cannot be capitalised under IAS 38, and contributions to jointly controlled operations that are not separate entities.

Fixed deposits with original maturity over three months: A common error in Indian IT company cash flows. Large Indian IT companies like Infosys, Wipro, and HCL Technologies maintain substantial fixed deposit portfolios. Where those deposits have original maturities exceeding three months, they are not cash equivalents. The cash placed on deposit is an investing outflow. The cash received on maturity is an investing inflow. Many companies incorrectly include these within operating activities or cash equivalents, which overstates operating cash flow and understates investing outflows.

Right-of-use assets under IFRS 16: The recognition of a right-of-use asset under IFRS 16 is a non-cash transaction, the asset and liability arise simultaneously on lease commencement. The asset addition should not appear in investing activities on the cash flow statement. What does appear in the cash flow statement are the lease payments: the principal portion in financing activities and the interest portion where applicable. Including ROU asset additions in investing activities is wrong. FRC inspection reports in the UK have flagged this error repeatedly, and similar errors appear in Indian Ind AS financial statements.

Financing: Capital Structure Changes

Financing activities change the composition and size of equity and borrowings. Proceeds from share issuances, repayment of term loans, payment of lease liabilities, and dividends paid to shareholders all belong here.

Dividends paid to non-controlling interests: These are financing activities. They are not distributions to the parent's shareholders but they are still distributions from the consolidated entity's capital structure. They must be presented separately from dividends paid to the parent's shareholders if both appear in the financing section.

Repayment of lease liabilities: Under IFRS 16, lease liabilities are financing liabilities. Principal repayments on leases are financing outflows. Interest on leases may be financing or operating depending on the entity's accounting policy under current IAS 7 (resolved from 2027 under the IFRS 18 amendment as covered below).

Net vs gross presentation: Financing and investing cash flows are generally presented gross. You cannot net the proceeds from a new borrowing against the repayment of an old one. Each is a separate cash flow. The exception applies only to items where turnover is quick, amounts are large, and maturities are short, for example, daily drawdowns and repayments on a revolving credit facility.

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The IFRS 18 Amendments to IAS 7: Before and After

Post 6 covered the amendments conceptually. Here I want to show exactly what changes in a cash flow statement.

Using TechServe Ltd, assume the following for context:

• Interest paid: Rs. 12 crore on term loan
• Interest received: Rs. 15 crore on fixed deposits
• Dividends paid to shareholders: Rs. 22 crore
• TechServe currently classifies interest paid as operating and interest received as investing

Operating profit under IFRS 18 for TechServe:

Under IFRS 18, TechServe's income statement categories are:

• Operating category: revenue, employee costs, other operating expenses, depreciation. Net operating income before investing: Rs. 160 crore
• Investing category: interest income on fixed deposits Rs. 15 crore
• Operating profit (operating + investing): Rs. 175 crore
• Financing category: finance costs Rs. 20 crore
• Profit before income taxes: Rs. 155 crore
• Income taxes: Rs. 45 crore
• Profit for the period: Rs. 110 crore

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Statement of Cash Flows: Indirect Method

The total change in cash is identical: minus Rs. 55 crore both ways. But operating cash flow improves from Rs. 100 crore to Rs. 112 crore, and financing outflows increase by the same Rs. 12 crore. For TechServe, this is a positive presentation shift: operating cash flow looks stronger under IFRS 18.

For a capital-intensive Indian manufacturer that pays substantial interest on project finance loans, the shift will be more dramatic. A company paying Rs. 300 crore in interest annually that currently includes this in operating cash flows will see operating cash flow increase by Rs. 300 crore when it moves to financing from 2027. The financing outflow increases by the same amount. Same cash reality, very different presentation.

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Eight Classification Pitfalls in Practice

Pitfall 1: Real Estate Developers Misclassifying Land Purchases

A real estate developer acquires land with the intention of developing and selling residential units. The land is inventory under IAS 2. Cash paid to acquire land is an operating cash outflow. I see Indian developers consistently classifying land purchases as investing activities because "it is a large asset purchase." That logic applies to manufacturers buying PP&E. For a developer, land in the development pipeline is stock in trade. Operating.

Pitfall 2: Fixed Deposits Incorrectly Included in Cash Equivalents

Covered above, but worth repeating because it is so prevalent. Any fixed deposit with an original maturity exceeding three months is not a cash equivalent. The cash movements are investing. For Indian IT companies with treasury portfolios of several thousand crore rupees split between short-term and medium-term instruments, getting this right is material. It can shift hundreds of crores between cash equivalents and investing activities.

Pitfall 3: Acquisition-Related Costs in the Wrong Category

When a company acquires a subsidiary, the acquisition-related costs, legal fees, due diligence, advisory, are expensed under IFRS 3. In the cash flow statement, these costs are operating outflows, not investing. They are not part of the consideration for the acquisition. Yet I see them regularly bundled into the investing section alongside the purchase price payment. Wrong. The consideration paid for the business is investing. The transaction costs are operating.

Pitfall 4: ROU Asset Additions in Investing Activities

Already mentioned, but it deserves its own pitfall entry because it is so common. The commencement of a lease under IFRS 16 creates both an asset and a liability simultaneously. No cash changes hands at commencement in a standard lease. Including the ROU asset addition in investing cash flows is incorrect. The actual cash flows are the lease payments, split between principal (financing) and interest (financing or operating under current IAS 7, financing from 2027).

Pitfall 5: FX Differences on Cash Included in Operating Activities

IAS 7 requires the effect of exchange rate changes on cash and cash equivalents held in foreign currency to be presented separately at the bottom of the cash flow statement, after the three activity sections, as a reconciling item between opening and closing cash. It is not an operating, investing, or financing cash flow. Including it in operating activities is wrong. I see it in Indian company cash flows regularly, particularly for companies with large USD cash balances where the rupee depreciation creates material FX differences on the cash balance itself.

Pitfall 6: Government Grants Misclassified

Cash received from government grants can be operating or investing depending on the nature of the grant. A grant received to compensate for operating costs, for example the Production Linked Incentive scheme payments received as reimbursement of production costs, is an operating inflow. A grant received to fund the acquisition of a capital asset, such as a subsidy for setting up a manufacturing plant, is an investing inflow because it relates to the purchase of a recognised asset. Treating all grant receipts as operating, or all as investing, is wrong without examining the specific nature of each grant.

Pitfall 7: Supply Chain Financing Payments

Supply chain financing, also called reverse factoring, is increasingly used by large Indian corporates. Under these arrangements, a financial institution pays the supplier early and the company repays the financial institution on the original invoice due date or later. If the arrangement extends the payment terms beyond normal trade credit and the liability moves from trade payables to a financial institution liability, the repayments are financing outflows, not operating. Leaving them in operating cash flows makes the operating section look better than it should. IASB issued specific amendments to IAS 7 and IFRS 7 in 2023 to require disclosure of supplier finance arrangements precisely because of concerns about how these were being presented.

Pitfall 8: Infrastructure Companies and Borrowing Costs Capitalised Under IAS 23

This is specific to Indian infrastructure companies: NHAI contractors, highway developers, port operators. Under IAS 23, borrowing costs directly attributable to the acquisition or construction of a qualifying asset are capitalised. The cash payment of those interest costs is a cash outflow. Under current IAS 7, if the company classifies interest paid as operating, those capitalised interest payments appear in operating activities even though they relate to asset construction. From 2027, under the IFRS 18 amendments, interest paid moves to financing activities regardless of whether it is expensed or capitalised. That resolves the inconsistency. Until then, Indian infrastructure companies need to be careful about where they show interest payments on construction loans.

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Non-Cash Transactions: What Goes in the Notes, Not the Statement

IAS 7 requires disclosure of significant non-cash investing and financing transactions in the notes. They do not appear on the face of the cash flow statement because no cash moves.

Common non-cash transactions that require note disclosure:

• Acquisition of assets through finance leases or IFRS 16 operating leases (ROU asset and lease liability arise simultaneously)
• Conversion of debt to equity
• Acquisition of a business through share-for-share exchange
• Settlement of a liability through transfer of assets

What I see missing in Indian company notes: the disclosure of lease commencements is often absent or insufficiently described. When a large Indian retailer like Reliance Retail signs 200 new store leases in a year, each creating a substantial ROU asset and lease liability, the aggregate non-cash transaction is material and must be disclosed. A single aggregate figure with a brief description satisfies IAS 7. Omitting it entirely does not.

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Ind AS 7 vs IAS 7: Key Differences

This is an area where Ind AS diverges from IAS 7 in a way that matters immediately, not just in 2027.

Under IAS 7, entities have the option to classify interest paid and interest and dividends received as operating cash flows. Ind AS 7 removes this option entirely. Interest paid must be classified as a financing activity. Interest received and dividends received must be classified as investing activities. This is not a future change. It applies to all Indian Ind AS companies today.

Additionally, dividends paid must be classified as a financing activity under Ind AS 7. IAS 7 permits dividends paid to be classified as operating.

This means Indian companies already apply the classification that IFRS 18's amendments will impose on full IFRS reporters from 2027. For Dip IFRS students familiar with Ind AS practice, this is worth knowing: what you have always seen in Indian financial statements for interest and dividend classification is already aligned with where full IFRS is heading.

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What Auditors Look For in the Cash Flow Statement

Three areas dominate in Big 4 cash flow reviews.

Completeness and accuracy of non-cash transaction disclosures. Auditors check that all significant non-cash transactions have been identified and disclosed in the notes. Lease commencements and business combinations settled in shares are the highest-risk areas.

Classification consistency. Auditors compare this year's classification of interest, dividends, and other items against the prior year. Unexplained reclassifications get challenged. If interest paid was operating last year and financing this year, that needs a policy change explanation, not a silent reclassification.

Operating cash flow quality. Auditors look at the relationship between operating profit and operating cash flow. A large and growing gap, where profit is high but operating cash conversion is poor, triggers additional procedures. Common causes: aggressive revenue recognition inflating receivables, capitalising costs that should be expensed, or working capital management that flatters the year-end position through accelerated collections or deferred payments.

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Dip IFRS Exam Angle

IAS 7 is consistently tested in Dip IFRS. Classification questions are the most common format: given a list of cash transactions, classify each as operating, investing, or financing, and justify the classification.

The high-mark answers on these questions do two things. First, they get the classification right. Second, they explain the principle behind the classification, not just the answer. "Interest received is classified as investing because it arises from financial assets that generate returns independently of operations" gets full marks. "Interest received: investing" does not.

Know the IAS 7 vs Ind AS 7 differences. Know the IFRS 18 amendments to IAS 7 and what changes from 2027. Examiners can ask about either. Know the definition of cash equivalents and the three-month original maturity guide. Know that only expenditures resulting in a recognised asset qualify as investing.

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FAQ

Can a company change from the indirect to the direct method?

Yes, but it is a change in accounting policy under IAS 8. The change must be justified as providing more reliable and relevant information. In practice, changes from indirect to direct are almost never made because the systems impact is significant.

Where does income tax paid appear when it relates to a capital gain on asset disposal?

Usually in operating activities. IAS 7 says tax paid is operating unless it can be specifically identified with a financing or investing transaction. In practice, companies rarely split their total tax payment between activity categories.

How are dividends from associates classified?

Dividends received from equity-accounted associates are investing cash flows. The investment in the associate is a long-term investing asset, and returns from it are investing inflows.

What about cash flows from discontinued operations?

IAS 7 requires separate disclosure of the cash flows from operating, investing, and financing activities attributable to discontinued operations. This can be done on the face or in the notes. The total line items on the face of the statement can include discontinued operations combined with continuing operations, with the split disclosed separately.

Is the indirect method reconciliation required in addition to the direct method statement?

No. An entity chooses one method. If it uses the direct method, it is encouraged but not required to also show the indirect method reconciliation. If it uses the indirect method, there is no requirement to provide direct method figures.

How does IFRS 16 affect the cash flow statement?

Lease payments are split into principal repayment (financing) and interest (financing or operating under current IAS 7, financing from 2027). The commencement of a lease is a non-cash transaction and does not appear on the face of the statement. Material lease commencements must be disclosed in the notes as non-cash transactions.

What is the correct treatment for capitalised borrowing costs in the cash flow statement?

The interest is paid in cash regardless of whether it is capitalised or expensed. The cash payment appears in the cash flow statement in whichever category the entity classifies interest paid (operating or financing under current IAS 7). The capitalisation treatment affects the income statement and balance sheet, not whether or where the cash appears.

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This is Post 7 of the Global Fin X IFRS Series. Previous: IAS 1 vs IFRS 18: What Stays, What Changes and What You Need to Do Before 2027. Next: IAS 8: Accounting Policies, Estimates and Errors: Where Companies Get It Wrong.