How to Audit the Statement of Cash Flows Under IAS 7

Why the cash flow statement keeps failing review

Most audit teams treat the cash flow statement as a compilation exercise. The client prepares it, the team checks the arithmetic, and the file moves on. That approach misses what IAS 7 actually asks the auditor to evaluate.

IAS 7.6 defines cash equivalents as short-term, highly liquid investments readily convertible to known amounts of cash and subject to an insignificant risk of changes in value. Clients routinely classify three-month term deposits with break penalties as cash equivalents. They aren’t. If breaking the deposit early incurs a material penalty, the “insignificant risk” condition in IAS 7.7 fails. That misclassification shifts both the opening and closing cash position.

The second issue is less obvious. IAS 7.43 requires disclosure of investing and financing transactions that don’t involve cash. Right-of-use asset additions under IFRS 16 are the most common example. A client signs four new vehicle leases totalling €180K. No cash moves. The assets and liabilities appear on the balance sheet, but the cash flow statement shows nothing. That’s correct for the cash flow statement itself, but IAS 7.43 still requires a separate disclosure note. In the AFM’s 2022 thematic review of IFRS 16 application, incomplete non-cash disclosures were flagged repeatedly across mid-tier files.

ISA 500.6 requires the auditor to design procedures that provide sufficient appropriate audit evidence for each material assertion. For the cash flow statement, that means testing classification (are operating, investing, and financing activities correctly categorised under IAS 7.10 to IAS 7.17), testing completeness of non-cash disclosures (IAS 7.43 to IAS 7.44), and reconciling the statement to underlying accounting records. If your file contains only an analytical review of year-over-year cash movements and a tick on the arithmetic, you haven’t met ISA 500.6.

What IAS 7 actually requires the auditor to verify

IAS 7 is a presentation and disclosure standard. It doesn’t create new measurement requirements. But it does impose specific classification rules that affect how transactions appear in the financial statements, and those classifications are auditable assertions.

The standard splits cash flows into three categories. Operating activities are defined by IAS 7.13 as the principal revenue-producing activities of the entity. Investing activities cover the acquisition and disposal of long-term assets and other investments (IAS 7.16). Under IAS 7.17, financing activities are those that result in changes in the size and composition of the equity capital and borrowings.

Those definitions sound straightforward. They aren’t in practice.

Interest paid can be classified as operating or financing (IAS 7.33). Dividends received can be operating or investing (IAS 7.33). Income taxes are normally operating, but IAS 7.35 allows allocation to investing or financing when the tax can be specifically identified with those activities. The entity chooses a policy, applies it consistently, and discloses it. Your job as the auditor is to verify that the classification policy is permitted under IAS 7, that the entity applies it consistently year over year, and that the disclosed policy matches what actually appears in the statement. A client who classified interest paid as operating in the prior year and moved it to financing this year without disclosure has a comparability problem under IAS 1.45 and IAS 8.

Classification testing under IAS 7.10 to IAS 7.17

Classification testing is the core audit procedure for the cash flow statement. You’re testing whether each material line item sits in the correct category.

Start with the items IAS 7 assigns by definition. Proceeds from issuing shares go to financing (IAS 7.17(a)). Purchases of property, plant and equipment go to investing (IAS 7.16(a)). Cash received from customers goes to operating (IAS 7.14(a)). These are binary. If they’re wrong, it’s a factual error.

The judgment calls live in the grey areas. Bank overdrafts repayable on demand form part of cash management under IAS 7.8 and can be included as a component of cash and cash equivalents. But a revolving credit facility with a 30-day notice period is borrowing, not cash management. The test is whether the overdraft forms an integral part of the entity’s cash management (IAS 7.8). If the entity has never drawn on it to cover day-to-day cash shortfalls, classifying it as a cash equivalent is hard to defend.

For each material line item, document: what the transaction is, which IAS 7 paragraph governs its classification, what the entity’s disclosed policy is, and whether the classification matches both the policy and the paragraph. Four columns in a working paper. That’s the procedure.

Where this gets missed: client-prepared cash flow statements often allocate transactions based on the general ledger account code rather than the IAS 7 definition. A payment coded to “loan repayments” in the GL might include both principal (financing under IAS 7.17(d)) and interest (operating or financing under IAS 7.33, depending on policy). If the client hasn’t split the payment, neither has your audit evidence. This is one of the most common classification errors in mid-tier files.

Government grants create another classification trap. A client receives a €500K innovation subsidy. The GL codes it to “other income.” The cash flow statement shows it as operating. But if the grant relates to the acquisition of a specific piece of equipment (IAS 20.24), the cash inflow is investing, not operating. The nature of the underlying activity determines the classification, not the GL account.

Dividends paid present a similar issue. IAS 7.34 allows classification as either operating or financing. Most European entities classify dividends paid as financing, which aligns with the financing activity definition in IAS 7.17. But the entity must disclose the policy, and it must apply it consistently. A Dutch entity paying an interim dividend in Q2 and a final dividend in Q4 must classify both the same way. If the interim sits in operating and the final in financing, that’s an inconsistency the reviewer will find.

Use the Financial Ratio Calculator to cross-check operating cash flow ratios against industry benchmarks. A sudden divergence between operating profit and operating cash flow is often a classification issue before it’s a substance issue.

Non-cash transactions: the disclosure clients forget

IAS 7.43 states that investing and financing transactions that do not require the use of cash or cash equivalents shall be excluded from the statement of cash flows. IAS 7.44 adds that these transactions shall be disclosed elsewhere in the financial statements in a way that provides all the relevant information about these activities.

The standard gives examples: acquiring assets by assuming directly related liabilities, acquiring an entity by means of an equity issue, and converting debt to equity (IAS 7.44). In practice, the most common non-cash transactions in mid-tier European engagements are IFRS 16 right-of-use asset additions, conversion of shareholder loans to equity, and asset acquisitions financed by vendor loans.

Testing for completeness is the challenge. These transactions don’t appear in the bank statements. They don’t show up in the cash receipts or payments journals. The audit team has to identify them from the balance sheet movements and the notes.

The procedure: compare opening and closing balances for all non-current asset, non-current liability, and equity accounts. Any movement that doesn’t have a corresponding cash flow entry needs explanation. If the explanation is “no cash moved,” that transaction probably requires IAS 7.43 disclosure. Start with the lease register for new IFRS 16 additions. Check the loan register for any debt conversions. The fixed asset register will show assets acquired through barter or vendor financing. Document each one and trace it to a disclosure note.

One common trap: partial cash transactions. A client buys equipment for €200K, pays €120K in cash, and finances €80K through a vendor loan. The cash flow statement should show €120K as an investing cash outflow. The €80K non-cash portion requires IAS 7.43 disclosure. Clients frequently show the full €200K as an investing outflow, overstating investing cash flows and missing the non-cash disclosure entirely.

Restricted cash creates a related issue. IAS 7.48 requires disclosure when a significant amount of cash held by the entity is not available for general use. A €1.2M escrow account securing a construction guarantee isn’t part of the entity’s operating cash. If the client includes it in the cash and cash equivalents line without disclosure, the closing position is overstated. Test restricted cash balances against the bank confirmations and any guarantee or escrow agreements in the file. Document whether each restricted balance qualifies as cash equivalents under IAS 7.6 or requires separate presentation.

Reconciling the operating section: direct vs. indirect method

IAS 7.18 allows entities to report operating cash flows using either the direct method (showing gross cash receipts and payments) or the indirect method (adjusting profit for non-cash items and working capital changes). IAS 7.19 encourages the direct method. In practice, over 95% of European entities use the indirect method because the data is easier to extract from existing accounting systems.

When the client uses the indirect method, the reconciliation starts with profit before tax and adjusts for depreciation, amortisation, impairment, gains or losses on disposal, finance costs, changes in working capital, and income tax paid. Each adjustment needs audit evidence.

The depreciation add-back should tie to the depreciation charge in the income statement and the fixed asset note. If it doesn’t, there’s either an error in the cash flow statement or an unrecorded adjustment. The working capital movements should reconcile to the balance sheet movements in trade receivables, inventories, trade payables, and other operating items. Where they don’t, look for non-cash entries in those accounts (provisions, write-offs, foreign exchange restatements) that need to be excluded from the cash flow reconciliation.

A useful cross-check: the IAS 16 Depreciation Calculator can verify whether the depreciation add-back is consistent with the entity’s asset base and useful life policies.

The direct method is less common but creates different audit challenges. Under IAS 7.18(a), the entity reports cash receipts from customers, cash payments to suppliers, cash payments to employees, and other operating receipts and payments separately. Each line needs to reconcile to supporting records. Cash receipts from customers should equal opening receivables plus revenue less closing receivables, adjusted for non-cash items (bad debt write-offs, foreign exchange). If the entity can’t produce this reconciliation from its accounting system, the direct method presentation may itself be unreliable.

One procedural point that saves time: build the cash flow reconciliation working paper from the balance sheet, not from the cash flow statement. Start with every balance sheet line item. Calculate the movement. Identify which movements are cash and which are non-cash. Then check whether the cash flow statement reflects the cash portion in the correct category. This approach catches both misclassification and omission in a single pass. Working from the cash flow statement backward into the balance sheet only catches what the client chose to include.

Worked example: Jansen Packaging B.V.

Client profile: Jansen Packaging B.V. is a mid-sized Dutch packaging manufacturer with €62M revenue, reporting under IFRS. The entity uses the indirect method for operating cash flows, classifies interest paid as a financing activity (IAS 7.33 policy), and had four significant transactions during the year requiring cash flow statement attention.

1. Classify interest paid

Jansen’s income statement shows €1.4M in finance costs. The bank statement confirms €1.3M in interest payments. That €100K gap traces to the unwinding of the discount on a decommissioning provision (IAS 37.60), which is a non-cash charge. In the cash flow statement, €1.3M appears as a financing outflow (per Jansen’s IAS 7.33 policy). The €100K non-cash finance cost appears as an add-back in the operating section reconciliation.

2. Test IFRS 16 right-of-use asset additions

Jansen signed two new warehouse leases during the year with combined right-of-use assets of €2.1M. No cash changed hands at inception. The balance sheet shows the €2.1M addition in right-of-use assets and a corresponding lease liability. The cash flow statement correctly excludes these from investing activities. But the financial statements contain no IAS 7.43 disclosure note for non-cash investing and financing activities.

3. Reconcile working capital movements

The operating section shows a €1.8M increase in trade receivables reducing operating cash flow. The balance sheet shows receivables moved from €8.2M to €10.4M, a €2.2M increase. The €400K discrepancy traces to a bad debt write-off (€310K, non-cash, correctly excluded from the cash flow adjustment) and a foreign exchange restatement on a USD receivable (€90K, also non-cash). Both exclusions are correct. The working capital adjustment in the cash flow statement (€1.8M) reconciles after removing these items.

4. Verify cash and cash equivalents composition

Jansen’s closing cash position per the cash flow statement is €4.7M. The bank confirmations total €5.1M. The €400K difference is a six-month term deposit with a €12K early break penalty. This deposit fails IAS 7.7 because it carries more than an insignificant risk of value change on early redemption. Jansen correctly excluded it from cash equivalents. Verify that the prior year applied the same treatment and that the IAS 7.46 reconciliation note discloses the components.

Practical checklist for your next engagement

1. Obtain the entity’s IAS 7.33 classification policy for interest paid, interest received, and dividends (both paid and received). Verify it matches prior year. If it changed, confirm IAS 8.14 disclosures are present.
2. Test every material line item in the cash flow statement against the relevant IAS 7 paragraph (IAS 7.13 to IAS 7.17). Document the paragraph reference for each classification decision.
3. Pull the lease register, loan register, and fixed asset register. Identify all non-cash investing and financing transactions. Trace each one to an IAS 7.43 disclosure note.
4. Reconcile the opening and closing cash and cash equivalents per the cash flow statement to the bank confirmations. Test each component against IAS 7.6 and IAS 7.7.
5. For indirect method presentations: reconcile every adjustment between profit and operating cash flow to an audited source (depreciation to the fixed asset note, working capital to the balance sheet, tax paid to the tax working paper).
6. Check that bank overdrafts included in cash equivalents (IAS 7.8) are genuinely repayable on demand and form part of active cash management. If the overdraft has a notice period exceeding 24 hours, it belongs in financing.

Common mistakes

• Treating the cash flow statement as a compilation product: Accepting the client’s cash flow statement and performing only arithmetic checks. ISA 500.6 requires substantive evidence for classification, completeness, and presentation. The AFM flagged insufficient work on the cash flow statement as a recurring theme in its 2021 and 2022 inspection cycles.
• Missing non-cash IFRS 16 lease additions: This became more frequent after IFRS 16 adoption in 2019. The FRC’s thematic review on IFRS 16 noted that non-cash disclosure completeness was a consistent weakness across audit files.
• Failing to split partially-cash transactions: The full amount ends up in investing activities, overstating investing cash outflows and omitting the IAS 7.43 disclosure for the non-cash component.

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Frequently asked questions

Further reading and source references

• IAS 7, Statement of Cash Flows: the source standard governing classification, presentation, and disclosure of cash flows.
• ISA 500, Audit Evidence: requires sufficient appropriate evidence for each material assertion, including the cash flow statement classifications.
• IFRS 16, Leases: the source of the most common non-cash investing and financing transactions requiring IAS 7.43 disclosure.
• IAS 20, Accounting for Government Grants: relevant to the classification of grant receipts that relate to asset acquisitions.