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Plain‑English explainer of HKAS 7 / IAS 7 for students, junior accountants and non‑specialists who find official standards too dense to read.
This article is based on Hong Kong Accounting Standards (HKAS / HKFRS), which are fully aligned with IAS / IFRS except for minor local tweaks, so the same principles generally apply under IAS / IFRS unless noted otherwise. The goal is to unpack HKAS 7 Statement of Cash Flows (equivalent to IAS 7) using plain English and practical, real‑life examples instead of technical jargon. It is written for students, junior accountants, audit juniors and finance professionals who want to understand not just “what the standard says” but how to actually read and prepare financial statements in line with it.
When you see “the company” or “the entity” below, you can think of any entity that prepares general purpose financial statements under HKFRS / IFRS.
How Do We Decide “Operating, Investing or Financing”?
If you work in accounting or audit in Hong Kong, you have probably seen this: a question or working paper lists a bunch of cash flows like “pay R&D expenses”, “buy machinery”, “issue new shares”, “pay lease instalments”, and asks you to split them into operating, investing and financing activities.
On paper the concepts seem simple, but once you face borderline items – for example, whether R&D is investing, whether a bank overdraft is part of cash equivalents, or how to split lease-related cash flows – you start hesitating.
The purpose of this article is to break down the classification logic in HKAS 7 (Statement of Cash Flows) into a clear judgment framework, then link it to common working situations and an integrated exercise.
Next time you see a similar question or transaction, you should be able to work through it systematically instead of guessing “which column” it belongs to.
What You Should Be Able To Do After Reading?
By the end, you should be able to:
- Explain in your own words what operating cash flows are, and how they relate to items in the statement of profit or loss.
- Clearly identify what belongs in investing activities, especially applying the key rule that only expenditure leading to the recognition of an asset can be treated as investing cash flows, so you avoid putting branding, advertising or training spend there.
- Understand the scope of financing activities, including changes in share capital and borrowings, cash flows for dividends and the principal portion of finance lease payments, and why the 2016 disclosure reform emphasised the “bridge-style” reconciliation for changes in financing liabilities.
- Deal with borderline cases (complex financial instruments, bank overdrafts, restricted cash, expenditure that does not become an asset) using substance-over-form and consistency principles.
1. Operating Cash Flows: Definition and Typical Items
In HKAS 7, operating activities are defined as the principal revenue‑producing activities of the entity and other activities that are not investing or financing.
In simple terms, operating activities are the day‑to‑day cash flows related to earning income and paying expenses, and they are a key indicator of the entity’s ability to sustain its operations.
In practice, operating cash flows are closely linked to the statement of profit or loss, because many income and expense items have a cash “shadow” in operating activities: cash receipts from customers, payments to suppliers, payroll, and tax payments, for example.
In typical working situations, you can naturally treat the following as operating cash flows:
- Cash collected from customers for goods or services
- Cash paid to suppliers for goods or services
- Cash paid for employee salaries, commissions and related benefits
- Cash paid for rent, utilities and other routine operating expenses
- Cash paid or received for taxes related to ordinary operations (for example, profits tax), unless they can be clearly attributed to investing or financing activities
For financial institutions, lending and interest receipts may form a core part of their revenue; in that case, related cash flows are classified as operating activities.
This reflects the HKAS 7 / IAS 7 emphasis on the nature of the business rather than a rigid rule that forces all interest or dividends into one section.
Many beginners think “operating cash flows” are simply “the profit or loss converted to cash basis”, but the two are not one‑for‑one.
- The statement of profit or loss shows income and expenses on an accrual basis.
- The statement of cash flows shows actual cash receipts and payments.
For example, a sale may be recognised as revenue this year even if the customer has not paid yet; the income appears in profit or loss now, but the operating cash inflow only appears in the year when cash is actually received.
Similarly, depreciation is an expense in profit or loss, but there is no cash outflow; under the indirect method, depreciation is added back when reconciling profit to operating cash flows.
A favourite exam twist is when a company holds assets to rent out and then sell later, which looks a bit like trading in investment properties.
HKAS 7 notes that if this buy‑rent‑sell pattern is part of the company’s ordinary business model (for example, a leasing company buying cars to lease out and then selling them after a period), the related cash flows (rental receipts and sale proceeds) are usually treated as operating activities.
The reason is that, for such an entity, leasing and selling those assets are themselves core revenue‑producing activities, not long‑term “investment” activities.
2. Investing Activities: Long‑term Assets and The “Recognised Asset Only” Rule
HKAS 7 describes investing activities as the acquisition and disposal of long‑term assets (such as property, plant and equipment and intangible assets) and other investments that are not cash equivalents.
These cash flows usually represent longer‑term allocations of resources to build future earning capacity, such as buying production lines, acquiring subsidiaries or purchasing bonds and shares for long‑term investment.
Put simply, investing activities involve using or recovering resources to generate returns in the future, rather than day‑to‑day income and expenses.
Typical examples include:
- Cash paid to acquire property, plant and equipment
- Cash paid to acquire intangible assets such as patents or capitalised development costs
- Cash received from selling long‑term assets
- Cash paid or received to buy or sell investments that are not cash equivalents (for example, long‑term bonds or equity investments)
A very important – and heavily tested – sentence was added when IAS 7 / HKAS 7 were revised in 2009: only expenditure that results in the recognition of an asset in the statement of financial position qualifies as investing cash flows.
The background: in the past, some companies treated expenditure that was expected to bring future economic benefits (for example, advertising, brand‑building campaigns, staff training) as investing cash flows, arguing that these are “investments in the future”.
Standard‑setters worried this blurred the boundary of investing activities, so they clarified: if an expenditure does not result in a recognised asset (for example, early‑stage R&D, brand advertising, start‑up costs), it cannot be classified as investing.
It must remain within operating cash flows.
HKAS 7 paragraph 16 spells out this idea and gives examples such as purchases of property, plant and equipment and capitalised development costs as investing cash outflows.
In practice, these types of expenditure are where errors are common; here is how the related cash flows should be classified:
- R&D expenditure:
- Research phase: usually expensed, no asset is recognised, so related cash flows are operating activities.
- Development phase: if criteria for capitalisation are met and an intangible asset is recognised, the capitalised portion is an investing cash outflow.
- Start‑up costs and opening ceremonies:
- In most cases these do not qualify for capitalisation and are expensed; the related cash flows are operating activities.
- Staff training costs:
- Standards and common interpretations say training costs cannot be capitalised, so related cash flows are operating, not investing.
- Brand‑building and advertising:
- Normally treated as current‑period expenses with no recognised asset; the cash flows therefore belong to operating activities.
The key point is not how management markets these items as having “long‑term benefits”; what matters is whether, in accounting terms, they result in a recognised asset on the statement of financial position.
For entities applying SME‑FRF / SME‑FRS, the structure of the standards is different from full HKFRS, but once they choose to prepare a statement of cash flows, the classification logic for operating, investing and financing activities is basically aligned with HKAS 7.
For example, cash flows related to acquiring and disposing of long‑term assets and other investments are still treated as investing activities.
In other words, even for smaller entities with fewer transactions, if they buy fixed assets, intangible assets or long‑term investments, the related cash flows should appear under investing activities.
The flip side: expenditures that “help the future” but are not capitalised on the statement of financial position must remain in operating activities.
This point is just as important in SME financial statements, especially when banks or investors are keen to see how much cash has truly been invested in long‑term assets.
3. Financing Activities: Equity, Borrowings and Lease Financing
Financing activities mainly cover cash flows that change the entity’s equity and borrowings.
You can think of them as “how the company raises funds from, and returns funds to, owners and lenders” – including both equity and debt.
HKAS 7 defines these activities in a way that highlights how they affect the capital structure, which is critical information for assessing financial risk and leverage.
Typical financing cash flows include:
- Cash proceeds from issuing shares (including IPOs and rights issues)
- Cash outflows for share buy‑backs or share repurchases
- Cash inflows from new bank loans or other borrowing instruments
- Cash outflows to repay loan principal
- Cash outflows for dividends paid (although there is some policy choice, many entities present these as financing)
Since HKFRS 16 Leases came into effect, many entities show “lease liabilities” with separate principal and interest components in the cash flow statement.
Under HKAS 7, payments of the principal portion of a lease liability are generally presented as financing cash outflows, because in substance this is a financing arrangement to obtain use‑of‑right assets; the principal component reflects repayment of borrowed funds.
The classification of interest is more flexible.
HKAS 7 allows entities to present interest paid as either operating or financing cash flows, depending on their accounting policy, provided the policy is applied consistently.
In practice, you will often see a note explaining the entity’s policy on classifying interest expense in the statement of cash flows – this is exactly the flexibility HKAS 7 permits.
In the 2016 “Disclosure Initiative” amendments, HKAS 7 introduced a specific requirement to disclose “changes in liabilities arising from financing activities”.
The idea is to give users a clearer picture of how the entity generated and repaid financing during the period, and how much of the movement comes from non‑cash factors such as foreign exchange differences, fair value changes or non‑cash acquisitions of subsidiaries.
The standard recommends, but does not strictly require, a reconciliation table that bridges the opening and closing balances of financing liabilities using cash flows, FX differences, fair value adjustments and other factors.
Even though this is a disclosure requirement, understanding it can significantly improve your grip on financing cash flows because it pushes you to analyse:
- Which cash flows actually belong to financing activities
- Which changes in financing liabilities are non‑cash (for example, converting a note payable into equity)
Once you think this way, it becomes much less likely that you will forget obvious financing cash flows when preparing or reviewing a cash flow statement.
4. Grey Areas and Judgment Calls: Non‑asset Expenditure, Cash Equivalents and Classification
Non‑asset Expenditure Wrongly Treated as Investing
As mentioned earlier, HKAS 7 is clear: only expenditure that leads to the recognition of an asset can be treated as an investing cash flow.
Yet in real‑life work, the following misclassifications are still very common:
- Treating cash flows for large advertising campaigns as investing activities simply because they are big and “good for long‑term branding”
- Classifying staff training costs as investing activities on the logic that “we are investing in people”
- Treating various start‑up costs for new businesses as investing cash flows
The simple check is: does the expenditure result in capitalisation and a recognised asset?
If the answer is no, the related cash flow should not be classified as investing; it belongs in operating activities.
Cash Equivalents and Bank Overdrafts: Short‑term Financing or Cash Management?
The detailed definition of cash and cash equivalents is a separate topic, but when we discuss classification, two questions come up so often that they are worth touching on here.
- Bank overdrafts:
- If an overdraft is repayable on demand and forms part of the entity’s day‑to‑day cash management (managed together with positive bank balances), it can be included within cash and cash equivalents on a net basis.
- If it is a specific short‑term borrowing arrangement, it should be treated as a financing liability, and the related cash inflows and outflows are financing activities.
- Highly liquid investments:
- Only investments with a maturity of three months or less from the date of acquisition, with low risk and high liquidity, qualify as cash equivalents.
- Purchases and sales of such instruments may not be treated as investing cash flows, because they are essentially part of cash management rather than long‑term investment.
Here the crucial part is the HKAS 7 definition of cash equivalents – short‑term, highly liquid, readily convertible to known amounts of cash, with insignificant risk of changes in value.
Buying these instruments is driven mainly by a need to park surplus cash temporarily rather than to make a genuine long‑term investment.
Cash Flows That Need Professional Judgment: Substance Over Form
In practice, not every cash flow fits neatly into a box; many require significant judgment.
Common examples include:
- Interest income and interest expense:
- Depending on the nature of the entity and its chosen policy, these may be operating or investing/financing activities. HKAS 7 allows some flexibility but insists on consistent treatment.
- Dividend income and dividend payments:
- Dividend income may be treated as investing (return on investments) or as operating (for an investment entity whose main business is earning dividends).
- Dividend payments are generally treated as financing, but some entities present them as operating; again, the key is consistency and clear disclosure.
- Complex financial instruments:
- For example, cash flows from convertible bonds or instruments with both liability and equity components have to be analysed based on whether they change the capital structure or are simply trades in investment instruments.
In these grey areas, keep two core requirements in mind:
- Substance over form: do not rely on the legal label (“note”, “bond”, “security”); focus on the economic substance – is this transaction really financing, investing or operating in nature?
- Consistency: once you adopt a classification policy (for example, classifying all interest paid as financing cash flows), apply it consistently and explain it in the notes so that users can compare periods and entities.
5. Integrated Case: Classifying Multiple Cash Flows for Company A
To tie everything together, consider a realistic Hong Kong‑listed manufacturing company, A Co, which produces and sells electronic products.
During the year, A Co has the following cash flows:
- Cash sales of products: customers pay HKD 50 million.
- Cash payments to suppliers for inventory: HKD 30 million.
- Cash paid to purchase a new production line: HKD 15 million.
- Cash paid for an R&D project: HKD 8 million, of which HKD 5 million meets the criteria for capitalisation and is recognised as an intangible asset, while HKD 3 million is expensed.
- Cash proceeds from issuing new shares: HKD 20 million.
- Cash dividends paid to shareholders: HKD 6 million.
- Interest paid on bank loans: HKD 2 million and repayment of loan principal: HKD 10 million.
- Cash paid for a factory lease: HKD 4 million, including HKD 3 million principal and HKD 1 million interest.
Let’s classify them one by one.
Cash Sales and Payments to Suppliers
- Cash sales of HKD 50 million:
- This is A Co’s core revenue source and part of its principal revenue‑producing activities, so it is an operating cash inflow.
- Cash paid for inventory of HKD 30 million:
- Inventory is a current asset used in ordinary operations; buying inventory is part of operating activities, so this is an operating cash outflow.
These are straightforward and reinforce the idea that “main business = operating activities”.
Purchase of Production Line
- Cash paid for machinery of HKD 15 million:
- The machine is property, plant and equipment, a long‑term asset recognised in the statement of financial position. It meets the definition of investing activities, so this is an investing cash outflow.
This is exactly the type of investing cash flow HKAS 7 paragraph 16 uses as a standard example: long‑term resource allocation to support future capacity and income.
R&D Spend: Capitalised vs Expensed Portions
- R&D expenditure of HKD 8 million:
- The HKD 5 million capitalised as an intangible asset creates a recognised asset, so it qualifies as an investing cash outflow.
- The remaining HKD 3 million is expensed and does not result in an asset, so it is an operating cash outflow and cannot be shown under investing activities.
This example shows exactly what the standard amendment wanted to fix: two parts of “R&D” expense are treated differently depending on whether they end up as recognised assets, not based on whether management thinks they “feel like an investment”.
Share Issue and Dividend Payments
- Cash proceeds from share issue of HKD 20 million:
- This increases share capital and changes the equity structure, so it is a financing cash inflow.
- Cash dividends paid of HKD 6 million:
- This is a distribution of returns to equity holders and is usually presented as a financing cash outflow.
HKAS 7 allows some policy choice in certain frameworks, but in exams and in much real‑world practice, treating dividend payments as financing is very common; unless a question states a different policy, you can normally use this classification.
Loan Interest and Principal
- Repayment of loan principal of HKD 10 million:
- A textbook financing cash outflow: it represents repayment of previous financing and directly affects the liability structure.
- Interest paid of HKD 2 million:
- Interest is the cost of obtaining finance and can be treated as either an operating or financing cash flow depending on A Co’s accounting policy.
- If the policy is to classify interest paid as a financing cash flow, the HKD 2 million appears under financing.
- If the entity treats interest as a recurring cost of financing its operations, it may present it as an operating cash outflow; the key is consistent application and appropriate disclosure.
Lease Payments: Principal vs Interest
- Lease principal of HKD 3 million:
- This reduces the lease liability, which in substance is repayment of financing obtained through a lease arrangement. It is classified as a financing cash outflow.
- Lease interest of HKD 1 million:
- As with loan interest, it can be classified as operating or financing according to the entity’s policy, but the chosen approach must be applied consistently.
This case shows that a single real‑world year easily involves all three activity categories.
The classification approach is:
- First ask: is this cash flow supporting day‑to‑day operations, investing in long‑term assets, or changing the capital structure?
- Then check: does it create a recognised asset, or does it change financing liabilities or equity?
If you follow this logic, most exam questions and working-paper classifications can be broken down clearly.
6. Conclusion: when in doubt, walk through HKAS 7’s “three paths”
When you face a messy list of cash flows in a statement of cash flows or in your working papers, pause and ask yourself three simple questions:
- Is this cash flow mainly supporting day‑to‑day business operations, investing for long‑term returns, or raising/repaying capital?
- If it is investment‑related spend, does it actually lead to a recognised asset in the statement of financial position? If not, should it fall back into operating?
- Does this cash flow directly change the company’s equity or borrowings? If yes, it is likely a financing activity.
Remember: operating activities cover “everyday cash in and out for running the business”; investing activities are long‑term resource allocations that must result in recognised assets; financing activities show how the company raises cash from, and returns cash to, shareholders and lenders.
For grey areas – interest and dividends, complex financial instruments, bank overdrafts – rely on substance over form and consistent policy choices, and explain your approach clearly in the notes.
If you want to improve further, try adding one short line of reasoning for each material cash flow in your working papers or study notes: “Why did I put this here?”.
Over time, this forces you to internalise the HKAS 7 classification logic so it becomes intuitive, instead of something you feel you must memorise word‑for‑word from the standard.
Key takeaways for students and junior accountants
- Use the three‑step lens: for every cash flow, ask whether it supports daily operations, invests in recognised long‑term assets, or changes equity/borrowings; this keeps your classification anchored in HKAS 7 / IAS 7.
- Do not let “sounds like an investment” mislead you: training, advertising, start‑up costs and many R&D expenses belong in operating activities unless they create a capitalised asset.
- In exams and in practice, clearly separate principal and interest: principal repayments on loans and leases are financing; interest needs a consistent policy and proper disclosure.
- When reviewing contracts or new transactions, think early about (a) whether the cash flows create assets or financing liabilities and (b) how they will appear in the cash flow statement; this makes drafting entries and working papers much easier.
- When you see bank overdrafts and short‑term investments, decide whether they are part of cash management (within cash and cash equivalents) or genuine financing/investing; document your rationale so others can follow it.
- Turn these questions into a habit: for each major line in the cash flow statement, write one sentence explaining why it is operating, investing or financing – this is exactly the kind of thinking examiners and senior reviewers look for.
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