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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.
Why Cash Flow Statements Deserve Your Time?
Many people reading listed company annual reports stop at the statement of profit or loss and the statement of financial position, and only glance at the statement of cash flows.
Yet in bank lending, covenant testing, investment analysis and internal management reporting, senior management and analysts often look at the cash flow statement first, because it reflects actual cash inflows and outflows instead of purely accrual‑based profits.
In day‑to‑day work – loan applications, reviewing financial ratios in loan agreements, forecasting cash flows, or assessing whether the company can pay dividends – the cash flow statement is one of the core documents.
If you only know how to “fill in the format” but do not understand the logic behind it, it will be hard to explain the numbers or pick up mis‑classifications and reconciliation errors in time.
This article starts from the overall structure of the cash flow statement, then walks through the direct method, indirect method, net presentation and foreign currency cash flows, and finally uses an integrated example to transform a profit or loss account and two statements of financial position into a full cash flow statement.
What You Should Be Able To Do After Reading?
By the end, you should be able to:
- Understand the overall structure of a cash flow statement: the three activity categories, the foreign exchange adjustment line, and how opening and closing cash and cash equivalents are linked.
- Apply the indirect method starting from profit, adjusting for non‑cash items, investing and financing‑related gains and losses, and changes in working capital.
- Identify which transactions can be reported on a net basis and understand how net presentation affects analysis and its limitations.
- Translate foreign currency cash flows, decide when approximate rates are acceptable, and explain why the effect of exchange rate changes is shown as a separate line rather than within the three activities.
1. Big Picture First: Structure and Presentation of The Cash Flow Statement
HKAS 7 / IAS 7 state that the purpose of a cash flow statement is to show the historical changes in cash and cash equivalents during a period, classified into operating, investing and financing activities.
In standard form, a cash flow statement usually includes:
- Net cash from operating activities
- Net cash from investing activities
- Net cash from financing activities
- Net increase or decrease in cash and cash equivalents (sum of the three activities)
- Opening balance of cash and cash equivalents
- Effect of exchange rate changes on cash and cash equivalents
- Closing balance of cash and cash equivalents
HKAS 7 requires all entities to present a statement of cash flows and to classify cash flows under these three types of activities so that users can assess the entity’s ability to generate cash and the timing of those cash flows.
Operating activities usually reflect cash flows from the core business; investing activities involve cash flows related to long‑term assets and financial investments; financing activities reflect borrowings, share issues, repayments and dividends and therefore the capital structure.
In the notes, the entity needs to disclose the composition of cash and cash equivalents – for example, cash on hand, demand deposits and short‑term highly liquid investments – and reconcile them to related items in the statement of financial position.
In practice, one common scenario is that bank balances include restricted cash or pledged deposits; in such cases, the notes should explain which parts are not cash equivalents, so users do not overestimate freely available cash.
2. Direct Method for Operating Activities: What It Is and Where It Sits In Practice
What The Direct Method Is Trying To Show
HKAS 7 allows two ways to present cash flows from operating activities: the direct method and the indirect method.
Under the direct method, the entity shows major classes of gross cash receipts and gross cash payments, such as “cash receipts from customers”, “cash paid to suppliers”, “cash paid to employees” and “cash paid for income taxes”.
Paragraph 19 of HKAS 7 explicitly encourages entities to use the direct method because it provides information that helps users estimate future cash flows in ways the indirect method cannot.
The standard’s wording is clearly more favourable towards the direct method, at least in theory.
Why Practice Is Dominated By The Indirect Method
Despite this encouragement, in Hong Kong and most IFRS jurisdictions, listed companies and typical entities almost all use the indirect method.
Key reasons include:
- System design: Most accounting systems are accrual‑based and built around the statement of profit or loss and the statement of financial position; extracting profit and balance sheet data is straightforward, but breaking them down into cash receipts and payments for the direct method often requires extra reports or manual work.
- Working papers and audit trail: The indirect method starts from profit and adjusts it, which is easier to trace in working papers and easier for auditors to verify the source of each adjustment.
- User habits: Analysts, banks and management are used to seeing an indirect‑method reconciliation from profit to operating cash flow; without strong incentives, entities are reluctant to switch to the direct method.
For your purposes, it is enough to understand that the direct method shows gross cash in and out categories, and that, in principle, the net operating cash flow figure under the direct and indirect methods should be the same.
The rest of this article focuses on the indirect method, because that is the format you will encounter most often in day‑to‑day accounting and audit work.
3. Indirect Method for Operating Activities: Walking from Profit to Cash
The indirect method is the most common way to present cash flows from operating activities in Hong Kong financial reporting and audit working papers.
The key idea is to start from profit and adjust it step by step to arrive at net cash from operating activities.
The Basic Framework of The Indirect Method
HKAS 7 explains that under the indirect method, the entity can start from profit before or after tax and adjust it to arrive at net cash from operating activities.
The main steps are:
- Add back non‑cash expenses and deduct non‑cash income
- Remove gains and losses related to investing or financing activities (their cash flows are shown under investing or financing activities)
- Adjust for changes in working capital items such as trade receivables, inventories and trade payables
Conceptually, you can write it as:
- *Net cash from operating activities ≈ Profit
- Non‑cash expenses− Non‑cash income± Working capital changes± Adjustments for gains and losses related to investing and financing activities**
In practice, it helps to draw a simple layout in your working paper: put “profit” at the top, then have three blocks under it – “non‑cash items”, “investing / financing‑related items” and “working capital changes” – and add or subtract each item until you reach net operating cash flow.
Non‑cash Items: Identifying “Book Only, No Cash” Effects
Non‑cash items are transactions and estimates that affect profit in the current period but do not involve any cash receipt or payment in that same period.
Typical examples include:
- Depreciation and amortisation
- Provisions (for impairment, litigation and other obligations)
- Deferred tax movements
- Unrealised foreign exchange gains and losses
- Fair value gains or losses on financial instruments where there is no actual cash transaction in the period
These items decrease or increase profit in the statement of profit or loss but do not correspond to cash flows in the period.
Therefore, under the indirect method:
- Non‑cash expenses (for example depreciation and increases in provisions) are added back.
- Non‑cash income (for example unrealised fair value gains) is deducted.
A practical tip: when preparing the cash flow statement working paper, list all “non‑cash” line items from the profit or loss account, and mark whether they should be added back or deducted.
If this step is done clearly, later review and audit work on the cash flow statement becomes much easier.
Gains and Losses Related to Investing And Financing Activities: Send Them to The Right Section
Quite a few gains or losses appear in profit or loss even though the underlying cash flows are investing or financing.
These items should not remain within “operating activities”.
Common examples include:
- Gains or losses on disposal of property, plant and equipment or investment properties
- The cash proceeds from disposal are investing cash inflows.
- The gain or loss is the difference between carrying amount and proceeds, so it must be removed from the operating reconciliation to avoid double‑counting.
- Fair value changes on financial instruments measured at fair value through profit or loss, when there were no actual cash transactions in the period – these are non‑cash and should be adjusted out.
Under the indirect method you will often see an adjustment line like “Less: gain on disposal of property, plant and equipment”.
This line is there to remove the gain from the operating section because the related cash inflow is correctly shown under investing activities.
Working Capital Changes: Pulling Accruals Back to Cash
Working capital includes trade receivables, other receivables, inventories, trade payables and other payables.
These items reflect timing differences between recognising income and expenses and actually receiving or paying cash.
Some common patterns:
- Trade receivables increase → more sales not yet collected in cash → negative impact on cash → deduct under the indirect method.
- Trade receivables decrease → past credit sales now collected in cash → positive impact on cash → add.
- Inventories increase → more purchases that have not yet fully turned into cost of sales → cash has gone out but expense is not fully recognised → deduct.
- Inventories decrease → using inventories bought in previous periods → current cost of sales is higher than current cash purchases → add.
- Trade payables increase → payments to suppliers are delayed → less cash has gone out → add.
- Trade payables decrease → more past payables have been settled → more cash has gone out → deduct.
In practice, you calculate period‑end minus period‑start balances to get the movement of each working capital item, then apply the above logic to adjust profit to cash.
A common audit check is to confirm that the directions “asset increase → deduct cash”, “liability increase → add cash” have been applied correctly and consistently.
HKAS 7 and SME‑FRF / SME‑FRS: Same Logic, Different Packaging
For entities using SME‑FRF / SME‑FRS, the framework is different from full HKFRS, but they also allow direct and indirect methods.
Teaching modules under SME‑FRS include many examples showing how to adjust from profit to net cash from operating activities, stressing clear disclosure of non‑cash items and working capital changes.
From a user’s perspective, whether you work under full HKFRS or SME‑FRF / SME‑FRS, the three key steps for the indirect method are the same:
- Identify and adjust non‑cash items
- Remove investing / financing‑related gains and losses
- Adjust for working capital movements
Presentation details may vary according to the entity’s policies or firm templates, but the core logic is aligned.
4. Net Presentation: When Can You Show Cash Flows Net?
When Is Net Presentation Allowed?
As a general rule, cash receipts and payments should be presented gross.
However, HKAS 7 allows net presentation in certain situations, such as:
- Cash flows where the company acts as an agent collecting and paying cash on behalf of customers (for example, collecting rent, taxes or insurance premiums as an intermediary).
- Cash flows with quick turnover, large amounts and short maturities, such as purchases and sales of certain short‑term investments. Presenting these gross may exaggerate transaction volume without adding useful information.
These situations share a common feature: gross information has limited extra value for users, while net presentation actually makes the cash flow statement clearer and more readable.
Impact on Analysis and Comparability
Even though the standard allows net presentation, from an analytical point of view large netted amounts can cause users to underestimate transaction volume or liquidity risk.
In practice, banks or investors sometimes ask for extra analyses to break out gross receipts and payments for certain items in order to assess credit risk or operational risk.
A practical balance is:
- Only use net presentation where HKAS 7 clearly permits it and where netting does not materially reduce transparency.
- Explain in the notes which items are presented on a net basis and describe their nature.
When preparing management accounts or financial information packs for banks, you can supplement the formal financial statements with additional schedules that show gross inflows and outflows for items presented net in the cash flow statement.
5. Foreign Currency Cash Flows And Exchange Differences
Translating Foreign Currency Cash Flows
For cash flows denominated in a foreign currency, HKAS 7 requires translation into the entity’s functional currency using the exchange rate at the date of the cash flow.
At the consolidated level, foreign subsidiaries’ cash flows also need to be translated using the transaction‑date rate or a reasonable approximation.
In practice, applying the spot rate to every single transaction is often not practical.
The standard therefore allows entities to use average rates when exchange rates do not fluctuate significantly – for example, monthly or quarterly averages.
Typical situations include:
- A foreign subsidiary with stable monthly income and expenses, where the parent uses a monthly average rate for translation.
- Cash flow forecasts prepared on a quarterly basis using an estimated average rate, then refined with more detailed methods at year‑end.
Why The Exchange Difference Line Is Separate From The Three Activities
The cash flow statement often has a separate line: “Effect of exchange rate changes on cash and cash equivalents”.
This line is not part of operating, investing or financing activities; it is presented separately as a reconciling item.
The reason is:
- Cash and cash equivalents may include foreign currency cash and bank balances.
- Even if there are no foreign currency cash receipts or payments during the period, changes in the exchange rate can change the functional currency amount of the cash balance at period‑end.
So the link in the cash flow statement is usually:
- *Opening cash and cash equivalents
- Net cash from operating activities
- Net cash from investing activities
- Net cash from financing activities
- / − Effect of exchange rate changes on cash and cash equivalents= Closing cash and cash equivalents**
The exchange difference line reflects the re‑measurement effect on foreign currency cash balances, not an actual cash inflow or outflow.
In working papers, many teams prepare a separate “foreign currency cash and cash equivalents reconciliation” that shows opening foreign currency balances, foreign currency cash flows during the period, and closing foreign currency balances, then uses exchange rates to compute the re‑measurement difference to match the amount shown in the cash flow statement.
A Simple Example: Re‑measuring Foreign Currency Cash
Suppose a company’s functional currency is HKD and:
- It holds USD 100 cash at the beginning of the year, when the exchange rate is 7.8.
- There are no USD cash receipts or payments during the year.
- At year‑end, the exchange rate is 8.0.
At the beginning of the year, the cash balance is HKD 780; at year‑end it is HKD 800.
The HKD 20 difference is due solely to exchange rate movements.
In the cash flow statement:
- Net cash flows from the three activities are zero (no actual cash movement).
- Opening cash and cash equivalents: HKD 780.
- Effect of exchange rate changes: +HKD 20.
- Closing cash and cash equivalents: HKD 800.
This presentation lets users see clearly that “the cash itself did not move; the change is purely from exchange rates”, avoiding the misunderstanding that the company did something special with its cash management.
6. Integrated example: building a full cash flow statement using the indirect method
To put everything together, consider a simplified example that shows how to use the indirect method plus balance sheet movements and FX information to complete a cash flow statement.
Given Information (Simplified)
Assume the following data for the year (HKD):
Extract from statement of profit or loss:
- Profit before tax: 600
- Depreciation: 120
- Gain on disposal of equipment (cash received): 30
- Interest expense: 40
- Income tax expense: 90
Key statement of financial position items:
- Trade receivables: opening 250, closing 290
- Inventories: opening 320, closing 280
- Trade payables: opening 200, closing 230
- Cash and cash equivalents: opening 180, closing 310
In addition, the company holds some USD cash; exchange rate movements during the year increased cash and cash equivalents by HKD 10.
Step 1 – Operating Activities (Indirect Method)
Start from profit before tax of HKD 600:
- Add back non‑cash item: depreciation 120 → +120
- Remove investing‑related gain: gain on disposal of equipment 30 → −30
Adjusted subtotal:
600 + 120 − 30 = 690.
Now adjust for working capital:
- Trade receivables increased by 40 (290 − 250) → cash outflow → −40
- Inventories decreased by 40 (280 − 320) → releases cash → +40
- Trade payables increased by 30 (230 − 200) → delayed cash outflow → +30
Working capital adjustment total: −40 + 40 + 30 = +30.
Operating cash flow before interest and tax is therefore:
690 + 30 = 720.
Assume that cash paid for interest and tax equals the expense amounts, and the entity’s policy is to treat both as operating cash flows:
- Interest paid: −40
- Income tax paid: −90
Net cash from operating activities:
720 − 40 − 90 = 590.
This HKD 590 is the figure you would see as “Net cash from operating activities (indirect method)”.
Step 2 – Investing and Financing Cash Flows
Assume the cash proceeds from the disposal of equipment were HKD 80 (carrying amount 50, gain 30):
- Investing activities: cash inflow of 80 from disposal of equipment.
If, in this simplified example, there were no new borrowings, repayments, share issues or dividends, then net cash from financing activities is zero.
In a real case, you would list each financing cash flow there in line with HKAS 7.
Step 3 – Effect of Exchange Rate Changes
From the given data, exchange differences increased cash and cash equivalents by HKD 10.
This amount is shown separately as “Effect of exchange rate changes on cash and cash equivalents”.
Step 4 – Check the Bridge from Opening to Closing Cash
Now bring the pieces together and check the link from opening to closing cash:
- Opening cash and cash equivalents: 180
- Net cash from operating activities: +590
- Net cash from investing activities: +80
- Net cash from financing activities: assumed 0
- Effect of exchange rate changes: +10
Total: 180 + 590 + 80 + 0 + 10 = 860.
If the actual closing cash and cash equivalents are 310, the numbers clearly do not reconcile, which means that in a real preparation you must be missing some cash flows (for example, loan repayments, dividend payments or additional investments).
One major purpose of the cash flow statement is exactly this: forcing you to check whether the cash story told by the profit or loss, the statement of financial position and the notes is internally consistent.
In real work, preparers usually:
- List all known investing and financing cash flows first (purchases of equipment, borrowings, repayments, dividends, etc.).
- Compute a “theoretical closing cash balance” and compare it with the statement of financial position.
- If there is a difference, investigate whether it is due to exchange differences, classification errors or missing transactions until everything reconciles.
Key takeaways for students and junior accountants
- When you see a cash flow statement using the indirect method, train yourself to classify each adjustment as a non‑cash item, an investing/financing‑related gain or loss, or a working capital movement; this turns a long list of adjustments into a clear story.
- When preparing working papers, sketch the framework first – profit at the top, then the three adjustment blocks – instead of copying last year’s template blindly; this helps you spot missing items.
- For foreign currency cash and subsidiaries, always check whether the “effect of exchange rate changes on cash and cash equivalents” line makes sense compared to the actual movement in foreign currency balances.
- In exams, always show your logic: clearly label which adjustments relate to non‑cash items, which to investing/financing, and which to working capital; this often earns method marks even if your final figure is slightly off.
- In real life, use the reconciliation from profit to operating cash flow as your standard lens when talking to management or banks – it is often the language they understand best when discussing performance and liquidity.
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