Operating activities are those activities linked to provision of goods or services by the entity, so the normal trading activities of the entity.
These are the principle revenue producing activities of the entity and other activities that don’t fall under the investing or financing activity categories.
They exclude cash from the purchase or sale of non-current assets, such as plant and machinery, or land and buildings.
These operating activities earn revenue and provide a profit for the entity.
Profit versus cash inflows
However, make sure you don’t confuse profit with cash inflows.
If the entity gives out long credit terms, the money from sales may not be received for some time after its earned.
You often see this with things like sofas, where the retailer gives the customer a year or two to pay for the goods once they’re sold.
In this case, revenue and profit will be recorded in one year, but the cash will not be received for a few periods after.
Examples of cash inflows from operating activities include:
- Receipts from customers for the sale of goods or supply of services
- Proceeds from litigation
- Insurance proceeds not related to investing or financing activities
- Dividends received
- Tax refunds
Examples of cash outflows from operating activities include:
- Payments to suppliers for purchases of goods or services
- Payments to employees
- Tax payments
- Interest paid (may also be a financing activity)
NB. Depreciation, bad debt expenses, reduction in carrying value of assets are all non-cash items and are excluded from the SOCF.
Taxes are generally classified as operating activities, unless they clearly relate to an investing or financing activity.
Dividends and interest
The classification of dividends and interest depends on the entity.
Some prefer to classify them as financing activities, others classify them as operating activities.
Whatever classification is used, it should be used consistently across periods.
Interest paid and received is usually classified as operating activities if the loans are used for day to day operations.
If the loans are used for other activities, it may be more appropriate to classify them as financing activities.
Dividends received are often classified as an investment activity.
Dividends paid can be classified as an operating activity or a financing activity.
Sometimes entities prefer to put dividends paid in the operating activity category, to show shareholders there are sufficient cash flows from operating activities to makes the payments.
Which format for SOCF is better?
IAS 7 permits two methods of preparing a cash flow statement:
- the direct method, and
- the indirect method
The only difference between the two is how cash flows from operating activities is presented.
The remaining sections and all other parts are the same.
IAS 7 prefers the direct method to be used, but it permits the use of the indirect method.
Most businesses prefer to use the indirect method, as they feel it takes more work to obtain the information to prepare a statement of cash flows using the direct method.
The direct method allows users of the financial statements to see and analyse each category of cash inflow and outflow.
However, the indirect method allows users see the link between profit in the statement of comprehensive income and the actual cash position of the company.
This allows users to assess the quality of the cash flows received.
For example, if the company reduced its inventory drastically, it would result in a cash inflow, but this might lead to lower sales in future periods if the entity runs out of stock.