Understanding Cash Flow Adjustments
Cash flow adjustments reconcile accrual-based profit to cash generated from operating activities by reversing non-cash items and reclassifying certain transactions to their appropriate cash flow categories. Under both IFRS (IAS 7) and US GAAP (ASC 230), the indirect method begins with profit or loss and adjusts for transactions that affected profit but did not result in operating cash flows, or that resulted in cash flows classified outside operating activities.
The fundamental principle is that profit includes revenues and expenses recognised on an accrual basis—when earned or incurred—rather than when cash changes hands. To determine actual cash generated, entities must add back non-cash expenses, deduct non-cash income, and account for changes in working capital items such as receivables, inventory, and payables.
While adjustments don't impact the net cash inflow or outflow, it can have a material impact on the classification of the amounts in question. If left unadjusted, these amounts default to operating activities, which may not correctly reflect the economic reality of the transactions.
These adjustments apply consistently under both IFRS and US GAAP, though certain classification differences exist for interest and dividends. The reconciliation ensures that the cash flow statement faithfully represents the entity's liquidity position and cash-generating ability, providing users with information that complements the accrual-based profit figures in the statement of comprehensive income.
Key Principle
Operating cash flow represents cash generated from the entity's principal revenue-generating activities. Adjustments remove non-cash items and reclassify cash flows that belong in investing or financing activities, ensuring each cash flow category presents economically meaningful information.
1. Depreciation and Amortisation
Depreciation of property, plant and equipment and amortisation of intangible assets are systematic allocations of the cost of long-lived assets over their useful lives. These expenses reduce profit but involve no cash outflow in the current period—the cash was spent when the asset was originally acquired.
When reconciling profit to operating cash flow, depreciation and amortisation expenses must be added back in full. This adjustment applies to all depreciation and amortisation charged to profit or loss, including amounts within cost of sales, operating expenses, or other expense categories.
Under both IFRS (IAS 16, IAS 38) and US GAAP (ASC 360, ASC 350), the treatment is identical. The actual cash outflow occurred when the asset was purchased, which was classified as an investing activity. The subsequent depreciation or amortisation merely allocates that historical cost to expense over time without affecting cash.
Example: ABC Ltd reports profit of £500,000 for the year. Depreciation expense of £80,000 and amortisation of intangible assets of £20,000 were included in profit. In the cash flow reconciliation, £100,000 is added back to profit because these are non-cash expenses.
Depreciation in Different Line Items
Depreciation may be embedded in cost of sales, distribution costs, or administrative expenses. The cash flow adjustment must capture the total depreciation expense regardless of where it appears in the statement of comprehensive income.
2. Gains and Losses on Disposal
When an entity disposes of property, plant and equipment, intangible assets, or other non-current assets, any resulting gain or loss is recognised in profit or loss. However, the cash proceeds from the disposal are classified as investing cash flows under both IFRS and US GAAP.
Gains on disposal must be deducted from profit when reconciling to operating cash flow, whilst losses must be added back. This adjustment removes the profit impact, with the full cash proceeds shown separately in investing activities.
A gain on disposal occurs when the cash proceeds exceed the carrying amount of the asset. This gain increased profit but does not represent operating cash generation—the cash inflow is from divestment of a long-term asset. Conversely, a loss reduced profit, but any cash received still appears in investing activities.
Example: DEF plc sold equipment with a carrying amount of £150,000 for £200,000 cash, recognising a gain of £50,000 in profit. In the cash flow statement, the £50,000 gain is deducted from profit in the operating activities reconciliation, and the full £200,000 proceeds are shown as an investing cash inflow.
The same principle applies to disposals of investments, subsidiaries, associates, or joint ventures. Gains reduce the reconciliation (because they inflated profit), and losses increase it (because they deflated profit), with the actual consideration received or paid classified as investing cash flows.
3. Tax Expense Adjustments
Tax expense in profit or loss comprises both current tax and deferred tax. Current tax represents the amount payable to or recoverable from tax authorities, whilst deferred tax reflects timing differences between accounting profit and taxable profit that will reverse in future periods.
Deferred tax is a non-cash item. Increases in deferred tax liabilities or decreases in deferred tax assets create tax expense but no immediate cash outflow, so they must be added back when reconciling profit to cash flow. Conversely, decreases in deferred tax liabilities or increases in deferred tax assets reduce tax expense but do not reflect cash receipts, so they must be deducted.
The actual cash paid for taxes is shown separately in the operating section of the cash flow statement (or, under US GAAP, may be classified as operating or, in limited circumstances, allocated to investing or financing if directly attributable to those activities).
Example: GHI Ltd reports tax expense of £120,000, comprising current tax of £100,000 and a deferred tax charge of £20,000. The £20,000 deferred tax charge is added back to profit in the reconciliation because it is non-cash. The £100,000 current tax is adjusted for changes in tax payables and prepayments to determine actual tax paid.
This treatment is consistent under both IFRS (IAS 12) and US GAAP (ASC 740). The reconciliation separates the accrual-based tax expense into its cash and non-cash components, presenting the true tax cash outflow.
See also
You may also be interested in our recent article where we discuss 7 reasons why your cash flow statement may not balance.
4. Interest Expense and Income
Interest expense and interest income recognised in profit or loss under the effective interest method may differ from the actual cash paid or received during the period. This occurs when loans are measured at amortised cost, resulting in non-cash accretion or amortisation of premiums, discounts, and transaction costs.
To reconcile profit to operating cash flow, the interest expense or income recorded in profit must be reversed out in full, and the actual cash interest paid or received is shown separately in the cash flow statement. The classification of these cash flows depends on the entity's accounting policy election, although IFRS 18 introduces significant restrictions for periods beginning on or after 1 January 2027.
Under current IFRS (IAS 7), entities may classify interest paid as either operating or financing cash flows, and interest received as either operating or investing cash flows. Under US GAAP (ASC 230), interest paid and interest received are generally classified as operating cash flows, though there are exceptions.
Example: JKL plc issued a bond with a face value of £1,000,000 at a discount of £50,000. Using the effective interest method, the entity recognises £80,000 interest expense in year one, but only pays £70,000 cash (the coupon payment). In the cash flow reconciliation, the £80,000 interest expense is reversed, and the £70,000 cash paid is classified according to the entity's policy—likely as financing cash outflow under IFRS.
The same principle applies to interest income from financial assets measured at amortised cost. If an entity recognises £30,000 interest income using the effective interest method but only receives £25,000 cash, the £30,000 is reversed and the £25,000 cash is classified separately.
Effective Interest Adjustments
Non-cash interest accretion on financial liabilities increases the carrying amount of the liability whilst increasing finance costs. This must be added back to profit. Conversely, non-cash interest income on financial assets must be deducted. Only cash interest flows affect the cash flow statement.
5. Foreign Exchange Differences
Foreign exchange differences arise from translating monetary assets and liabilities denominated in foreign currencies, or from settling foreign currency transactions. These differences may be realised (resulting from actual transactions) or unrealised (resulting from period-end revaluations).
Unrealised foreign exchange gains and losses are non-cash items that must be reversed in the cash flow reconciliation. They affected profit but did not result in cash flows—they merely reflect retranslation of outstanding balances at closing exchange rates.
Realised foreign exchange differences do result in cash flows, but these must be reversed out of operating profit and reclassified to match the classification of the underlying transaction. For example, realised forex on trade receivables remains in operating activities, whilst realised forex on loan repayments is classified as financing cash flows.
Example: MNO Ltd holds a foreign currency payable of $100,000. At the year-end, the payable is retranslated, resulting in an unrealised exchange loss of £5,000 that reduces profit. This £5,000 is added back in the cash flow reconciliation because no cash moved. When the payable is settled next year, the realised exchange difference at settlement will be reclassified to financing activities (as the payable relates to borrowing).
6. Share of Profit from Associates
When an entity has significant influence over an associate, it accounts for the investment using the equity method. Under this method, the entity recognises its share of the associate's profit or loss in its own profit or loss, with a corresponding increase or decrease in the carrying amount of the investment.
This share of profit is not cash—it merely reflects the entity's interest in the associate's earnings. To reconcile profit to operating cash flow, the share of profit from associates must be removed. Only dividends actually received from the associate represent cash inflows.
Dividends received from associates are classified as investing cash flows under IFRS (IAS 7), or may be classified as operating or investing cash flows under US GAAP (ASC 230), depending on the entity's accounting policy.
Example: PQR plc owns 30% of an associate and recognises £60,000 as its share of the associate's profit for the year. During the year, the associate paid a dividend of £40,000, of which PQR's share is £12,000 cash received. In the cash flow statement, the £60,000 share of profit is deducted from profit in the reconciliation, and the £12,000 dividend received is shown as an investing cash inflow.
7. Dividend Income
Dividend income from investments in equity instruments is recognised in profit or loss when the entity's right to receive payment is established. However, dividends are not cash generated from operating activities—they represent returns on investments.
Dividend income must be shown separately in the cash flow statement, not as part of cash flows from customers or operating activities. Under IFRS, dividends received may be classified as either operating or investing cash flows. Under US GAAP, dividends received are generally classified as operating cash flows.
When reconciling profit to operating cash flow, dividend income is typically deducted from profit, and the cash dividends received are then presented separately according to the entity's classification policy.
Example: STU Ltd recognised £15,000 dividend income from listed equity investments. In the cash flow reconciliation, the £15,000 is deducted from profit, and £15,000 is shown separately as "dividends received" in the investing section (under IFRS, if that is the entity's policy choice).
8. Impairment Losses
Impairment losses on assets such as goodwill, property, plant and equipment, intangible assets, or financial assets are non-cash expenses. They reduce the carrying amount of assets and decrease profit, but they do not result in a cash outflow.
When reconciling profit to operating cash flow, all impairment losses must be added back because they are non-cash. This applies to impairments under IAS 36 (IFRS) or ASC 350 and ASC 360 (US GAAP) for non-financial assets, and under IFRS 9 or ASC 326 for financial assets.
Reversals of impairment (permitted for certain assets under IFRS but generally prohibited for non-financial assets under US GAAP) are non-cash income and must be deducted from profit when reconciling to cash flow.
Example: VWX plc recognised a goodwill impairment of £200,000 and an impairment of trade receivables (expected credit losses) of £30,000. Both amounts reduced profit. In the cash flow reconciliation, the total £230,000 is added back to profit because these impairments are non-cash adjustments to asset carrying amounts.
The only cash impact occurs later, if and when the impaired asset is disposed of or written off. At that point, the cash proceeds (if any) are classified as investing or operating cash flows depending on the nature of the asset.
9. Inventory Write-Downs
Inventory is measured at the lower of cost and net realisable value under IFRS (IAS 2) and the lower of cost and net realisable value or, for certain entities, market value under US GAAP (ASC 330). When net realisable value falls below cost, a write-down is recognised as an expense in cost of sales.
This write-down is a non-cash expense—it reduces the carrying amount of inventory and decreases profit but does not involve a cash outflow. Therefore, inventory write-downs must be added back to profit when reconciling to operating cash flow.
The write-down creates a timing difference: the cash was spent when the inventory was purchased (reflected in the movement in inventory and payables), but the write-down expense occurs later. The reconciliation removes this non-cash expense, with the cash impact already captured through working capital movements.
Example: YZA Ltd wrote down inventory by £40,000 to net realisable value. This £40,000 expense reduced profit. In the cash flow reconciliation, £40,000 is added back because the write-down is non-cash. The original cash paid for the inventory was reflected when inventory increased and payables were settled.
If inventory subsequently increases in value (permitted under IFRS but not US GAAP for write-downs), the reversal of the write-down is non-cash income that must be deducted from profit in the cash flow reconciliation.
10. Bad Debt Provisions
Bad debt provisions, now typically referred to as loss allowances for expected credit losses under IFRS 9 and ASC 326, represent management's estimate of receivables that will not be collected. Movements in these provisions must be adjusted in the cash flow reconciliation.
An increase in the loss allowance is a non-cash expense that reduces profit but does not involve a cash outflow—it is merely a reduction in the carrying amount of receivables. This increase must be added back to profit when reconciling to cash flow.
A decrease in the loss allowance is non-cash income that increases profit without a cash inflow. This decrease must be deducted from profit in the reconciliation.
When receivables are actually written off against the provision, there is no impact on profit (the expense was recognised when the provision was created) and no cash flow impact (no cash was ever received). The write-off reduces both the receivables balance and the provision simultaneously.
Example: BCD plc increased its loss allowance on trade receivables by £25,000 during the year, recognising this as a bad debt expense. In the cash flow reconciliation, the £25,000 is added back to profit because it is a non-cash expense. The movement in net receivables (gross receivables less provision) is then included in the working capital adjustments to show the cash impact of credit sales and collections.
11. Group-Specific Adjustments
Consolidated cash flow statements require certain adjustments specific to group accounting. These include gains on bargain purchases (negative goodwill) and foreign currency translation reserves reclassified through profit or loss.
A gain on bargain purchase arises when the fair value of identifiable net assets acquired in a business combination exceeds the consideration paid. This gain is recognised immediately in profit or loss under both IFRS 3 and ASC 805. However, it is a non-cash item resulting from the measurement of the acquisition, not from operations. The gain must be deducted from profit in the cash flow reconciliation, with the actual cash paid for the acquisition shown in investing activities.
When a foreign operation is disposed of (and control is lost), the cumulative foreign currency translation reserve (FCTR) related to that operation is reclassified from equity to profit or loss. This reclassification affects profit but is non-cash—it merely recycles previously recognised exchange differences. The reclassified FCTR must be reversed in the cash flow reconciliation, with the actual cash proceeds from disposal shown in investing activities.
Example: EFG Group acquired a subsidiary for cash of £500,000. The fair value of identifiable net assets was £550,000, resulting in a gain on bargain purchase of £50,000 recognised in profit. In the consolidated cash flow statement, the £50,000 gain is deducted from profit in the reconciliation, and £500,000 is shown as cash used in investing activities for the acquisition.
12. Movement in Provisions
Provisions are liabilities of uncertain timing or amount, recognised when the entity has a present obligation resulting from past events, and it is probable that an outflow of economic benefits will be required to settle the obligation. Common provisions include warranties, restructuring, legal claims, and environmental remediation.
When a provision is created or increased, an expense is recognised in profit or loss. This expense is non-cash—no payment has been made yet. The provision increase must be added back to profit when reconciling to cash flow.
When a provision is utilised (i.e., cash is paid to settle the obligation), the provision decreases and cash flows out. This cash outflow is an operating cash flow. However, because the expense was recognised when the provision was created, there is no expense when the provision is utilised, so no further adjustment is needed in the reconciliation.
Decreases in provisions due to reassessment (e.g., a provision is no longer required) create non-cash income that must be deducted from profit in the reconciliation.
Example: HIJ Ltd recognised a restructuring provision of £100,000 during the year, creating a restructuring expense. In the cash flow reconciliation, the £100,000 is added back because it is non-cash. Next year, when HIJ pays £100,000 to settle redundancy costs, the cash outflow is an operating cash flow, but there is no expense (the expense was last year), so the provision movement for utilisation shows as a decrease in the provision balance without requiring a further profit reconciliation adjustment.
This treatment under IAS 37 (IFRS) and ASC 450 (US GAAP) ensures that the timing of cash outflows is separated from the accrual-based expense recognition.
Unwinding of Discount on Provisions
Provisions measured at present value are increased each period as the discount unwinds, creating a finance cost. This unwinding is non-cash and must be added back to profit when reconciling to cash flow, similar to other non-cash interest accretion.
Practical Examples
Example 1: Comprehensive Reconciliation
NOP Ltd reports profit before tax of £400,000 for the year ended 31 December 2025. The following information is relevant:
- Depreciation: £70,000
- Amortisation of intangibles: £15,000
- Loss on disposal of equipment: £8,000
- Impairment of goodwill: £50,000
- Share of profit from associate: £20,000
- Dividend income from investments: £5,000
- Increase in loss allowance on receivables: £12,000
- Share-based payment expense (equity-settled): £18,000
- Increase in restructuring provision: £25,000
- Unrealised foreign exchange loss: £3,000
The reconciliation of profit before tax to operating cash flow before working capital changes would be:
| Item | Amount (£) |
|---|---|
| Profit before tax | 400,000 |
| Add: Depreciation | 70,000 |
| Add: Amortisation | 15,000 |
| Add: Loss on disposal | 8,000 |
| Add: Impairment of goodwill | 50,000 |
| Less: Share of profit from associate | (20,000) |
| Less: Dividend income | (5,000) |
| Add: Increase in loss allowance | 12,000 |
| Add: Share-based payment expense | 18,000 |
| Add: Increase in provision | 25,000 |
| Add: Unrealised forex loss | 3,000 |
| Operating cash flow before working capital changes | 576,000 |
Example 2: Interest and Tax Adjustments
QRS plc reports profit before tax of £250,000. The tax expense is £60,000 (comprising current tax of £55,000 and deferred tax charge of £5,000). Interest expense of £30,000 was recognised using the effective interest method, but only £28,000 cash was paid.
In the cash flow statement:
- The £5,000 deferred tax charge is added back (non-cash)
- The £30,000 interest expense is reversed
- The £28,000 cash interest paid is classified separately (operating or financing, depending on policy)
- Actual tax paid is shown separately after adjusting for movements in tax payables
This separation ensures that profit-based accruals are distinguished from actual cash flows, providing users with clear information about the entity's liquidity.
Conclusion
Cash flow adjustments are essential to reconcile accrual-based profit to actual cash generated from operations. By reversing non-cash items such as depreciation, amortisation, impairments, and provisions, adjusting for timing differences in interest and tax, and reclassifying certain items like disposal gains and dividend income, entities present a faithful representation of their cash-generating ability.
These adjustments apply consistently under both IFRS and US GAAP, though classification differences exist for certain items such as interest and dividends. Understanding these adjustments is critical for financial statement preparers, auditors, and users who rely on cash flow information to assess liquidity, solvency, and financial flexibility.
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