Reconciling profit to cash from operations
Which non-cash items and working capital movements turn a client's profit into operating cash under the indirect method, and what IFRS 18 changes.
By Achekam · · 5 min read · For Accountants & audit firms in South Africa, Nigeria, Kenya
A client made a healthy profit and has less money in the bank than a year ago. The owner wants to know where the cash went. The operating section of the cash flow statement is meant to answer exactly that question, and under the indirect method it does so by walking from profit to cash one adjustment at a time.
For the preparer, that walk is also a diagnostic. Every line in it comes from a movement somewhere else in the statements, so a figure that looks wrong in the reconciliation usually means something is wrong in the balance sheet or the income statement. Getting the direction of each adjustment right is the first skill; reading what the result says is the second.
The starting point, now and under IFRS 18
IAS 7 allows operating cash flows to be reported by the direct method, which discloses major classes of gross cash receipts and payments, or by the indirect method, which adjusts profit or loss for the effects of non-cash transactions, deferrals or accruals, and items of income or expense associated with investing or financing cash flows. Most small and medium clients use the indirect method because it can be built from the trial balance.
That starting point is changing. According to the IFRS Foundation's IAS 7 page, when the IASB issued IFRS 18 in April 2024 it amended IAS 7 to require the operating profit or loss subtotal required by IFRS 18 as the starting point for the indirect method. The same page says the amendment introduced new requirements for classifying interest and dividend cash flows. The IAS 7 page gives no effective date for these amendments; the IFRS Foundation's IFRS 18 page states that IFRS 18 is effective for annual reporting periods beginning on or after 1 January 2027. Until a client applies IFRS 18, the reconciliation starts from whichever profit figure its current presentation uses; plan the change for its first IFRS 18 year.
Non-cash items: add back, take off
ACCA's article on cash flow statements explains the first group of adjustments: depreciation and losses on disposal of property, plant and equipment are added back, and non-cash income such as gains on disposal is deducted.
The logic is that these items changed profit without moving cash in the operating period. Depreciation spreads an earlier purchase over time; the cash left when the asset was bought and is shown in investing activities. A gain on disposal is part of the disposal proceeds, which also belong in investing activities, so leaving the gain in operating cash would count it twice.
The same reasoning extends to other items a client's statements may contain: impairment losses, movements in provisions, unrealised foreign exchange differences and fair value changes. For each, ask two questions. Did it move cash in the operating period? Is the related cash shown elsewhere in the statement? If the answer to the first is no, it comes out of the reconciliation.
Working capital: which way each movement goes
ACCA's article sets out the second group: increases in inventories and trade receivables are deducted and decreases added back, with the opposite treatment for trade payables.
A way to remember it, in words:
| Movement during the year | Effect on cash compared with profit | In the reconciliation |
|---|---|---|
| Inventory went up | Cash spent on stock not yet sold | Deduct |
| Receivables went up | Sales made but not yet collected | Deduct |
| Payables went up | Costs incurred but not yet paid | Add |
| Inventory or receivables went down | Earlier investment turned into cash | Add |
| Payables went down | Paid off earlier costs | Deduct |
Prepayments behave like receivables and accruals like payables. Back to the owner: a profitable client with less cash has often built up stock, been slow to collect, or paid suppliers faster than before. The working capital lines show which.
Why a wrong adjusting entry shows up here
Because the reconciliation is built from movements, it is sensitive to errors in year-end entries. Some examples of what that looks like:
- Depreciation posted against the wrong account. If the charge is credited to a payables or accruals account instead of accumulated depreciation, the add-back for depreciation is matched by a strange increase in payables, and investing activities show the wrong asset purchases.
- An accrual posted twice. Payables rise for no commercial reason, and operating cash looks better than the bank statement supports.
- A reclassification between current and non-current. A loan moved into current liabilities can appear as a working capital movement if it is not separated out.
When the operating cash figure does not agree with what the client's bank statements suggest, start by checking the year-end adjusting entries, not the cash flow statement itself.
Checking the Studio's figures in Achekam
In Achekam's Studio, the cash flow statement's current-year column is worked out from the change in balances, and staff can type their own figure for any line, which then takes priority. Comparatives can come from a person's figures, last year's issued statements or a prior-year set a person reviews.
The derived figures are a sound first draft for the working capital lines. Where a movement includes something that is not operating, such as an unpaid amount for equipment within payables, the preparer types the corrected figure and keeps the working that explains it.
For depreciation, Achekam does not calculate the charge. It presents the depreciation in the trial balance and flags when the charge does not agree with the movement in accumulated depreciation. Resolve that flag before trusting the add-back. If the cause is a wrong adjusting entry, staff reverse it, and the reversal is recorded with who did it and why rather than the entry being deleted; then post the right one.
A reviewer's quick test
- Does operating cash, plus investing and financing, agree to the change in cash and cash equivalents?
- Do the add-backs agree to the notes for depreciation, impairment and disposals?
- Is each working capital movement explained by the balance sheet, after removing non-operating items?
- Are any typed figures supported by a working paper?
- For clients nearing IFRS 18, has the new starting point been noted for planning?
Classifying cash flows covers which section each line belongs in, and finding tax paid, asset purchases and dividends paid works through the lines that sit below operating cash. If a client is weighing the alternative presentation, direct or indirect method compares the two. Next time an owner asks where the profit went, walk them through the working capital lines first.
General guidance only, not advice on your own circumstances. Tax and payroll rules change: check the current position with the authority or your adviser.
