This often confuse students who are studying Statement of Cash Flows that what is the correct way of disclosing or presenting interest paid or received and dividends paid or received during the period. Many students even after learning how to prepare a cash flow statement remain unclear that under what activity should we show interest paid/received and dividends paid/received.
International Accounting Standard (IAS) 7 Statement of Cash Flows in para 31 requires:
Cash flows from interest and dividends received and paid shall each be disclosed separately. Each shall be classified in a consistent manner from period to period as either operating, investing or financing activities.
From the above statement we can understand the following:
- Entity shall not disclose the interest and dividends received and paid on net basis i.e. interest or dividend received shall not be set off against interest or dividend paid. In simple words each shall be disclosed separately in Statement of Cash Flows.
- Entity is given an option to make its own decision that under what activity in Statement of Cash Flows the interest paid/received and dividends paid/received be disclosed. For example, entity can disclose interest paid either as operating activity or financing activity. Same is the case with interest received that entity has the option to disclose it either under the heading operating activity or investing activity
- Whatever choice entity makes it shall be followed as an accounting policy consistently from period to period. Again, it is left on the entity to decide what is appropriate in a given circumstances.
The reason that why we do not have clear cut basis for classifying such items in statement of cash flows is that accountants and standard setters have differing opinions. For example:
- Interest and dividends paid according to some accountants shall be disclosed as operating activity as it is paid out of the profits generated by entity’s operating activities. Also, interest paid (interest expense) is considered in computing profit and loss for the period.
On other hand, another group of accountants suggests that as interest is paid on loans and loans are classified under financing activity therefore any interest paid should be disclosed as financing activity
- Interest and dividends received in the eyes of some accountants shall be disclosed as part of operating activity as such incomes are considered in computation of profit and loss figure and also as such incomes are applied in entity operations for example, interest received on term deposit is used to pay salaries or other operating expenses.
However, equally large number of accountants believe that interest and dividends received should be classified as investing activities as they are connected with the investments made by the entity and as investments are disclosed under investing activity therefore any return on investment should also be disclosed as investing activity.
From the above discussion, we can see that even IAS 7 is not giving us a single and conclusive instruction on classification of interest and dividends paid and received. Therefore, in my opinion it will be good if we settle ourselves with a mix of conceptual understanding and industrial practice. Following are the suggestions in this regard:
Interest paid shall be disclosed under operating activity as it is paid out of the profits generated from operations. Also, common practice is that interest paid is treated under the heading of operating activities.
Dividends are a bit tricky as it involves two kinds of shares i.e.
- shares that are classified under equity (e.g. ordinary shares) and;
- shares that are classified as non-current liability (e.g. redeemable preference shares)
Dividends paid on first type of shares is basically appropriation of profits and are not considered in profit and loss determination therefore, they are most commonly disclosed under financing activity.
Dividends paid on second type of shares is basically an expense and is same as interest expense which also means that such dividends are considered in profit and loss determination therefore, it would be good that if the disclosed with interest paid under operating activities.
However, common practice is that any dividends paid irrespective of type of shares are disclosed under financing activities.
Interest and Dividends received
Interest and dividends received, although considered in profit or loss determination should be disclosed under investing activities as return on investment is not applied for meeting operating expenses and even if it is applied by entity then most of time no specifications are made. Therefore, it is better to disclose it under the same headings where relevant investments are disclosed in statement of cash flows i.e. investing activities.
The common practice for interest and dividends received is to disclose them under investing activities heading of statement of cash flows.