The Securities and Exchange Commission is calling on companies to tighten accounting procedures and controls pertaining to statement of cash flows, amid a steady rise in restatements associated with that rather nettlesome financial document.
Kirk Crews, a professional accounting fellow at the SEC, recently said the Office of the Chief Accountant has studied cash flow restatements in recent years and notices, at least in the sample selected for review, “the majority of errors were due to relatively less complex applications” of U.S. Generally Accepted Accounting Principles. Crews was speaking at the annual national conference of the American Institute of Certified Public Accountants.
Given the rising number of mistakes in what should be routine areas of GAAP, he suggested companies take a fresh look at their controls to prepare and review the cash flow statement. “Given the increasing nature of mis-statements, this should likely include risk assessment and monitoring controls in addition to control activity-level controls,” he said.
Crews provided some questions for companies to ponder, mostly focused on the information companies have, the people doing the work, and the timing. “How are you collecting the financial data necessary to prepare the statement of cash flows?” he asked. “What processes are in place to ensure this information is complete and accurate, especially to the extent new or non-recurring transactions have occurred? Are there manual processes that are ad hoc that could be standardized or automated?”
For corporate accounting staff preparing the statement of cash flows, Crews suggested companies take a closer look at whether they understand the principles in Accounting Standards Codification Topic 230, Statement of Cash Flows. “Are there ways you can provide them with better training to perform their job?” he asked. “Do those individuals reviewing the statement of cash flows have enough expertise to identify and prevent mis-statements in their review process?” Crews also suggested companies consider whether staff need more time to do their work. “Are there ways to prepare and review the statement of cash flows earlier in the financial statement closing process?”
“With limited classification guidance, classification is left open to management judgment. You’ve got lots of different people interpreting what they think the rules mean.”
Chuck Mulford, Director, Financial Analysis Lab, Georgia Tech
Given the concerns raised by the SEC, the Public Company Accounting Oversight Board chimed in at the same conference to indicate that inspectors will be looking at auditors’ work on the cash flow statement as well. “Did the issuer and auditor appropriately identify and address all significant transactions that might have a meaningful impact on the statement?” asked Helen Munter, PCAOB director of registration and inspections.
Restatement figures overall have held steady in recent years following a spike in the mid-2000s, but cash flow restatements have risen steadily in the past five years. In 2009, only 65 restatements (8.7 percent of all restatements), could be attributed to errors in the cash flow statement, according to data from Audit Analytics. By 2013, cash flow restatements numbered 174—more than 20 percent of all restatements.
In the view of Chuck Mulford, director of the Financial Analysis Lab at Georgia Tech, the steady increase in cash flow restatements represents a slow awakening to the importance of cash flow presentation to investors, coupled with scant guidance in accounting standards on how to classify cash flows as arising from either operating, investing, or financing activities.
The accounting standard that gives management the guidance it needs to classify cash flow into one of those three buckets is “only a couple of paragraphs long,” he says. “With limited classification guidance, classification is left open to management judgment. You’ve got lots of different people interpreting what they think the rules mean.”
The Financial Accounting Standards Board is in the early stages of considering whether to provide new guidance on the statement of cash flows, and possibly new disclosure requirements, to reduce diversity in practice. FASB staff’s early research revealed questions and uncertainties in a number of areas, including how to treat debt prepayment and extinguishment costs, changes in restricted cash, zero coupon bonds, dividends from equity method investees, cash flows from securitizations, and insurance proceeds, including proceeds from company-owned life insurance.
STATEMENT OF CASH FLOWS
Below is an excerpt from a recent speech by Kirk Crews, professional accounting fellow at the SEC, highlighting some key points the SEC has gleaned about cash flow statements.
From time to time, the staff reviews restatement data to understand current trends and potential practice issues. One observation that we felt warranted further understanding was that while the total number of restatements over the past five years has been relatively consistent, restatements due to errors in the statement of cash flows continue to increase year over year. Given these results, the staff spent time trying to understand what might be driving recent cash flow restatements. While this process involved reading disclosures and making certain assumptions, the staff noted that in the sample of items we reviewed the majority of the errors were due to relatively less complex applications of GAAP, such as failure to appropriately account for capital expenditures purchased on credit. The staff has been considering why the statement of cash flows seems to be increasingly prone to error. While we do not have the information that would be necessary to perform a thorough root cause analysis, given we are in the midst of calendar year ends, let me suggest you consider the following aspects of your process and controls for preparing the statement of cash flows.
Information – How are you collecting the financial data necessary to prepare the statement of cash flows? What processes are in place to ensure this information is complete and accurate, especially to the extent new or nonrecurring transactions have occurred? Are there manual processes that are ad hoc that could be standardized or automated?
People – Do those individuals preparing the statement of cash flows understand the principles in Topic 230? Are there ways you can provide them with better training to perform their job? Do those individuals reviewing the statement of cash flows have enough expertise to identify and prevent misstatements in their review process?
Timing – Are there ways to prepare and review the statement of cash flows earlier in the financial statement closing process?
Of course all of this implicates internal control over financial reporting, and based on the continuing trend of restatements in this area, the staff thinks it is appropriate for management to consider and evaluate the existing controls around the preparation and review of the statement of cash flows. Given the increasing nature of misstatements, this should likely include Risk Assessment and Monitoring controls in addition to Control Activity level controls.
Mulford has been chirping about many of the same issues for years, producing research reports dating back more than a decade showing inconsistent classification approaches in many of the same areas. “The cash flow statement has always been viewed as a distant stepchild to the income statement and the balance sheet,” he says. “It was almost treated as an afterthought. It was viewed as containing measures that aren’t as important as net income, earnings per share, or shareholder’s equity, so auditors tended not to challenge the misclassifications.”
Charlie Soranno, managing director at Protiviti, says he sees that tendency in practice. “We tend to see clients looking at the statement of cash flow as a presentation-only exercise,” he says. “It’s done after the recognition and measurement statements are done, and they kind of treat it that way.”
Soranno says he tries to encourage companies to think of all three statements simultaneously, rather than putting the cash flow statement together on a net basis. “If you have complex consolidation, why not think about the balance sheet, income statement, and cash flow statement by entity, so you can unearth problems before the financial statements are finalized and produced?” he asks.
The SEC raised a fuss over cash flow classifications in 2005 and 2006, sparked by a speech by then-staffer Joel Levine at the same annual AICPA conference to call for corrections in a number of areas, especially classification of cash flows due to discontinued operations. The issues Levine raised were so pervasive, the SEC was hammered with questions about whether companies should restate to comply. Ultimately, the SEC communicated through professional guidance that staff would not object to corrections outside of restatements.
The solution now is for companies to get back to basics, says Robert Chersi, a former CFO and executive director of Pace University’s Center for Global Governance, Reporting, and Regulation. “Knowing that it’s a 2015 hot topic for both the SEC and the PCAOB, it’s really incumbent on corporate accountants to focus on this,” he says. “Analyze where the information is coming from, and make sure you understand the topic well.”