As regulators, auditors, and investors have focused attention on the accuracy of the cash-flow statement in the past few years, an increasing number of restatements in 2005 and 2006 can be linked to problems with cash-flow reporting.
Restatements related to the statement of cash flow numbered in the single digits in 2000, representing only a tiny fraction of all restatements. However, the number rose steadily from 2002 to 2004, and surged to 118 in 2005 and 208 in 2006.
Taub
“It’s becoming clearer that the cash-flow statement is quite important to investors, yet it’s sometimes an afterthought for companies in putting together their financial statements,” says Scott Taub, managing director with Financial Reporting Advisers and former deputy chief accountant for the Securities and Exchange Commission. “The SEC has been asking more questions, the auditors have been asking more questions. As more attention is being paid, more problems are found and corrected.”
Financial Accounting Statement No. 95, Statement of Cash Flows, requires cash to be classified into one of three areas—operating, financing or investing—so mistakes on the cash-flow statement are the result of misclassifications, says Chuck Mulford, director of the Financial Analysis Lab at Georgia Tech. As a result, restatements arising from cash-flow errors do not hit earnings, but instead affect how cash flow is classified, he explains.
Mulford
“That’s important because investors are very interested in operating cash flow and its close cousin, free cash flow,” Mulford says. “When that’s wrong, an investor’s whole perception about a company’s performance is thrown off. Operating cash flow is viewed as sustainable, ongoing, renewable cash flow. Anytime that is misreported, even if total cash flow is correct, investors are being misled.”
Taub stresses the importance of getting the cash flow breakdown between operating, investing, and financing activities correct. “Although some might think that these errors are unimportant because they are just classification errors, the fact is that if classification of cash flows wasn’t considered important, we wouldn’t have a cash-flow statement at all,” he says.
Mulford and Taub both say numerous classification errors have been getting increasing attention lately, but they note a few of the more common problems.
GUIDANCE
An excerpt from the Division of Corporate Finance’s recently released report on accounting and disclosure issues follows.
1. Discontinued Operations (New)
An increasing number of registrants are reporting discontinued operations, based on the
criteria of FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived
Assets. Because of this increased frequency, the staff has become aware of a wide diversity in
practice of reporting cash flows from discontinued operations in the cash flow statements. While the notion of identifiable cash flows is integral to the model, SFAS 144 is silent with respect to
reporting the cash flows associated with the discontinued operations.
SFAS 95 requires that an entity report its cash inflows and outflows according to whether
they relate to operating, investing, or financing activities. Footnote 10 of the statement
specifically addresses discontinued operations and says that separate disclosure of cash flows
pertaining to discontinued operations reflected in the operating, investing, and financing
categories is not required. The footnote continues and states that an enterprise that nevertheless
chooses to report separately operating cash flows of discontinued operations shall do so
consistently for all periods affected.
While there are variations in cash flow presentation for discontinued operations, the staff
believes the key consideration is whether they conform to the basic disclosure requirement in
FAS 95 that all cash flows be reported as relating to either operating, investing, or financing
activities. Some of the variations that appear to be consistent with this disclosure requirement
include:
Combining the cash flows generated from discontinued operations with the cash
flows from continuing operations within each of the 3 categories;
Separately identifying the cash flows related to discontinued operations within
each of the 3 categories, or just separately for operating cash flows; and,
Displaying the cash flows related to discontinued operations separately for
operating, investing and financing activities near the bottom of the statement, just
before "net increase or decrease in cash and cash equivalents."
SFAS 95 does not appear to support aggregating operating, investing, and financing cash
flows from discontinued operations into a single line item, as some registrants have presented.
Also, FAS 95 does not appear to support presenting cash flows from operating, investing, and
financing activities of the discontinued operations all within the operating cash flow category.
Registrants who have discontinued operations should carefully consider how to present
disclosures about their cash flows within the Liquidity and Capital Resources section of MD&A.
Management should pay particular attention to describing how cash flows from discontinued
operations are reflected in their cash flows statements, and, if material, they should quantify
those cash flows if they are not separately identified in those statements. In addition,
management should describe how it expects the absence of cash flows, or absence of negative
cash flows, related to the discontinued operations to impact the company's future liquidity and
capital resources, and should discuss any significant past, present, or upcoming cash uses as a
result of discontinuing the operation.
Source
Current Accounting And Disclosure Issues In The Division Of Corp. Finance (SEC; Nov. 30, 2006)
Some companies, for example, have tripped over how to classify cash flow related to the sale of merchandise under long-term payment plans, Taub says. Rather than reflect the operating cash inflow as the cash is collected on the payment plan, as required by FAS 95, some companies had reported an operating cash inflow for the total amount of the transaction at the time of sale with an offsetting investing cash outflow.
Troublespot:
Discontinued Operations
Another rough patch for companies has been in the classification of cash related to discontinued operations; the SEC Division of Corporation Finance highlighted that topic in its most recent outline of accounting and disclosure issues that have raised some concern. The staff said Statement 95 “does not appear to support” lumping all operating, investing and financing cash flows from discontinued operations into a single line item, nor does it support presenting all cash flow from discontinued operations in the operating cash flow category (see excerpt at right).
Mulford says another common problem is the misclassification of cash outflows related to operations. That was the problem for Blockbuster in 2005, for example, when it purchased videos and classified the cash outflow as an investing use of cash when in fact it should have been recorded as an operating use of cash.
Add to the list the manner in which companies have treated retained interest on securitized receivables, says Mulford. “There’s been a lot of confusion about where to put that on the cash-flow statement. Some were putting it in investing cash flow, some were putting it in operating. So there have been restatements to fix that.”
The SEC has offered companies opportunities over the past few years to correct cash-flow classification errors without restating—most notably in early 2006 following a conference of the American Institute of Certified Public Accountants, where an SEC staffer touched off a bevy of questions and debate after pointing out the numerous ways it’s been done incorrectly. Following the conference, the SEC staff said companies could correct their classification errors in their next regular filing without restating.
Mulford says the new focus on FAS 95 can serve as a case study in how principles-based accounting rules are applied. “There are so few rules on how to classify cash flows, a lot of companies have been doing what they want to do,” he says. “The cash-flow statement is a good experiment in what you get with principles-based accounting: few rules and many judgments.”
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