Statement of cash flows – increasingly prone to error

Here’s an extract from a recent speech delivered at the 2014 AICPA National Conference on Current SEC and PCAOB Developments by T. Kirk Crews, Professional Accounting Fellow in the Office of the Chief Accountant:

  • “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 (relevant principles)? 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.”

Crews is talking about US GAAP of course, but much of what he says should resonate in the context of IFRS as well. Few practitioners will fall into the “obvious” traps of recognizing a cash inflow for share issuances that actually occurred in exchange for debt conversions, or that kind of thing. But it’s much more common, just as he notes, to fail to analyze balances typically regarded as working capital changes – particularly accounts receivable and payable – to identify elements that relate to investing and financing activities. For smaller entities in particular, this omission might once in a while have a highly material impact on key cash flow measures (although for such entities, these measures are probably insufficiently stable anyway to be key performance indicators, as they are for larger, established entities).

As we discussed here, the IASB’s recent exposure draft of proposed changes to IAS 7 suggests requiring “a reconciliation of the amounts in the opening and closing statements of financial position for each item for which cash flows have been, or would be, classified as financing activities in the statement of cash flows, excluding equity items.” In the IASB’s words, this additional information about financing activities can be used to verify an investor’s understanding of the entity’s cash flows and improves investors’ confidence in forecasting an entity’s future cash flows, among other things. Still, this additional step wouldn’t, in itself, catch the kind of issue noted above, if preparers interpret the proposed change (as seems intended) to require reconciling only those amounts for which the entire cash-related change constitutes a financing activity (borrowings, lease liabilities and the like) rather than those for which a portion of the item might be constituted as such. As I mentioned before, this leads in the direction of the long-standing arguments in favour of requiring reconciliations of the changes in all outstanding asset and liability balances (although these wouldn’t necessarily catch this particular matter either).

Anyway, Crews’ broad comments are certainly worth considering by IFRS preparers, even if (here too, unlike the audience he’s addressing directly) they’re not required to formally report on the effectiveness of internal control over financial reporting. Again, big-ticket items like major financing transactions should probably be prominent enough to reduce the risk of error, but even then, oversights can occur regarding related costs, such as legal expenses treated as prepayments and/or payables. And you never know, this might be an area where the process of looking at existing systems actually generates other benefits, such as useful enhancements to internal reporting…

The opinions expressed are solely those of the author

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