This past year marked the 30th anniversary of the statement of cash flows as a required financial statement. FASB’s efforts in developing the then-new standard were heavily influenced by the objectives and concepts set forth in Statement of Financial Accounting Concepts (SFAC) 1, Objectives of Financial Reporting by Business Enterprises, and SFAC 5, Recognition and Measurement in Financial Statements of Business Enterprises. Statement of Financial Accounting Standards (SFAS) 95, Statement of Cash Flows, intended to overcome the questioned usefulness of the previously required statement of changes in financial position and the inconsistences in preparers’ definition of “funds.” SFAS 95, as amended, is now incorporated in Accounting Standards Codification (ASC) Topic 230, “Statement of Cash Flows.”
Despite its long history, the cash flow statement continues to present reporting challenges, as evidenced by recurring findings reported by the AICPA’s peer review program and inconsistencies in reporting various cash flows. Similar cash flow reporting deficiencies have been noted in public company reporting, as evidenced by PCAOB inspection findings, restatements, and SEC comment letters (Dana R. Hermanson, Richard W. Houston, and Zhongxia Ye, “Accounting Restatements Arising From PCAOB Inspections of Small Audit Firms,” The CPA Journal, September 2010, http://bit.ly/2y611hw; PCAOB, “Information about 2015 Inspections,” Staff Inspection Brief, October 2015, http://bit.ly/2Oexn4r; Ernst & Young, SEC Comments and Trends,September 2017).
This article highlights practice issues with the statement of cash flows in terms of common reporting deficiencies, recent updates issued by the FASB, and potential changes coming in the future.
Prior to SFAS 95, the statement of changes in financial position, which focused most often on working capital, was required by Accounting Principles Board Opinion 19. During the 1980s, both financial statement users and preparers expressed dissatisfaction with this reporting basis and the diversity in practice for different definitions of funds, cash, and cash flow from operations, as well as different forms of presentation in the statement (SFAS 95, Appendix A: Background Information). In fact, many users of financial statements defaulted to the calculation of earnings before interest, tax, depreciation, and amortization (EBITDA) as a surrogate for operating cash flows to meet their informational needs. The primary cause of these difficulties was a lack of understanding on the part of users, preparers, and many auditors—a misunderstanding that for some persists to this day. In addition, FASB saw the reporting of working capital changes as inconsistent with its subsequently issued SFAC 1, which indicated that financial reporting should provide users with information to assess the amounts, timing, and uncertainty of cash flows.
After a project of approximately six years that included discussion memoranda, exposure drafts, hearings, task forces, and numerous comment letters, FASB issued SFAS 95 in November 1987. The standard required a statement of cash flows to be included in a full set of financial statements and encouraged—but did not require—the use of the direct method of reporting cash flows from operating activities. In 2016, FASB issued three Accounting Standards Updates (ASU 2016-14, ASU 2016-15, and ASU 2016-18) that modified cash flow reporting standards.
A statement of cash flows is required whenever a business or not-for-profit (NFP) entity provides a set of financial statements that reports both financial position and results of operations. A statement of cash flows should be provided for each period for which the results of operations are reported. A frequent reporting deficiency noted in peer reviews is omitting a cash flow statement for each period covered by the statements of operations; this deficiency is especially common in the case of nonpublic company comparative interim financial statements where monthly and year-to-date results are reported together. SEC regulations, while still requiring a statement of cash flows, permit an abbreviated level of detail reporting.
AICPA Statements on Standards for Accounting and Review Services (SSARS) permit compiled statements that omit substantially all disclosures or the statement of cash flows if the omission is disclosed in the accountant’s report. A common finding in peer reviews is the failure to include the required report disclosure language when the cash flow statement has been omitted. Another reporting deficiency involves erroneously including the disclosure language in compilation reports for income tax basis financial statements that are presented without a cash flow statement. This is clearly incorrect, because a statement of cash flows is not required in tax-basis financial statements.
Definition of Cash
As originally conceived, the statement of cash flows was intended to explain the change in the amounts at the beginning and end of the period titled “cash” or “cash and cash equivalents” in the statements. Cash equivalents were “generally” (the word used by FASB) defined as short-term, highly liquid investments meeting certain maturity, risk, and convertibility criteria; however, not all investments with similar characteristics are required to be considered cash equivalents. Accordingly, entities must establish and disclose as a policy a definition concerning which short-term, highly liquid investments are treated as cash equivalents.
Entities often have amounts of cash and cash equivalents that are restricted and reported elsewhere in the statement of financial position. Over time, questions and diversity in practice developed in the classification and reporting of changes in restricted cash and transfers between restricted and unrestricted cash amounts.
To improve the reporting of cash flows and eliminate the inconsistences in reporting restricted cash flows, FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash (a consensus of the FASB Emerging Issues Task Force). The ASU added the requirement to explain the change during the reporting period in the entity’s total cash, which is defined as the aggregation of cash, cash equivalents, and amounts of restricted cash and restricted cash equivalents. When the amounts representing total cash are reported in more than one line item on the statement of financial position, the ASU added the requirement to either report on the face of the statement or disclose in the notes to the financial statements the line items and amounts of cash, cash equivalents, restricted cash, and restricted cash equivalents that sum to the total amount of cash shown in the statement of cash flows at the beginning and end of the corresponding period (Exhibit 1).
Reconciliation of Cash, Cash Equivalents, and Restricted Cash within the Statement of Financial Position and Total Cash Shown in the Statement of Cash Flows
Interestingly, ASU 2016-18 does not provide a definition of restricted cash or restricted cash equivalents. FASB concluded its intent was not to change existing practices for what entities report as restricted cash or restricted cash equivalents, but to provide relevant information about the sources and uses of an entity’s total cash flows.
The new requirements are effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019. Early adoption is permitted, and the amendments should be applied using a retrospective transition method to each period presented.
It is worth noting that FASB has questioned the concept of cash equivalents. In its 2010 draft of an ASU on financial statement presentation, the board proposed eliminating the concept, concluding at that time that cash equivalents neither possess the same characteristics as cash nor have the same risk. FASB acknowledged that cash equivalents can be critical in an entity’s cash management, but their use did not justify the grouping of dissimilar assets. Accordingly, a future change by FASB excluding cash equivalents as part of cash may be forthcoming.
For nongovernment entities, a statement of cash flows should report the net cash provided or used in operating, investing, and financing activities and the net effect of those flows in such a manner that reconciles the total beginning and ending cash and cash equivalents. The presentation of cash flows from operating activities, however, has been controversial since the statement was first developed. FASB, and certain users, have always preferred reporting operating activities using the direct method, in which the major classes of operating cash receipts and payments are reported. Some users believe the direct method provides little or no useful information, and many preparers have noted the difficulties and prohibitive costs in capturing the information.
Preparers have consistently endorsed the use of the indirect method of reconciling net income to the total net operating cash flow. Current standards permit either reporting format but require entities using the direct method to also include a reconciliation of net income to net cash flow from operating activities. The standards, however, are not clear whether such reconciliation must appear on the face of the statement, as is usually done, or disclosed in the notes. SEC regulations permit entities to exclude the reconciliation from interim reports on Form 10-Q. Although FASB has always encouraged the use of the direct method, the indirect method is the predominant presentation method.
In efforts to improve financial reporting for NFPs, FASB initially proposed the elimination of the optional indirect presentation method. FASB’s rationale was that the direct method provides more useful information (which is highly debatable) and the indirect method contributes to the underutilization of the statement of cash flows. In addition, through its outreach activities, FASB learned that the direct method first-year implementation costs were primarily in the nature of training and mapping information available from existing systems and did not involve significant costs for new systems or significant ongoing costs or complexities.
ASU 2016-14, Not-for-Profit Entities (Topic 958): Presentation of Financial Statements of Not-for-Profit Entities, finalized the changes in the presentation of financial statements of NFPs and continued the option of using either the direct or indirect method of presenting operating cash flows; however, the new standard also removed the requirement to include the reconciliation when using the direct method. FASB concluded that the differences between NFPs and business entities and the interests of users of their financial statements no longer justify requiring NFPs to incur the costs of providing the indirect reconciliation of operating cash flows to change in net assets. The board also concluded that removing the impediment of the indirect reconciliation might encourage more NFPs to choose the direct method. The board decided that there is sufficient merit in waiting for further study of the costs of those NFPs that switch to using the direct method as well as of the related issues for reporting by business entities.
FASB’s activities related to NFPs and ASU 2016-14 were not the first discussions concerning the elimination of the indirect method of reporting operating cash flows. FASB’s 2010 draft on financial statement presentation (discussed above) proposed the required use of the direct method to report operating cash flows, with the level of disaggregation of cash flows to be determined at a later date. To reduce the cost of implementing the direct method, entities could compute the cash flows indirectly from changes in asset and liability balances in lieu of making changes in their information systems. FASB’s proposal also included the continued presentation of the reconciliation of net income to net operating cash flows. Again, the board’s action suggests the possibility of future changes in the statement of cash flows that may affect all entities.
The statement of cash flows classifies cash receipts and cash payments as resulting from investing, financing, or operating activities. Peer review findings commonly include the misclassification of the financing and investing activities that are specifically illustrated in the standard; for example, it is incorrect to report the proceeds of a new debt borrowing as an investing activity or the cash payment for equipment acquisitions as a financing activity.
Not all cash flow situations, however, are addressed in the standards. This contributed to the diversity in reporting classification of certain common but infrequent cash flows. To improve the consistency of reporting, FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (a consensus of the Emerging Issues Task Force), which clarified the classification of cash flows related to eight specific issues and provided additional guidance to identify and apply the predominant principle for reporting situations not addressed in the standards (Exhibit 2). For example, cash payments for debt prepayment or debt extinguishment costs should be classified as cash outflows from financing activities. At the settlement of zero-coupon debt instruments (or similar low coupon interest debt instruments), a preparer should classify the portion of the cash payment attributable to the accreted interest related to the debt discount as a cash outflow from operating activities, and the portion of the cash payment attributable to principal as a cash outflow from financing activities. Cash proceeds received from the settlement of insurance claims should be classified on the basis of the related insurance coverage (that is, the nature of the loss). To illustrate, the guidance for cash settlements states:
Proceeds related to inventory-type losses should be reported as operating cash inflows, while proceeds from capital-asset-type losses would be reported as investing activity cash inflows. For insurance proceeds that are received in a lump sum settlement, an entity should determine the classification and allocate the proceeds on the basis of the nature of each loss included in the settlement. In the case of distributions received from equity method investees, the reporting entity should make an accounting policy election to use either a “cumulative earnings approach” or a “nature of distribution approach” and classify the proceeds as operating or investing consistent with the policy election.
ASU 2016-15 Cash Flow Issues
Not all cash flow situations, however, are addressed in the standards. This contributed to the diversity in reporting classification of certain common but infrequent cash flows.
Other cash flow reporting issues clarified in the ASU include contingent consideration payments made after a business combination, proceeds from the settlement of corporate-owned life insurance policies, and beneficial interests in securitization transactions. It also provides guidance for the classification of cash receipts and payments that have aspects of more than one class of cash flows.
The amendments in ASU 2016-15 were effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019. Early adoption is permitted. An entity that elects early adoption must adopt all of the amendments in the same period. The amendments should be applied using a retrospective transition method to each period presented; if it is impracticable to apply the amendments retrospectively for some of the issues, the amendments for those issues should be applied prospectively as of the earliest date practicable.
The classification of cash flows related to interest and dividends received and interest paid as operating activities has been controversial since the statement of cash flows was first introduced. FASB’s recent activities related to NFP reporting suggest changes may be coming regarding the classification of cash flows. Among the proposed changes in ASU 2016-14 was the reclassification of interest and dividends received as investing cash flows and classifying interest paid as a financing cash flow. In addition, cash flows resulting from purchases and sales of long-lived assets would be classified as operating cash flows rather than as investing cash flows. These proposed classification changes were also included in FASB’s 2010 financial statement presentation exposure draft, discussed above. These repeated discussions at the board suggest that classification changes are coming for all entities—the only question being when.
Gross and Net Cash Flows
FASB has always maintained that information about the gross amounts of cash receipts and cash payments during a period is more relevant than information about net amounts (SFAS 95, paragraph 75). For example, separately reporting the total proceeds from the disposal of plant assets and the cash outlays for their acquisition is more informative than simply reporting the net change in plant assets as a cash flow. A common peer review finding is reporting net, rather than gross, changes in plant assets or long-term debt as cash flows.
Not all reporting situations, however, are clearly defined. There is a common issue over the presentation of what may be called “constructive receipt” (e.g., when a lender or lessor advances loan proceeds directly to the vendor in a finance asset purchase or capital lease). The purchaser/lessee either reports gross as both a cash inflow and outflow or net as a noncash financing and investing activity. The standard is silent on this matter, and practice varies.
Exceptions exist to the gross reporting requirement. Items with large amounts, quick turnovers, and maturities of three months or less may be reported based on their net change. While some exceptions are industry-specific, such as demand deposits of banks or customer accounts of broker-dealers, revolving lines of credit represent a more common reporting situation. To be eligible for the net reporting option, however, the underlying credit agreement must be repayable on demand or related to a note with a term of less than three months. On the other hand, if borrowings and repayments are under an agreement with a term greater than three months, the cash flows must be reported on a gross basis. Accordingly, the proper reporting of the cash flow is contingent on an understanding of the underlying debt agreement.
The proper reporting of bank overdrafts or negative cash balances on the statement of cash flows depends upon the underlying nature of the reporting situation. Bank overdrafts, which represent checks written without sufficient funds in the entity’s bank account that are cleared by the bank and create an obligation for the entity, should be considered financing activities. On the other hand, book overdrafts, which relate to a temporary excess of outstanding written checks in excess of funds on deposit in a particular bank account, are analogous to accounts payable and may be considered an element of cash flows from operating activities. Accordingly, the proper reporting of the cash flow as a financing or operating activity requires a clear understanding of the cause of the overdraft or negative cash balance.
More Guidance to Come?
In 1979, FASB replaced the statement of changes in financial position with the statement of cash flows as a required financial statement. In doing so, FASB continued to permit some flexibility in reporting formats and made what some believe to be arbitrary decisions on the classification of cash flows. Since its introduction, peer review findings have identified areas where practitioners and preparers have struggled with implementing or applying the standard. To address reporting inconsistencies and to expand the scope of cash flows included in the statement, FASB recently issued guidance in the form of several ASUs. Several issues, however, remain unresolved (Exhibit 3), and FASB’s deliberative process suggests that additional significant changes may be on the horizon.
Unresolved Cash Flow Issues