The SEC’s Office of Chief Accountant appears to be taking a hard look these days at statements of cash flows. In “The Statement of Cash Flows: Improving the Quality of Cash Flow Information Provided to Investors,” SEC Chief Accountant Paul Munter discusses the importance of the statement of cash flows, the failure of companies and auditors to prepare and review cash flows statements with an appropriate level of care and the mischaracterization of classification errors on the cash flows statement as immaterial, resulting in questionable “little r” restatements. Munter cautions that “preparers and auditors may not always apply the same rigor and attention to the statement of cash flows as they do to other financial statements, which may impede high quality financial reporting for the benefit of investors.”  According to Munter, that conclusion is evidenced by both the prevalence of restatements associated with the statement of cash flows as well as by the staff’s “observations of material weaknesses in internal control over financial reporting…around the preparation and presentation of the statement of cash flows.” It’s worth noting here that, as reported by the WSJ, other SEC representatives have also been raising these same issues at conferences regarding inadequate attention to the statement of cash flows and lack of objectivity in assessing the materiality of cash flow errors. Statements like this one from the Chief Accountant and others at OCA usually warrant close attention because they signal topics on which the staff is focused and often presage Enforcement activity on these same subjects.

Munter explains that the statement of cash flows has a number of purposes: it “helps investors assess the issuer’s potential to generate positive future net cash flows, meet its financial obligations, and pay dividends or otherwise return cash to investors. Investors also may use cash flow information to evaluate an issuer’s need for external financing, to determine the reasons for differences between net income and associated cash receipts and payments, and to understand the effects of both its cash and noncash investing and financing transactions on an issuer’s financial position. In addition, cash flow information is often used as a proxy to understand earnings quality.” As a result, the “statement of cash flows represents a critical piece of a complete picture of an issuer’s financial health and operations. Issuers and auditors have a responsibility, under securities laws and professional standards, to apply the same high level of care and professionalism to the preparation, review, and audit of the statement of cash flows as is required for the other financial statements.”  

Materiality.  Munter begins by citing a recent report from Audit Analytics, Financial Restatements, A 20-Year Review: 2003—2022 (November 2023), which identified cash flows as the fourth most common accounting issue cited in restatements from 2003 through 2022, including the most frequently cited issue among large accelerated filers. And, Munter continued, in a “significant majority of these restatements,” there have been issues with the materiality analyses; in many cases, the companies concluded that the errors were not material and filed “little r” restatements, correcting prior period errors in the current period. The staff of OCA was apparently not always on board with that conclusion. For example, some companies’ analyses concluded that because the error was only a classification error, it was not material. But the staff was not persuaded: “classification itself is the foundation of the statement of cash flows. Accurately classifying cash flows as operating, investing, or financing activities is paramount to investors understanding the nature of the issuer’s activities that generated and used cash during the reporting period. Therefore, issuers and auditors must consider all relevant facts and circumstances to thoroughly and objectively evaluate the total mix of information and determine if such classification errors are material to a reasonable investor.” In his statement, Munter reminds issuers, auditors and others that the analysis of the materiality of an error in the statement of cash flows must be objective and conducted from the perspective of a reasonable investor, whether evaluating the financial statement impact or the ICFR impact, “including the significance of the statement of cash flows to the investor’s complete understanding of the financial condition of the company.” Munter notes that the ICFR assessment by management “must consider the magnitude of the potential misstatement that could result from a control deficiency, and we note that an actual error is only the starting point for determining the potential impact and severity of a deficiency.”

Presentation and disclosure.  Munter observes that proper classification can be challenging, so companies should be sure to raise the issues early in the process.  Companies also need to focus on investor needs, including disclosure of significant accounting policies that materially affect cash flow classification and supplements to the statement of cash flows disclosing noncash investing and financing activities to “facilitate an investor’s understanding of how these activities affect recognized assets or liabilities even when there are no resulting cash receipts or payments during the period.”

Internal Controls.  For effective ICFR, Munter says, companies must have “risk assessment processes and controls in place to facilitate risk identification, analysis, and response related to the preparation and presentation of the statement of cash flows.” Controls designed around the income statement and balance sheet may have an indirect effect (because the statement of cash flows is reconciled to them), but Munter believes that “more direct controls are critical and should not be overlooked, such as those regarding the classification of cash flows and the disclosure of noncash items.”

Independent auditors.  Munter expects auditors to design and implement audit procedures that are specifically responsive to the risks related to the statement of cash flows, such as inaccurate classification of cash flows and incomplete supplemental disclosure of noncash items. Simply reconciling reported cash flows to the balance sheet or income statement would not be adequate. In addition, Munter reminds auditors that the materiality level established for the financial statements as a whole should apply and that “it would not be appropriate” for auditors to establish a higher materiality level for the statement of cash flows.

Improving cash flow information for investors.  Munter encourages companies to consider how best to present the information for investors, including disaggregation of amounts currently reported in the statement of cash flows, a change that investors have indicated in surveys that they would favor.  Surveys of investors have also indicated that they would prefer companies to prepare their statements of cash flows using the “direct method.”

Academic studies have apparently also shown that the direct method provides decision-useful information, and issuers reporting under US GAAP are encouraged to use it for some classes of information.  Nevertheless, Munter acknowledges, “nearly all issuers continue to use the indirect method.”  Maybe they should rethink that, Munter suggests, especially in light of advances in technology that may facilitate collection of the relevant information. Or, companies could consider supplementary “disclosure of specific major classes of gross cash receipts and payments, such as cash collected from customers, cash paid to employees, and cash paid to suppliers.”  Munter also encourages audit committees to discuss with management and the independent auditor the potential use of the direct method. Finally, he encourages feedback from investors, preparers, auditors, and other stakeholders on any  standard-setting projects with cash flow implications.

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