Statement of Cash Flows

Common Pitfalls of this Middle Child

Ahh — the Statement of Cash Flows, the bane of every staff accountant. This article will describe some of the pitfalls of preparing the Statement of Cash Flows. But first, a bit of history.

When I first entered public accounting as a staff accountant during the Accounting Principles Board (APB) era, the Statement of Cash Flows was not a required financial statement. Instead, a Statement of Changes in Financial Position was required under GAAP. This legacy statement focused primarily on changes in working capital rather than cash flows. To the best of my memory, it was a reasonably easy financial statement to prepare. However, during the 1970s and early 1980s, there was growing dissatisfaction with this statement due to the diversity of practice and lack of focus on cash flows.

Accordingly, in 1987, the Financial Accounting Standards Board (successor to the APB) issued Statement of Financial Accounting Standard (SFAS) No. 95 (codified in ASC 230), which replaced the relatively easy-to-prepare (but less useful) Statement of Changes in Financial Position with the more difficult-to-prepare but more useful, Statement of Cash Flows. The Statement of Cash Flows focuses more directly on a company’s cash flows and provides more consistent and pertinent information to the end users.

Navigating the Treacherous Waters of ASC 230

As any seasoned CPA or construction industry CFO knows, preparing a Statement of Cash Flows can feel like trying to build a skyscraper on quicksand. When you think you’ve figured it out, a tricky transaction throws your carefully constructed statement into disarray. Let’s dive into the murky depths of ASC 230 and explore some of the most common pitfalls and challenging aspects of this deceptively complex financial statement.

The Classification Puzzle

The most frequent error in preparing the Statement of Cash Flows is misclassifying cash flows among the three categories of cash flow activities: operating, investing, and financing. Here are some clues for solving this puzzle:

• Operating activities: Think income statement and changes in current assets and current liabilities
• Investing activities: Always related to assets, and it is usually associated with long-term assets
• Financing activities: Always related to liabilities and equity and typically involves changes in long-term liabilities

However, these are only guidelines and do have exceptions. For example, changes in a current bank line of credit are categorized as financing activities.

One of the trickier areas is insurance claims. Cash receipts from insurance claims are generally classified based on the nature of the loss. For example, for an inventory loss, the cash proceeds received on the claim are classified as an operating cash flow. For a loss related to PPE, the insurance proceeds are classified as an investing activity.

Another area to watch is customer notes receivable. They are classified as an operating cash flow instead of an investing activity.

The Non-Cash Transaction Pitfall

Another stumbling block is the treatment of non-cash transactions. It’s easy to fall into the trap of including these in the cash flow statement as if cash changed hands. For example, when you finance the acquisition of a new excavator through a note payable, it’s too easy to present the total purchase price in investing activities and the new note balance in financing activities. However, no cash flowed, except for the possibility of the payment of a deposit on the equipment and other upfront capitalized costs. Otherwise, this transaction shouldn’t appear in the main body of the cash flow statement.

Instead, non-cash transactions should be disclosed separately, either in a narrative at the bottom of the statement or in a separate footnote. It’s essential information but doesn’t belong in the body of the cash flows statement because no cash changed hands.

Getting Snagged in the Improper Netting of Cash Flows

CPAs often mistakenly report the net amount of certain cash receipts and payments. FASB ASC 230-10-45-7 to 230-10-45-9 provides guidance on when it is appropriate to report cash flows on a net basis instead of a gross basis in the statement of cash flows. Generally, reporting on a gross basis is more relevant because it provides greater detail on cash receipts and payments. However, there are circumstances where net reporting is acceptable and sufficient.

• Quick Turnover: Items with fast turnover rates, large amounts, and short maturities can be netted (e.g., certain investments, loans receivable, and debt)
• Short-term Maturities: Assets or liabilities with original maturities of three months or less can be reported net. This includes specific items like investments (excluding cash equivalents), loans receivable, and debt.

For purposes of the quick turnover criteria described above, netting may be appropriate regardless of the balance sheet classification as current or long-term.

Here are some examples where the netting of cash receipts and payments is appropriate:

• Investments: Purchasing and selling a short-term treasury bill with less than three months maturity from the date of acquisition can be netted.
• Loans Receivable: Issuing and collecting short-term loans due within three months can be netted.
• Debt: Issuing and repaying short-term debt, such as a loan to a related party, with original maturities of three months or less can be netted. Remember that amounts due on demand are considered (by definition) to have maturities of three months or less. Those with original maturities over three months will present borrowings and payments at the gross amounts in the financing section.

  However, revolving lines of credit may be somewhat more dubious. In practice, some companies that borrow and quickly repay large amounts on their bank line of credit with original maturities greater than three months present the cash flow activity at the net amount in the financing section of the statement. This approach’s rationale is that short-term borrowings with quick turnover are akin to cash management activities rather than long-term financing arrangements. Therefore, reporting them on a net basis clarifies the company’s cash flow dynamics. While this practice is not strictly in line with GAAP, it has become accepted for certain revolving credit facilities. However, companies should carefully consider the materiality and usefulness of information when deciding between gross and net presentation for revolvers.

Misreporting Interest and Taxes Paid

The amount of interest and income taxes paid is often overlooked or improperly reported when using the indirect method. Remember, we’re talking about cash paid, so accrual balances must be adjusted to the cash basis for proper reporting.

Improper Handling of Restricted Cash

ASU 2016-18 requires that total cash and cash equivalents include restricted cash. Failing to do so is a common mistake that can distort a company’s cash position.

Conslusion

Preparing an accurate Statement of Cash Flows under ASC 230 requires attention to detail and a thorough understanding of the guidance. By being aware of these common pitfalls described above, CPAs can improve the quality and reliability of this important financial statement.