A guide to the statement of cash flows

In December 2023, SEC Chief Accountant Paul Munter released a statement addressing the importance of the statement of cash flows to providing investors with high-quality financial information. Mr. Munter reminded preparers and auditors of their professional responsibilities related to the statement of cash flows, noting the staff's observation that they “may not always apply the same rigor and attention to the statement of cash flows as they do to other financial statements.” Key takeaways from Mr. Munter's statement include the following:

• To mitigate the risk of restatements, it is critical for issuers and auditors to perform an objective materiality analysis of “both the financial statement and ICFR impacts [footnote omitted] of an error in the statement of cash flows, including the significance of the statement of cash flows to the investor's complete understanding of the financial condition of the company.”
• With respect to disclosures related to the statement of cash flows, issuers should “focus on investor needs when determining how best to communicate relevant cash and noncash information.”
• It is essential to have “[a]ppropriate 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.”

The SEC staff expects “auditors to design and implement audit procedures that are specifically responsive to [risks of material misstatement] in the statement of cash flows, rather than simply reconciling reported cash flows to the balance sheet or income statement.”

Mr. Munter also addressed this topic at the 2023 AICPA & CIMA Conference on Current SEC and PCAOB Developments. He referred to his statement (see above) on improving the quality of cash flow information provided to investors and emphasized the following points:

• The statement of cash flows is a primary financial statement, and its importance is equal to that of the other statements; however, the SEC staff has anecdotally observed that the processes and internal controls issuers use to prepare the statement of cash flows are not always as rigorous as they are for the other statements. For example, the staff has seen instances in which issuers and their external auditors have presented errors in the statement of cash flows as simply a matter of classification and, therefore, as an immaterial restatement. Mr. Munter noted that classification is the focus of the statement of cash flows and that all errors in the statement of cash flows should be evaluated in the same manner as other accounting errors, both qualitatively and quantitatively.
• Issuers could consider using the direct method to report operating cash flows or otherwise supplementing their use of the indirect method with disclosures about specific major classes of gross cash receipts and payments (e.g., cash collected from customers).
• Audit committees may, as part of their oversight role, discuss with management and external auditors the potential use of the direct method or whether to provide additional disclosures about gross cash receipts and payments. Emphasis should be on the needs of investors.
• Issuers are encouraged to provide the most transparent and complete information they can to investors regarding cash generation and utilization, provided that such presentation is permissible under the standards.

SEC Deputy Chief Accountant Jonathan Wiggins also observed that diversity in practice may not be a sufficient justification for the acceptability of a certain presentation in the statement of cash flows. However, he acknowledged that there may be limited scenarios in which diversity in practice exists, no classification error is present, and an entity may reasonably conclude that a cash flow belongs in one category or another.

One scenario in which entities should use significant judgment is when the legal terms of the agreement stipulate the allocation of cash flows to a single element in a transaction but the consideration should be allocated to multiple elements for accounting purposes. For example, consider a scenario in which an entity enters into a revenue contract for fixed consideration of $1 million and agrees to give the customer 100 free shares of the entity. In this situation, US GAAP would require the reallocation of part of the contractual consideration received under the revenue contract to the shares issued. In such circumstances, cash receipts would have characteristics of more than one class of cash flows.

Examples of SEC comments¹:

1. Please tell us your basis for classifying the capitalization of contract costs as an investing cash flow activity as opposed to an operating activity.
2. We note that you present increases and decreases in book overdrafts as cash flows from financing activities. In this regard, please provide us with your basis for reporting changes in book overdrafts as cash flows from financing activities instead of cash flows from operating activities. Also, clarify whether the overdraft is with a bank.
3. Please explain why you classified your short-term investments as trading and why the corresponding cash flows have been classified as investing instead of as operating in your Statements of Cash Flows. See ASC 320 and ASC 230-10-45-20.

ASC 230 requires entities to classify cash receipts and cash payments as operating, investing, or financing activities on the basis of the nature of the cash flow. Many of the SEC staff’s comments are related to understanding the classification or potential misclassification among these three cash flow categories. In some cases, the SEC staff has raised questions about the presentation of cash inflows resulting from a transaction in a manner inconsistent with the underlying balance sheet classification.

Examples of SEC comments:

1. Please revise the other assets and liabilities, net line item to present changes in other assets separately from other liabilities and further break out any material components. Refer to ASC paragraphs 230-10-45-7 and 45-29.
2. We note that you present the caption investments in property and equipment, net. Please revise future filings to separately present the cash inflows and cash outflows for property and equipment on a gross basis as discussed in ASC 230-10-45-26.

The SEC staff may challenge whether it is appropriate to report the net amount of certain cash receipts and cash payments on the face of the statement of cash flows. Generally, cash payments should not be presented net of cash receipts in the statement of cash flows. However, ASC 230-10-45-7 through 45-9 state that although reporting gross cash receipts and gross cash payments provides more relevant information, financial statement users sometimes may not need gross reporting to understand certain activities.

Further, the netting criteria in ASC 230-10-45-8 (turnover is quick, the amounts are large, and the maturities are short) must be met for an entity to present investing and financing activity on a net basis. Accordingly, the SEC staff may ask a registrant to revise the presentation or to explain (in accordance with ASC 230) why it is appropriate to report certain cash flows on a net basis rather than on a gross basis.

Example of an SEC comment:

1. We note your “Accounts Payable days” are [X] days as of [the fiscal year end]. We further note your Accounts Payable days [have] increased substantially over the past ten years . . . Please tell us if you are engaging in supply chain finance operations and mechanisms, such as reverse factoring or similar methods to increase your Accounts Payable days. Otherwise, please explain how you have been able to achieve such extended accounts payable terms with your suppliers.

The SEC staff has recently issued comments to registrants that use extended vendor payable arrangements involving the participation of a paying agent or other financial institution. Under such programs, the paying agent or financial institution may settle the payment obligation directly with the registrant’s supplier, for a fee, earlier than the extended payment term. Because there is no explicit authoritative guidance on these arrangements, the SEC staff has challenged registrants’ determinations of whether the payments (1) constitute trade payables, which would represent operating activities, or (2) are more akin to debt, which would represent financing activities. Before the issuance of ASU 2022-04, which requires enhanced disclosures about supplier finance programs, there were no explicit disclosure requirements for such programs. Therefore, the staff has encouraged registrants to provide enhanced disclosures in MD&A about their extended vendor payable arrangements, such as the following:

1. A description of the program; the material and relevant terms of the program, including the risks along with the general benefits.
2. Amounts settled through the program; and impacts of the program on the registrant’s payment terms to suppliers, days payable outstanding, working capital, liquidity, and capital resources.
3. Amounts remaining in trade payables at year-end for which the registrant’s supplier has elected early payment (i.e., the balance sheet impact).