The Statement of Cash Flows: Improving the Quality of Cash Flow Information Provided to Investors
Paul Munter
Chief Accountant
Dec. 4, 2023
Introduction: The Importance of Cash Flow Reporting for Investors[1]
The statement of cash flows is integral to a complete set of financial statements, and it should therefore be subject to the same level of due professional care, effective internal controls, and robust, high-quality audit as other financial statements.[2] Unfortunately, we have observed 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. This is evidenced by the statement of cash flows consistently being a leading area of financial statement restatements,[3] and by our observations of material weaknesses in internal control over financial reporting (“ICFR”) around the preparation and presentation of the statement of cash flows.
The information presented in the statement of cash flows 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.[4] In addition, cash flow information is often used as a proxy to understand earnings quality.[5]
For these reasons, the statement of cash flows is a critical component of high quality financial reporting for investors. Accordingly, we remind issuers and auditors to approach the preparation, review, and audit of the statement of cash flows with a focus on quality for the benefit of investors.
Key Reminders of Professional Responsibilities around the Statement of Cash Flows
Materiality
The statement of cash flows has consistently been a leading area of restatements,[6] and we have observed that a significant majority of these restatements represent prior period errors corrected in the current period comparative financial statements, or what are referred to colloquially as “little r” restatements.[7] This indicates that issuers are routinely making a determination that errors in the statement of cash flows do not constitute a material error in prior periods. We remind issuers, auditors, and others of the importance of performing an objective analysis from the perspective of a reasonable investor when evaluating the materiality[8] of both the financial statement and ICFR impacts[9] 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.
In certain instances, the staff in OCA have been presented with analyses that conclude an error in the statement of cash flows is not material because it is an error in classification only. We have not found such analyses and their corresponding arguments persuasive since 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.
Presentation and Disclosure
We have observed that determining the appropriate classification of cash flows as operating, investing, or financing activities can, at times, require significant judgment. Accordingly, we believe it is important that issuers identify both routine and nonroutine transactions that may raise challenging cash flow classification issues early enough in the financial statement reporting process to allow sufficient time for the issuer to address and for the auditor to properly evaluate such issues.
The disclosures related to the statement of cash flows are also critical to investors. We remind issuers that the requirement to disclose significant accounting policies includes those policies that materially affect the determination of cash flow classification.[10] Additionally, issuers must supplement the statement of cash flows with disclosure of noncash investing and financing activities[11] 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. We believe it is critical for issuers to focus on investor needs when determining how best to communicate relevant cash and noncash information.
Internal Controls
Appropriate 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 are essential to establishing and maintaining effective ICFR.[12] Because amounts reported in the statement of cash flows are reconciled to income statement activity and balance sheet changes,[13] controls designed around those other financial statements may indirectly address risks in the statement of cash flows. However, we believe 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
The importance of the statement of cash flows is also highlighted directly in the auditor’s report. In forming its opinion, an auditor evaluates whether the financial statements present fairly, in all material respects, an entity’s financial position, results of operations, and cash flows in conformity with the applicable financial reporting framework.[14]
The risks of material misstatement related to the statement of cash flows, such as inaccurate classification of cash flows and incomplete supplemental disclosure of noncash items, are distinct from those in the other financial statements. We expect auditors to design and implement audit procedures that are specifically responsive to those risks in the statement of cash flows, rather than simply reconciling reported cash flows to the balance sheet or income statement.
Auditing the statement of cash flows starts during audit planning, which requires a comprehensive understanding of the issuer’s business.[15] We remind auditors that in planning the audit and when evaluating errors, a materiality level is established for the financial statements as a whole and it would not be appropriate for auditors to establish a materiality level for the statement of cash flows that exceeds the materiality level for the financial statements as a whole.[16]
Improving Cash Flow Information for Investors
We encourage issuers to carefully consider how to best present cash and noncash information, and whether additional information should be disclosed to facilitate an investor’s understanding of the statement of cash flows and the financial statements as a whole. For example, we believe issuers could further disaggregate amounts currently reported in the statement of cash flows, disclose additional information to better enable investors to understand the relationships between amounts reported in the statement of cash flows and those in the statement of financial position, and consider reporting operating cash flows under the direct method.
Investors have provided feedback regarding the need for such disaggregated cash flow information and the benefits of the direct method.[17] Academic studies have also indicated that reporting cash flows under the direct method provides decision-useful information.[18] Despite the fact that under U.S. GAAP issuers are encouraged to report major classes of gross cash receipts and gross cash disbursements from operating activities through use of the direct method,[19] nearly all issuers continue to use the indirect method.[20]
In light of continued requests from investors for additional cash flow transparency, we encourage issuers to carefully evaluate whether the needs of investors would be better served if issuers used the direct method. As part of this evaluation, we believe issuers should consider whether their ability to collect information about gross operating cash receipts and payments has been improved by advances in technology. We note that those issuers that continue to report cash flows using the indirect method could supplement such cash flow information with 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.
We encourage audit committees, as part of their important oversight role, to discuss with management and the independent auditor the potential use of the direct method or additional disclosures of gross cash receipts and payments, with an emphasis on investor needs. We also note that independent auditors can use their communications with the audit committee around alternative accounting treatments to facilitate this dialogue.[21]
Finally, we encourage investors, preparers, auditors, and other stakeholders to engage with standard setters whenever any standard-setting project could result in cash flow implications. Separately, the FASB recently added a project to its technical agenda to make targeted improvements to the statement of cash flows,[22] and we believe it is critically important for stakeholders to provide constructive feedback as this project progresses. We also encourage stakeholders to provide observations that could inform additional potential standard-setting projects specific to the statement of cash flows.[23] In our view, such stakeholder observations could include continued feedback on the benefits and costs related to application of the direct method, and specific, detailed suggestions that could help the FASB identify other timely and cost-effective solutions that would further enhance the decision-usefulness of the statement of cash flows.
Conclusion
The responsibility of issuers to provide reliable, high quality financial information to investors is foundational to the integrity of our capital markets system. 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. Investors should be provided with transparent, meaningful, and high-quality cash flow information that is subject to rigor in both preparation and auditing, consistent with the other components of the financial statements.
As always, OCA is available for consultation on accounting, financial reporting, internal control, and auditing concerns or questions, especially those involving unusual, complex, or novel transactions for which no clear authoritative guidance exists, including any such matters related to the statement of cash flows.[24]
[1] This statement is provided in the author’s official capacity as the Commission’s Chief Accountant but does not necessarily reflect the views of the Commission, Commissioners, or other members of the staff. This statement is not a rule, regulation, or statement of the Commission. The Commission has neither approved nor disapproved its content. This statement, like all staff statements, has no legal force or effect: it does not alter or amend applicable law, and it creates no new or additional obligations for any person. “Our” and “we” are used throughout this statement to refer to the staff of the Office of the Chief Accountant (“OCA”).
[2] A complete set of financial statements includes statements of financial position, income and comprehensive income, stockholders’ equity, and cash flows, as well as notes to the financial statements. See Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 205-10-45-1A. See also ASC 235-10-05-1 through 05-4 and ASC 235-10-50-1 through 50-3. See also Rules 3-01 through 3-04 of Regulation S-X [17 CFR §§ 210.3-01 – 3-04] and Rule 4-01 of Regulation S-X [17 CFR § 210.4-01]. While this statement focuses on considerations for financial statements prepared in accordance with U.S. GAAP, similar concepts and requirements would apply under International Financial Reporting Standards (“IFRS”). Foreign private issuers may prepare their financial statements in accordance with IFRS as issued by the International Accounting Standards Board without reconciliation to U.S. GAAP. See Acceptance from Foreign Private Issuers of Financial Statements Prepared in Accordance with International Financial Reporting Standards without Reconciliation to U.S. GAAP, Release No. 33-8879 (Dec. 21, 2007) [73 FR 986 (Jan. 4, 2008)].
[3] See Audit Analytics, Financial Restatements, A 20-Year Review: 2003 – 2022, at 5 and 10 (noting that cash flows have been the fourth most common accounting issue cited in restatements from 2003 through 2022, including the most frequently cited issue among large accelerated filers) (November 2023).
[4] See ASC 230-10-10-1 through 10-2.
[5] See Patricia Dechow, Weili Ge, & Catherine Schrand, Understanding Earnings Quality: A Review of the Proxies, their Determinants, and their Consequences, 50 J. Acct.& Econ. 344 (2010).
[6] See supra note 3.
[7] See Paul Munter, Assessing Materiality: Focusing on the Reasonable Investor When Evaluating Errors (Mar. 9, 2022).
[8] The Supreme Court has held that a fact is material if there is “a substantial likelihood that the [...] fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976); see also Basic, Inc. v. Levinson, 485 U.S. 224 (1988) (as the Supreme Court has noted, determinations of materiality require “delicate assessments of the inferences a ‘reasonable shareholder’ would draw from a given set of facts and the significance of those inferences to him....” TSC Industries, 426 U.S. at 450). See also FASB, Statement of Financial Accounting Concepts No. 8—Conceptual Framework for Financial Reporting—Chapter 3, Qualitative Characteristics of Useful Financial Information (As Amended) (Aug. 2018); Staff Accounting Bulletin (“SAB”) No. 99, Materiality (Aug. 12, 1999); SAB No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (Sept. 13, 2006).
[9] Management’s ICFR effectiveness assessment 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.
[10] See ASC 235-10-50-1 through 50-3. See also ASC 230-10-50-1.
[11] See ASC 230-10-50-3 through 50-6.
[12] See Paul Munter, The Importance of a Comprehensive Risk Assessment by Auditors and Management (Aug. 25, 2023).
[13] As required by ASC 230-10-45-29, a reconciliation of net income of a business entity to net cash flow from operating activities shall be provided regardless of whether the direct or indirect method of reporting net cash flow from operating activities is used.
[14] See Public Company Accounting Oversight Board (“PCAOB”) Auditing Standard (“AS”) 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, paragraph .08(e).
[15] See AS 2101, Audit Planning, paragraph .07.
[16] See AS 2105, Consideration of Materiality in Planning and Performing an Audit, paragraphs .06 and .07.
[18] See Jeffrey Hales & Steven F. Orpurt, A Review of Academic Research on the Reporting of Cash Flows from Operations, 27 Acct. Horizons 539 (2013). See also Steven F. Orpurt & Yoonseok Zang, Do Direct Cash Flow Disclosures Help Predict Future Operating Cash Flows and Earnings?, 84 The Acct. Rev. (2009).
[19] See ASC 230-10-45-7 and ASC 230-10-45-25.
[20] See James Schmutte and James R. Duncan, The Statement of Cash Flows Turns 30: Common Reporting Deficiencies and Recent Changes, The CPA Journal (2019), 8 (stating that “[a]lthough FASB has always encouraged the use of the direct method, the indirect method is the predominant presentation method”). See also Orpurt & Zhang supra note 18, 904 (finding, based on a sample of statements of cash flows included in public filings from 1989 through 2002, “approximately 2-3 percent…include a [direct method] disclosure with the percentage decreasing through time to 0.48 percent in 2002.”)
[21] See AS 1301, Communications with Audit Committees, paragraph .13(g) (providing that the auditor must communicate to the audit committee all alternative treatments permissible under the applicable financial reporting framework for policies and practices related to material items that have been discussed with management, including the ramifications of the use of such alternative disclosures and treatments and the treatment preferred by the auditor). See also Section 10A(k) of the Securities Exchange Act [15 U.S.C. § 78j-1(k)] and Rule 2-07(a)(2) of Regulation S-X [17 CFR § 210.2-07(a)(2)].
[22] See FASB, Technical Agenda Project Update, Statement of Cash Flows–Targeted Improvements (stating that “[t]he objective of this project is to make targeted improvements to the statement of cash flows to provide investors with decision-useful information. The project will explore (1) reorganizing and disaggregating the statement of cash flows for financial institutions to improve the decision usefulness of that statement and (2) developing a disclosure about an entity’s cash interest received.”)
[23] In addition to its technical agenda project on the statement of cash flows (see supra note 22), the FASB also has a project on its research agenda to explore further potential improvements to the statement of cash flows. See FASB, Objectives of Research Projects, Statement of Cash Flows.
[24] More information about how to initiate a dialogue with OCA, what to expect from the consultation process, and what information should be included in a consultation submission in order for OCA to most quickly address a company’s or auditor’s question is available on OCA’s webpage, available at https://www.sec.gov/page/communicating-oca.