Improving the statement of cash flows financial reporting standards

In August 2016 the 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 goes into effect for public business entities whose fiscal years begin after December 15, 2017.  The goal of ASU 2016-15 is to reduce diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows under Topic 230, Statement of Cash Flows, and other Topics.

With this goal in mind, this ASU addresses eight specific statement of cash flows (SCF) classification issues.  They include:

  1. Debt Prepayment or Debt Extinguishment Costs – Cash payments for debt prepayment or debt extinguishment costs should be classified as cash outflows for financing activities.
  2. Settlement of Zero-Coupon Debt Instruments or Other Debt Instruments with Coupon Interest Rates That Are Insignificant in Relation to the Effective Interest Rate of the Borrowing – At the settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing, the issuer should classify the portion of the cash payment attributable to the accreted interest related to the debt discount as cash outflows for operating activities, and the portion of the cash payment attributable to the principal as cash outflows for financing activities.
  3. Contingent Consideration Payments Made after a Business Combination – Cash payments not made soon after the acquisition date of a business combination by an acquirer to settle a contingent consideration liability should be separated and classified as cash outflows for financing activities and operating activities.  Cash payments up to the amount of the contingent consideration liability recognized at the acquisition date (including measurement-period adjustments) should be classified as financing activities; any excess should be classified as operating activities.  Cash payments made soon after the acquisition date of a business combination by an acquirer to settle a contingent consideration liability should be classified as cash outflows for investing activities.
  4. Proceeds from the Settlement of Insurance Claims – 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).  For insurance proceeds that are received in a lumpsum settlement, an entity should determine the classification on the basis of the nature of each loss included in the settlement.
  5. Proceeds from the Settlement of Corporate-Owned Life Insurance Policies, including Bank-Owned Life Insurance Policies – Cash proceeds received from the settlement of corporate-owned life insurance policies should be classified as cash inflows from investing activities.  The cash payments for premiums on corporate-owned policies may be classified as cash outflows for investing activities, operating activities, or a combination of investing and operating activities.
  6. Distributions Received from Equity Method Investees – When a reporting entity applies the equity method, it should make an accounting policy election to classify distributions received from equity method investees using one of two approaches: (1) cumulative earnings approach or (2) nature of the distribution approach.  These two approaches are further described within this ASU.  Disclosures related to changes in accounting principle may be required depending on an entity’s elections.
  7. Beneficial Interests in Securitization Transactions – A transferor’s beneficial interest obtained in a securitization of financial assets should be disclosed as a non-cash activity, and cash receipts from payments on a transferor’s beneficial interests in securitized trade receivables should be classified as cash inflows from investing activities.
  8. Separately Identifiable Cash Flows and Application of the Predominance Principle – The classification of cash receipts and payments that have aspects of more than one class of cash flows should be determined first by applying specific guidance in GAAP.  In the absence of specific guidance, an entity should determine each separately identifiable source or use within the cash receipts and cash payments on the basis of the nature of the underlying cash flows.  An entity should then classify each separately identifiable source or use within the cash receipts and payments on the basis of their nature in financing, investing, or operating activities.  In situations in which cash receipts and payments have aspects of more than one class of cash flows and cannot be separated by source or use, the appropriate classification should depend on the activity that is likely to be the predominant source or use of cash flows for the item.

Current GAAP is either unclear or does not include specific guidance on these eight SCF classification issues included in the amendments in this ASU.  With this in mind, the ASU is an improvement to GAAP because it provides guidance for each of these eight issues, thereby reducing the current and potential future diversity in practice.

Errors in the statement of cash flows

An interesting data point in the context of the SCF is that in the last five years the second most common issue cited in financial statement restatements related to errors in the SCF.  The following chart depicts SCF errors compared to six other common restatement issues between 2001 and 2015:

scf-restatements

As one can gather, these eight SCF classification issues may be perceived as addressing non-routine transactions.  According to the Audit Analytics August 2016 report on SOX 404 Disclosures, which I wrote about in a previous post, in 2015 approximately 5% of auditor attestations cited ineffective internal controls over financial reporting (ICFR) due, at least in part, to SCF classification issues.  Although this is a relatively small percentage compared to the total number of ICFR failures in 2015, these SCF classification issues typically related to non-routine transactions.

With the new guidance in ASU 2016-15, we can expect improvements in the disclosures related to the SCF; however, it’s unclear at this juncture what extent of influence the adoption of the ASU will have on mitigating ICFR failures going forward.

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Proving out cash and revenues

For many small business owners, ensuring that revenue and cash make sense when compared to each other is a critical exercise since cash is the most liquid account in the financial statements (which means it can be highly susceptible to theft) and revenue is often times the largest and/or one of the most important accounts to measure business performance.  How does one know if all cash receipts have been properly entered into the accounting system?  How does one verify that all revenues have been reported in the ledger for the period?

One such exercise can greatly help businesses to answer these questions, called a “proof of cash and revenue.”  By proving out cash and revenue, businesses can get comfortable that either (1) the accounting accurately reflects all business transactions or (2) there are transactions not appropriately accounted for, triggering additional investigation.

A proof of cash and revenue exercise is rather simple, although differing degrees of complexity in a business could complicate the exercise.  In essence a proof of cash and revenue exercise takes all cash receipts from an entity’s bank account statement and removes any non-revenue deposits (such as cash transfers from one bank account to another, proceeds from sale of equipment, bank account interest received, insurance reimbursements, and so forth) to arrive at what I will call “revenue deposits.”

Next, beginning-of-the-period accounts receivable, gross (make it a positive number) is netted against end-of-the-period accounts receivable, gross (make it a negative number).  The result is added to revenues from the general ledger (“G/L”).  The theory in adding beginning accounts receivable and subtracting ending accounts receivable is that the beginning accounts receivable is “assumed” to have been collected within the period, meanwhile the ending accounts receivable has not yet been collected, and, therefore, it will not show up in the bank account statement for the period.  I will refer to this calculation as “adjusted revenue per G/L”.

The final step is to compare “revenue deposits” to “adjusted revenue per G/L” and investigate any variance that exceeds what is considered to be an acceptable variance.

When done right, this exercise can uncover errors in accounting, missing deposits, or even fraud.  Although this exercise is fruitful for businesses that have standard revenue recognition practices, one can see that when customer sales exist with multiple elements, whereby “delivering” a service or a product to a customer doesn’t necessarily result in revenues (but rather some or all deferred revenue), a proof of cash and revenue is not likely to yield meaningful results.

Having said this, I’ve assisted a number of clients in performing this proof of cash and revenue analysis and clients gain valuable insight into their business practices and controls that they otherwise may not be aware of.

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