Common errors in cash flow statements

Following on from our recent articles explaining what cash and cash equivalents are and disclosures required when cash is subject to restrictions, we embark on a journey to highlight common errors Tier 1 and Tier 2 for-profit and Public Benefit Entity (PBE) preparers make when preparing the cash flow statement.
 

The cash flow statement is one of the four primary financial statements and provides extremely valuable (material) information to users, particularly in respect of an entity’s liquidity, going concern and general financial health. Together with the basis of preparation note and the auditor’s report, the cash flow statement is the key statement users should read when trying to analyse the overall financial health of an entity.

In Part 1 of our series, we look at the following common errors that could result in the cash flow statement being materially misstated:

• Overstating operating cash inflows
• Grossing up non-cash settlements
• Netting off transactions.

Overstating net operating cashflows

Overstating net operating cashflows can occur when cash outflows that should be classified as operating activities are instead shown as investing or financing outflows. In addition, where cash inflows from investing or financing activities are incorrectly shown as operating cash inflows. We discuss these scenarios in more detail below.
 

Treating operating cash outflows as investing cash outflows
Showing negative cash outflows from operating activities, or declining cash inflows is a potential indicator of potential entity failure, insolvency, etc. Therefore, preparers may be incentivised to classify as many cash outflows as possible as part of investing activities.

‘Operating activities are the principal revenue-producing activities of the entity and other activities that are not investing or financing activities.’ NZ IAS 7 definition of operating activities (PBEs: “Operating activities are the activities of the entity that are not investing or financing activities.” PBE IPSAS 2 definition of operating activities) ‘The separate disclosure of cash flows arising from investing activities is important because the cash flows represent the extent to which expenditures have been made for resources intended to generate future income and cash flows. Only expenditures that result in a recognised asset in the statement of financial position are eligible for classification as investing activities.’ Extract of IAS 7.16 (emphasis added) (PBEs: Extract of PBE IPSAS 2.25 (emphasis added))

If expenditure does not create a recognised asset, then it cannot be shown as a cash outflow from investing activities. This definition closely links with what can be capitalised under NZ IAS 38 Intangible Assets (PBEs: PBE IPSAS 31 Intangible Assets). Common errors include showing the following costs as investing cash outflows:

• Advertising
• Research
• Training
• Initial costs of set up
• Repairs
• Spend on exploration activities, where the entity’s policy is to expense exploration and evaluation costs.

Treating operating cash outflows as financing cash flows

Preparers may attempt to disclose certain operating cash outflows as financing cash outflows. NZ IAS 7 (PBEs: PBE IPSAS 2) requires that financing cash flows include cash repayments of amounts borrowed, and cash payments by a lessee for the reduction of the outstanding liability relating to a lease. Common errors include showing:

• Payments to trade creditors as financing cash flows
• Payments on short-term and low value leases as financing cash flows (i.e., leases where a lease liability is not recognised in the statement of financial position).
• Contingent payments on business combinations (PBEs: PBE combinations) above the initial liability amount as being from financing or investing activities.

Treating investing cash inflows as operating cash flows

Similarly, preparers may incorrectly present cash inflows from investing activities as operating cash inflows. Investing cash inflows include cash receipts from:

• The sale of property, plant and equipment (PPE), intangibles and other long-term assets.
• The sale of (or maturity of) investments such as debt or equity instruments in other entities and interests in joint ventures (other than receipts from instruments considered to be cash and cash equivalents and those held for trading or dealing purposes).
• The repayment of advances and loans made to other parties (other than loans and advances made by financial institutions – which are presented as operating activities).
• Futures contracts, forward contracts, option contracts and swap contracts (except when the contracts are held for dealing or trading purposes, or the receipts are classified as financing activities).

Common classification errors include incorrectly showing the following as cash inflows from operating activities:

• Sale proceeds from (or proceeds from the maturity of) long-term investments.
• Sale proceeds from the disposal of PPE.
• Sale proceeds from the sale of an associate, joint venture or subsidiary (PBE: controlled entity)
• Cash receipts for repayments of advances and loans made to other parties.
• Cash receipts from futures contracts and forward contracts (classified as hedging investing cash flows).
• Proceeds in respect of deferred consideration for the sale of PPE or a business.

Grossing up non-cash settlements

A correctly prepared cash flow statement is very important for an investor to analyse loan performance, and the entity’s ability to raise debt and equity funding. We commonly see entities incorrectly grossing up transactions in the cash flow statement where there has been no cash impact.

Example 1

On 1 January 20X1, Entity A loans $50,000 to Entity B. Interest is charged at 10% per annum on the loan, payable quarterly in arrears. During 20X1, Entity B made all four quarterly interest payments, but during 20X2, Entity B experienced financial difficulties and was unable to pay interest on the loan. Interest is therefore, being capitalised. Entity A’s year-end is 31 December. The table below compares the incorrect and correct presentation in the cash flow statement by Entity A.
 

	Incorrect presentation (gross up) $	Correct presentation (no gross up) $
Statement of financial position
Loan receivable  ($50,000 plus $5,000 accrued interest)	55,000	55,000
Cash flow statement
Operating cash inflows
Interest income	5,000	Nil
Investing cash outflows
Loans to borrowers	(5,000)	Nil

Incorrectly grossing up the loan receivable with the $5,000 of accrued interest (for an advance to borrower) in investing activities with a corresponding cash inflow of $5,000 for interest received when this is not a cash flow through Entity A’s bank account

Example 2

Entity C issued a convertible note in 20X1 with an anti-dilution feature. In 20X5, the note was converted into equity, resulting in Entity C issuing significantly more shares than were originally intended when the note was issued. The note was converted because Entity C was unable to repay the amount owing on the note.

	Incorrect presentation (gross up) $	Correct presentation (no gross up) $
Cash flow statement
Financing cash flows
Proceeds from issue of share capital	1,000	Nil
Repayment of borrowings	(1,000)	Nil

Incorrectly grossing up cash inflows and outflows from financing activities creates the impression of liquidity (that is, the ability of Entity C to repay borrowings and raise new equity).

 

Netting off transactions

Given the specific financing arrangements of an entity, the stability or otherwise of an entity’s financing arrangements can be significant to a user.  That is, the entity having to repay loans, raise new financing, etc. A common error is to net off loan repayments and new financing.

Example 3

Entity D reported long-term borrowings of $10,000 with Big Bank as at 30 June 20X1. During the year it breached various loan covenants and was forced to refinance with a variety of promissory notes and convertible notes.
 

	Incorrect presentation (net) $	Correct presentation (gross up) $
Cash flow statement
Financing cash flows
Cash raised from new borrowings	Nil	10,000
Repayment of borrowings	Nil	(10,000)

Incorrect netting creates the false impression that Entity D has stable financing arrangements.

 

We are here to help

Given the importance of the cash flow statement to investors, it is vital entities present operating, investing and financing cash flows accurately. This is not as simple as one might think. Please contact our Financial Reporting Advisory team for help.

For more on the above, please contact your local BDO representative.
This article has been based on an article that originally appeared on BDO Australia, read the original article here.