Cash flow statements need improvement

On 17 November 2020 the Financial Reporting Council (FRC) issued a Press Release stating that the preparation of cash flow statements needs to significantly improve. This release followed the FRC’s review of corporate reporting for 2019/20.

While the review focuses on those entities which report under IFRS, the content of the FRC’s corporate reporting review can be applied to financial statements prepared under UK GAAP for private entities.

The FRC have challenged companies where they have found deficiencies in their cash flow statements. Notably, the FRC challenged:

• material inconsistencies between items in the cash flow statement and the notes;
• missing or incorrectly classified cash flows; and
• inconsistencies between financing cash flows and the reconciliation of changes in liabilities arising from financing activities in the notes.

The FRC have also identified several areas for improvement in the disclosure of accounting policies for the treatment of significant and large, one-off transactions in the cash flow statement. The FRC are also concerned about ‘boilerplate’ disclosures in respect of liquidity risk and related issues. Conversely, the FRC have noted improvements in going concern, viability and liquidity disclosures.

The FRC’s Corporate Reporting Review 2019/20 confirms that a number of companies agreed to restate their cash flow statements following queries raised by the FRC and according to the FRC’s Thematic review: Cash flow and liquidity disclosures (Nov 2020), the cash flow statement has featured in the top ten most frequently raised topics by the FRC.

The FRC strongly recommends that companies consider the guidance and case study which was provided in the 2019 Corporate Reporting Review on pages 12 to 14.

Concerns raised by the FRC in respect of the cash flow statement are as follows:

Reported cash flows

• Companies with reverse factoring arrangements failed to explain how the related cash flows were presented and the overall impact of those arrangements on the cash flow statement.
• Non-cash amounts were presented as cash flows, such as assets acquired under finance leases and non-cash finance changes.
• Proceeds from borrowings and repayment of borrowings were offset as opposed to being shown gross.
• Errors were noted where the cash flow statement was prepared on an indirect basis. The report cites share-based payment charges being deducted from pre-tax profit instead of being added back.
• The FRC identified material unexplained inconsistencies in reported cash flows and disclosures provided in other sections of the financial statements, such as in the strategic report.

Accounting policies

• Queries were raised by the FRC where accounting policies stated that cash equivalents included amounts with an original maturity of more than three months. IAS 7 Cash Flow Statements explains that an investment normally qualifies as a cash equivalent when it has a short maturity of, say, three months or less from the date of acquisition (this is also the same under FRS 102, para 7.2).

Classification of cash flows

• Certain costs such as acquisition-related costs and consideration for post-acquisition services were charged to profit and loss. However, the related cash flows were classified as investing cash flows rather than operating cash flows.
• Cash flows in respect of acquisition from non-controlling interests were classified as investing activities rather than as financing activities.
• Derivative-related cash flows were classified as financing activities even though the derivatives related to operational hedges and hedges of net investments in foreign operations.

Other issues

• The FRC noted that some entities’ financial review did not discuss significant cash flow matters, such as significant changes in operating cash flow and movements in restricted cash.
• Some reconciliations of liabilities arising from financing activities failed to meet the IAS 7 requirements. For example, because they were presented on an aggregate basis for an entity’s net debt, including cash and cash equivalents and derivative assets, which are not liabilities from financing activities.
• Some companies failed to make the required disclosures in accordance with IAS 7. For example, they failed to disclose dividends received from associates and joint ventures or net cash paid on acquisitions.

Next steps

The FRC’s thematic review states that they will write to three companies which were included in their sample where there is a substantive question concerning their cash flow statement. In addition, the FRC will write to a further five companies to draw their attention to aspects of their disclosures where improvements are required.

The FRC have also said that they will challenge companies where they do not see:

• Clear explanation of going concern, viability and liquidity information, such as availability of cash, undrawn borrowing facilities and compliance with covenants.
• Disclosure of assumptions and judgements made in assessing going concern and viability.
• Disclosure of supplier financing arrangements, including the impact on liquidity risk management.
• Evidence of robust pre-issuance reviews to ensure cash flow statements and related notes are compliant with the requirements of IAS 7 and free from basic errors.
• Consistency between the amounts and descriptions of items in the cash flow statement, and other areas of the annual report including: the strategic report, other primary statements, disclosures of changes in financing liabilities and other notes.
• Disclosure of any judgements in relation to the cash flow statement, particularly for large, one-off transactions, and disclosure of related accounting policies, such as for the composition of cash and cash equivalents, the presentation of interest and contingent consideration.

The FRC’s thematic review contains a useful summary of historical cash flow statement errors where corrective action was required as follows:

Category: Accounting and standards, Audit