The statement of cash flows does NOT report

We have all heard it: “Cash is king.”

However, preparers are often guilty of hasty, mechanical preparation, which ultimately leads to unnecessary errors that make the statement from thereon less useful. 

If cash is king, don’t we owe the statement that tells its story a little more respect? If you agree, here are what we consider to be the top 10 errors on the statement of cash flows. 

1. Misclassifying the three categories of cash flows

All cash flows originate at one of these three categories: operating, investing or financing. The most common error when preparing the cash flows is the improper categorization therein. 

When in doubt, there are a few tips that can help you choose correctly. Remember that each category is generally associated with a financial statement “area” that they can be tracked back to, as noted below. Also remember that there is an exception to every rule ….

Investing activities are typically related to changes in long term assets: Common examples include purchasing fixed assets, certificates of deposits, marketable securities (What do we do with extra cash?).

Financing activities are typically related to changes in long term liabilities and/or equity: This includes notes payable and issuance of stock, all of which are sources of financing for the company’s needs (How do we get cash from outside the company?). This section also discloses changes in lines of credit (a short-term liability). This is an example of the exception to the rule. 

Operating activities are typically related to the income statement and changes in current assets and current liabilities: This includes really almost everything else, such as any cash flows that are the result of operations, even if there is a financing or investing facet to them. For example, investing in inventory or financing via accounts payable are still operating activities (How well do we generate cash flows?).

This is also the area you should probably focus your time on in the financial review. Negative cash flows from operations might seem concerning, but maybe that is totally normal during certain periods and should be frightening at others. Tracking and analyzing is the best way to know. 

2. Not applying the fourth category of cash-flows

Wait, I thought you said there were only three categories …. 

The truth is that there is kind of a fourth category: non-cash transactions. This category is often missed and improperly included in the statement of cash flows as if cash changed hands. 

A good example is dealer-provided financing. When purchasing a new vehicle via the issuance of a note payable, there is a tendency to show the gross purchase price and the new note balance in full within the investing and financing areas, respectively. Yet there was actually no cash that changed hands in this transaction. We simply signed a piece of paper. 

If items are financed through a financial institution, as opposed to a dealer, it may be proper to account for the gross transaction, as the substance and form may mirror each other. For example, the bank may have actually cut a check to the company. However, this is more commonly the exception than the rule.

3. Not disclosing non-cash transaction

Many things in life don’t make sense. Add to that list needing to disclose non-cash transactions on the statement of cash flows. The same way it is a common error to gross up investing and financing line items for non-cash transactions, it is an error to omit any mention of them. The form of presentation can vary, be it tabular or in a narrative at the bottom of the statement of cash flows. If there are several and/or complex non-cash transactions, a separate footnote might be a more viable option. 

4. What’s in a name?

Line items on the statement of cash flows often times represent the change in balance sheet accounts or a line on statement of operations. There is no reason why the descriptions should not match word for word. If it was important enough to break out on the balance sheet, it should be broken out on the statement of cash flows as well, not netted with other line items. 

Investing and financing verbiages are also often labeled incorrectly. Mixing these up is easy to do and can confuse the reader. For example, “proceeds from” assumes a cash inflow. Anything that is a cash outflow needs a fitting description, such as “repayment of.” 

This can be especially tricky if you are preparing comparative financials that have different cash flows in either period. While not always practical, coming up with a generic description that fits both in- and outflows, such as Cash Flows from Line-of-Credit Activity, is wise. We also recommend changing the “increase or (decrease)” in cash to simply “change in.” That way you can’t be wrong. The reader is smart enough to know that a negative is a cash outflow and a positive is a cash inflow.

5. The simplest thing

I know it goes without saying that cash at the bottom of the statement of cash flows should tie to the balance sheet, but I also know that last-minute tweaks from tardy parties or new info are commonplace when preparing the financials.

When these last-minute changes happen, we have a tendency to remember to update the balance sheet and statement of operations and, true to form, ignore the effects on the statement of cash flows. Often, ignoring these changes is going to mean ending cash on the statement of cash flows doesn’t tie back to the balance sheet. Check this one more time before you hit print or send that email to the management team. 

6. Do as I say, not as I do

GAAP provides pretty clear instructions that netting together two related types of cash flows is not acceptable. For example, purchases and sales of investments should never be netted together; rather, there should be a line for purchases and a line for sales. 

However, in certain circumstances, it has become acceptable in the industry to see this netting. The most common example is cash flows from line-of-credit activities. While GAAP is clear that borrowings and repayments on lines of credit should be reported gross, the industry has gravitated towards net reporting as the norm. The preparer of the statement should be aware of the gross borrowings and repayments, and, if they are material, should evaluate if it would be useful to the reader to present these as two separate line items. 

7. Marketable securities

Marketable securities are always a challenge on the statement of cash flows and, because of this, an area where multiple errors are common place. 

Dividends, interest income, realized capital gains and soon to be changes in unrealized gain (loss) on holdings (already effective for publicly traded and early adopters) are all included in net income (loss). 

However, these are not part of operating actives and therefore need to be reversed as reconciling items included in operating activities on the statement of cash flows. When presenting these, be aware of how they are presented on the statement of operations, as two or three lines may be warranted. This might also be true in the investing section as well. As was already noted, gross numbers should be used, and therefore proceeds from sales, and purchases should not be netted together. 

8. Paid-in-full

Generally speaking, it is good if accounts receivable goes down. Because, you know, cash is king. 

However, bad debts and/or changes in the allowance for doubtful accounts are an example of accounts receivable reducing in a bad way. When this happens, you need to make sure you are not including this on the change in accounts receivable under cash flows from operating activities on the cash flows. Rather, it needs to be broken out under the adjustment reconciling net income to cash from operations. 

9. Interest and taxes

Another item that is often overlooked is the amount of interest and income taxes paid when using the indirect method of reporting the statement of cash flows. It is common to not only miss these disclosures but also improperly report them even when included. 

Remember, we are talking about cash paid, so accrual balances need to be adjusted to cash basis for proper reporting. It is often debated whether we should include these disclosures even if the amount is $-0-. Sounds exciting, right? One opinion is that including it at $-0- lets the reader know you considered it. However, as mentioned before, there are exceptions to every rule. For example, on a non-tax-paying pass-through entity, we often see the omission of income taxes paid.  

10. Know your business

This can get tricky. For example, you are in the business of equipment rental, there is a strong chance you have fixed assets (investing) and very similar inventory assets (operating). The sale of one piece of equipment versus another results in different cash flows. 

Conclusion

Whether or not you agree with the “cash is king” mantra or not, it certainly will dictate many important business decisions. Making the right decisions is what sets us ahead of the competition, and having accurate and timely financials (including the statement of cash flows) is an important step to make this reality. Hopefully these tips will help in achieving this competitive edge. 

Which would not be shown in a cash flow statement?

What is reported in statement of cash flows?