Material weaknesses in internal control related to the statement of cash flows.
This discussion focuses on material weaknesses cited in auditors' reports that are related to the statement of cash flows; the types of companies with such weaknesses; the specific nature of these weaknesses, including some notable examples; and the companies' efforts to remediate these weaknesses. This analysis will highlight some common pitfalls that CPAs should avoid, especially given the SEC's prior focus on cash flow misclassification issues and the costs associated with restatements and with adverse internal control opinions.
Concerns Related to the Statement of Cash Flows
The SEC and previous researchers have raised issues related to the statement of cash flows and classification challenges faced by companies. In 2005 and 2006, for example, the SEC expressed concerns about misclassifications in the statement of cash flows and allowed companies to correct such errors without going through the official restatement process. In an article in the Journal of Accounting and Public Policy, Dana Hollie, Curtis Nicholls, and Qiuhong Zhao provided background on this SEC effort, including a discussion of research by Mulford and Mullins--which contributed to the SEC's focus on this area--that highlighted several examples of statement of cash flows misclassifications related to various types of receivables ("Effects of Cash Flow Statement Reclassifications Pursuant to the SEC's One-Time Allowance," vol. 30, no. 6, 2011, pp. 570-588). In an earlier article, Hugo Nurnberg and James A. Largay highlighted the complexities of the classifications within the statement of cash flows ("Interest Payments in the Cash Flow Statements," Accounting Horizons, December 1998, pp. 407-418). Finally, Susan Scholz found 360 restatements from 1997 to 2006 that were related to classifications within the statement of cash flows (The Changing Nature and Consequences of Public Company Financial Restatements: 1997-2006, U.S. Department of the Treasury, April 2008, p. 41). Based on this prior research, it is clear that the statement of cash flows has been an area of complexity and challenge for some public companies, often resulting in restatements of previously issued financial statements.
Overview of the Data
To provide greater insight into the cash flow area, the authors searched the Audit Analytics database for fiscal years 2004 to 2010 to identify companies that had more than $75 million in market capitalization and adverse auditor reports on their internal controls. The analysis next focused specifically on material weaknesses related to the database category "Cash flow statement (FAS [Financial Accounting Standards] 95 [Statement of Cash Flows]) classification errors" in order to isolate issues related to the statement of cash flows; this revealed 109 adverse auditor reports citing such weaknesses. The authors then reviewed the companies' SEC filings in order to analyze and categorize their material weaknesses and any remediation efforts; this process involved considerable judgment, due to the nature of the disclosures, the presence of several material weaknesses in some companies, and the fact that some remediation efforts appeared to address multiple material weaknesses. The analysis attempted to focus on the key elements of the remediation efforts.
As shown in Exhibit 1, the companies with cash flow--related material weaknesses cited in their auditor reports were relatively large: their median market value, revenues, and assets ranged from $440 million to $710 million. The companies were most heavily concentrated in manufacturing, fmancial services, and services; most had Big Four auditors. The median number of material weaknesses per company was 1 (range, 1 to 12).
EXHIBIT 1 Companies with Material Weaknesses Related to the Statement of Cash Flows Median Company Size Market Capitalization * $499,472 Revenues $443,655 Assets $712,171 Standard Industrial Classification Codes [dagger] 1000-1999, Mining and Construction 5 2000-3999, Manufacturing 28 4000-4999, Transportation and Communication 11 5000-5999, Wholesale and Retail 16 6000-6999, Financial, insurance, and Real Estate 28 7000-8999, Services 20 Total 108 External Audit Firm Big Four 98 Other National Firms 6 Local Firms 5 Total 109 Total Number of Material Weaknesses Median number of material weaknesses per company 1 Range of material weaknesses per company 1-12 * Data were available for only 107 of the 109 total companies analyzed. [dagger] Data were available for only 108 of the 109 total companies analyzed. Note: Table made from bar graph.
Nature of the material weaknesses. Although all of the material weaknesses examined relate, in some way, to the statement of cash flows, they reflect a number of different concerns. Two fundamental issues are highlighted in the eight categories found in Exhibit 2: First, many companies simply made errors in their statement of cash flows, reflected in the categories related to preparation, presentation, classification, and application of accounting principles. Second, the primary causes of these errors appear to be inadequate review, staffing deficiencies, and problems in the closing process. To provide a sense of the specific nature and magnitude of some of the issues, it is helpful to consider a few examples. One lending company stated in its SEC filling:
EXHIBIT 2 Nature of Cash Flow Material Weaknesses Type of Weakness Example and Number Reported Preparation 33 "Management has concluded that the internal control over financial reporting, specifically with respect to the preparation of the Consolidated Statement of Cash Flows, is not effective" Review 30 "Inadequate review process in place as it relates to the reporting of certain non-cash transactions in the statements of cash flows" Presentation 19 "Company did not maintain effective controls over the complete and accurate presentation and disclosure of short-term investments" Improper 18 "We classified these securities as cash and Classification cash equivalents rather than short-term investments as required by generally accepted accounting principles (GAAP)" Application of 15 "Company did not maintain effective internal Accounting control over the financial reporting and close Principles function to appropriately apply generally accepted accounting principles ensuring the adequacy of amounts and completeness of disclosures in the consolidated financial statements, resulting in the misclassification of cash flows from floor plan financing" Inadequate 15 "We lacked adequately trained finance and Staffing accounting personnel with appropriate U.S. generally accepted accounting principles [U.S. GAAP] expertise. As a result, an effective internal secondary review of technical accounting matters could not be performed in certain circumstances" Disclosure 9 "There were ineffective controls to record non-cash contributions of utility plant from developers and disclosure of these non-cash transactions in the statement of cash flows" Financial 6 "Company's processes, procedures and controls Close/Financial related to the financial reporting close Reporting process were not effective to ensure that the consolidated financial statements were appropriately recorded in accordance with generally accepted accounting principles" Note: Wording is taken from selected companies' SEC filings. The adjustment recorded was to properly classify cash used for origination of mortgage loans of $3.6 billion from cash flows from investing activities to cash flows from operating activities for the year ended December 31, 2004. As a result, cash used in operating activities was increased and cash used in investing activities was decreased by $3.6 billion on the statement of cash flows.
Thus, the company had a reclassification of $3.6 billion in its statement of cash flows, decreasing cash flow from operations by $3.6 billion. The adjustment brought operating cash flows from roughly negative $300 million to negative $3.9 billion, and increased investing cash flows from negative $2.7 billion to positive $900 million.
Another company stated in its SEC filling: Management determined that the Company's consolidated statements of cash flows for each of the three years in the period ended December 31, 2004 should be restated to reclassify $16,740,000; $6,666,000; and $65,197,000, respectively, from net cash used in investing activities to net cash provided by operating activities as they relate to distributions of income received from investments in partially-owned entities accounted for on the equity method.
Again, mere is a large stun (up to 1c'.0 million) between investing and operating activities, which in one case more than doubled cash flows provided from operations.
Finally, a third company stated in its SEC fillings:
The year end 2005 restatement reclassifies $40,102,000 expended for escrow deposits and purchased notes receivable pertaining to hotel and land acquisition from net cash provided by operating activities to net cash used in investing activities. The 2004 restatement reclassifies $4,900,000 pertaining to the issuance of a note receivable and investments in our hotels from net cash used in operating activities to net cash provided by investing activities. The March 31, 2005 quarter end restatement reclassifies $8,000,000 of cash spent for escrow deposits related to a hotel acquisition from net cash used in investing activities to net cash provided by operating activities.
This company had significant annual and interim reclassifications (up to $40 million) between operating and investing activities, with the direction of the reclassification varying by period.
Each of these three examples highlights the large magnitude of restatements that can occur due to the misclassification of items within the statement of cash flows. Cash flows generated by operating activities tend to be important to investors because they are generated from core business activities and, thus, can be expected to offer a good indication of future cash flows.
One interesting finding (in terms of the raw number of occurrences) was that many misclassifications of cash flows had the end result of overstating cash flows from operations--if the cash flows were inflows, they tended to be placed in operating activities when they should have been recorded as financing activities; if they were outflows, they tended to be placed in investing activities rather than operating activities. Such misstatements would overstate the ratios commonly used in financial statement analysis, such as free cash flow (net cash provided by operating activities minus capital expenditures) and coverage ratios like the cash-debt-coverage ratio (net cash provided by operating activities divided by total debt). Accordingly, misclassifications in the statement of cash flows can significantly affect financial statement analysis.
Remediation efforts. Exhibit 3 summarizes the companies' efforts to remediate material weaknesses related to the statement of cash flows. As noted above, some remedial efforts appeared to relate to more than just the material weaknesses related to cash flows. The authors attempted to focus on the key elements of the remediation efforts, such as improving the quality of the review process involved in the statement of cash flows; restating, if needed; and enhancing the people and processes around the statement of cash flows.
EXHIBIT 3 Remediation Efforts Type of Remediation Example and Number Reported Review 34 "Accelerate the timing of certain review and monitoring activities during the financial statement closing process, specifically as it relates to the statement of cash flows" Restatement * 32 "Based on the impact of these accounting errors, we restated our condensed consolidated interim financial statements as of and for the periods ended September 30, 2009 and 2008 and December 31, 2009 and 2008" Accounting Staff 16 "Enhancement of the accounting, corporate tax and internal audit functions by increasing the number of adequately trained personnel capable of anticipating and identifying risks critical to financial reporting" Process 15 "Improving the collection from our head office Improvements and our subsidiaries of financial data required to produce U.S. GAAP and IFRS statements, standardizing the data collection procedures and assigning data collection responsibilities to designated personnel" Training 13 "Provide additional training and cross-training to our existing personnel, including areas of new and emerging accounting standards" New 10 "Management has implemented a process to aid Process/Procedure in correctly classifying amounts related to acquisitions reflected in the consolidated statement of cash flows, including a more detailed cash flow statement preparation checklist" Design/Implement 7 "Design and implementation of enhanced Controls controls to aid in the correct preparation, review, presentation and disclosures of our consolidated statement of cash flows. Management will monitor, evaluate and test the operating effectiveness of these controls" Documentation 6 "During the fourth quarter of 2006, the Company implemented and in 2007, the Company plans to continue to enhance and improve the documentation and review of required information associated with the preparation of its quarterly and annual filings" Hire Consultants 5 "Continued engagement of third-party accounting professionals to provide IFRS and U.S. GAAP consulting services" Note: Wording is taken from selected companies' SEC filings. * includes cases in which the restatement led to the disclosure of a material weakness in internal control, as well as either restatements of prior financial statements or restatements of prior management assessments of internal control effectiveness.
Comparison of Large and Small Companies
Overall, the percentage of larger public companies receiving adverse SOX section 404 reports for any reason has declined markedly since 2004. For example, Audit Analytics (SOX 404 Dashboard Year 6 Update) indicates that the percentage of adverse reports has dropped from nearly 17% in the first year of SOX section 404 to approximately 2% in 2009. This same pattern is also found within the subset of weaknesses related to the statement of cash flows examined here. Specifically, more than half of the 109 cash flow--related material weaknesses occurred in 2004 or 2005, with only a handful per year from 2008 to 2010. It appears that the vast majority of larger public companies have remediated their cash flow--related material weaknesses.
To provide some initial insight into the challenges facing smaller public companies, the authors also searched the Audit Analytics database for companies with less than $75 million in market capitalization and adverse management reports on internal control that cited cash flow issues. (Given their exemption from external audits of internal control, such companies would not receive SOX section 404 auditor reports.) From 2004 to the present, only 24 cases of adverse management reports on internal control cited cash flow issues. It appears that without auditor attestation of internal control effectiveness in place, the reporting of material weaknesses related to cash flows is much lower for smaller public companies. This finding is consistent with that in Scholz's aforementioned report: accelerated filers were more likely to restate their financial statements due to cash flow classification issues than nonaccelerated filers (Scholz, p. 45).
It is possible that smaller public companies face fewer complexities in their classification of cash flows. It is also possible that the lack of auditor attestation of internal controls for smaller companies reduces the number of material weaknesses detected and identified that are related to the statement of cash flows. Consistent with this conjecture, Jean C. Bedard and Lynford Graham found that auditors detect the vast majority of internal control deficiencies ("Detection and Severity Classifications of Sarbanes-Oxley Section 404 Internal Control Deficiencies," Accounting Review, May 2011). Therefore, for smaller companies (where only management attests to the effectiveness of controls), the actual prevalence of material weaknesses related to the statement of cash flows is much less clear and may be understated.
It appears that the complexity of the statement of cash flows--combined with deficiencies in specific controls, the review process, and the staffing or training of accountants--can result in misstatements, restatements, and adverse internal control opinions. Such events can be quite costly to companies, in terms of time, professional fees, remediation costs, and even reputation damage. While most large public companies appear to have moved past previous issues with the statement of cash flows, such issues might represent emerging or ongoing risks for smaller public companies. The authors encourage CPAs associated with smaller public companies to consider how they can help mitigate the types of material weaknesses highlighted above, especially the preparation, review, presentation, and classification of cash flow statements.
CPAs in both public practice and industry should carefully consider new or emerging areas of accounting complexity and should develop effective controls and review processes around these areas. This is underscored by a recent analysis of restatement causes by Marlene Plumlee and Terri Lombardi Yohn, which stated:
For those restatements attributed to some characteristic of the accounting standards, the primary contributing factor is the lack of clarity in applying the standards and/or the proliferation of the literature because the original standard lacked clarity ("An Analysis of the Underlying Causes Attributed to Restatements," Accounting Horizons, March 2010, pp. 41-64).
Identifying and addressing those areas in the accounting standards that present increased complexity and lack of clarity is vitally important to all participants in the financial reporting process. When areas of complexity are identified, management needs to develop appropriate controls and review processes to address the risk of misstatements. Qualified personnel are critical, whether they are in-house employees or outside consultants who provide initial training and oversight of emerging risk areas.
Daniel M. Ivaneevich, PhD, and Susan H. Ivancevich, PhD, are professors and Dixon Hughes Goodman Faculty Fellows at the University of North Carolina--Wilmington. Dana R Hermanson, PhD, is a professor and Dinos Eminent Scholar Chair at Kennesaw State University, Kennesaw, Ga.
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|Author:||Ivancevich, Daniel M.; Ivancevich, Susan H.; Hermanson, Dana R.|
|Publication:||The CPA Journal|
|Date:||Dec 1, 2012|
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