SEC Guidance on Statement of Cash Flows

By: Cydney Posner

In January 2005, Corp Fin sent letters to companies in certain industry groups regarding the presentation of their statements of cash flows. To publicize the issue (or, as the SEC put it, "to affect wide-spread awareness of this issue"), the SEC has now posted this guidance in the form of a sample letter. The SEC's guidance emphasizes the importance of appropriate classification and presentation of items in the consolidated statement of cash flows: "we expect registrants to give significant attention to the preparation of their consolidated statement of cash flows in order to ensure it provides an accurate presentation of their actual cash receipts and cash payments based on activity (operating, investing and financing), which in turn assists the reader in determining the registrant's ability to meet its obligations, pay dividends, generate cash flows sufficient to grow its business, etc." The guidance acknowledges that, although most companies use the "short-cut indirect method," the staff believes that the "direct method" (which clearly discloses amounts for items such as cash paid to suppliers and employees and cash collected from customers and which the SEC has been promoting for several years) provides better disclosure. As a result, the SEC encourages companies to "put more time and effort into ensuring that the statement of cash flows, and related disclosure in the financial statement footnotes and in MD&A, is meaningful and useful to users of the financial statements."

The sample letter relates to the presentation, as investing activities, of the origination and subsequent collection of finance receivables from inventory sales. The SEC points out that SFAS 95 states that cash receipts form the sales of goods or services should be treated as operating cash flows, whether they stem from the direct collection of the receivable, the sale of the receivable to others or the issuance of a note. Likewise, companies should not present cash flows between the company and/or its consolidated subsidiaries as an investing cash outflow and an operating cash inflow when there has not been a cash inflow to the company on a consolidated basis from the sale of inventory.

Although these misclassifications do not comply with GAAP, the SEC states that it will not object to disclosures that "do not specifically reference the correction of an error" (which could require restatement), so long as the company:

"1. Correctly presents the consolidated statements of cash flows for all periods presented;

2. Indicates that management’s decision to change the classification of the cash flow effects of long-term customer receivables, including sales-type lease receivables, stemmed from concerns raised by the staff of the Securities and Exchange Commission about the previous presentation; and

3. Includes prominent disclosure that:

   a) Describes how the accounting for these transactions was historically reflected in the consolidated statements of cash flows, including an explicit statement that no cash was received by the company on a consolidated basis when the sale was made to the customer;

   b) States that the consolidated statements of cash flows has been adjusted to reflect the fact that there was no cash received by the consolidated entity upon the initial sale of inventory, resulting in the elimination of the effects of the intercompany transactions, and to properly classify cash receipts from the sale of inventory as operating activities;

   c) Includes a reconciliation of the amount previously presented for the affected line items to the amount currently presented for each period; and

   d) Discusses the effect of these transactions in the liquidity and cash flow section of MD&A."

The SEC also recommends that companies consider disclosure that identifies where the cash flows related to the sale of inventory are classified in the consolidated statements of cash flows and explains the nature of the receivables/notes/loans and where the cash flows from these transactions are classified in the consolidated statements of cash flows.

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