Do you struggle with creating cash flow statements? Would you like to know how to correct cash flow statement errors? Below I explain how. We'll also discuss when you can omit cash flow statements and if it’s desirable or undesirable to do so.
Cash flows are the lifeblood of any entity. Therefore, we must ensure the correctness of cash flow statements. For many small businesses, the auditor creates and audits this statement. So we need to make sure we do so correctly.
Correcting Cash Flow Errors
Cash flow statement errors can be challenging, but, in many cases, there is a simple solution.
Example from My Office
This morning a staff member came to my office and said, "Something is out on my cash flow statement, and I don't know how to fix it. It has to do with PPP loan forgiveness of $280,000." (Most people know where the problem is, but they don't know how to correct the outage.)
So I told him what I've said to many over the years. "Imagine there are three physical buckets: operating, investing, financing. Then pretend the transaction in question is the only one of the year." Next, ask, "was cash received, and if yes, how much?" And finally, "in what bucket should I place the cash?" Mentally you are placing physical dollars in the three physical buckets even though cash is received electronically and physically.
Returning to my conversation with my staff member, I asked, "did the business receive any PPP money in the current year?" He said, "no, all came in the prior year." My next question was, "how much cash belongs to any of the three buckets in the current year?" And he said, "none."
The PPP money was a cash inflow that went into the financing bucket in the prior year. In the current year, there is no cash, only forgiveness. It's a noncash transaction. Now, think about the journal entry to recognize the loan forgiveness: the company debited the loan payable and credited a revenue account.
So if the company uses the indirect method in its cash flow statement, it begins with net income. We know $280,000 of PPP loan forgiveness is in net income. If we pretend that's the only transaction, then net income is $280,000. And how much cash was received in the current year? Yes, $0. So we know we need to subtract $280,000 from net income to get to $0 cash flows from operations. Just below net income, we'd include a line titled "PPP loan forgiveness," subtracting the PPP amount to arrive at $0.
There's the answer to this problem, and this example explains how to correct cash flow statement errors.
Isolate Cash Flow Problem
The mistake most people make in solving cash flow problems is trying to think about several different transactions simultaneously. Try to focus on one transaction at a time.
The cash flows from investing and financing are usually easy to determine. Why? Because we reflect the actual cash inflows and outflows in those sections of the cash flow statement. Problems commonly arise in the operating area because of the indirect method (starting with net income and backing into cash flow from operations). When they do, see if you can determine the net change in each of the three buckets. You can back into the net change for operations if you know the net cash change and the net changes for investing and financing: subtract the net amounts for investing and financing from the net cash change. Then you can work from there to see why cash flow from operations is out (if that is the troublesome area).
Three Steps to Correct Cash Flow Statement Errors
From there, use these three steps to correct cash flow statement errors:
- Pretend the transaction is the only transaction for the year
- Determine how much cash was received for that transaction, if any
- Determine whether the amount in question is operating, investing, or financing
Spreadsheet with Balance Sheet Changes
Of course, I also recommend you place the current year balance sheet with comparative prior period numbers in an Excel spreadsheet. That way, you can see the changes in the numbers. Identify the investing and financing changes such as the investment and debt balance sheet lines. The remaining balance sheet changes are operating lines. The cash change on the spreadsheet is your net cash change on the statement.
Cash Flow Statement Importance
We, as auditors, pay less attention to cash flows than we should. We often focus on revenues, net income, or equity, but not cash flows. Why? I believe it's our training: our trainers tell us revenues, net income, and equity are most important. But if you were buying a business or loaning money to the company, would you pay attention to cash flows? Almost certainly. What if you were valuing the business? Would you pay attention to cash flows? Yes, again.
Cash flows from operations might be the most crucial number in the financial statements since it is the entity's lifeblood. Show me a business that generates no cash flow from operations, and I'll show you a company that will go under (in most cases).
In evaluating going concern, the company and auditors review cash flows. After all, the going concern assessment is about whether a company can meet its ongoing obligations to pay its future bills. So cash flow information is crucial for companies with continuing losses or deficit equity positions.
Financial statements sometimes don't contain a cash flow statement. But should they?
Omitting Cash Flow Statements
It is permissible to omit the cash flow statement in a compilation--and most accountants do. True even for financial statements created under generally accepted accounting principles. (You may not omit the statement from audited or reviewed financial statements if GAAP is in use unless the auditor's report is modified.)
And special purpose financial statements such as tax-basis don't require a cash flow statement even if audited or reviewed.
But is it wise to omit this statement? Maybe not. All businesses, even small ones, need to know how much cash is coming in or going out by category--not just net income. And I'm sure lenders appreciate cash flow information: that's how businesses pay loans.
Of course, the decision to include or omit the statement (when it's optional) for small businesses is a cost/benefit decision. Creating the cash flow statement requires an increase in the fee for compilations, for example. And the owners may not desire to pay the additional amount.
Businesses usually don't need cash flow information for interim compilations, such as monthly financial statements. But the company owners or management might find value in annual cash flow statements.
Cash Flow Information
Use the three steps listed above to hone in on cash flow statement outages. Hopefully, doing so will aid you in making corrections. And consider including cash flow statements in all financial statements, if desired by your client.