Blind Freddy – Common errors in cash flow statements

Following on from our successful previous ‘Blind Freddy’ series, this month we highlight some common ‘Blind Freddy’ errors relating to the preparation and presentation of cash flow statements.

The ‘Blind Freddy’ proposition was introduced into Australian financial reporting by Justice Middleton in the Centro case.

The cash flow statement is one of the four primary financial statements and provides extremely valuable (material) information to users, particularly in respect of an entity’s liquidity, going concern and general financial health. Together with the basis of preparation note and the auditor’s report, when trying to analyse the risk of an entity failing, the cash flow statement is the key statement users should read.

In this article we look at common errors that result in the cash flow statement, prepared under AASB 107 Statement of Cash Flows, being misstated. These fall into the following areas:

  • Overstating operating cash inflows
    • Treating operating cash outflows as investing cash flows
    • Treating operating cash outflows as financing cash flows
    • Treating investing cash inflows as operating cash flows
    • Treating financing cash inflows as operating cash flows
  • Grossing up non-cash settlements
  • Netting off transactions
  • Errors with foreign currency
  • Errors in determining what is ‘cash’ or a ‘cash equivalent’.

Overstating operating cash inflows

Treating operating cash outflows as investing cash flows

Showing negative cash outflows from operating activities, or declining cash inflows, is a potential indicator of potential failure, insolvency, etc. Therefore there are incentives for preparers to classify as many items as they can as part of investing activities.

AASB 107 definition of ‘operating activities’

‘Operating activities are the principal revenue-producing activities of the entity and other activities that are not investing or financing activities.’



AASB 107.16

‘..Only expenditures that result in a recognised asset in the statement of financial position are eligible for classification as investing activities.’


For this reason, if expenditure does not create a recognised asset, then it cannot be shown as a cash outflow from investing activities. In particular, this definition closely links with what can be capitalised under AASB 138 Intangible Assets. Common ‘Blind Freddy’ mistakes include showing the following as investing cash outflows:

  • Advertising
  • Research
  • Training
  • Initial costs of set up
  • Repairs
  • Spend on exploration activities, where the entity’s policy is to expense exploration and evaluation costs.

Treating operating cash outflows as financing cash flows

AASB 107 requires that financing cash flows include cash repayments of amounts borrowed, and cash payments by a lessee for the reduction of the outstanding liability relating to a finance lease.
Common ‘Blind Freddy’ mistakes include:

  • Treating payments to trade creditors as financing cash flows
  • Treating payments of operating leases as financing cash flows
  • Treating contingent payments on business combinations as financing or investing.

Treating investing cash inflows as operating cash flows

Common ‘Blind Freddy’ mistakes include:

  • Treating sale proceeds from the sale of available for sale (AFS) investments as operating cash flows
  • Showing sale proceeds from the disposal of property, plant and equipment (PPE) as operating cash flows
  • Showing sale proceeds from the sale of an associate, JV or a subsidiary as operating cash flows
  • Showing cash receipts on advances and loans made as operating cash flows
  • Showing cash receipts from futures contracts and forward contracts (classified as hedging investing cash flows) as operating cash flows (e.g. hedges taken out for PPE).

Another common error is the treatment of proceeds in respect of deferred consideration for the sale of PPE or a business as operating cash flows.

Treating financing cash inflows as operating cash flows

Common ‘Blind Freddy’ mistakes include:

  • Showing cash proceeds from issuing shares as operating cash flows
  • Showing cash proceeds from issuing loans, notes, bonds, mortgages and other short-term or long-term borrowings as operating cash flows.

Grossing up non-cash settlements

A correctly prepared cash flow statement is very important for an investor to be able to analyse the performance of loans, and the ability of the entity to raise equity. A common ‘Blind Freddy’ error is incorrectly grossing up transactions in the cash flow statement.

Example 1

Entity A’s only asset is a $10,000 loan to Company B. 10% interest is charged per annum on the loan, payable quarterly in arrears.
Company B is in financial difficulty and is unable to pay interest on the loan. Interest is therefore being capitalised.

 

Incorrectly grossing up

Correctly treated

Notes

Income statement

 

 

 

Interest income

1,000

1,000

 

 

 

 

 

Balance sheet

 

 

 

Loan receivable

11,000

10,000

 

Accrued interest receivable

 

1,000

 

 

 

 

 

Cash flow statement

 

 

 

Operating cash inflow

 

 

 

 

 

 

 

Interest income

1,000

Nil

Incorrect gross up gives the misleading impression that Company B is actually servicing its debt

 

 

 

 

Investing cash outflow

 

 

 

 

 

 

 

Loans to borrowers

(1,000)

Nil

 

 

 

 

 


Example 2

Company A issued a convertible note in 2008 containing a ‘ratchet’ feature.

In 2015, the note was converted into equity by issuing significantly more shares than were originally intended when the note was issued.
The main reason for conversion was the inability of Company A to repay the amount owing on the note.

 

Incorrectly grossing up

Correctly treated

Notes

 

 

 

 

Cash flow statement

 

 

 

 

Financing cash flows

 

 

 

 

 

 

 

Cash raised from equity raise

1,000

Nil

Incorrect gross up creates impression of liquidity (being able to repay borrowings and being able to raise equity)

 

 

 

 

Repayment of borrowings

(1,000)

Nil

 


Netting off transactions

Given the specific financing arrangements of an entity, the stability or otherwise of an entity’s financing arrangements can be significant to a user. That is, the entity having to repay loans, raise new financing, etc. A common ‘Blind Freddy’ error is to net off loan repayments and new financing.

Example 3

Company A reported long-term borrowings of $10,000 with Big Bank at 30 June 2014. During the year it breached various loan covenants and was forced to refinance with a variety of promissory notes and convertible notes.

 

Incorrectly netting off

Correctly treated

Notes

 

 

 

 

Cash flow statement

 

 

 

 

Financing cash flows

 

 

 

 

 

 

 

Cash raised from new borrowings

Nil

10,000

Incorrect netting creates impression of stable financing arrangements

 

 

 

 

Repayment of borrowings

Nil

 (10,000)

 


Errors with foreign currency

The preparation of a cash flow statement is significantly complicated when the group has subsidiaries with a different functional currency to that of the group’s presentation currency. Again, errors can occur that lead to the overstatement of operating cash flows. These errors include:

  • Foreign exchange (FX) movements in cash held in the subsidiary’s functional currency that is different from presentation currency
  • FX gains and losses on foreign currency loans
  • Incorrectly translating cash receipts from financing activities
  • Incorrectly translating cash payments for investing or financing activities.

Example 4 - FX movements in cash held in the subsidiary’s functional currency that is different from presentation currency

Exchange rate USD to AUD as at 30 June 2014 was 1: 1.

Exchange rate USD to AUD as at 30 June 2015 was 1: 0.7.   

Group’s presentation currency is AUD but Subsidiary B has a USD functional currency.

At both 30 June 2014 and 2015, Company B has cash at hand of $10,000 USD.

This amount translates to $10,000 AUD as at 30 June 2014 and $14,286 as at 30 June 2015. Recognising that there is no profit impact on this translation, there is an amount of $4,286 when reconciling the opening and closing cash positions. This amount should not be included in operating cash inflows, but is shown as a separate line on the cash flow statement.

Example 5 - FX movements in cash held in the subsidiary’s functional currency that is different from presentation currency

Exchange rate USD to AUD as at 30 June 2014 was 1: 1.

Exchange rate USD to AUD as at 30 June 2015 was 1: 0.7.

Company A has a USD functional currency. It has long term borrowings of $10,000 AUD.

This amount translates to $10,000 USD as at 30 June 2014 and $7,000 as at 30 June 2015.

This retranslation represents an FX gain in Company A’s income statement, but it does not represent an operating inflow.

Example 6 - Incorrectly translating cash receipts from financing

The group’s presentation currency is AUD but Subsidiary B has a USD functional currency.

The subsidiary borrows $10,000 (USD) on 31 May 2015. This amount remains unspent at 30 June 2015.

Exchange rate USD to AUD as at 30 June 2014 was 1: 1.

Exchange rate USD to AUD as at 30 June 2015 was 1: 0.7.

Exchange rate USD to AUD at 31 May 2015 was 1: 0.75.

The average USD to AUD exchange rate for the year was 1: 0.90. 

The group incorrectly translates the cash receipt at the average annual exchange rate, rather than the exchange rate as at 31 May 2015 (being the receipt of the cash).
Assume the group had no cash as at 1 July 2014.

 

Incorrect translation

Correctly treated

Notes

 

 

 

 

Cash flow statement

 

 

 

 

 

 

 

Cash flows from operating activities

$3,175

Nil

 

 

 

 

 

 

Financing cash flows

 

 

 

Cash from financing activities

$11,111

$13,333

Incorrectly translated using average FX rates for the year. Should be translated at FX rate on loan date (1: 0.75)

 

 

 

 

Net cash inflows

$14,286

$13,333

 

 

 

 

 

Impact of FX on foreign cash balances

Nil

$953

 

 

 

 

 

Cash at 1 July 2014

Nil

Nil

 

 

 

 

 

Cash at 30 June 2015

$14,286

$14,286

 

 

 

 

 


Errors in determining what is ‘cash’ or a ‘cash equivalent ‘

AASB 107.7

‘Cash equivalents are held for the purpose of meeting short-term cash commitments rather than for investment or other purposes. For an investment to qualify as a cash equivalent it must be readily convertible to a known amount of cash and be subject to an insignificant risk of changes in value. Therefore, an investment normally qualifies as a cash equivalent only when it has a short maturity of, say, three months or less from the date of acquisition.’


Common ‘Blind Freddy’ errors in classification include:

  • Treating term deposits as cash
  • Treating long-term term deposits with less than three months to maturity as cash
  • Treating investments in equity instruments as cash.

Next month

In next month’s Accounting News we continue the series with a discussion on discontinued operations.