The FRC released its thematic review of cash flow and liquidity disclosures in November 2020 with the objective of helping companies avoid making basic errors in their cash flow statement, whist picking up on the themes from the FRC’s Lab project: Disclosures on the sources and uses of cash.
The review also considers the strategic report in addition to turning the spotlight on going concern and viability assessments because the management of cash flows and liquidity is critical to these assessments. This article summarises the key findings of the review.
The cash flow statement
While the FRC found that most companies do comply with the requirements of IAS 7, the review identified various examples of failures to comply and several areas where the disclosures could - and should - be improved.
Classification of cash flows
The FRC was concerned that it found many of the cash flow statement errors through simple desktop reviews and asks why were these not spotted as part of the pre-issuance review? The review highlights:
- Companies often incorrectly classify the cash flows between the three categories of operating, investing and financing; the FRC found a number of instances where operating cash flows were included within investing, and vice versa.
- This mistake was particularly prevalent where companies had acquisitions and disposals of subsidiaries, on items such as deferred or contingent consideration and acquisition expenses.
- Cash outflows should only be classified as investing if they result in an asset being recognised in the balance sheet.
- Companies often failed to provide reconciliations for working capital movements (which form part of the operating cash flows reconciliation) that could not be tied directly into the notes.
Changes in liabilities arising from financing activities
Many companies are failing to provide the requisite information to meet the disclosure objective of IAS 7.44A. This disclosure should:
- Only include items that are in the financing category on the cash flow statement
- Only include actual cash flows in the cash movements line
- Include a subtotal for the liabilities arising for financing activities if presented as part of a broader ‘net debt’ reconciliation.
Cash flow accounting policy and significant judgements
Companies frequently exclude cash flow statements from their accounting policies and significant judgements disclosure. The better policies covered the accounting for particular transactions and their presentation within the cash flow statement, such as:
- The policy for interest and dividends
- The presentation of contingent and deferred consideration
- The presentation of cash flows under supplier financing arrangements
- The cash flows related to leases (short term payments, interest, principal payments).
In addition, disclosure of any critical judgements should not be overlooked. When a standard only includes relatively high level guidance, applying the requirements often involves the application of judgement. Accounting judgements applied in the other primary statements, those relating to hedge accounting, for example, may have a consequential effect on the cash flow statement that might also require disclosure.
Definition of cash and cash equivalents
This was a specific area where the judgements applied were frequently not disclosed. Disclosures should explain any judgement made and – in a clear link to the liquidity disclosures – include information on the terms of deposits such as maturity, break clauses and interest rates.
The FRC re-emphasised the views of the IFRS Interpretations Committee from March 2018 in respect of borrowings, such as a bank overdraft, classified as cash and cash equivalents for the purpose of the cash flow statement. If the balance does not often fluctuate between positive and negative amounts, this indicates that it does not form part of the entity’s cash management and instead represents a form of financing.
Policy for interest and dividends
IAS 7 gives companies an accounting policy choice regarding the presentation of interest and dividends, and the FRC would like companies to disclose their policy.
Other disclosure reminders
Other areas mentioned include a reminder to provide the cash flow disclosures required for discontinued operations and to detail any material non-cash investing or financing transactions.
The strategic review section of the report should cover the balance sheet date, the point up to which the accounts are signed, and the future. Any significant obligations that might impact on cash in the future, for example supplier financing, pension commitments or contingent liabilities should be disclosed and the anticipated impact discussed.
Where cash flow and liquidity alternative performance measures (APMs) are presented, these should be accompanied with comprehensive and clearly labelled disclosures which explain the key terms used. Companies also need to ensure they refer to these APMs using consistent terminology throughout the financial statements.
The report highlights that few companies include any disclosure of cash flow or liquidity KPIs, which the FRC questioned given how fundamental these are to company performance.
The review emphasised very clearly that the FRC expects all companies to reassess their disclosure of principal risks and uncertainties in future reporting periods to ensure liquidity risks are appropriately disclosed. These risks should be entity specific and accompanied by clear descriptions which cover the changes to the risks now and anticipated future changes, taking into account external market factors. The disclosure should include a description of the mitigating actions and factors. This disclosure should also link back to the strategy and KPIs.
Liquidity disclosures need to be both qualitative as well as quantitative, and may need to be supplemented with additional information on changes to liquidity risk management (which will be more common at the moment) and/or entity specific policies. Investors are particularly interested in these disclosures at this time, so entities should explain their liquidity position clearly. FRC suggestions included:
- Putting all the maturity tables together in the same place
- Considering expansion of the time bands used in the maturity analysis
- Linking the figures back to the financial statements by including a contractual amounts column
- Disclosing any seasonal impact on liquidity and including additional information where helpful.
Where a company has banking covenants the FRC expects them to disclose enough detail for the impact on liquidity to be assessed. This detail – such as the terms, testing, any changes in covenant levels over time, headroom, waivers, and post year end changes – should be provided even where the company has complied all year. If additional restrictions are imposed, for example on distributions, this should also be disclosed.
Working capital and supplier financing arrangements
As these have become more commonplace, the FRC expects more comprehensive disclosure of their use and the reliance on them. Disclosures should include:
- A description of the supplier financing arrangement and the purpose of it (this should detail the interest or fees payable and the impact on company liquidity)
- A comprehensive accounting policy detailing how the amounts related to it are presented in the balance sheet and cash flow statement
- The impact of the facility on KPIs such as net debt.
Going concern and viability
Anticipating that the going concern assessment is likely to be more difficult this year, the FRC reiterated the messages given in previous thematic reviews and its annual report and provided a list of characteristics of better disclosure. The overriding message is that companies need to move away from the high level, general disclosures to something much more detailed. Disclosures should:
- Explain the material uncertainties that exist – including any exposure to vulnerable sectors, countries or suppliers
- Detail the different going concern scenarios modelled
- Give more information on the inputs that were stress tested and the effect
- Detail any reverse stress testing performed and the outcome
- Describe how the board challenge the going concern assessment, and the governance process around this.
The better disclosures were clearly laid out with headings covering each key aspect of the disclosure and companies might find it helpful to use this as a prompt to include all the relevant information.
The viability assessment should be consistent with the going concern assessment but have a greater focus on the longer term. Over the longer assessment period it is expected that more areas will be subject to uncertainty and there will be different scenarios to consider.
The FRC’s message is clear; financial statements should be transparent about the company’s position both at the year end and beyond, and give the additional information that stakeholders want to see. This message echoes those given throughout 2020 - the FRC’s Financial Reporting Lab has released publications during the year which provide additional useful guidance and real life examples for going concern and viability statements, particularly for reporting during the pandemic – see Reporting in times of uncertainty – a look forward.
Read the FRC’s full review at - Cash flow and liquidity disclosures.
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