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Auditor as Watchdog, Understanding the Statement of Cash Flows

Grace Singer, CPA 10.27.2016 | eVisor

Auditors' Watchdog Role Requires Professional Skepticism

Whether auditing a public or private company, certified public accountants are required to assume a "public watchdog" role and approach all audits with a healthy dose of professional skepticism.

This role helps explain why auditors want concrete, third-party evidence to verify management's assertions. Here's a closer look at how professional skepticism factors into an audit.

PCAOB |Professional Skepticism

The Public Company Accounting Oversight Board (PCAOB) expects auditors to:

  • Identify and assess risks of material misstatement;
  • Test controls and substantive procedures; and
  • Evaluate audit results to form an audit opinion.

These expectations also apply to auditors of private companies, based upon guiding principles from the AICPA. The AICPA's Code of Professional Conduct requires CPAs to be independent from their attestation clients. In other words, auditors must:

  1. Act with integrity, and
  2. Exercise objectivity and professional skepticism.

Areas of Interest

Professional skepticism is particularly important in examining areas that involve significant management judgment or transactions outside the normal course of business. Examples of such areas include nonrecurring reserves, financing transactions, and related-party transactions. In addition, auditors consider the impact of uncorrected misstatements, evaluate the potential for management bias, and assess whether financial statements are presented fairly.

Professional skepticism also plays a critical role in an auditor's consideration of fraud. Where the risk of fraud is high, an auditor might modify planned audit procedures to gather more reliable evidence in support of financial statement assertions. For example, an auditor might obtain confirmation from an independent third party, engage a specialist, or examine documentation from independent sources to corroborate management representations.

A Win-Win Situation

The purpose of an audit is to provide investors, lenders, and other stakeholders with an opinion that management-prepared financial statements are presented fairly, in all material respects, in conformity with the applicable financial reporting framework. Without a healthy dose of professional skepticism, the value of an audit is diminished.

 

Understanding the Statement of Cash Flows

The statement of cash flows, arguably the most misunderstood and underappreciated part of a company's annual report,  highlights the sources and uses of cash.  Here is a brief overview of how this statement is organized and what the Financial Accounting Standards Board (FASB) has recently done to make it more user-friendly.

Cash Flows from Operations

The first section of the statement of cash flows adjusts accrual-basis net income for items related to normal business operations, such as gains, losses, depreciation, taxes and net changes in working capital accounts. The end result is cash-basis net income.

Cash Flows from Investing Activities

This section reveals whether a company is reinvesting in its future operations or divesting assets for emergency funds. If a company buys or sells property, equipment, or marketable securities, the transaction generally shows up here.

Cash Flows from Financing Activities

The final section shows the company's ability to obtain cash from lenders and investors. It includes new loan proceeds, principal repayments, dividends paid, issuances of securities or bonds, and additional capital contributions by owners.

Recent Changes

The FASB recently issued Accounting Standards Update No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, to reduce diversity in practice. The updated guidance clarifies that:

  • Debt prepayment and extinguishment costs are classified as financing outflows.
  • Accreted interest related to zero-coupon debt instruments are generally classified as operating outflows; the principal portion is a financing outflow.
  • Contingent payments from a business combination are classified as investing outflows if paid soon after the acquisition date. Later contingent payments are classified as financing outflows. Any payment over the liability is classified as an operating outflow.

The guidance also prescribes how to report certain insurance proceeds and payments, distributions from equity method investees, beneficial interests in securitization transactions, and cash flows that qualify under more than one classification. For public companies, the changes are effective for years beginning after December 15, 2017, and interim periods within those years. Private companies have an extra year to comply.

Call for Help

The statement of cash flows provides valuable insight about financial health and potential weaknesses, but it's not always clear how to classify transactions. Contact your Berdon advisor or Grace Singer, CPA, Berdon LLP, New York Accountants