Act Now, and Avoid a Restatement

The SEC extends an olive branch to companies that correct misstatements of cash flow from discontinued operations.
Marie LeoneMarch 20, 2006

In an unusual move, the Securities and Exchange Commission issued a staff position allowing companies with certain cash-flow statement problems to fix their mistakes without classifying the adjustment as a restatement. Companies that take advantage of the SEC’s largess must do so before their next filing period following February 15, 2006 or lose the chance to avoid a restatement, according to the document.

The leniency is important because restatements tend to carry a stigma that weakens investor confidence, says Charles Mulford, an accounting professor in the DuPree College of Management at the Georgia Institute of Technology. Mulford adds that he’s glad the SEC is taking a second look at cash-flow-statement problems, especially ones that have been hanging around for nearly 20 years.

The amnesty program concerns FAS 95 (Statement of Cash Flow), a standard issued in 1987. The SEC’s recent move focuses on the section of the guidance dealing with discontinued operations, which refers specifically to the disposal of a company unit that contains its own clearly defined operations and cash-flow. Typically, that means a business group or a line of a business that’s shut down or sold.

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

The SEC reprieve is being offered to companies that misclassified cash flow from discontinued operations and are therefore noncompliant with FAS 95. Under the accounting rule, companies must separate cash flow into three categories: operations, financing, and investing. The separation gives readers of cash flow statements insight into how a company generates cash and enables them to compare results from one period to the next.

Further, FAS 95 gives companies a choice of reporting cash flow from continuing operations and discontinued operations together or treating the two separately. But the accounting treatment must be consistent from period to period. Some companies combine cash flows from continuing and discontinued operations in one period while listing them separately in the next period. That inconsistency is a breach of FAS 95.

Companies also run afoul of FAS 95 by not using the three category classifications, adds SEC officials. While some companies properly separate cash flow from continuing operations into the three categories, for example they mistakenly lump together all the cash flow from discontinued operations into a single line item. When that happens, anyone reading a financial statement can’t identify which of the three segments was affected by the one-time discontinued operations event.

The misclassification is a “presentation” issue, which probably explains why the SEC is giving companies the chance to make the adjustment without dubbing it a restatement, notes L. Charles Evans, a partner with the accounting principles group at Grant Thornton LLP. While such an adjustment doesn’t affect cash-flow totals or change income-statement tallies, it does increase transparency, he says.

Indeed, making sure investors get a fuller picture is the main reason the SEC wants companies to correct their presentation errors. “The correction will allow investors to better understand what contributes to ongoing sustainable cash flow,” Mulford comments.

To be sure, the SEC’s move won’t save companies very much time or money, as auditors and in-house accountants still have to make the correction and adjust affected periods. But for the companies involved, it may eliminate some of the reputational risk associated with restatements.

No one—not auditors, academics, or the SEC—seems to know exactly how many companies misclassified cash flow from discontinued operations. The problem, however, isn’t limited to any particular industries or company size, says Lillian Ceynowa, director of the Center for Public Company Audit Firms (CPCAF), a unit of the AICPA that works closely with regulators to disseminate rule interpretations.

In a year-end speech to the American Institute of Certified Public Accountants (AICPA), Joel Levine, an associate chief accountant for the SEC’s Division of Corporation Finance, noted that FAS 95 misclassifications were on the rise. He attributed the increase to an uptick in the number of companies reporting on discontinued operations as per FAS 144 ( Accounting for the Impairment or Disposal of Long-Lived Assets). FAS 144, which went into affect in 2002, broadened the scope of what accountants consider a discontinued operation.

Companies choosing to adjust their cash-flow statements without having the SEC consider it a restatement must provide “enhanced disclosures,” according to a CPCAF alert issue in February. For example, the modified columns in the cash-flow statements must be labeled either “revised” or “restated”—the term “reclassified” won’t cut it, says the notice.

Footnote disclosure is required and must be specific, according to the notice by the AICPA unit, which claims that it was advised by the SEC staff. In other words, the SEC doesn’t want companies filing boilerplate language to describe the FAS 95 adjustment. That includes avoiding such standard fare as, “Certain prior year amounts have been reclassified for comparative purposes to conform to current year presentations.”

In any case, notes Mulford, the stepped-up scrutiny by the SEC regarding the FAS 95 classification problem is long overdue. He explains that when the standard was issued, companies and their accountants were mostly concerned about slotting cash flows into what were then the three new reporting categories.

As a result, accountants and auditors grew lax about classifying cash flow from discontinued operations. “The bad behavior was condoned” by regulators,” he notes, and soon the standard accepted excuse, for misclassification became “That’s the way it’s always been done.”

Now that the SEC has brought the issue to light, companies would do well to go beyond what’s mandated in FAS 95, the professor contends. In fact, the professor would like to see all companies break out cash flow from discontinued operations. “If a company really has its investors’ best interests at heart, I think it would like to explain what role discontinued operations plays,” he says.

Understanding Which ERP Modules Your Business Needs – And When