Cash Flow Statement Classification (ASC 230) – Beneficial interests in securitization transactions
If you are an auditor or if you prepare financial statements, let me start by asking you a few questions. Which financial statement is your primary focus? Which is the last that you focus on? Undoubtedly, the statement of cash flows ends up pretty far down the list and is often the one that receives the least attention from both a preparation and an audit perspective. Yet, it is often the statement that receives the most attention from investors and analysts. It has also received quite a lot of focus in recent years from the SEC, especially regarding cash flow statement classification and beneficial interests in securitization transactions. From 2004 – 2023, cash flow statement classification was the third most cited issue in total restatements, equating to 12% of all restatements during that period according to a June 2024 report published by Audit Analytics.
The SEC has also issued numerous comment letters to companies regarding proper classification of cash flows and cited issues in this area in a number of speeches. Why? ASC 230, Statement of Cash Flows, was issued over 35 years ago and hasn’t changed much since. On top of that, there really are only three ways to classify: investing, financing, or operating! Sounds pretty easy, so why all the issues? The reasons are many, but one key reason is that the guidance isn’t always clear, and there are a lot of gray areas with certain types of cash flows. In this series of eight blog posts focused on classification of cash flows, we’ll explore a few specific areas where there have been challenges in practice but for which there is specific guidance in ASC 230. This includes cash flow statement classification for cash flows related to beneficial interests in securitization transactions.
Areas covered
The eight areas that we will discuss in this series of blog posts are:
- Proceeds from the settlement of insurance claims
- Debt prepayment or debt extinguishment costs
- Settlement of zero-coupon debt instruments
- Contingent consideration payments made after a business combination
- Proceeds from the settlement of corporate-owned or bank-owned life insurance policies
- Distributions received from equity method investees
- Beneficial interests in securitization transactions
- Separately identifiable cash flows and application of the predominance principle
Let’s take a look at one of those eight areas, distributions received from equity method investees. The best way to explore this cash flow classification issue is through a scenario followed by a question and answer. While this post focuses on the classification of the beneficial interest obtained in a securitization and cash receipts and payments related to that beneficial interest, we’ll talk about the classification of all of the cash flows in a securitization transaction to give the complete picture.
Scenario: Cash flow statement classification
Walk the Line, Inc. is a distributor of high-end walking shoes, selling to a number of shoe stores. Although they earn a modest margin from the sale of shoes, a significant amount of their profits also comes from the securitization of their customer receivables. Every quarter, Walk the Line sells half of their portfolio of outstanding receivables to a special purpose entity (SPE), in return for cash and a beneficial interest, and holds the other half of receivables and collects under the normal financing terms. The beneficial interest is in subordinated securities, which is the lowest tranche in the structure. The subordinated securities pay based on their contractual terms.
Questions and solutions: Cash flow statement classification
Question: How should the following be classified in Walk the Line’s cash flow statement?
- Cash received from customers (for the 50% of receivables that are retained)
- Cash received from the SPE for initial sale of receivables to the SPE
- Receipt of the beneficial interest
- Cash received from the beneficial interest (the transferor has the right to receive cash from the securitization entity’s collections on the trade receivables, in this case a subordinated tranche)
Answer:
- Cash received from customers
Operating. These are just “regular” receivables and cash receipts related to receivables are operating activities. - Cash received from transfer to SPE
Also operating. ASC 230-10-16 states that “cash receipts from sales of goods or services, including receipts from collection or sale of accounts and both short- and long-term notes receivable from customers arising from those sales. The term goods includes certain loans and other debt and equity instruments of other entities that are acquired specifically for resale”.
Additionally, ASC 230-10-43-21 states that, “some loans are similar to securities in a trading account in that they are originated or purchased specifically for resale and are held for short periods of time. Cash receipts and cash payments resulting from acquisitions and sales of loans shall be classified as operating cash flows if those loans are acquired specifically for resale and are carried at fair value or at the lower cost or fair value.” - Receipt of the beneficial interest
According to ASC 230, this should not be classified at all. Rather it should be disclosed as noncash activity. The FASB believes that this reflects the actual form of the securitization transaction because the transferor of the assets does not receive or pay cash to obtain the beneficial interest. - Cash received from the beneficial interest
ASC 230 clarifies that these cash flows should be classified as investing regardless of whether they are longer term receivables that may have an interest component. Overall, the conclusion reached is that an interest component, if any, would be relatively small and that overall investing activity classification is consistent with treating the transferor’s beneficial interests like an investment security. There is an interesting and informative write-up in the Basis of Conclusions section of ASU 2016-15, which updated ASC 230 for this guidance, that provides insight into this issue and the FASB’s thought process in reaching this conclusion.
Final Thoughts
We’ve now addressed one of the eight cash flow classification issues covered in this blog post series. Check out the additional blogs in this series for more cash flow classification issues and answers!
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Disclaimer
This post is for informational purposes only and should not be relied upon as official accounting guidance. While we’ve ensured accuracy as of the publishing date, standards evolve. Please consult a professional for specific advice.
