Cash Flow Statement Classification (ASC 230) – Distributions from equity method investees
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, especially when considering cash flow statement classification distributions from equity method investees. It has also received quite a lot of focus in recent years from the SEC. 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 distributions received from equity method investees.
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. Remember, an equity method investee is one which the reporting entity has “significant influence” over through its equity ownership.
Scenario: Cash flow statement classification
One Piece at a Time Co. exports vintage American cars to independent dealerships in Europe. It does, however, have a 25% ownership (500,000) share in one of those dealerships, Highwayman Motors. It accounts for this investment using the equity method. Since its initial investment in Highwayman Motors, the cumulative amount through December 31 of its share of Highwayman’s net income is $1 million. On December 31, One Piece at a Time receives a dividend of $1 for each share of Highwayman stock it owns. This is the first ever dividend paid by Highwayman.
Questions and solutions: Cash flow statement classification
Question: How should the cash received for this dividend be reported in the statement of cash flows?
Answer: IT DEPENDS! One Piece at a Time must make an accounting policy election to use either the cumulative earnings approach or the nature of the distribution approach. This accounting policy election must be applied consistently to all investees.
An investor will elect either the cumulative earnings approach or the nature of the distribution approach to determine whether distributions received from equity method investees are returns on an investment or returns of an investment. Returns on an investment are operating cash flows and returns of an investment are investing cash flows.
The first method is referred to as the cumulative-earnings approach and is based on a comparison of cumulative distributions received by the investor to the investor’s cumulative equity in GAAP earnings from the investee. Under this method, cumulative distributions received up to the amount of cumulative equity in GAAP earnings represent returns on investment and are classified as cash flows from operating activities. Cumulative distributions received in excess of cumulative equity in GAAP earnings recorded represent liquidating dividends or returns of investments and are classified as cash flows from investing activities. In our example, if this method is selected, the cash flow from the dividends received would be classified as operating because the cumulative distributions received are not in excess of cumulative equity.
The second acceptable method for determining the classification of distributions from investees is referred to as the nature of the distribution approach. Under this method, the classification of distributions from investees in the statement of cash flows is based upon an evaluation of the specific facts and circumstances of each distribution to determine the nature of the activity or activities of the investee that generated the distribution as either a return on investment or a return of investment. For example, distributions received from property sales or debt refinancing would be classified as cash flows from investing activities, whereas distributions from cash generated by automobile sales would be classified as cash flows from operating activities. If an entity elects this approach and does not have the information necessary to evaluate the specific facts and circumstances of a distribution, it must apply the cumulative earnings method for that investee as an accounting change on a retrospective basis.
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!
About GAAP Dynamics
We’re a DIFFERENT type of accounting training firm. We view training as an opportunity to empower professionals to make informed decisions at the right time. Whether it’s U.S. GAAP, IFRS, or audit training, we’ve trained thousands of professionals since 2001, including at some of the world’s largest firms. Our promise: Accurate, relevant, engaging, and fun training. Want to know how GAAP Dynamics can help you? Let’s talk!
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.
