Cash Flow Statement Classification (ASC 230) – The Predominance Principle
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 concerning cash flow statement classification and the predominance principle. 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 separately identifiable cash flows and application of the predominance principle in accordance with ASC 230.
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.
Scenario: Cash flow statement classification
Bird on a Wire, Inc. (BOW) purchased several used aircraft engines to use for parts. The engines still had some useful life, so prior to being stripped and used for parts to service their own aircraft engines, BOW decided to lease the engines out to other companies on a year-by-year lease contract.
Question and solution: Cash flow statement classification
Question: How should the cash outflows to acquire the used aircraft engines be classified in the statement of cash flows?
Answer: It depends. If the engines were purchased solely for their used parts, operating would be the appropriate classification. If the engines were purchased solely to be leased out to other airlines, investing would be the appropriate classification. The issue here is that the cash outflow has multiple attributes (i.e. outflows were for both operating AND investing activities. In this situation, judgment must be applied to determine what is the predominant attribute to determine the proper classification. In other words, if the main purpose of the acquisition and the “main source of cash” was to use the engines for spare parts, then operating is the appropriate classification. If, however, leasing of the engines was expected to result in the most benefit to Up and Away, investing might be the appropriate classification!
ASC 230 provides clarity to these types of situations to address prior diversity in practice. Prior to amendments to ASC 230, the guidance was unclear about whether and when cash receipts and payments should be classified into more than one class of cash flows and when classification should be based on the predominant cash flow. The amendments to ASC 230 provide additional guidance that clarifies when an entity should separate cash receipts and cash payments and classify them into more than one class of cash flows (including when reasonable judgment is required to estimate and allocate cash flows) and when an entity should classify the aggregate of those cash receipts and payments into one class of cash flows based on predominance.
In applying the additional guidance, the classification of cash receipts and payments should be determined first by applying specific guidance in ASC 230 and other applicable ASC topics. In the absence of specific guidance, a reporting entity should determine each separately identifiable source (for inflows) or each separately identifiable use (for outflows) within the cash receipts and cash payments based on the nature of the underlying cash flows. A reporting entity should then classify in financing, investing, or operating activities the cash receipts and payments for each nature that was separately identified. In situations in which cash receipts and payments have aspects of more than one class of cash flows and those aspects cannot be separately identified by their nature, the appropriate classification should depend on the activity that is likely to be the predominant source or use of cash flows for the item, which is the case in our example.
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.
