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, ranking 2nd in frequency of issue occurrence in restatements according to a May 2016 study 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 30 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 is a lot of gray area with certain types of cash flows. As a result, the FASB issued ASU 2016-15 Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, to address eight areas that weren’t clear, leading to diversity in practice. The classification issues covered in ASU 2016-15 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
It’s now time to walk the line and properly classify cash flows in the statement of cash flows. Let’s take a look at one of the eight issues recently addressed by the FASB in ASU 2016-15, settlement of insurance claims. A separate blog is available for each of the other issues and can be accessed by clicking the items in the above list.
The best way to explore this cash flow classification issue is through a scenario followed by a question and answer.
Scenario: Ring of Fire, Inc. produces fireworks at each of seven factories that it operates. On October 28, an accidental fire started at one of the factories. The factory was full of firework inventory and quickly exploded and burned to the ground. Ring of Fire received insurance proceeds by the end of the year covering the value of the factory and its contents, inventory, and also for the business interruption it suffered. Ring of Fire does not plan to rebuild the factory and will consolidate production at another facility.
Question: How should Ring of Fire classify the insurance proceeds it received in its statement of cash flows as of December 31?
Answer: A combination of all 3 classifications!
Insurance proceeds for the building and its contents – Investing (even though Ring of Fire does not plan to rebuild, this is still an investing activity just as a sale of a building would flow through investing activities)
Insurance proceeds for the destroyed inventory – Operating
Insurance proceeds for business interruption – Operating
Prior to the issuance of ASU 2016-15, the guidance was not clear on this issue. While many entities interpreted the guidance this way, others did not, leading to diversity in practice. ASU 2016-15 inserts a paragraph into the ASC that makes it clear that entities should classify insurance settlement proceeds based on the related insurance coverage (the nature of the loss). Any lump-sum insurance settlements, such as the one in our scenario, that relate to more than one type of loss should be allocated to each type of loss in determining how the proceeds should be classified. This leads to components of a lump-sum settlement being classified differently based on their nature. This guidance does not apply to proceeds from corporate-owned or bank-owned life insurance policies. The classification of those proceeds is addressed in a separate issue.
We’ve now addressed one of the eight cash flow classification issues in ASU 2016-15. Check out the additional blogs in this series for more cash flow classification issues and answers!
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