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 2 nd 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, debt prepayment or debt extinguishment costs . 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: Ira Hayes, Inc. issued a $1 million 5-year bond to Dylan, Inc. This bond is fixed-rate, paying 5% annually and was issued at par. The bond is pre-payable at any time before the maturity date, but prepayment carries a penalty.
Question: Assuming the prepayment option is exercised, how should the penalty be classified in the statement of cash flows?
Answer: As a cash outflow for financing activities.
Prior to guidance in ASU 2016-15 there was diversity in practice, because a prepayment penalty can be based on a number of factors, including an approximation of the interest that will not be paid as a result of early settlement. Therefore, some entities classified these penalty payments as operating cash flows (because they were compensating for lost interest, which is an operating cash flow) while others classified these penalty payments as financing cash flows consistent with the repayment of the debt principle. ASU 2016-15 clarifies this former inconsistency by stating that cash payments for debt prepayment or debt extinguishment costs should be classified as cash outflows for financing activities.
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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