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, proceeds from the settlement of COLIs or BOLIs. A separate blog is available for each of the other issues and can be accessed by clicking the items in the above list.

What are COLIs and BOLIs? No, we aren’t talking about bacteria or Italian food, and certainly not a mix of the two! COLIs are “corporate-owned life insurance policies” and BOLIs are “bank-owned life insurance policies. What’s the difference between the two? Not much, except that BOLIs are owned by banks and COLIs are owned by non-banking entities. These are types of life insurance policies taken out by a company (or a bank) on the lives of key employees. The company (or bank) pays the premium on the insurance, but is also the policy beneficiary. Companies and banks take out these policies for a few different reasons, but a main driver is the tax benefit they provide. The proceeds received after death are generally tax free and can be used to cover costs in hiring the key employee’s replacement, or to fund employee benefit liabilities, for example. A notable benefit also comes from the benefit to after-tax net income that arises when the cash value of the policy becomes larger than the premiums paid.

There has been diversity in practice in the classification treatment of cash flows related to these policies. Let’s take a look at the cash flow classification issues with these through a scenario followed by a couple of questions and answers.

Scenario: Folsom Inc. is a privately-held company that provides uniform services for prison guards. Its shareholders are each key executives of the company. Folsom has taken out company-owned life insurance policies (COLIs) on each of its key executives. These are universal life policies that have a term life component as well as a savings component, which is invested to provide a cash buildup.

The company has not specifically indicated how they will utilize the proceeds from the death benefit, or whether they will even hold the policies that long considering they have a cash surrender value. One option is that the company can utilize the death benefit proceeds to fund the buy-sell transaction that would be triggered upon death of one of the shareholders.

Question 1: How would Folsom classify any proceeds received from the policy?

Answer 1: As cash inflows from investing activities. The FASB recognizes that life insurance policies are purchased by companies for a variety of purposes. They can be used to fund buy-sell transactions triggered by the death of a shareholder/officer, to provide employee benefits, to provide overall protection/compensation for loss of a key person, or to provide a benefit directly to the deceased’s beneficiaries. As a result of these varied reasons, diversity in practice existed regarding the classification of proceeds. Some entities classified the proceeds based on the objectives or purposes of acquiring the COLI. For example, the term component could be considered income replacement (operating cash flows) while the investment component would be an investing cash flow. While the objectives do vary, it was decided that cash proceeds should be classified as cash inflows from investing activities, since the majority of the FASB’s Emerging Issues Task Force members believe that COLI policies are purchased primarily as investment vehicles.

Question 2: What about the cash outflows from the premium payments?

Answer 2: As investing activities, operating activities, or a combination of both. The reason for the choice here is to allow companies the ability to align the classification of premiums paid with the classification of proceeds received. However, that does not have to be the case, therefore operating is also allowed.

Note that while our example was a corporate-owned life insurance policy (COLI), the guidance also covers bank-owned life insurance policies (BOLIs).

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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