Walk the Line: Classifying Cash Flows under ASC 230 – Issue 6 of 8
Walk the Line: Classifying Cash Flows under ASC 230 – Issue 6 of 8

Walk the Line: Classifying Cash Flows under ASC 230 – Issue 6 of 8

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:

It’s now time to walk the line and properly classify items 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, distributions received from equity method investees . 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. Remember, an equity method investee is one which the reporting entity has “significant influence” over through its equity ownership.

Scenario: 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.

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.

The guidance provided in ASU 2016-15 is substantially consistent with previous SEC interpretations on this topic.

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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This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.

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