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, beneficial interests in securitization transactions. 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. While ASU 2015-16 only covers the classification of the beneficial interest obtained in a securitization and cash receipts and payments related to that beneficial interest, we’ll talk about the classification of all of the cash flows in a securitization transaction.

Scenario: Walk the Line, Inc. is a distributor of high-end walking shoes, selling to a number of shoe stores. Although they earn a modest margin from the sale of shoes, a significant amount of their profits also comes from the securitization of their customer receivables. Every quarter, Walk the Line sells half of their portfolio of outstanding receivables to a special purpose entity (SPE), in return for cash and a beneficial interest, and holds the other half of receivables and collects under the normal financing terms. The beneficial interest is in subordinated securities, which is the lowest tranche in the structure. The subordinated securities pay based on their contractual terms.

Question: How should the following be classified in Walk the Line’s cash flow statement?

1. Cash received from customers (for the 50% of receivables that are retained)
2. Cash received from the SPE for initial sale of receivables to the SPE
3. Receipt of the beneficial interest
4. Cash received from the beneficial interest (the transferor has the right to receive cash from the securitization entity’s collections on the trade receivables, in this case a subordinated tranche)

Answer:

1. Cash received from customers 
   Operating. These are just “regular” receivables and cash receipts related to receivables are operating activities.
2. Cash received from transfer to SPE 
   Also operating. ASC 230-10-16 states that “cash receipts from sales of goods or services, including receipts from collection or sale of accounts and both short- and long-term notes receivable from customers arising from those sales. The term goods includes certain loans and other debt and equity instruments of other entities that are acquired specifically for resale”. 
   Additionally, ASC 230-10-43-21 states that, “some loans are similar to securities in a trading account in that they are originated or purchased specifically for resale and are held for short periods of time. Cash receipts and cash payments resulting from acquisitions and sales of loans shall be classified as operating cash flows if those loans are acquired specifically for resale and are carried at fair value or at the lower cost or fair value.”
3. Receipt of the beneficial interest 
   According to ASU 2016-15, this should not be classified at all. Rather it should be disclosed as noncash activity. The FASB believes that this reflects the actual form of the securitization transaction because the transferor of the assets does not receive or pay cash to obtain the beneficial interest.
   
4. Cash received from the beneficial interest 
   Prior to the issuance of ASU 2016-15, there was diversity in practice on how to classify cash received from a beneficial interest in previously transferred trade receivables. ASU 2016-15 clarifies that these cash flows should be classified as investing regardless of whether they are longer term receivables that may have an interest component. Overall the conclusion reached is that an interest component, if any, would be relatively small and that overall investing activity classification is consistent with treating the transferor’s beneficial interests like an investment security. There is an interesting and informative write-up in the Basis of Conclusions section of ASU 2016-15 that provides insight into this issue and the FASB’s thought process in reaching this conclusion.

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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