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, separately identifiable cash flows and application of the predominance principle. 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: Bird on a Wire, Inc. (BOW) purchased several used aircraft engines to use for parts. The engines still had some useful life, so prior to being stripped and used for parts to service their own aircraft engines, BOW decided to lease the engines out to other companies on a year-by-year lease contract.
Question: How should the cash outflows to acquire the used aircraft engines be classified in the statement of cash flows?
Answer: It depends. If the engines were purchased solely for their used parts, operating would be the appropriate classification. If the engines were purchased solely to be leased out to other airlines, investing would be the appropriate classification. The issue here is that the cash outflow has multiple attributes (i.e. outflows were for both operating AND investing activities. In this situation, judgment must be applied to determine what is the predominant attribute to determine the proper classification. In other words, if the main purpose of the acquisition and the “main source of cash” was to use the engines for spare parts, then operating is the appropriate classification. If, however, leasing of the engines was expected to result in the most benefit to Up and Away, investing might be the appropriate classification!
ASU 2016-15 provides clarity to these types of situations to address diversity in practice. Prior to ASU 2016-15, the guidance was unclear about whether and when cash receipts and payments should be classified into more than one class of cash flows and when classification should be based on the predominant cash flow. The ASU provides additional guidance that clarifies when an entity should separate cash receipts and cash payments and classify them into more than one class of cash flows (including when reasonable judgment is required to estimate and allocate cash flows) and when an entity should classify the aggregate of those cash receipts and payments into one class of cash flows based on predominance.
In applying the additional guidance, the classification of cash receipts and payments should be determined first by applying specific guidance in Topic 230 and other applicable Topics. In the absence of specific guidance, a reporting entity should determine each separately identifiable source (for inflows) or each separately identifiable use (for outflows) within the cash receipts and cash payments based on the nature of the underlying cash flows. A reporting entity should then classify in financing, investing, or operating activities the cash receipts and payments for each nature that was separately identified. In situations in which cash receipts and payments have aspects of more than one class of cash flows and those aspects cannot be separately identified by their nature, the appropriate classification should depend on the activity that is likely to be the predominant source or use of cash flows for the item, which is the case in our example.
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!
About GAAP Dynamics
We’re a DIFFERENT type of accounting training firm. We don’t think of training as a “tick the box” exercise, but rather an opportunity to empower your people to help them make the right decisions at the right time. Whether it’s U.S. GAAP training, IFRS training, or audit training, we’ve helped thousands of professionals since 2001. Our clients include some of the largest accounting firms and companies in the world. As lifelong learners, we believe training is important. As CPAs, we believe great training is vital to doing your job well and maintaining the public trust. We want to help you understand complex accounting matters and we believe you deserve the best training in the world, regardless of whether you work for a large, multinational company or a small, regional accounting firm. We passionately create high-quality training that we would want to take. This means it is accurate, relevant, engaging, visually appealing, and fun. That’s our brand promise. Want to learn more about how GAAP Dynamics can help you? Let’s talk!
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.