Chapter 6 — Classification of Cash Flows

6.1 Investing Activities

ASC 230-10-20 defines investing activities, in part, as follows:

Investing activities include making and collecting loans and acquiring and disposing of debt or equity instruments and property, plant, and equipment and other productive assets, that is, assets held for or used in the production of goods or services by the entity (other than materials that are part of the entity’s inventory). Investing activities exclude acquiring and disposing of certain loans or other debt or equity instruments that are acquired specifically for resale.

ASC 230-10

45-12 All of the following are cash inflows from investing activities:

Receipts from collections or sales of loans made by the entity and of other entities’ debt instruments (other than cash equivalents, certain debt instruments that are acquired specifically for resale as discussed in paragraph 230-10-45-21, and certain donated debt instruments received by not-for-profit entities (NFPs) as discussed in paragraph 230-10-45-21A) and collections on a transferor’s beneficial interests in a securitization of the transferor’s trade receivables
Receipts from sales of equity instruments of other entities (other than certain equity instruments carried in a trading account as described in paragraph 230-10-45-18 and certain donated equity instruments received by NFPs as discussed in paragraph 230-10-45-21A) and from returns of investment in those instruments
Receipts from sales of property, plant, and equipment and other productive assets
Subparagraph not used
Receipts from sales of loans that were not specifically acquired for resale. That is, if loans were acquired as investments, cash receipts from sales of those loans shall be classified as investing cash inflows regardless of a change in the purpose for holding those loans.

For purposes of this paragraph, receipts from disposing of loans, debt or equity instruments, or property, plant, and equipment include directly related proceeds of insurance settlements, such as the proceeds of insurance on a building that is damaged or destroyed.

45-13 All of the following are cash outflows for investing activities:

Disbursements for loans made by the entity and payments to acquire debt instruments of other entities (other than cash equivalents and certain debt instruments that are acquired specifically for resale as discussed in paragraph 230-10-45-21)
Payments to acquire equity instruments of other entities (other than certain equity instruments carried in a trading account as described in paragraph 230-10-45-18)
Payments at the time of purchase or soon before or after purchase to acquire property, plant, and equipment and other productive assets, including interest capitalized as part of the cost of those assets. Generally, only advance payments, the down payment, or other amounts paid at the time of purchase or soon before or after purchase of property, plant, and equipment and other productive assets are investing cash outflows. However, incurring directly related debt to the seller is a financing transaction (see paragraphs 230-10-45-14 through 45-15), and subsequent payments of principal on that debt thus are financing cash outflows.
Payments made soon after the acquisition date of a business combination by an acquirer to settle a contingent consideration liability.

6.1.1 Securities Lending

Many entities with significant investments in marketable securities engage in securities-lending transactions. In one form of securities-lending transaction, the transferor relinquishes securities and agrees to repurchase them for a fixed amount on a specified future date. The transferee, to secure its obligation to return the securities (or similar securities), posts cash collateral in an account that is inaccessible to the transferor unless the transferee fails to deliver the securities.

Assume that the transaction fails to satisfy the derecognition criteria of ASC 860 and that the transferor and the transferee record the transfer as a secured borrowing. The transferor classifies the amount provided by the transferee as “collateral received” or “restricted cash” rather than including it in “cash and cash equivalents.” ASC 860-30-45-1 states that if the transferee “has the right by contract or custom to sell or repledge” the transferred securities, the transferor reports the transferred securities “in its statement of financial position separately . . . from other assets not so encumbered.”

The transferor is entitled to earnings on the cash in the restricted account and is obligated to pay the transferee (i.e., the borrower of the securities) a rebate, representing a portion of those earnings.

The sale and repurchase of the securities are noncash transactions (i.e., an exchange of investments) unless the transferee fails to deliver the securities and the transferor obtains access to the cash in the account.

6.1.2 Distributions From Equity Method Investments

ASC 230 distinguishes between returns of investment, which should be classified as cash inflows from investing activities (see ASC 230-10-45-12(b)), and returns on investment, which should be classified as cash inflows from operating activities (see ASC 230-10-45-16(b)). Accordingly, to make the appropriate classification in the statement of cash flows, entities must determine whether distributions received from an equity method investee represent a “return on” or a “return of” the related investment.

ASC 230-10-45-21D indicates that there are two acceptable methods for determining whether distributions from equity method investments are returns on investment or returns of investment. Under the first method (the “cumulative earnings” approach), distributions are presumed to be returns on investment. When classifying the related cash flows under this approach, an entity should compare cumulative (i.e., since inception) distributions received by the investor, less distributions received in prior periods that were determined to be returns of investment, with the investor’s cumulative equity in earnings. Cumulative distributions received that do not exceed cumulative equity in earnings represent returns on investment and should be classified as cash inflows from operating activities. Cumulative distributions received in excess of the investor’s cumulative equity in earnings represent returns of investment and therefore should be classified as cash inflows from investing activities.

Under the second method (the “nature-of-the-distribution” approach), an entity evaluates the specific facts and circumstances of each distribution to determine its nature. Unlike the cumulative earnings approach, the nature-of-the-distribution approach does not presume that a distribution is a return on investment; rather, an entity using this approach must conduct an analysis to determine the nature of each distribution and may be required to use significant judgment in making this determination. Examples of distributions that may represent returns of investment include, but are not limited to, liquidating dividends and dividends representing proceeds from the sale of property, plant, and equipment (PP&E). These distributions should be classified as cash inflows from investing activities to the extent that they are considered to represent returns of investment.

An entity can elect to apply either of these approaches as an accounting policy and must select a single method for all of its equity method investments. Under either approach, an entity should comply with the disclosure requirements in ASC 235-10-50-1 through 50-6. However, if an entity selects the nature-of-the-distribution approach for its equity method investments but cannot obtain the information it needs to evaluate the nature of the distributions for any individual equity method investment, the entity must report a change in accounting principle retrospectively by applying the “cumulative earnings” approach to any such equity method investment. In other words, an entity is not required to apply the cumulative earnings approach to all of its equity method investments when it is unable to obtain adequate information for certain equity method investments; rather, this approach must only be applied to the equity method investments for which the information could not be obtained.

Connecting the Dots

Although entities are permitted to elect the approach under which distributions may be evaluated, it does not remove the requirement for entities to evaluate whether each distribution from an equity method investment represents a return on investment or a return of investment, particularly when entities elect the nature-of-the-distribution approach. In other words, because the nature-of-the-distribution approach does not presume that a distribution is a return on investment, it requires that an entity analyze each distribution to determine its nature. Further, entities that elect the cumulative earnings approach may generally presume distributions to represent a return on investment, unless such distributions represent returns of investment (i.e., they exceed the investor’s cumulative equity in earnings).

In addition, because ASC 230 does not provide guidance on how much information (e.g., the type and sufficiency of investee information) an entity needs to determine the nature of a distribution, an entity that applies the nature-of-the-distribution approach will most likely need to use significant judgment in making this determination. We generally believe that such information should be sufficiently reliable and that the degree of reliability is likely to increase in proportion to the materiality of the distribution.

Note that while the guidance in ASU 2016-15 clarified the cash flow classification of distributions received from equity method investees, it did not address the presentation of distributions that are received from equity method investees and measured by using the fair value option. Accordingly, an entity should apply ASC 825-10-45-3 when considering how to classify distributions received from equity method investees and measured by using the fair value option. Under that guidance, an entity classifies “cash receipts and cash payments related to items measured at fair value according to their nature and purpose as required by Topic 230.”

We thus believe that it would be appropriate for an entity that measures an equity method investment by using the fair value option to apply by analogy the “nature-of-the-distribution” approach discussed above. Such an entity would classify distributions received as operating activities or investing activities in accordance with the nature and purpose of the distribution.

Example 6-1

Company A is a calendar-year-end company that has a 20 percent equity investment in Company B but no other equity investments. On January 1, 20X7, A made an initial $10,000 cash investment in B. Company A accounts for its investment in B as an equity method investment and has elected to use the cumulative earnings approach to determine the classification of distributions from B in its statement of cash flows. Further, there are no basis differences between A’s equity investment and the underlying assets in B.

Company A’s share of income or loss in the equity of B and A’s related share of dividend distributions for the six years and five years after the initial investment, respectively, are as follows:

Classification of B’s distributions in A’s respective annual statements of cash flows is as follows:

Under the cumulative earnings approach, because the distributions that A received for the years ended December 31, 20X8, and December 31, 20X9, are in excess of A’s cumulative share of earnings in the equity of B for these same years, such distributions received represent a return of A’s investment in B. Therefore, such distributions should be classified as investing inflows. In other words, the fact that A had cumulative deficits in B’s earnings for both of the first two years (ended December 31, 20X9) indicates that B was funding A’s share of each year’s dividend through A’s initial investment in B. Consequently, the dividends represent returns of A’s investment in B.

As of December 31, 20Y0, only a portion of the cumulative distributions received (less prior-year distributions that were returns of A’s investment) was in excess of the inception-to-date cumulative earnings in B’s equity. The excess portion was therefore classified as an investing activity (i.e., as a return of A’s investment in B), and the remaining portion was classified as an operating activity (i.e., as a return on A’s investment in B).

As of December 31, 20Y1, A’s cumulative distributions received, less any prior-year distributions that were returns of investment, did not exceed the cumulative earnings in equity; therefore, the entire amount of distributions received is classified as an operating activity that reflects a return on A’s equity method investment in B. Conversely, on December 31, 20Y2, cumulative distributions received, less any prior-year distributions that were returns of investment, fully exceeded the cumulative earnings in equity; therefore, the entire amount of distributions received in 20Y2 should be classified as an investing activity that reflects a return of A’s equity method investment in B.

6.1.3 Property, Plant, and Equipment Acquired on Account

ASC 230-10-45-29 states that the reconciliation of net income to net cash flows from operating activities must separately report all major classes of reconciling items, “including, at a minimum, changes during the period . . . in payables pertaining to operating activities.” Therefore, the change in accounts payable included in this reconciliation should exclude changes in payables related to investing or financing transactions (e.g., the change in payables incurred in the current and previous reporting periods to acquire or construct PP&E and other productive assets).

Furthermore, the noncash investing activity disclosed by an entity should be limited to the amount of the liability incurred for assets acquired during the current reporting period that remains unpaid as of the end of the reporting period; it should not merely be the period-to-period change in the liability account used to track productive assets purchased on account. Noncash activity should be disclosed separately in a schedule or described in a narrative disclosure.

In the period in which the liability is settled, the amount paid should be classified as a cash outflow for investing activities or financing activities, depending on the payment terms of the transaction. Specifically, ASC 230-10-45-13(c) characterizes payments “at the time of purchase or soon before or after purchase to acquire property, plant, and equipment and other productive assets” as cash outflows for investing activities. The SEC staff has informally interpreted the term “soon” in this context as indicating a period of three months or less, which is consistent with the period used for other ASC 230 considerations (e.g., the definition of cash equivalents in ASC 230-10-20 [see Chapter 4], the determination of net or gross presentation in ASC 230-10-45-9 [see Chapter 3], and contingent consideration classified as a liability [see Chapter 7]).

Therefore, if an entity purchases PP&E and other productive assets and the terms of the transaction require payment within three months of the transaction date, the payment would be classified as an investing outflow. Generally, if the payment terms of the transaction extend beyond three months, any payment made after three months would be classified as a financing outflow. However, there may be limited circumstances in which payments made after three months (but less than one year) could be classified as investing outflows — for example, if payment terms extend beyond three months but such terms are consistent with standard industry practice as well as with terms that are customary for the vendor. Entities are encouraged to discuss these circumstances with their accounting advisers. Payments made in connection with terms that require discounting under ASC 835 (i.e., generally of more than one year) should be classified as financing outflows even if the payment terms are consistent with industry practice and considered customary for the vendor.

Example 6-2

In December 20X4, Company A purchased equipment from a supplier on account for $500,000, which was included in the total year-end accounts payable balance of $4 million. Company A paid the $500,000 payable due to the supplier in January 20X5. In December 20X5, A purchased equipment from a supplier on account for $1 million, which was included in the total year-end accounts payable balance of $6 million. Company A paid the $1 million payable due to the supplier in January 20X6.

In preparing its 20X5 cash flow statement, A would (1) reduce the total $2 million increase in accounts payable by the $500,000 change in nonoperating accounts payable (which increased from $500,000 to $1 million) and report a total increase in operating accounts payable of $1.5 million; (2) present an investing cash outflow for the $500,000 payment made in January 20X5; and (3) disclose a noncash investing activity of $1 million, representing the unpaid liability that was incurred during 20X5 to acquire the equipment.

In preparing its 20X6 cash flow statement, A would reflect the $1 million decrease in accounts payable as an investing activity outflow for the acquisition of the equipment.

Example 6-3

Company A, a telecommunications company, enters into a contract with Vendor B to receive equipment, construction, and installation services for a network build-out with payment terms of 270 days for the equipment and 90 days for construction and installation services. These payment terms are consistent with industry practice for similar equipment and services and are customary for B. Vendor B bills A for the equipment, construction, and installation of the network build-out on January 31, 20X6. In accordance with the payment terms, A pays B for the construction and installation services at the end of April 20X6 and the equipment at the end of October 20X6. Because the payment terms are consistent with industry practice, are customary for B, and do not need to be discounted under ASC 835, it would be appropriate for A to classify both payments to B as investing outflows even though the payment terms for the equipment extend beyond three months. In determining whether a period of more than three months but less than a year is in accordance with ASC 230-10-45-13(c) — which indicates that “[p]ayments at the time of purchase or soon before or after purchase to acquire property, plant, and equipment and other productive assets” are investing activities — A must use judgment and consider its specific facts and circumstances.

6.1.4 Securities

ASC 320-10

45-11 Cash flows from purchases, sales, and maturities of available-for-sale securities and held-to-maturity securities shall be classified as cash flows from investing activities and reported gross for each security classification in the statement of cash flows. Cash flows from purchases, sales, and maturities of trading securities shall be classified based on the nature and purpose for which the securities were acquired.

ASC 321-10

45-1 An entity shall classify cash flows from purchases and sales of equity securities on the basis of the nature and purpose for which it acquired the securities.

ASC 230-10

45-19 Cash receipts and cash payments resulting from purchases and sales of securities classified as trading debt securities accounted for in accordance with Topic 320 and equity securities accounted for in accordance with Topic 321 shall be classified pursuant to this Topic based on the nature and purpose for which the securities were acquired.

Debt securities are accounted for in accordance with ASC 320, while equity securities (with certain exceptions) are accounted for in accordance with ASC 321. In accordance with ASC 230-10-45-19, for trading debt securities and equity securities, an entity is required to present the related cash receipts and payments in the statement of cash flows in a manner consistent with the nature and purpose for which the entity acquired such securities.

6.1.4.1 Debt Securities

In accordance with ASC 320, an entity is required to initially recognize purchases of debt securities as trading, available for sale, or held to maturity. An entity that actively and frequently purchases, sells, or trades securities with the intent to sell them in the near term (e.g., hours or days) to generate short-term profits should classify such purchases as trading securities. However, ASC 320-10-25-1(a) indicates that “[c]lassification of a security as trading shall not be precluded simply because the entity does not intend to sell it in the near term.” In addition, as noted in ASC 320-10-25-1(b), a debt security that is not classified as trading or held to maturity must be classified as an available-for-sale security.

Investments in debt securities classified as trading and available for sale are initially recognized at fair value in the statement of financial position, with subsequent changes in fair value recognized in net income and other comprehensive income (OCI), respectively, in each reporting period. Further, cash flow activity associated with debt securities classified as available for sale and held to maturity is classified as investing activities, while cash flow activity associated with trading securities is classified on the basis of the security’s nature and the entity’s intent to sell or hold the security.

However, while an entity’s election to classify a debt security as trading results in income statement recognition of subsequent changes in the security’s fair value ― not unlike the recognition of financial assets and liabilities for which an entity elects the fair value option under ASC 825 — entities that elect to classify securities as trading have questioned whether cash activities related to such securities should be presented as operating or investing activities.

An entity’s election of the fair value option for financial assets and liabilities under ASC 825 does not affect its cash flow statement classification of receipts and payments associated with financial assets and financial liabilities. Specifically, ASC 825-10-45-3 states, “Entities shall classify cash receipts and cash payments related to items measured at fair value according to their nature and purpose as required by Topic 230.”

Accordingly, we believe that an entity should assess why debt securities are classified as trading. In other words, an entity should assess whether it is required to classify debt securities as trading in accordance with ASC 320 (i.e., because the securities that are acquired are intended to be sold within hours or days). We believe that if an entity is required to classify debt securities as trading securities, the related cash flow activities should be presented as operating activities in the entity’s statement of cash flows. Our view is based on ASC 230-10-45-20, which contains a general principle under which cash flows pertaining to securities or other assets acquired principally for resale in the near term must be classified in operating activities.

We believe that when an entity elects to classify debt securities as trading, the frequency of purchases and sales of securities should be assessed as a basis for determining an entity’s intent. For example, we believe that daily trading is analogous to trading securities under ASC 320 and that the related cash flows therefore should be presented as operating cash flows. Conversely, and in the absence of the intent to trade to generate short-term profits, nondaily trading may not reflect trading activities and, therefore, presentation of related cash flows as investing activities would be required in such cases.

6.1.4.2 Equity Securities

In accordance with ASC 321, equity securities (except those accounted for under the equity method or those that result in consolidation of the investee) are measured at fair value, with changes in fair value recognized through net income.

As with debt securities classified as trading, an entity needs to consider the nature of the equity securities, and why they were acquired, to determine the appropriate presentation in the statement of cash flows. That is, an entity that actively and frequently purchases, sells, or trades equity securities, intending to sell them in the near term (e.g., hours or days) to generate short-term profits, would generally present such cash flow activity as operating activities; otherwise, presentation within investing activities would generally be required.

6.1.5 Company- and Bank-Owned Life Insurance Policies

ASC 230-10

45-21C Cash receipts resulting from the settlement of corporate-owned life insurance policies, including bank-owned life insurance policies, shall be classified as cash inflows from investing activities. Cash payments for premiums on corporate-owned life insurance policies, including bank-owned life insurance policies, may be classified as cash outflows for investing activities, operating activities, or a combination of cash outflows for investing and operating activities.

Entities purchase life insurance policies for various reasons (e.g., to fund employee benefit costs and protect against the loss of key persons). Such policies are typically described as company-owned life insurance (COLI). ASC 230 addresses cash receipts (and premium payments) related to COLI, including bank-owned life insurance (BOLI) policies. The guidance in ASC 230-10-45-21C, which is predicated on a notion that COLI policies, including BOLI policies, are purchased primarily as investment vehicles, requires that an entity classify cash proceeds received from the settlement of COLI policies, including BOLI policies, as cash flows from investing activities.

In addition, entities are permitted, but not required, to align the classification of premiums paid with the classification of proceeds received. Therefore, cash payments for premiums may be classified as cash outflows for investing activities, operating activities, or a combination of cash flows for investing and operating activities.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.