6.4 More Than One Class of Cash Flows
ASC 230-10
45-22 Certain cash receipts and payments may have
aspects of more than one class of cash flows. The classification of those cash
receipts and payments shall be determined first by applying specific guidance in
this Topic and other applicable Topics. In the absence of specific guidance, a
reporting entity shall determine each separately identifiable source or each
separately identifiable use within the cash receipts and cash payments on the
basis of the nature of the underlying cash flows, including when judgment is
necessary to estimate the amount of each separately identifiable source or use.
A reporting entity shall then classify each separately identifiable source or
use within the cash receipts and payments on the basis of their nature in
financing, investing, or operating activities.
45-22A In situations in which cash receipts and payments
have aspects of more than one class of cash flows and cannot be separated by
source or use (for example, when a piece of equipment is acquired or produced by
an entity to be rented to others for a period of time and then sold), the
appropriate classification shall depend on the activity that is likely to be the
predominant source or use of cash flows for the item.
45-23 Another example where cash receipts and payments include more than one class of cash flows involves a derivative instrument that includes a financing element at inception, other than a financing element inherently included in an at-the-market derivative instrument with no prepayments, because the borrower’s cash flows are associated with both the financing element and the derivative instrument. For that derivative instrument, all cash inflows and outflows shall be considered cash flows from financing activities by the borrower.
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Certain cash receipts and payments may have aspects of more
than one class of cash flows. Paragraph BC39 of ASU 2016-15 provides guidance on
“when an entity should separate cash receipts and cash payments and classify
them into more than one class of 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.” The classification of cash receipts and
payments that have aspects of more than one class of cash flows should be
determined by first applying specific guidance in U.S. GAAP. When such guidance
is not available, financial statement preparers should separate each
identifiable source or use of cash flows within the cash receipts and cash
payments on the basis of the nature of the underlying cash flows. Each
separately identified source or use of cash receipts or payments should then be
classified on the basis of its nature. Classification based on the activity that
is most likely to be the predominant source or use of cash flows is only
appropriate when the source or use of cash receipts and payments has multiple
characteristics and is not separately identifiable.
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In accordance with ASC 230, the classification of cash flows with characteristics of more than one class of cash flows is a three-step process and, as noted above, an entity should not default to classification based on predominance. Unless an entity can conclude that sources or uses of cash payments or receipts are not separately identifiable, the entity must first allocate amounts of each cash receipt or payment that has aspects of more than one class of cash flows on the basis of the nature of the underlying cash flows for each separately identifiable source or use of cash. However, because the guidance does not define the term “separately identifiable,” entities must use judgment when applying the guidance.
The first step in the process is to determine whether there is explicit guidance
in ASC 230 or other U.S. GAAP regarding the classification of the related cash flows. The
example below illustrates guidance from ASC 230 that would address the portion of the
payment for long-lived assets used in operations (i.e., as investing activities) and the
portion for the inventory (i.e., as operating activities).
Example 6-6
Entity A rents office equipment to customers and separately sells supplies such
as paper and ink cartridges. In 20X6, A enters into an asset purchase agreement
with Entity B to purchase printers and related ink cartridges for $1.5 million.
The transaction does not represent the acquisition of a business; therefore, A
accounts for the transaction as an asset acquisition. On the basis of their
relative fair values, A records $1.2 million for the purchase of the printers as
investing cash outflows because the printers will be used in A’s operations as
rentals (i.e., equipment under operating leases). Entity A records $300,000 for
the purchase of the ink cartridges as operating cash outflows because they
represent inventory that A will sell.
If no guidance explicitly addresses
classification, the second step is to determine whether cash flows are separately
identifiable. ASC 230-10-45-22 notes that entities should identify each separate source and
use of cash on the basis of the nature of the underlying cash flows and states “including
when judgment is necessary to estimate the amount of each separately identifiable source or
use.” Consider the following example:
Example 6-7
Entity A’s primary operations consist of sales and rentals of commercial trucks. In 20X6, A enters into
a transaction to purchase 100 trucks of the same make and model from Entity B for $10 million. At the time
of the purchase, A does not know precisely how many of the trucks will be sold and how many will be rented;
however, A is able to reasonably estimate that 60 trucks will be sold (i.e., inventory) and that the remaining 40
will be rented (i.e., long-lived depreciable assets). Accordingly, on the basis of its estimate of the nature of the
underlying cash flows, A classifies $6 million as operating outflows for its estimate of inventory purchases and
$4 million as investing outflows for its estimate of purchases of depreciable long-lived assets.
In the example above, the entity purchases trucks (which are similar assets)
that it regularly uses in its operations as rentals and for resale. When the entity
purchased the trucks, it did not know exactly how many units would be rented and how many
would be sold; however, the entity used judgment and estimated the cash flows for each
category (operating and investing). In other words, at the time of purchase, the entity
estimated the cash flows for each category on the basis of how it planned to use each truck.
Example 6-8
Biotech Company X enters into two contemporaneous arrangements
with Pharmaceutical Company Y: (1) a license and collaboration arrangement
within the scope of ASC 606 and (2) a share purchase arrangement in which X
sells shares of its common stock to Y. Biotech Company X determines that the
common stock purchased should be accounted for under applicable authoritative
literature (e.g., at fair value as of the issuance date). The fair value of the
common shares is excluded from the consideration allocated to the revenue unit
of account. To the extent that the contractual consideration for the common
shares is higher or lower than the fair value, the difference — positive or
negative — is allocated to the revenue unit of account. The total consideration
for the arrangements is $50 million, collected in full, of which the share
contract provides for a $14 million purchase price for the shares. When the
shares were issued, their fair value was $15 million; accordingly, for
accounting purposes, $15 million would be allocated to the sale of the common
stock to Y, even though the legal contract price is $14 million. The remaining
$35 million would be allocated to the revenue unit of account and accounted for
in accordance with ASC 606.
Under ASC 230-10-45-22, “a reporting entity shall determine each separately
identifiable source or each separately identifiable use within the cash receipts
and cash payments on the basis of the nature of the underlying cash flows [and]
shall then classify each separately identifiable source or use within the cash
receipts and payments on the basis of their nature in financing, investing, or
operating activities.”
Accordingly, in the statement of cash flows, X should recognize the proceeds
received for the sale of common stock ($15 million) in financing activities and
the consideration allocated to the ASC 606 revenue contract ($35 million) in
operating activities.
As illustrated in the example above, an entity may enter into a contract
with a customer that includes both revenue and nonrevenue elements, such as a contract that
includes performance obligations subject to ASC 606 and an equity component that is within
the scope of other authoritative literature. In accordance with ASC 230-10-45-22, such an
entity would present the consideration received from the customer “on the basis of the
nature of the underlying cash flows.”
The third step is to determine classification of cash flows on the basis of
predominance in situations in which cash receipts and payments have aspects of more than one
class of cash flow and the entity is unable to separately identify sources and uses of cash
flows (note that this is not the case in Example 6-7 because the entity could estimate the category, which in that case
was based on the entity’s intent at the time the original cash flow occurred). Such
scenarios may occur when the same piece of equipment is sold but, at the time of purchase,
the asset will be used in the entity’s operations for a short period before resale. In such
situations, an entity may need to classify all of the cash outflows in the same category on
the basis of the activity that is likely to be the predominant use of the cash flows (i.e.,
the investing outflows in the example below are based on predominance).
Example 6-9
A company provides health care equipment to patients for a monthly rental fee. At times, the company may
also sell the rental equipment to patients. In other words, the entity sells the same asset that it uses in its
operations as rentals and classifies the cash outflows for asset purchases on the basis of the predominant
source of cash flows (i.e., the entity’s use of the assets as rentals). Therefore, because the purchases of health
care equipment are presented as a cash outflow from investing activities upon acquisition, proceeds from the
sale of the health care equipment should be presented as a cash inflow from investing activities.
Note that an entity should apply the same three-step process when the
disposition of assets may have aspects of more than one class of cash flows. Consider the
example below.
Example 6-10
Assume the same facts as in Example 6-6, except that, rather than purchasing printers and
related ink cartridges, Entity A is selling these items in a single transaction
for $1.5 million. Entity A accounts for the transaction as an asset disposition.
On the basis of their relative fair values, A records $1.2 million for the sale
of the printers as investing cash inflows because the printers have been used in
A’s operations as rentals (and the presentation is consistent with the cash
outflows when the printers were originally acquired). Entity A records $300,000
for the sale of the ink cartridges as operating cash inflows because they
represent inventory that A was holding for sale as part of its normal operations
(and the presentation is consistent with the cash outflows when the ink
cartridges were originally acquired).
In addition, an entity’s intended use of an asset may change when compared with
its intended use at the time the asset was acquired. Such changes in an asset’s intended use
may also make it challenging to determine how to classify cash inflows and outflows.
Consider Example 6-7, in which
the entity purchases assets, intending to use some of the assets purchased in its operations
(as rentals) and resell others. The entity may purchase a piece of equipment to rent to
customers but may later decide to sell the asset rather than rent it to customers. Because
the entity purchased the asset while intending to use it in its operations, the cash
outflows were classified as investing activities. However, because the entity also regularly
resells equipment (representing a revenue transaction for the entity), a question arises
regarding whether the cash inflows from the sale of the asset should be classified as
operating activities. Therefore, classifying the cash outflows and inflows on the basis of
the intent that existed when the respective cash flows occurred would result in the
differing classification of inflows and outflows for the same asset (i.e., investing
activities for the purchases of equipment to be rented and operating activities for revenue
from their sales). Conversely, if cash flows for the asset’s purchase and sale are
classified consistently (e.g., both are presented on the basis of original intent
representing an investing activity and therefore the subsequent sale would also be investing
rather than operating), the cash flow presentation may not be consistent (i.e., not
symmetrical) with how balances are presented in the other financial statements because
presentation in other financial statements reflects the entity’s change in intent.
In a manner consistent with the SEC staff’s remarks at the 2006 AICPA Conference on Current SEC and
PCAOB Developments and comment letters to registrants, we believe that an entity should be consistent
in how it classifies cash outflows and inflows related to an asset’s purchase and sale. Further, cash
flow classification should be consistent even if doing so creates asymmetry with how the transaction is
presented in the balance sheet and income statement. When such asymmetry exists, an entity should
include appropriate disclosures that explain such differences.
6.4.1 Classification of Cash Flows for Emission Allowances and Related Transactions
Emission trading (or “cap-and-trade”) programs are administered by governing bodies (i.e., governments or governmental agencies) to control or reduce the emission of pollutants or greenhouse gases. The most common programs in the United States cover emissions of sulfur dioxide and nitrogen oxide. Outside the United States, there are similar programs to control the emission of greenhouse gases (e.g., carbon dioxide). In the current U.S. cap-and-trade programs, governing bodies typically issue rights (allowances) to participating entities to emit a specified level of pollutants. Each individual emission allowance (EA) has a vintage year designation (i.e., the year the allowance may be used). EAs with the same vintage year designation are fungible and can be used by any party to satisfy pollution control obligations for emissions from any source within the governing bodies’ associated control area during the vintage year or, potentially, subsequent years (i.e., many EA programs permit carryforward to subsequent years). EAs are generally granted several years in advance. For example, sulfur dioxide allowances in the United States have already been allocated and delivered to participating entities for the next 30 years.
Entities can choose to buy EAs from, and sell EAs to, other entities, which is
typically initiated through a broker. Entities can also enter into nonmonetary exchanges
of EAs of one vintage (e.g., use in 2020) for EAs of another vintage (e.g., use in 2030) —
commonly referred to as vintage year swaps. At the end of a compliance period, a
participating entity must either (1) deliver to the governing bodies EAs sufficient to
offset the entity’s actual emissions or (2) pay a fine.
Markets to buy and sell EAs in the United States continue to develop. The extent of development depends on the type of EA and whether the EA is related to a national, regional, or state program.
Discussions with the FASB and SEC staffs have indicated that two methods of
accounting for EAs are acceptable: (1) the inventory model and (2) the intangible asset
model. While both are permitted, the intangible asset model is preferable. Although the
FASB added a project to its agenda to address the accounting for EAs, the project was
removed from the Board’s agenda in January 2014. As of the date of this publication, the
FASB is currently deliberating its project on accounting for environmental credit
programs. However, no final standard has been issued; therefore, entities should choose
one method and apply it consistently to a given category of EA. For example, an entity
could hold two categories of EA, “held for use” and “held for sale,” each with its own
accounting method. However, within a category, the method must be consistently
applied.
Under the inventory model, cash inflows and outflows from sales and purchases of
EAs are generally classified as operating activities in the statement of cash flows. Under
the intangible asset model, such inflows and outflows are generally classified as
investing activities in the statement of cash flows given that intangible assets are
generally consumed over a long period. However, when an entity purchases EAs and intends
to use them solely to offset a compliance obligation within 12 months (or the entity’s
normal operating cycle), the related cash outflows may be classified within operating
activities. The compliance obligation is associated with emissions generated from the
entity’s core operations. In the absence of the purchase of EAs, the entity would be
required to settle its compliance obligation in cash by paying a government-assessed
penalty. The compliance obligation related to an emission trading program is analogous to
a tax to be paid for the entity’s emissions. While an entity may purchase the EAs from a
counterparty that differs from the regulatory body to which the entity owes the compliance
obligation, the purchase of EAs may be viewed as akin to a prepayment of the compliance
obligation associated with emissions generated by the entity’s core operations.
6.4.2 Classification of Cash Flows of Repayments of Zero-Coupon Bonds and Other Debt Instruments With Coupon Interest Rates That Are Insignificant in Relation to the Effective Interest Rate of the Borrowing
ASC 230-10
45-15 All of the following are cash outflows for
financing activities: . . .
b. Repayments of amounts borrowed, including the portion of the
repayments made to settle zero-coupon debt instruments that is
attributable to the principal or the portion of the repayments made to
settle other debt instruments with coupon interest rates that are
insignificant in relation to the effective interest rate of the borrowing
that is attributable to the principal. . . .
45-17 All of the following are cash outflows for
operating activities: . . .
d. Cash payments to lenders and other creditors for interest, including
the portion of the payments made to settle zero-coupon debt instruments
that is attributable to accreted interest related to the debt discount or
the portion of the payments made to settle other debt instruments with
coupon interest rates that are insignificant in relation to the effective
interest rate of the borrowing that is attributable to accreted interest
related to the debt discount. For all other debt instruments, an issuer
shall not bifurcate cash payments to lenders and other creditors at
settlement for amounts attributable to accreted interest related to the
debt discount, nor classify such amounts as cash outflows for operating
activities. . . .
45-25 In reporting cash flows from operating
activities, entities are encouraged to report major classes of gross cash
receipts and gross cash payments and their arithmetic sum — the net cash flow
from operating activities (the direct method). (Paragraphs 230-10-55-1 through
55-4 and paragraph 230-10-55-21, respectively, discuss and illustrate a method
by which those major classes of gross operating cash receipts and payments
generally may be determined indirectly.) Entities that do so shall, at a
minimum, separately report the following classes of operating cash receipts
and payments: . . .
e. Interest paid, including the portion of the payments made to settle
zero-coupon debt instruments that is attributable to accreted interest
related to the debt discount or the portion of the payments made to settle
other debt instruments with coupon interest rates that are insignificant
in relation to the effective interest rate of the borrowing that is
attributable to accreted interest related to the debt discount. . .
.
6.4.2.1 Presentation of Cash Flows by the Issuer
An entity that issues zero-coupon bonds to an investor records the
proceeds from the bonds’ issuance as a financing cash inflow. The bonds are accreted to
their redemption value in accordance with the “interest” method,3 as described in ASC 835 (i.e., the carrying amount of the bonds increases from
issuance until maturity [or earlier if prepayment is allowed] for the accrued interest
to arrive at the bonds’ redemption value). On the maturity date (or earlier if
prepayment is allowed), the entity repays (1) the original proceeds (the principal
amount of the bonds) and (2) the accrued interest from the date of issuance. Before the
bonds’ maturity (or the date of prepayment, if earlier), the interest expense is
presented in the statement of cash flows as a reconciling item between net income and
cash flows from operating activities, since no interim cash payments are made for the
periodic accrual of interest.
At redemption, the cash paid to settle the interest component is
reflected as a cash outflow from operating activities in the statement of cash flows in
accordance with ASC 230-10-45-17 and ASC 230-10-45-25 as the accrued interest is
recognized in earnings. The cash paid to settle the principal is reflected as a cash
outflow from financing activities in the statement of cash flows in accordance with ASC
230-10-45-15.
Example 6-11
On January 1, 20X2, Company A issues 1,000 zero-coupon
bonds, each with a face amount of $1,000, and A receives proceeds of
$600,000 upon issuance. The zero-coupon bonds mature in five years (on
December 31, 20X6).
In fiscal years 20X2–20X6, A records annual interest
expense of $80,000, which is calculated as ($1,000,000 redemption value –
$600,000 proceeds received) ÷ 5 years, to accrete the zero-coupon bonds to
their redemption value. Company A has determined that the amount of the
interest expense accrued annually on a straight-line basis ($80,000) would
not materially differ from the amount of interest expense accrued under the
interest method.
On December 31, 20X6, A redeems the zero-coupon bonds for
$1 million. Amounts that A would present in its statement of cash flows for
specific years are as follows:
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December 31, 20X2:
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The initial cash proceeds of $600,000 received upon issuance of the zero-coupon bonds would be reflected as a cash inflow from financing activities.
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The interest expense of $80,000 recorded to accrete the zero-coupon bonds to their redemption value would be reflected as a reconciling item between net income and cash flows from operating activities.
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December 31, 20X3–20X5:
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The interest expense of $80,000 recorded to accrete the zero-coupon bonds to their redemption value would be reflected as a reconciling item between net income and cash flows from operating activities.
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December 31, 20X6:
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Of the $1 million of cash paid, $600,000 represents the amount paid to settle the principal amount of the zero-coupon bonds and would be reflected as a cash outflow from financing activities.
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The remaining $400,000 of cash paid (i.e., the interest expense of $80,000 recorded in each of the five fiscal years) would be reflected as a cash outflow from operating activities because the interest was recognized in earnings.
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In addition to zero-coupon bonds, the guidance in ASC 230-10-45-15,
ASC 230-10-45-17, and ASC 230-10-45-25 also applies to other debt instruments “with
coupon interest rates that are insignificant in relation to the effective interest rate
of the borrowing that is attributable to the principal.” The objective of including
these other debt instruments (rather than all debt instruments) is to improve
comparability related to entities’ presentation of economically similar
transactions.
Connecting the Dots
ASC 230 does not define the term “insignificant” or otherwise
provide guidance on what would constitute insignificant coupon rates. Consequently,
entities that issue other debt instruments with coupon rates that are insignificant
in relation to the effective interest rate attributable to the principal will most
likely need to exercise greater judgment in evaluating the portion of the rates that
is insignificant. We generally believe that an entity should determine whether an
interest rate is insignificant by looking to the market. For example, a 1 percent
coupon rate may not be insignificant if the market rate is 2 percent. However, an
entity may conclude that a 1 percent coupon rate is insignificant compared with a
market rate of 10 percent and that the 1 percent rate is therefore within the scope
of ASC 230-10-45-15, ASC 230-10-45-17, and ASC 230-10-45-25.
6.4.2.2 Presentation of Cash Flows by the Investor
While the guidance in ASC 230-10-45-15, ASC 230-10-45-17, and ASC
230-10-45-25 specifically addresses only the debtor’s (i.e., the issuer’s) cash flow
statement classification, we believe that it is also relevant to the investor’s cash
flow statement classification. Therefore, we think that the following payments should
generally be classified as operating activities: (1) the portion of payments received
upon settlement of zero-coupon debt instruments that is attributable to accreted
interest and (2) the portion of payments received upon settlement of other debt
instruments with coupon interest rates that are insignificant in relation to the
effective interest rate of the borrowing that is attributable to accreted interest
(including debt instruments that contain periodic interest coupons that are payable in
kind [see Section 6.4.3]).
The principal portion received on these debt instruments would continue to be classified
as an investing activity.
6.4.3 Debt Instruments That Contain Interest Payable in Kind
Entities may issue debt instruments that require or permit the payment of the periodic interest coupons in kind. The ASC master glossary defines payment-in-kind bonds as follows:
Bonds in which the issuer has the option at each interest payment date of making interest payments in cash or in additional debt securities. Those additional debt securities are referred to as baby or bunny bonds. Baby bonds generally have the same terms, including maturity dates and interest rates, as the original bonds (parent payment-in-kind bonds). Interest on baby bonds may also be paid in cash or in additional like-kind debt securities at the option of the issuer.
On the basis of the EITF’s deliberations leading up to the issuance of ASU
2016-15 (codified in ASC 230), we understand that the requirements discussed in the
previous section apply to all debt instruments that are economically similar to
zero-coupon bonds (including debt instruments that contain periodic interest coupons that
are payable in kind).4 Therefore, we believe that the guidance in ASC 230-10-45-15, ASC 230-10-45-17, and
ASC 230-10-45-25 should be considered for debt instruments that:
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Require periodic interest coupons to be paid in kind through an addition to the contractual principal amount of the original debt instrument.
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Permit the debtor to pay each periodic interest coupon in cash or in kind, with any payments made in kind added to the contractual principal amount of the original debt instrument.
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Require periodic interest coupons to be paid in kind through the issuance of a new debt instrument that has the same terms as the original debt instrument.
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Permit the debtor to pay each periodic interest coupon in cash or in kind, with any payments in kind paid through the issuance of a new debt instrument that has the same terms as the original debt instrument.
The guidance discussed above (and in Section 6.4.2) should not affect the classification of cash
flows for the following types of financial instruments that contain periodic coupons that are
payable in kind:
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Convertible debt instruments or convertible preferred stock instruments that are settled through the issuance of common stock — The settlement of convertible securities for common stock is treated as a noncash investing or financing activity.
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Preferred stock instruments that are classified in equity — The issuer of preferred stock classifies payments of dividends on, and redemptions of, equity-classified preferred stock instruments as financing activities. Therefore, the ASU’s guidance does not apply to the issuer; however, it does apply to the investor. Under this guidance, the investor would be required to classify (1) dividends received on equity-classified preferred stock instruments as operating activities and (2) redemptions of equity-classified preferred stock instruments as investing activities.
Footnotes
3
ASC 835-30-35-4 states that “[o]ther methods of amortization may
be used if the results obtained are not materially different from those that would
result from the interest method.”
4
We generally believe that when ASU 2016-15 is applied, debt
instruments that contain periodic interest coupons that are payable in kind are
economically similar to zero-coupon bonds.