Chapter 6 — Classification of Cash Flows

ASC 230 requires entities to classify cash receipts and cash payments as operating, investing, or financing activities on the basis of the nature of the cash flow. Grouping cash flows into one of these three categories enables investors and creditors to evaluate significant relationships within and between those activities. Such presentation also links similar cash flows (e.g., cash proceeds from and repayments of borrowings), facilitating further analysis of the reporting entity’s activities.

The most appropriate classification of a particular cash flow may not always be clear because, as indicated in ASC 230, “[c]ertain cash receipts and payments may have aspects of more than one class of cash flows.” Paragraph BC39 of ASU 2016-15 states that, in such circumstances, entities must determine the appropriate classification by considering when to (1) “separate cash receipts and cash payments and classify them into more than one class of cash flows” and (2) “classify the aggregate of those cash receipts and payments into one class of cash flows based on predominance.” See Section 6.4 for more information about when cash payments and receipts have more than one class of cash flows.

This chapter provides an overview of the three cash flow categories as well as guidance on how to apply the cash flow categorization principles in a number of situations.

6.1 Investing Activities

6.1.1 Securities Lending

6.1.2 Distributions From Equity Method Investments

6.1.3 Property, Plant, and Equipment Acquired on Account

6.1.4 Securities

6.1.5 Company- and Bank-Owned Life Insurance Policies

6.2 Financing Activities

6.2.1 Debt Extinguishments and Modifications

6.2.2 Transactions With Noncontrolling Interest Holders

6.2.3 Debt Issue Costs

6.2.4 Advance Payments Received From Customers or Other Third Parties

6.3 Operating Activities

6.3.1 Long-Term Trade Receivables

6.3.2 Cash Proceeds From Insurance Claims

6.3.3 Planned Major Maintenance

6.3.4 Employee Benefit Plans

6.4 More Than One Class of Cash Flows

6.4.1 Classification of Cash Flows for Emission Allowances and Related Transactions

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

6.4.3 Debt Instruments That Contain Interest Payable in Kind

6.5 Changes to Historical Classification

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. 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 last six and five years, 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.

6.2 Financing Activities

ASC 230-10-20 defines financing activities as follows:

Financing activities include obtaining resources from owners and providing them with a return on, and a return of, their investment; receiving restricted resources that by donor stipulation must be used for long-term purposes; borrowing money and repaying amounts borrowed, or otherwise settling the obligation; and obtaining and paying for other resources obtained from creditors on long-term credit.

ASC 230-10

45-14 All of the following are cash inflows from financing activities:

Proceeds from issuing equity instruments
Proceeds from issuing bonds, mortgages, notes, and from other short- or long-term borrowing
Receipts from contributions and investment income that by donor stipulation are restricted for the purposes of acquiring, constructing, or improving property, plant, equipment, or other long-lived assets or establishing or increasing a donor-restricted endowment fund
Proceeds received from derivative instruments that include financing elements at inception, whether the proceeds were received at inception or over the term of the derivative instrument, other than a financing element inherently included in an at-the-market derivative instrument with no prepayments
Subparagraph superseded by Accounting Standards Update No. 2016-09.

45-15 All of the following are cash outflows for financing activities:

Payments of dividends or other distributions to owners, including outlays to reacquire the entity’s equity instruments. Cash paid to a tax authority by a grantor when withholding shares from a grantee’s award for tax-withholding purposes shall be considered an outlay to reacquire the entity’s equity instruments.
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.
Other principal payments to creditors who have extended long-term credit. See paragraph 230-10-45-13(c), which indicates that most principal payments on seller-financed debt directly related to a purchase of property, plant, and equipment or other productive assets are financing cash outflows.
Distributions to counterparties of derivative instruments that include financing elements at inception, other than a financing element inherently included in an at-the-market derivative instrument with no prepayments. The distributions may be either at inception or over the term of the derivative instrument.
Payments for debt issue costs.
Payments, or the portion of the payments, not made soon after the acquisition date of a business combination by an acquirer to settle a contingent consideration liability up to the amount of the contingent consideration liability recognized at the acquisition date, including measurement-period adjustments, less any amounts paid soon after the acquisition date to settle the contingent consideration liability. See also paragraph 230-10-45-17(ee).
Payments for debt prepayment or debt extinguishment costs, including third-party costs, premiums paid, and other fees paid to lenders that are directly related to the debt prepayment or debt extinguishment, excluding accrued interest.

The next sections discuss certain types of financing cash flows.

6.2.1 Debt Extinguishments and Modifications

If a borrower settles a debt financing arrangement before the maturity date, a lender may include a prepayment penalty in the financing agreement, often on the basis of a number of factors, such as an approximation of remaining interest that will not be paid given the early extinguishment.

ASC 230-10-45-15(g) specifies that cash outflows for financing activities include “[p]ayments for debt prepayment or debt extinguishment costs, including third-party costs, premiums paid, and other fees paid to lenders that are directly related to the debt prepayment or debt extinguishment, excluding accrued interest.” Further, paragraph BC7 of ASU 2016-15 specifies that the EITF concluded that debt extinguishment costs “should include all costs for the prepayment or extinguishment of debt (that is, third-party costs, premiums paid to repurchase debt in an open-market transaction, and other fees paid to lenders).”

Although ASC 230 does not address debt modifications,1 we believe that when debt is restructured and is accounted for as a modification rather than as an extinguishment, an entity should follow the principles in ASC 230 and classify the fees paid to the creditor on the modification date as a financing cash outflow. Our view is based on the fact that, in accordance with ASC 470-50-40-17(b), fees paid to the creditor on the modification date are “associated with the . . . modified debt instrument” and (1) capitalized on the balance sheet as a reduction to the modified debt and (2) “amortized as an adjustment of interest expense over the remaining term of the . . . modified debt instrument using the interest method.” Since the fees paid to the creditor to modify the debt reduce the liability on the balance sheet, such fees are akin to the payment of principal (or a debt discount, which, on the balance sheet, is netted against the proceeds from the debt issued); accordingly, such payments would be presented as financing cash outflows in the statement of cash flows.

Further, we believe that any fees paid to a third party other than the creditor in connection with a debt modification, including those incurred in connection with a troubled debt restructuring (TDR), should generally be classified as operating cash outflows because, in accordance with ASC 470-50-40-18(b), the payment must be expensed. Therefore, since such fees enter into the determination of net income, they would be presented as operating activities. See Section 6.3 for further discussion of operating activities.

6.2.1.1 Troubled Debt Restructurings

As part of a TDR, an entity may recognize a gain because the carrying amount of the debt is greater than the total future cash payments specified by the modified terms. In such a case, the entity should present cash payments made after the TDR as financing cash outflows, including interest payments. In accordance with ASC 470-60-35-5, all payments are treated as reductions to the carrying value of the debt instead of interest expense for accounting purposes.

If an entity does not recognize a gain as part of a TDR because the carrying amount of the debt is equal to or lower than the total future cash payments specified by the modified terms, the entity should present any debt payments made after the TDR in a manner consistent with the presentation of payments made on nontroubled debt. Consequently, an entity should present interest payments as operating outflows in accordance with ASC 230-10-45-17(d) and principal repayments as financing outflows in accordance with ASC 230-10-45-15(b).

For additional discussion of TDRs, see Chapter 11 of Deloitte’s Roadmap Issuer’s Accounting for Debt.

6.2.2 Transactions With Noncontrolling Interest Holders

ASC 810-10-45-23 indicates that “[c]hanges in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary shall be accounted for as equity transactions (investments by owners and distributions to owners acting in their capacity as owners).” Accordingly, payments to acquire noncontrolling interests in a subsidiary, or those associated with the sale of noncontrolling interests in a subsidiary, should be classified as financing activities in the statement of cash flows.

Direct costs of purchasing or selling noncontrolling interests in a subsidiary, when control is maintained, should generally be recorded as an adjustment to additional paid-in capital (APIC) and be classified as financing cash outflows in the statement of cash flows. However, indirect costs of purchasing or selling noncontrolling interests in a subsidiary, when control is maintained, should generally be reflected as an expense in the income statement and should be classified as operating cash outflows in the statement of cash flows. These conclusions are supported by analogies to ASC 810, SAB Topic 5.A, and the nonauthoritative guidance in AICPA Technical Q&As Section 4110.09.

SAB Topic 5.A provides guidance on accounting for costs related to the issuance of equity securities, stating that “[s]pecific incremental costs directly attributable to a proposed or actual offering of securities may properly be deferred and charged against the gross proceeds of the offering.” Therefore, direct costs of issuing equity securities are generally reflected as a reduction of the amount that would have otherwise been recorded in APIC. SAB Topic 5.A further states that “management salaries or other general and administrative expenses may not be allocated as costs of the offering and deferred costs of an aborted offering may not be deferred and charged against proceeds of a subsequent offering.” These indirect costs are generally reflected as an expense in the income statement.

In addition, the nonauthoritative guidance in AICPA Technical Q&As Section 4110.09 states that although there is no authoritative literature on costs entities incur to acquire their own stock, some “believe that costs associated with the acquisition of treasury stock should be treated in a manner similar to stock issue costs.” Under SAB Topic 5.A, direct costs associated with the acquisition of treasury stock may be added to the cost of the treasury stock.

Distributions to noncontrolling interest holders (in their capacity as equity holders) are considered equity transactions and should be reflected as cash outflows for financing activities in accordance with ASC 230-10-45-15. Entities that determine that it is appropriate to classify the cash outflows associated with these distributions outside of financing activities in the statement of cash flows are encouraged to consult with their accounting advisers.

6.2.3 Debt Issue Costs

ASC 230-10-45-15(e) notes that cash outflows for financing activities include “[p]ayments for debt issue costs.” To the extent that debt issue costs are paid to the lender, they should be presented net in the statement of cash flows, since such a transaction effectively represents a reduction of borrowed amounts. However, any debt issue costs paid to other parties should be presented separately in the statement of cash flows and should not be presented net against the proceeds received. In other words, such fees should be presented separately as financing activities (i.e., on a gross basis), regardless of whether the borrower pays the debt issue costs to the other party directly or the lender retains the borrowing costs from the debt proceeds and remits them to the other party. Importantly, the balance sheet classification of debt issue costs (as a reduction of the related debt liability rather than as an asset) does not depend on the party to whom the debt issue costs are paid and therefore does not change if the fees are paid to the lender or to other parties. For additional considerations related to debt extinguishments and modifications, see Section 6.2.1.

6.2.4 Advance Payments Received From Customers or Other Third Parties

When a supplier receives up-front payments from a customer (i.e., the payment represents consideration for the goods or services that the supplier provides to the customer), the receipt of such advance payments should be presented as operating cash inflows in accordance with ASC 230-10-45-16(a). In addition, refunds of customer deposits represent operating cash outflows in accordance with ASC 230-10-45-17(f).

When an entity receives advance payments from a third party in an agency relationship, which must be refunded to that same party or another third party, the cash receipts in these situations are akin to borrowings rather than for the provision of goods or services. Therefore the cash receipts should generally be presented as financing cash inflows, with the subsequent repayments classified as financing cash outflows.

Example 6-4

Company M is a payroll processor that receives funds from clients in advance before it remits those funds to the client’s employees. The cash flows from the funds received from, and paid on behalf of, M’s clients are reported as financing activities in the statement of cash flows.

Footnotes

While ASU 2016-15 clarified the presentation of certain payments related to debt extinguishments in the statement of cash flows, it did not address the cash flow presentation related to fees a debtor pays to the creditor when the debt is modified in accordance with ASC 470-50.

6.3 Operating Activities

ASC 230-10-20 defines operating activities as follows:

Operating activities include all transactions and other events that are not defined as investing or financing activities (see paragraphs 230-10-45-12 through 45-15). Operating activities generally involve producing and delivering goods and providing services. Cash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income.

ASC 230-10

45-16 All of the following are cash inflows from operating activities:

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, as discussed in paragraph 230-10-45-21.
Cash receipts from returns on loans, other debt instruments of other entities, and equity securities — interest and dividends.
All other cash receipts that do not stem from transactions defined as investing or financing activities, such as amounts received to settle lawsuits and refunds from suppliers.

45-17 All of the following are cash outflows for operating activities:

a. Cash payments to acquire materials for manufacture or goods for resale, including principal payments on accounts and both short- and long-term notes payable to suppliers for those materials or goods. The term goods includes certain loans and other debt and equity instruments of other entities that are acquired specifically for resale, as discussed in paragraph 230-10-45-21.

b. Cash payments to other suppliers and employees for other goods or services.

c. Cash payments to governments for taxes, duties, fines, and other fees or penalties.[2]

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.

e. Cash payment made to settle an asset retirement obligation.

ee. Cash payments, or the portion of the payments, not made soon after the acquisition date of a business combination by an acquirer to settle a contingent consideration liability that exceed the amount of the contingent consideration liability recognized at the acquisition date, including measurement-period adjustments, less any amounts paid soon after the acquisition date to settle the contingent consideration liability. See also paragraph 230-10-45-15(f).

f. All other cash payments that do not stem from transactions defined as investing or financing activities, such as payments to settle lawsuits, cash contributions to charities, and cash refunds to customers.

45-18 Banks, brokers and dealers in securities, and other entities may carry securities and other assets in a trading account. Characteristics of trading account activities are described in Topics 255 and 940.

45-20 Cash receipts and cash payments resulting from purchases and sales of other securities and other assets shall be classified as operating cash flows if those assets are acquired specifically for resale and are carried at fair value in a trading account.

45-21 Some loans are similar to debt 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 also 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 of cost or fair value. For example, mortgage loans held for sale are required to be reported at the lower of cost or fair value in accordance with Topic 948.

Pending Content (Transition Guidance: ASC 326-10-65-1)

45-21 Some loans are similar to debt 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 also 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 of amortized cost basis or fair value. For example, mortgage loans held for sale are required to be reported at the lower of amortized cost basis or fair value in accordance with Topic 948.

45-21A Cash receipts resulting from the sale of donated financial assets (for example, donated debt or equity instruments) by NFPs that upon receipt were directed without any NFP-imposed limitations for sale and were converted nearly immediately into cash shall be classified as operating cash flows. If, however, the donor restricted the use of the contributed resource to a long-term purpose of the nature of those described in paragraph 230-10-45-14(c), then those cash receipts meeting all the conditions in this paragraph shall be classified as a financing activity.

The next sections address certain types of operating cash flows.

6.3.1 Long-Term Trade Receivables

As indicated above, ASC 230-10-45-16 states that cash collections from sales of goods or services on account are cash inflows from operating activities. Further, at the 2004 AICPA Conference on Current SEC and PCAOB Developments, Todd Hardiman, associate chief accountant in the SEC’s Division of Corporation Finance, emphasized that all cash collections stemming from the sale of inventory are operating cash flows, regardless of whether the cash flows represent:

Immediate cash collections from customers.
Collections of cash from receivables obtained in exchange for inventory (short-term or long-term).
The proceeds of the sale of customer receivables (originated in exchange for inventory) to third parties (e.g., in a securitization accounted for under ASC 860).

In addition, during the conference, Craig Olinger, deputy chief accountant in the SEC’s Division of Corporation Finance, indicated that this classification is required in situations in which the extension of credit is provided by a captive finance subsidiary.

Example 6-5

Company A sells a product for $500. The customer finances its purchase with a loan from Company B (a captive finance subsidiary of A). When B makes the loan to the customer, it remits $500 to its parent (A) on behalf of the customer.

For A, the initial transaction (sale of the product) is a noncash transaction. However, when B receives a payment on the loan from the customer, the payment should be treated as an operating cash flow in A’s consolidated financial statements because the payment is related to sales of A’s inventory.

Connecting the Dots

ASC 230-10-50-4 notes that the transferor’s initial receipt of the beneficial interest in a securitization of trade receivables should be disclosed as a noncash activity. In addition, ASC 230-10-45-12(a) (as amended by ASU 2016-15) clarifies that subsequent cash receipts from payments on such beneficial interests should be classified as investing activities. Entities that may have classified subsequent receipts of the beneficial interest as operating activities will need to be mindful of the amended guidance in ASC 230-10-45-12(a). As a result, the ASU has resulted in a change in practice for some entities.

6.3.2 Cash Proceeds From Insurance Claims

ASC 230-10-45-21B states that “[c]ash receipts resulting from the settlement of insurance claims, excluding proceeds received from [COLI] policies and [BOLI] policies, shall be classified on the basis of the related insurance coverage (that is, the nature of the loss).” In addition, for lump-sum settlements, “an entity shall determine the classification on the basis of the nature of each loss included in the settlement.” The purpose of such clarifications is to provide financial statement users with more relevant information.

For example, insurance settlement proceeds received as a result of a claim made in connection with the destruction of productive assets should be classified as cash inflows from investing activities because the settlement proceeds could be analogous to proceeds received on the sale of such assets. However, proceeds received as a result of claims related to a business interruption should be classified as operating activities.

6.3.3 Planned Major Maintenance

Transportation assets in certain industries (e.g., the airline and shipping industries) may be subject to major maintenance activities at specified intervals in accordance with regulations applicable to the industry. These activities are known as planned major maintenance activities. For example, vessels participating in the United States Coast Guard’s alternate compliance program with the American Bureau of Shipping must meet specified “seaworthiness” standards to maintain required operating certificates. To meet such standards, vessels must undergo regular inspection, monitoring, and maintenance, referred to as “dry-docking.” Typical dry-docking costs include costs for blasting and steel coating as well as steel replacement.

When determining an accounting policy for dry-docking costs, many shipping entities apply ASC 908 for analogous guidance on overhaul costs. ASC 908-360-25-2 provides three alternatives for accounting for overhaul costs:

Direct expensing method — Actual costs are expensed as incurred.
Built-in overhaul method — The costs of components subject to overhaul are segregated at purchase and are amortized to the date of the initial overhaul. The process is repeated thereafter.
Deferral method — Actual costs are capitalized and amortized to the next overhaul.

Informal discussions with the SEC staff have revealed that an entity should classify dry-docking expenditures in operating activities in the statement of cash flows, regardless of the method the entity uses to account for these expenditures.

However, classification of these expenditures as operating activities is not limited to dry-docking costs for shipping vessels and thus would apply to planned major maintenance activities in other industries.

6.3.4 Employee Benefit Plans

When an employer makes contributions (discretionary and nondiscretionary) to an employee benefit plan in connection with employee services rendered, such payments, although perhaps initially contributed to a trust, will ultimately be paid to employees. Therefore, the employer should classify those payments as cash flows for operating activities in the statement of cash flows, regardless of whether such payments are voluntary or are required by ERISA.

Further, when an entity files for bankruptcy, it may enter into an agreement with the Pension Benefit Guaranty Corporation regarding its employee benefit plan liabilities. Typically, such an agreement requires the entity to make payments for its employee benefit plan liabilities at the time of, or after, its emergence from bankruptcy. Although these payments may extend over a number of years, they still ultimately concern employee services rendered and therefore should be classified as cash flows for operating activities in the statement of cash flows. This classification is required even if the entity is later required to apply “fresh-start” reporting under ASC 852. This classification is also consistent with views expressed by the SEC staff.

Footnotes

ASU 2016-09 removed from ASC 230-10-45-17(c) the notion that “the cash that would have been paid for income taxes if increases in the value of equity instruments issued under share-based payment arrangements that are not included in the cost of goods or services recognizable for financial reporting purposes also had not been deductible in determining taxable income. (This is the same amount reported as a financing cash inflow pursuant to paragraph 230-10-45-14(e).)”

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.

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.

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.

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 6-8

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 following example:

Example 6-9

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. 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 intangible asset model, cash inflows and outflows from sales and purchases of EAs are generally classified as investing activities in the statement of cash flows; however, under the inventory model, they are classified as operating activities in the statement of cash flows.

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:

Payments of dividends or other distributions to owners, including outlays to reacquire the entity’s equity instruments. Cash paid to a tax authority by a grantor when withholding shares from a grantee’s award for tax-withholding purposes shall be considered an outlay to reacquire the entity’s equity instruments.
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.
Other principal payments to creditors who have extended long-term credit. See paragraph 230-10-45-13(c), which indicates that most principal payments on seller-financed debt directly related to a purchase of property, plant, and equipment or other productive assets are financing cash outflows.
Distributions to counterparties of derivative instruments that include financing elements at inception, other than a financing element inherently included in an at-the-market derivative instrument with no prepayments. The distributions may be either at inception or over the term of the derivative instrument.
Payments for debt issue costs.
Payments, or the portion of the payments, not made soon after the acquisition date of a business combination by an acquirer to settle a contingent consideration liability up to the amount of the contingent consideration liability recognized at the acquisition date, including measurement-period adjustments, less any amounts paid soon after the acquisition date to settle the contingent consideration liability. See also paragraph 230-10-45-17(ee).
Payments for debt prepayment or debt extinguishment costs, including third-party costs, premiums paid, and other fees paid to lenders that are directly related to the debt prepayment or debt extinguishment, excluding accrued interest.

45-17 All of the following are cash outflows for operating activities:

b. Cash payments to other suppliers and employees for other goods or services.

c. Cash payments to governments for taxes, duties, fines, and other fees or penalties.[3 ]

e. Cash payment made to settle an asset retirement obligation.

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:

Cash collected from customers, including lessees, licensees, and the like
Interest and dividends received. Interest and dividends that are donor restricted for long-term purposes as included in the list of financing activities and paragraph 230-10-45-14(c) are not part of operating cash receipts.
Other operating cash receipts, if any
Cash paid to employees and other suppliers of goods or services, including suppliers of insurance, advertising, and the like
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
Income taxes paid
Other operating cash payments, if any.

Entities are encouraged to provide further breakdowns of operating cash receipts and payments that they consider meaningful and feasible. For example, a retailer or manufacturer might decide to further divide cash paid to employees and suppliers (category (d) in the preceding paragraph) into payments for costs of inventory and payments for selling, general, and administrative expenses.

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,4 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 6-10

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:

December 31, 20X2:
- 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.
- 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.
December 31, 20X3–20X5:
- 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.
December 31, 20X6:
- 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.
- 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.

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.

6.4.3 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).5 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:

Require periodic interest coupons to be paid in kind through an addition to the contractual principal amount of the original debt instrument.
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.
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.
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.

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 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 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). The principal portion received on these debt instruments would continue to be classified as investing activities.

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:

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.
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

See footnote 2.

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.”

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.

6.5 Changes to Historical Classification

In certain instances, an entity may elect to change its historical classification of certain items in the statement of cash flows. We do not believe that such a change in classification would represent a change in accounting principle as defined in ASC 250 if the entity is able to conclude that both the previous classification and the new classification are acceptable under GAAP. Instead, the change should be viewed as a change from one acceptable presentation to another acceptable presentation in accordance with ASC 230. Further, an entity should retrospectively apply the revised classification for each year presented in the financial statements and include appropriate disclosure of the change.

Conversely, a change to an entity’s policy for determining which items are treated as cash equivalents represents a change in accounting principle for which the entity must demonstrate preferability in accordance with ASC 250 (see Section 4.1 regarding the definition of cash and cash equivalents).

Example 6-11

Entity A has decided to change the approach it uses for presentation in its statement of cash flows in the current year from the direct method to the indirect method, since management considers presentation under the indirect method to be more informative and readily understandable by financial statement users.

Both the direct method and the indirect method are acceptable under U.S. GAAP, and the change is considered to be a change in presentation, which is analogous to a reclassification. Entity A will retroactively reclassify the statement of cash flows presented and disclose the reclassification in the notes to the financial statements.