Chapter 6 — Classification of Cash Flows

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.

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.

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

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

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.

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.

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.

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.

Direct costs of purchasing or selling NCIs 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 NCIs 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 NCI 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.

Although ASC 230-10-45-15(e) states that cash outflows for financing activities include debt issue costs, an entity may be able to classify such costs as operating cash flows in certain instances. Under ASC 470-50-40-21, when an entity modifies or exchanges a line-of-credit or revolving-debt arrangement with the same creditor, any costs and fees incurred in connection with a modification or exchange must “be deferred and amortized over the term of the new arrangement.” The cash flow classification of these costs may depend on whether the entity intends to immediately access the funds provided by the arrangement. If the entity intends to draw down on amounts provided by the line-of-credit or revolving-debt arrangement after the modification or exchange, the costs and fees associated with the modification or exchange would be classified as financing cash outflows in accordance with ASC 230-10-45-15(e). However, if the entity does not intend to draw down on amounts after the modification or exchange but has entered into the arrangement to have the ability to access cash in the future, we believe that it would be acceptable to present the costs and fees associated with the modification or exchange as operating cash flows.

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. The changes in those advance payments generally should be classified as financing activities in a manner consistent with our understanding of the SEC staff’s view that the holding of funds on behalf of others is analogous to proceeds received from borrowings. Under this view, an entity may conclude that, as with bank deposits, the predominant source of the related cash flows is the receipt of cash in a custodial or fiduciary capacity.

According to this view, the borrowings are considered outstanding until the custodial entity delivers the funds to satisfy its client obligations and such delivery is deemed a repayment of the borrowing. Therefore, the cash receipts should generally be presented as financing cash inflows, with the subsequent repayments classified as financing cash outflows.

We believe that an operating classification may also be acceptable. 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).

Entities that plan on presenting the cash flow activity from this type of arrangement within operating activities should consider consulting with their accounting and financial advisers. According to this view, an entity may conclude that the predominant source of the related cash flows is the receipt and disbursement of cash as part of the entity’s ordinary revenue-generating activities and an integral part of providing its service offering. See Section 4.1.3 for further discussion of the classification of funds held for others on the balance sheet.

Mr. Hardiman also indicated that this classification is required in situations in which the extension of credit is provided by a captive finance subsidiary.

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.

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.

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.

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.

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:

• 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.

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.