Summaries of Accounting

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 Classification Issues in Cash Flow Statements

Preface:
The below mentioned knowledge summarizes the articles published by Financial Accounting Standards
Board (FASB) and Mr. Mike Shamblin & Matt Neilson tackling the categorization and classification issues
in cash flow statements.

Preamble:
Accounting is based upon accrual concepts that report revenues as earned and expenses as incurred,
rather than when received and paid. Accrual information is perhaps the best indicator of business
success or failure. However, one cannot ignore the importance of cash flows. For example, a rapidly
growing successful business can be profitable and still experience cash flow difficulties in trying to keep
up with the need for expanded facilities and inventory. On the other hand, a business may appear
profitable, but may be experiencing delays in collecting receivables, and this can impose liquidity
constraints. Sophisticated analysis will often reveal such issues therefore accounting profession has seen
fit to require another financial statement that clearly highlights the cash flows of a business entity. This
required financial statement is appropriately named the Statement of Cash Flows.

Classifications in Cash Flow Statements:

One objective of financial reporting is to provide information that is helpful in assessing the amounts,
timing, and uncertainty of an organization’s cash inflows and outflows. As a result, the statement of cash
flows provides three broad categories that reveal information about operating activities, investing
activities, and financing activities. In addition, businesses are required to reveal significant noncash
investing / financing transactions as well.

Operating Activities: Operating activities are the main revenue-producing activities of the entity that
are not investing or financing activities. To generalize, cash from operating
activities is generally linked to those transactions and events that enter into the
determination of income. However, another way to view “operating” cash flows is
to include anything that is not an “investing” or “financing” cash flow.

Cash inflows from operating activities consist of receipts from customers for

providing goods and services, and cash received from interest and dividend
income (as well as the proceeds from the sale of “trading securities”).

Cash outflows consist of payments for inventory, trading securities, employee

salaries and wages, taxes, interest, and other normal business expenses.

Investing Activities: Investing activities are the acquisition and disposal of long-term assets and other
investments that are not considered to be cash equivalents.
 Cash inflows from investing activities result from items such as the sale of longer-
term stock and bond investments, disposal of long-term productive assets, and
receipt of principal repayments on loans made to others.

Cash outflows from investing activities include payments made to acquire plant
assets or long-term investments in other firms, loans to others, and similar items.

Financing Activities: Financing activities are those that alter the equity capital and borrowing structure
of the entity.

Cash inflows from financing activities include proceeds from a company’s issuance

of its own stock or bonds, borrowings under loans, and so forth.

Cash outflows for financing activities include repayments of amounts borrowed,

acquisitions of treasury stock, and dividend distributions.

At a quick glance, the following chart may seem helpful in understanding the classifications of relevant
cash based activities:

Issues in certain classifications:

There are potential distinctions between International Accounting Standards (IAS) and U.S. GAAP along
with which come certain issues of item classifications. Items such as interests and dividends have always
been a debatable matter.

International Financial Reporting Standards (IFRS) allow managers flexibility in classifying interest paid,
interest received, and dividends received within operating, investing, or financing activities within the
statement of cash flows. In contrast, U.S. Generally Accepted Accounting Principles (GAAP) requires
these items to be classified as operating cash flows only.

IFRS permits interest received (paid) to be disclosed in the investing (financing) section of a cash flow
statement. The global viewpoint also provides more flexibility in the classification of dividends received
(and paid). Additionally, international standards encourage disclosures of cash flows that are necessary
to maintain operating capacity, versus cash flows attributable to increasing capacity.

Similarly, some stakeholders also indicated that there is diversity in practice in how certain cash receipts
and cash payments are presented and classified to which Financial Accounting Standards Board (FASB)
provided an update in 2015-16 addressing eight specific cash flow issues with the objective of reducing
the existing diversity in practice. The issues and its guidance provided have been summarized as follows:

Debt prepayment or debt extinguishment costs: Should now be categorized as cash outflows from
financing activities.

Settlement of zero coupon debt instruments: Should be divided into two parts.  Accrued interest related
to a debt discount should be categorized as cash outflow for operating activities, and principal payments
should be categorized as cash outflow for financing activities.

Contingent consideration payments  made after a business combination: Should be categorized based

on timing.  If cash is paid soon after the date of acquisition, it should be categorized as cash outflow for
investing activities.  If not paid soon after such date, payments should be categorized as outflow for
financing activities up to the amount of the contingent liability recorded on the acquisition date. 
Payments in excess of the recorded liability should be categorized as outflow for operating activities.
While the update does not explicitly define the term “soon,” it does suggest that three months or less is
a good standard.

Proceeds from settlement of insurance claims: Should be categorized based on the nature of the loss
incurred.

Proceeds from settlement of corporate-owned life insurance policies, including bank-owned life
insurance policies: Should be categorized as cash inflow from investing activities.

Distributions received from equity-method investees: Should be categorized using either the cumulative
earnings approach or the nature of distribution approach.  If the cumulative earnings approach is
selected, distributions are recorded as cash inflows from operating activities unless the cumulative
distributions received, less the distributions received in prior periods, exceed the cumulative equity in
investee earnings.  In such a case, the excess should be categorized as cash inflow from investing
activities.  If the nature of distribution approach is selected, distributions are categorized based on the
nature of the activities that generated the distribution.

Beneficial interest in securitization transactions: Should be reported as non-cash activity with related

cash payments categorized as cash inflows from investing activities.

Separately identifiable cash flows: Should first be determined by applying current guidance in generally
accepted accounting principles.  If no specific guidance is available, each separately identifiable payment
or receipt should be categorized based on the nature of the cash flow.  In cases where the cash flows
cannot be separated, the payment or receipt should be categorized using the predominance principal. 
Application of this principal involves categorizing cash based on the predominant source or use of funds.