Statement of Cash Flows: Classification

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Accounting Analysis II: Accounting for Liabilities and Equity

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University of Illinois at Urbana-Champaign

Accounting Analysis II: Accounting for Liabilities and Equity

8 notes

Cours 4 sur 5 dans Specialization Financial Reporting

This course is the fourth course in a five-course Financial Reporting Specialization. This course focuses on the recognition, measurement and subsequent accounting for equity, pensions, share-based compensation and cash flows utilizing the FASB Accounting Standards Codification and other resources.

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Module 7 Statement of Cash Flows

In this module, you will be introduced to the statement of cash flows. We will learn how to classify cash flows as investing, financing, or operating activities. The module will conclude with a comparison of the statement of cash flows prepared using the direct and indirect methods.

Statement of Cash Flows: Classification10:58

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John Hepp
Clinical Assistant Professor of Accountancy
Department of Accountancy

So, welcome back. In this lesson we'll talk about classification.

You'll recall we talked about that is going to classify

all cash receipts and cash payments are into investing,

financing, and operating activities.

And you'll recall the judgment is required.

Some people may not agree exactly on what the appropriate classification is at all times.

So, let's start at the bottom.

Usually, when the statement of cash is presented they

put the cash flows from operating activities at the top,

and then investing and then finding and say we're going to start down there with

investing and financing particularly when we're doing the direct method.

Why? Because if you cannot identify cash flows and investing or financing activity,

it's going to be an operating activity.

So, we're going to try and put what we can into those activities first,

and then if it doesn't meet the definition of an investing or financing activity,

well we know it's going to go up in our operating.

So, again, investing activities include making and collecting loans,

acquiring disposing of debt or equity instruments.

This is the definition we talked about in the first lesson.

Investments in certain financial instruments,

so cash flows from purchases sales of maturities of available for

sale securities are classified as cash flows from investing activities,

those are reported gross in the statement of cash flows.

All the following are cash inflows from investing activity,

so we've got receipts from collections or sales of loans,

made by the entity receipts from sales of equity instruments of other entities,

not t your own entities.

If it's your own, issuance of your own stock,

that's a financing activity.

But if it's somebody else's stock that you've bought and you're going to sell,

it's an investing activity.

So, receipts from sales of property, plant and equipment,

receipts from sales of loans that specifically acquired from resale.

What are some outflows, again,

disbursements for loans to repayment of loans,

payments to acquire equity instruments and other entities, not your own.

If you acquire your own equity instruments as treasury stock,

that's going to be considered a financing activity.

Payments at the time of purchase are soon before or after purchase to acquire property,

plant and equipment and other productive assets.

This includes interests capitalized as part of the cost of those assets,

and also payments right after a business combination.

Sometimes when you enter into a business combination,

there is some sort of liability that's sort of pending and awaiting resolution.

So, if that's resolved soon after the acquisition date,

that's considered an investing outflow,

if it happens later, it's just going to be an operating activity most likely.

What about insurance proceeds?

This is an area where judgment is involved,

because insurance is not technically an operating activity,

it's risk management activity.

I get insurance to ensure that if one of my assets or the life of one of my employees,

or my business as a whole is not precluded

from operating due to some natural disaster occurs,

I'm going to have insurance proceeds to cover any losses that could happen.

So, how do we classify insurance proceeds?

Well the general rule is you follow the money.

Insurance recoveries for capital items are investing cash flows.

So, if I have a building that I have invested in,

and it's destroyed by fire,

the proceeds from that would be considered investing cash flow.

What about on loss of operations?

Suppose the insurance also covers for a warehouse.

It also covers the rental of additional rent warehouse space,

while I rebuild my warehouse that was destroyed by fire.

Well that would be considered an operating cash flow.

It's not an investing activity,

because it's going for operating.

It's a recovery really of my operating expenses.

Let's look at any examples.

So, we have a hurricane strike.

Sunshine resorts, they suffered damage in a hurricane.

The policy covers damage to the property,

and losses from business interruption,

this is very common for businesses to have.

They can't have their business interrupted where all their expenses continued,

their loan payments are on their payroll, everything is continuing,

so it's very common to have something called business interruption insurance.

So, if they receive a check for a hundred thousand dollars,

that represents a negotiated settlement that doesn't specify what it's covering,

it's covering both, how would you classify the cash flows?

Well, you would use the best information available,

and allocate the proceeds between operating cash flows,

and investing cash flows.

So, you are render unto you're investing,

that which is investing,

you'll render unto your operating that, which is operating.

What about financing activities?

So, those are going to include obtaining resources from owners.

We talked about this, resources from donors,

resources from creditors, resources on long term credit.

So, some examples here, some inflows,

proceeds from issuing equity instruments,

and that will include treasury stock and it's reissue,

proceeds from short or long term borrowing,

and receipts from contributions and

investment income restricted for acquiring constructing or improving PPE.

This is something that affects not for profit organizations primarily,

and some outflows payment of dividends.

Dividends are an investing outflow,

they're not an operating cash flow,

outlays to acquire the entities equity instruments,

that's your treasury stock,

or repurchases stock repurchase,

and then any repayment of amounts borrowed,

including repayments to make to settle zero coupon debt instruments.

We'll talk about that in a little bit.

The discount is the repayment of the discount is considered to be a financing activity.

As long as the payments are attributable to the principal,

if their repayment of the discount is actually the interest payment on the instrument,

then that's going to be an operating activity.

So, it's a matter of interest,

while repayment of debt is generally considered to be a financing cash flow,

that's the repayment of the principal,

amounts that are paid for interest are considered to be

operating cash flows under US gap.

So, repayment of the principal is a financing cash flow.

Any payments that are interest,

are considered to be an operating cash flow, under US GAAP.

Now the classification of interest under IFRS is

a policy choice and interest there in fact is often classified as a financing cash flow.

So, that's an important difference between US GAAP and IFRS,

you should be aware of when it comes to the statement of cash flows.

So, you do need some judgment in looking to see especially with a zero coupon bond,

but with any bond that's issued at a discount or premium,

how much is actually attributable to a financing activity,

and how much is an operating activity.

So, when the debt is issued at face value, you don't have a problem,

the entire amount of the proceeds is going to be a financing activity,

and the entire amount of the repayment,

absent the interest of course that you pay is going to be a financing cash flow.

But, what happens when cash is issued at a discount?

Well the interest expense is going to be greater than the stated rate,

which also means that the interest expense every period is going to

be more than the cash flows, that you pay.

And the same thing with premiums,

when the debt is issued at a premium,

the interest expense is going to be less than the stated rate,

which means it's going to be less than the cash flows.

So, what you're going to have a difference between

the income statement amount of interest expense on these transactions,

and the amount of cash paid.

So, again, the repayment of those discounts or the failure to repay that premium,

actually it's going to be recorded as a financing cash flow.

When there's a premium and you receive more cash flows at the beginning,

that excess amount that you receive is actually

going to be considered a form of interest,

and it was going to be accounted for as a operating cash flow.

And again, when you repay the debt at the end when there's a discount,

I only received maybe 900 but I'm repaying 100,

that additional amount is also considered to be an operating cash flow,

because it's part of your interest expense.

So, when you repay that debt,

the portion that's attributable to the discount is going to

be recorded as a operating cash flow.

Why does that do it?

Well, this makes it all evened out.

Recall that, since my interest and

my cash flows were unequal during the whole term of the loan,

due to the premium or the discount,

by doing classifying that repayment of the discount or the receipt of the premium,

and the early part as an operating expense,

then now the cash interest payments

plus the cash payment for the discount or the cash receipts for the discount,

will now equal the gap interest expense.

So, those reconcile to it.

It seems kind of complicated, it is complicated,

but it's a way otherwise of avoiding the issue that you have,

what is something that is clearly interest especially for instruments

that are issued with a zero coupon that are simply issued at a discount.

Otherwise you would not be able to properly classify the amounts that

really are interest as interest expense on the statement of cash flow.

So, this is a way of evening it out.

Other debt related cash flow,

so payments for initial direct costs of issuing debt,

those that are also considered financing cash flows,

or payment to extinguish debt early are financing cash flows.

But, you have to make sure that any accrued interests that you

had that was due on that is classified as an operating cash flow,

so, you're going to have to make a distinction between the

two when you have an early extinguishment of debt.

And then operating activities.

It's just everything else,

all other transactions and events that are not

defined as investing or financing activities.

So, that concludes our discussion of classification.

We'll move on to an example in the next lesson. Thank you.

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