Preparing the statement of cash flows is mostly mechanical until a cash payment has more than one character. A contingent consideration payment, a debt prepayment penalty or an insurance recovery each raises the same question: operating, investing or financing? ASU 2016-15 settled several of those questions, and the answers surprise clients who classify by how the item was recorded in the income statement.
This guide covers the classification framework, the items that cause the most disputes, and the audit tests. For the indirect method mechanics, see /us/blog/statement-of-cash-flows-indirect-method-asc-230.
How does ASC 230 decide the class?
Each discrete cash receipt and payment, or identifiable part of one, is classified by its nature, regardless of the item it relates to. The test runs in order. First ask whether the flow meets the definition of investing or financing. If it meets neither, it is operating. Operating activities are generally the cash effects of transactions and other events that enter into the determination of net income.
- Investing: making and collecting loans, buying and selling debt or equity securities of other entities, and acquiring and disposing of productive assets.
- Financing: borrowing and repaying, obtaining equity and returning capital to owners.
How is contingent consideration classified?
This is the most asked question. ASU 2016-15 sets the approach for contingent consideration paid after a business combination:
- Soon after the acquisition date. The whole payment is an investing outflow.
- Later, up to the acquisition-date liability. ASU 2016-15 classifies payments up to the contingent consideration liability recognized at the acquisition date, including measurement-period adjustments, as financing outflows.
- Later, above the acquisition-date liability. The excess is an operating outflow. The amount up to the acquisition-date liability is financing.
The Codification does not define "soon after." The ASU 2016-15 Basis for Conclusions describes a payment made within a relatively short period after the acquisition date, for example three months or less, as an extension of the acquisition payment. Use three months as the working reference, and document the judgment for any payment close to the boundary.
An illustration. A company acquires a business and records contingent consideration of $100,000 at the acquisition date. Remeasurement raises it to $130,000, and the company pays $130,000 six months after the acquisition.
| Account | Debit | Credit |
|---|---|---|
| Contingent consideration liability | 130,000 | |
| Cash | 130,000 |
Cash flow statement: financing outflow $100,000 and operating outflow $30,000. Had the same payment been made within the first month, the full $130,000 would be an investing outflow. For the recognition and remeasurement entries, see /us/blog/asc-805-contingent-consideration-earnouts.
Where do other contested items go?
| Item | Class |
|---|---|
| Debt prepayment and extinguishment costs | Financing |
| Debt issue costs | Financing |
| Insurance proceeds for damage to productive assets | Investing (classified by the nature of the loss) |
| Insurance proceeds for business interruption | Operating (classified by the nature of the loss) |
| Proceeds from settling corporate-owned or bank-owned life insurance | Investing |
| Distributions from equity method investees | Operating if a return on investment, investing if a return of investment, under the investor's policy election (cumulative earnings or nature of the distribution) |
| Interest paid and taxes paid | Operating |
| Capitalized cloud implementation costs | Same class as the hosting fees (ASU 2018-15) |
Insurance proceeds received in one lump sum are split by the nature of each loss in the settlement.
An illustration of a debt prepayment. A company repays a $1,000,000 note early and pays a $50,000 prepayment penalty.
| Account | Debit | Credit |
|---|---|---|
| Notes payable | 1,000,000 | |
| Loss on extinguishment of debt | 50,000 | |
| Cash | 1,050,000 |
The whole $1,050,000 is a financing outflow. In the indirect method, the $50,000 loss is added back in operating activities and the cash is shown in financing. See /us/blog/asc-470-debt-modification-vs-extinguishment-10-percent-test.
When can cash flows be netted?
ASC 230 favors gross reporting of investing and financing flows. Netting is limited to items that turn over quickly, in large amounts, with short maturities. Operating cash flows may be presented by the direct or indirect method.
Audit angle
- Obtain the cash flow worksheet. Agree every line to the trial balance changes and to the balance sheet, including noncash activity such as seller financing.
- Identify unusual cash payments. Scan the cash disbursements journal for acquisitions, earnout payments, debt payoffs and insurance receipts.
- Test each unusual item by nature. Obtain the agreement and classify each flow, splitting a payment that has more than one character.
- Test contingent consideration. Agree the acquisition-date fair value to the business combination workpapers, the payment date to the bank statement, and the split between financing and operating. Document the timing judgment.
- Check debt costs. Check that prepayment penalties and issue costs sit in financing and that the add-back of any loss is in operating.
- Check netting. Check that borrowings and repayments are gross unless a permitted exception applies.
- Foot and cross-foot. Agree ending cash, including restricted cash, to the balance sheet.
Common misstatements: classifying the whole earnout payment as operating because it hit expense, debt penalties in operating, nonoperating items left in operating, and borrowings netted against repayments.
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Sources
- PwC Viewpoint, Financial statement presentation guide, 6.8 Common cash flow classification issues (6.8.20 contingent consideration): https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/financial_statement_/financial_statement___18_US/chapter_6_statement__US/68_common.html
- PwC Viewpoint, Financial statement presentation guide, 6.7 Classification of cash flows: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/financial_statement_/financial_statement___18_US/chapter_6_statement__US/67_class.html
- PwC Viewpoint, Financial statement presentation guide, 6.6 Gross versus net reporting: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/financial_statement_/financial_statement___18_US/chapter_6_statement__US/66gross.html
- FASB, ASU 2016-15, Classification of Certain Cash Receipts and Cash Payments (effective dates, contingent consideration, debt costs, insurance, BOLI, equity method distributions, Basis for Conclusions): https://storage.fasb.org/ASU%202016-15.pdf
- FASB, ASU 2018-15, Customer's Accounting for Implementation Costs in a Cloud Computing Arrangement (cash flow classification): https://storage.fasb.org/ASU%202018-15.pdf
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