Memo No. Issue Summary No. 1, Supplement No. 2. Issue Date October 29, Meeting Date(s) EITF November 12, 2015

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1 Memo No. Issue Summary No. 1, Supplement No. 2 Memo Issue Date October 29, 2015 Meeting Date(s) EITF November 12, 2015 Contact(s) Jenifer Wyss Lead Author, Project Lead (203) Jane Rizzuto Co-Author (203) Justin Gwizdala Co-Author (203) Jin Koo Co-Author (203) Mark Pollock EITF Coordinator (203) Robert Uhl EITF Liaison (203) Project Project Stage Dates previously discussed by EITF Previously distributed Memo Numbers EITF Issue No. 15-F, "Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments" Initial Deliberations May 14, 2015 EITF Educational Meeting, June 18, 2015, September 17, 2015 Issue Summary No. 1, dated June 4, 2015, Supplement No. 1, dated September 3, 2015 Purpose of This Memo 1. The purpose of this memo is to assist Task Force members as they consider classification of certain cash receipts and payments in the statement of cash flows. 2. This memo is structured as follows: (a) (b) Background Information Issue 4 Restricted Cash The alternative views presented in this Issue Summary Supplement are for purposes of discussion by the EITF. No individual views are to be presumed to be acceptable or unacceptable applications of Generally Accepted Accounting Principles until the Task Force makes such a determination, exposes it for public comment, and it is ratified by the Board. Page 1 of 25

2 (c) (d) (e) Next Steps Appendix A Definitions of Financing, Investing, and Operating Activities from the Master Glossary of the Codification Appendix B Summary of Alternatives and Staff Recommendations Background Information 3. There are nine specific cash flow classification issues to be addressed in Issue 15-F. To date, the Task Force has discussed and reached tentative conclusions on eight of those issues. This memo discusses Issue 4 Restricted Cash, the issue for which tentative conclusions have not yet been reached. Issue 4: Restricted Cash 4. Significant diversity exists in the classification and presentation of changes in restricted cash on the statement of cash flows. Entities classify the changes in operating, investing, or financing activities, or in a combination thereof. 5. At the June 18, 2015 EITF meeting, several Task Force members expressed concerns about the lack of a definition of restricted cash in GAAP. Those Task Force members commented that restricted cash appears to be investment-like when it is contractually and/or legally restricted. However, when restricted cash is self-designated as restricted and maintained in the general cash account, it seems to be other than investment-like. 6. Additionally, several Task Force members questioned whether and when cash payments and receipts can be made directly from and into restricted cash. Some Task Force members observed that those cash payments and receipts may be noncash items under existing GAAP. Others suggested that it may be appropriate to assume that the restriction lapses right before a reporting entity makes a cash payment directly from restricted cash; therefore, the direct cash payments would be presented in the body of the statement of cash flows as an inflow and a corresponding outflow. 7. As a result, the following three subissues have been identified: Page 2 of 25

3 (a) Definition of restricted cash (Subissue 4a) (b) Classification of changes in restricted cash (Subissue 4b) (c) Presentation of cash payments and cash receipts that directly affect restricted cash (Subissue 4c). 8. Since the June 18, 2015 meeting, the staff has performed additional outreach on Subissues 4a and 4c with five public accounting firms, two FASB advisory groups composed of auditors, preparers, and users, and an accounting analyst. The outreach primarily focused on issues that are common among all types of entities rather than just industry-specific issues. Feedback received is included in the staff analysis section of each Subissue. The staff notes that not-for-profit entities (NFP) have unique issues that are incremental to for-profit entities, and additional time is needed for the staff to perform outreach with NFP stakeholders to adequately address the NFP-specific issues and to provide the Task Force with a complete analysis of the restricted cash issues. However, the staff thinks that it is appropriate for the Task Force to discuss the analysis performed to date in the context of for-profit entities. Subissue 4a Definition of Restricted Cash 9. Stakeholders indicated that the lack of a definition of restricted cash in the Master Glossary contributes to the diversity in the presentation and classification of changes in restricted cash on the statement of cash flows and the balance sheet. Therefore, defining restricted cash is intended to reduce the diversity in both statements. The Master Glossary includes definitions of cash and cash equivalents, as follows: Cash Consistent with common usage, cash includes not only currency on hand but demand deposits with banks or other financial institutions. Cash also includes other kinds of accounts that have the general characteristics of demand deposits in that the customer may deposit additional funds at any time and also effectively may withdraw funds at any time without prior notice or penalty. All charges and credits to those accounts are cash receipts or payments to both the entity owning the account and the bank holding it. For example, a bank's granting of a loan by crediting the proceeds to a Page 3 of 25

4 customer's demand deposit account is a cash payment by the bank and a cash receipt of the customer when the entry is made. Cash Equivalents Cash equivalents are short-term, highly liquid investments that have both of the following characteristics: a. Readily convertible to known amounts of cash b. So near their maturity that they present insignificant risk of changes in value because of changes in interest rates. Generally, only investments with original maturities of three months or less qualify under that definition. Original maturity means original maturity to the entity holding the investment. For example, both a three-month U.S. Treasury bill and a three-year U.S. Treasury note purchased three months from maturity qualify as cash equivalents. However, a Treasury note purchased three years ago does not become a cash equivalent when its remaining maturity is three months. Examples of items commonly considered to be cash equivalents are Treasury bills, commercial paper, money market funds, and federal funds sold (for an entity with banking operations). Question for the Task Force 1. What should be the definition of restricted cash? Staff Analysis and Outreach Subissue 4a 10. All of the stakeholders indicated that self-designated cash should be excluded from the definition of restricted cash because the self-designation could frequently change based on decisions made by management. However, some of the stakeholders thought separate consideration should be given to NFPs because of their unique characteristics (for example, board-designated funds, donor-restricted contributions, and endowments). 11. The majority of the stakeholders stated that cash that has legal and/or contractual restrictions imposed by a third party and cannot be withdrawn or used by the entity without approval from that third party should be included in the definition of restricted cash. However, a concern was raised by a couple of stakeholders about whether compensating balance Page 4 of 25

5 arrangements 1 would fall under the definition of restricted cash because such arrangements may or may not restrict the withdrawal or use of cash. 12. Some stakeholders also raised concerns about the interaction between a GAAP definition of restricted cash and the disclosure requirements in SEC Regulation S-X, Reg , which states that separate disclosure shall be made of the cash and cash items that are restricted as to withdrawal or usage. The provisions of any restrictions are required to be described in a note to the financial statements. Restrictions may include legally restricted deposits held as compensating balances against short-term borrowing arrangements, contracts entered into with others, or company statements of intention with regard to particular deposits; however, time deposits and short-term certificates of deposit are not generally included in legally restricted deposits. 13. Those stakeholders noted that because of the current lack of a definition of restricted cash, the description in SEC Regulation S-X, Reg is being used in practice by some entities as a definition. While the majority of stakeholders indicated that self-designated cash should be excluded from a GAAP definition of restricted cash, that exclusion could cause confusion when applying Reg , which requires disclosures of company statements of intentions with regard to particular deposits. 14. Some examples of general types of restrictions placed on cash include: financing obligations, bankruptcy reorganizations, insurance claims, securitization transactions, litigation purposes, escrowed funds for a business combination, and operational obligations. 15. The staff has identified the following alternatives to address Subissue 4a: Alternative A Restricted cash should be defined as cash that is subject to a legal or contractual restriction by a third party for a specified purpose and is restricted as to withdrawal or usage. 1 A compensating balance arrangement can be described as funds that a borrower is required to keep on deposit in a financial institution in accordance with a loan agreement. For example, a corporation agrees to maintain $1 million in its checking account at a bank in exchange for the bank agreeing to lend up to $10 million to the corporation at 1 percent below the prime lending rate. Page 5 of 25

6 Alternative B Restricted cash should be defined as cash that includes amounts that are self-designated by management, and cash that is subject to a legal or contractual restriction by a third party for a specified purpose and is restricted as to withdrawal or usage. Alternative A 16. Proponents of the definition of restricted cash in Alternative A think that it is likely broad enough to encompass the most prevalent forms of restrictions that are placed on cash by a third party. The Master Glossary defines contract as an agreement between two or more parties that creates enforceable rights and obligations. Proponents indicate that the definition of contract is used in a number of Topics and is generally understood in practice. While the term contract is not specifically used in the definition of restricted cash proposed in Alternative A, the staff thinks that the term contractual (undefined) should be interpreted as an agreement between two parties that creates enforceable rights and obligations. 17. The definition of a contract emphasizes that a contract exists when there is agreement between two or more parties. There are situations in which an entity s cash is restricted by a court of law for a specific purpose (for example, for claims filed in a bankruptcy reorganization) and cannot be withdrawn or used by the entity for reasons other than that specified purpose. It could be unclear in those circumstances whether a court order that imposes cash restrictions would constitute agreement by both the entity and the court or whether this is a decision that the court made unilaterally. However, because the definition of restricted cash in Alternative A includes legal restrictions and restrictions related to withdrawal or usage, proponents think that in situations in which an entity's cash is restricted by a court order, it would be clear that such a restriction constitutes restricted cash. 18. Proponents of the definition in Alternative A think that it would segregate unavailable cash from cash that is available for use in an entity s operations. Those proponents believe that making a distinction between unavailable and available cash would provide relevant information to users about an entity s liquidity and the amount of limitations on cash and cash equivalents. 19. Proponents of the definition of restricted cash in Alternative A believe that it addresses the issue about whether cash associated with compensating balance requirements would be Page 6 of 25

7 considered restricted cash. Those proponents note that when a compensating balance arrangement exists but does not legally restrict the use of cash because there is no prohibition on the withdrawal of funds, the cash would not be included in restricted cash as defined in Alternative A. When a compensating balance arrangement restricts the withdrawal or usage of funds, those proponents think that the cash would be included in restricted cash, as defined in Alternative A. For example, a compensating balance arrangement that specifies an amount of cash that must be on deposit at the end of each day would not be considered restricted cash because the entity is able to use or withdrawal the cash at other times. 20. Opponents think that the definition of restricted cash in Alternative A is appropriate for entities other than NFPs, but that it does not consider the unique aspects of NFPs. Therefore, the definition of restricted cash in Alternative A may not be appropriate for all types of entities. Under Alternative A, donor-restricted gifts of cash that are received by an NFP for an endowment fund 2 would likely be considered restricted cash. Opponents of Alternative A think that those funds should be excluded from the definition of restricted cash. Opponents note that the definition of endowment fund, which includes donor-restricted gifts of cash, is clearly stated in GAAP and well understood in practice. 21. Additionally, an NFP is required under existing GAAP to disclose information to enable users of its financial statements to understand the following about its endowment funds, which includes both the NFP s donor-restricted endowment fund 3 and board-designated endowment fund 4 : net asset classification, net asset composition, changes in net asset composition, spending policies, and related investment policies. Opponents of Alternative A think that these required disclosures clearly explain the type of restrictions on cash included 2 The Master Glossary defines endowment fund as an established fund of cash, securities, or other assets to provide income for the maintenance of a not-for-profit. The use of the assets of the fund may be permanently restricted, temporarily restricted, or unrestricted. Endowment funds generally are established by donor-restricted gifts and bequests to provide either of the following: a. A permanent endowment, which is to provide a permanent source of income b. A term endowment, which is to provide income for a specified period. 3 The Master Glossary defines donor-restricted endowment fund as an endowment fund that is created by a donor stipulation requiring investment of the gift in perpetuity or for a specified time. Some donors may require that a portion of income or gains or both be added to the gift and invested subject to similar restrictions. The term does not include a Board-Designated Endowment Fund. See Endowment Fund. 4 The Master Glossary defines board-designated endowment fund as an endowment fund created by an NFP s governing board by designating a portion of its unrestricted net assets to be invested to provide income for a long but unspecified period (sometimes call funds functioning as endowment or quasi-endowment funds). See Endowment Fund. Page 7 of 25

8 in endowment funds and therefore is unnecessary to include in the definition of restricted cash. 22. Similar to gifts of cash for an endowment fund, opponents of Alternative A also believe that gifts of cash that are received by an NFP that by donor stipulation are restricted for a specified purpose should be excluded from the scope of the definition of restricted cash because guidance already exists about the classification of certain gifts with donor-imposed restrictions on the statement of financial position and classification of receipts from contributions and investment income that are donor-restricted in the statement of cash flows. Alternative B 23. The difference between Alternative A and Alternative B is that Alternative B includes cash that is self-designated as restricted by an entity s management as unavailable for use in an entity s current operations. 24. Proponents of Alternative B indicate that including cash that is self-designated by management as unavailable for use in an entity s current operations in the definition of restricted cash would be more consistent with the description of the disclosures required in SEC Regulation S-X, Reg Therefore, better alignment would exist between the GAAP definition and the disclosures required by the SEC. 25. Proponents of Alternative B acknowledge that self-designated cash restrictions are subject to change. However, including self-designations in restricted cash could provide insight into an entity s plans for the cash and the amount of cash available to fund current operations. 26. Opponents of Alternative B observe that while information about self-designated restrictions on an entity s cash that makes it unavailable for current period operations might be useful to financial statement users, the restrictions are subject to change based on decisions made by management. Opponents of Alternative B believe that there is the potential for manipulation and frequent changes to occur when entities have the ability to control what is reported as restricted cash in the financial statements. Therefore, the opponents believe that only cash that is restricted by a third party for a specified purpose and is restricted as to withdrawal or usage should be included in the definition of restricted cash. Page 8 of 25

9 Staff Recommendation Subissue 4a 27. The staff thinks that the definition of restricted cash in Alternative A is appropriate for cash restrictions that are most common among all types of entities, but that additional outreach and research should be performed with NFP stakeholders to determine whether or how the definition of restricted cash should be modified to address NFP-specific characteristics. Consistent with stakeholder feedback, the staff believes that self-designated restrictions on cash should not be included in the definition of restricted cash because the restrictions are subject to change based on management decisions. Subissue 4b Classification of Changes in Restricted Cash 28. Changes in restricted cash occur when restricted cash is established (for example, transfer of cash from unrestricted cash to restricted cash) and when the restrictions are released (for example, transfer of cash from restricted cash to unrestricted cash). For purposes of the staff analysis, unrestricted cash is synonymous with cash and cash equivalents. As noted and addressed in Subissue 4c, changes in restricted cash can also occur when cash payments are made directly from restricted cash and cash receipts are deposited directly into restricted cash from a source outside the entity. 29. Sometimes restricted cash is set aside in a separate bank account, and other times restricted cash is maintained in the same bank account along with unrestricted cash. The fact that a separate bank account is not established for restricted cash does not mean that the cash is without restrictions. If the withdrawal or usage of the cash would create a consequence to the entity that is a sufficiently large disincentive for non-performance, then the staff thinks that the cash is restricted. When entities commingle restricted and unrestricted cash in the same bank account, cash receipts and payments are tracked separately for financial reporting purposes. Regardless of whether the transfers occur between separate bank accounts or whether the restricted and unrestricted cash is maintained in the same bank account and tracked separately for financial reporting purposes, the movement of cash between restricted and unrestricted cash results in cash flows that should be classified in the statement of cash flows because Topic 230 requires presentation of the changes during the period in cash and cash equivalents. Page 9 of 25

10 30. Entities presently classify the changes in restricted cash in operating, investing, or financing activities, or in a combination thereof. Stakeholders indicated that it is unclear whether the classification should be based on the nature of the cash flows or the purpose of the restriction. Question for the Task Force 2. How should the changes of the principal balances in restricted cash be classified in the statement of cash flows when cash and cash equivalents have been affected? Staff Analysis Subissue 4b 31. The staff has identified the following potential alternatives to address Subissue 4b: Alternative A Changes of the principal balances in restricted cash that affect cash and cash equivalents should be based on the nature of the cash flows and, therefore, classified as investing activities in the statement of cash flows. Alternative B Changes of the principal balances in restricted cash that affect cash and cash equivalents should be classified based on the purpose of the restricted cash. Alternative C Include restricted cash with cash and cash equivalents on the statement of cash flows. Alternative A 32. Under Alternative A, the classification of changes of the principal balances in restricted cash that affect cash and cash equivalents would be based on the nature of the cash flows. Proponents of Alternative A believe that Topic 230 requires that classification should be based on the nature of the cash flows. That is, inherent in the definitions of financing, investing, and operating activities, classification is based on the nature of the cash flow without regard to whether it stems from another item such as a transaction. In other words, the term nature in this context can be described as the characteristics or features that a cash receipt or payment exhibits without regard to whether the cash receipt or payment is linked to other transactions. For example, the nature of proceeds received by an entity from a debt borrowing that will be used to construct a building are financing, which is consistent with the guidance that states that financing activities include proceeds from borrowings. Page 10 of 25

11 Classification of the proceeds based on linking it to the use of the proceeds (that is, constructing a building) would result in an investing activity classification, which is inconsistent with the current guidance, as noted above. 33. In evaluating the nature of the cash flows related to restricted cash, the descriptions of financing, operating, and investing activities in Topic 230 were considered (the actual Glossary definitions are included in Appendix A): Financing Activities - The definition of financing activities includes obtaining resources from owners and providing them with a return, and borrowing money and repaying amounts borrowed. The cash flows associated with both the establishment of and the release of the principal balances in restricted cash that are simply transfers between unrestricted and restricted cash are not representative of these activities. Therefore, proponents of Alternative A think that the nature of the cash flows do not fit within financing activities. Operating Activities - While the definition of operating activities is a residual category, meaning operating activities include all transactions and other events that are not defined as investing or financing, Topic 230 does state that operating activities generally involve producing and delivering goods and providing services. The cash flows associated with both the establishment of and the release of the principal balances in restricted cash do not directly relate to producing and delivering goods and providing services. Furthermore, cash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income. The cash flows associated with both the establishment and release of restricted cash that are simply transfers between unrestricted and restricted cash do not enter into the determination of net income. For those reasons, proponents of Alternative A think that the nature of the cash flows do not fit within operating activities. Investing Activities Cash flows from investing activities include the purchase and sales of equity securities, debt securities, and property, plant and equipment. Restricted cash generally results from a contractual requirement to commit money or to invest cash balances for a particular purpose and the contractual requirement limits an entity s ability to withdraw funds at any time. Page 11 of 25

12 34. Based on their review of the descriptions of operating, investing, and financing, proponents of Alternative A believe that a balance on deposit in a restricted cash account is most analogous to an investment whose return of principal requires the satisfaction of conditions rather than a mere withdrawal demand. Accordingly, deposits and withdrawals of principal balances in restricted cash accounts represent the creation or return of investment. Therefore, the nature of the cash flows associated with both the establishment and the release of the principal balances in restricted cash most closely fits within the definition of investing activities. 35. Proponents of Alternative A also observe that determining the classification of cash receipts and payments based on the nature of the restriction results in a consistent cash flow classification and provides more decision useful information to financial statement users. 36. Furthermore, FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, paragraph 24(c), states that statements of cash flows commonly show a great deal about an entity s current cash receipts and payments, but a cash flow statement provides an incomplete basis for assessing prospects for future cash flows because it cannot show interperiod relationships. Statements of earnings and comprehensive income, especially if used in conjunction with statements of financial position, usually provide a better basis for assessing future cash flow prospects of an entity than do cash flow statements alone. 37. Generally, cash is restricted for a future purpose (for example, future cash flows for the payment of litigation claims, self-insurance and workers compensation obligations, and financing obligations). Because the cash flow statement provides an incomplete basis for assessing prospects for future cash flows and cannot show interperiod relationships, classifying the changes in restricted cash based on the purpose of the restriction is contrary to the information that CON 5 intends the statement of cash flows to provide. 38. Proponents of Alternative A also highlight that classifying changes in restricted cash based on the purpose of the restricted cash could result in reflecting a duplicate cash flow classification, which some people may believe is inappropriate. Page 12 of 25

13 39. For those reasons, Alternative A was supported by the five public accounting firms in the staff s outreach, the majority of the FASB Advisory Group members who provided feedback, and a preparer representing a large multi-national public business entity. Alternative B 40. Proponents of Alternative B observe that classifying the changes of the principal balances in restricted cash based on the purpose for restriction is more understandable to a financial statement user. Those proponents believe that classifying changes of the principal balances in restricted cash based on its nature (that is, investing activities) does not provide the user with information about the purpose of the restriction. 41. One member of an FASB advisory group indicated that he believes that Alternative B is more appropriate because classifying the changes of the principal balances in restricted cash based on its purpose is a logical approach to presenting information on the statement of cash flows. 42. Proponents of Alternative B also indicate that because changes of the principal balances in restricted cash do not precisely fall into the definitions of financing, investing, and operating activities, the most reasonable way to classify these changes is based on the purpose of the restriction. Alternative C 43. In Alternative C, restricted cash would be included in the statement of cash flows along with cash and cash equivalents. That is, transfers between cash and cash equivalents and restricted cash would not be presented in the statement of cash flows; only the ultimate cash outflow from the entity or deposits from third parties directly into a restricted cash account would be presented within the statement of cash flows. The effect of this alternative on the statement of cash flows as compared to current GAAP is that it would remove the line item that presents changes in restricted cash, and it would increase the total of the statement of cash flows because restricted cash would be included. This approach is similar to GASB Statement No. 9, Reporting Cash Flows of Proprietary and Nonexpendable Trust Funds and Governmental Entities That Use Proprietary Fund Accounting, which states that a statement of cash flows Page 13 of 25

14 should explain the change during the period in cash and cash equivalents regardless of whether there are restrictions on their use. 44. Proponents of Alternative C think that this approach would reduce diversity in practice and resolve all of the classification and presentation issues related to restricted cash in the statement of cash flows. That is, it would address the transparency concerns related to a noncash disclosure alternative, alleviate concerns about reporting changes in restricted cash as if they were changes of cash and cash equivalents when cash is not transferred to or from a segregated account, and obviate the need to determine whether changes in restricted cash should be classified based on the nature or the purpose of the restriction (that is, the ultimate cash payments made directly from restricted cash to third parties and the cash receipts directly deposited into restricted cash from third parties would be classified based on their nature, consistent with the classification of other cash flows). 45. Proponents of Alternative C think that the most important information to provide financial statement users with is the ultimate cash flows that affect the reporting entity. Furthermore, the amount of cash that is restricted and the change in restricted cash during the period can be gleaned from the statement of financial position. 46. Opponents think that Alternative C would diminish the value of the cash flow statement because it would commingle restricted and unrestricted cash in the statement of cash flows, which could reduce transparency of the cash flows specifically related to cash that is restricted and cash that is unrestricted. Similar to an investment and its cash flows, which are presented separately from cash and cash equivalents, proponents believe that the restricted cash and its cash flows also should be presented separately from cash and cash equivalents. 47. Opponents of Alternative C also note that such a change would represent a fundamental change to Topic 230 because Topic 230 states that the primary objective of a statement of cash flows is to provide relevant information about the cash (as defined) receipts and payments of an entity during a period. 48. Subissue 4c addresses issues that arise when cash payments are made directly from restricted cash and cash receipts are deposited directly into restricted cash. However, if the Task Force Page 14 of 25

15 reaches a tentative conclusion supporting Alternative C, Subissue 4c does not need to be considered. Comparison of Classifications Alternative A versus Alternative B 49. As noted above, Alternative A would result in a consistent cash flow classification of changes of the principal balances in restricted cash, while under Alternative B the cash flow classification would vary based on the purpose of the restriction. In the following two examples it is assumed that transfers of cash occur between restricted and unrestricted cash in order to establish the restricted cash account and to release the restriction. The following two examples illustrate the differences in the cash flow classification based on nature and purpose: Example 1: An entity is required by its insurer to establish a restricted cash account for future payment of workers' compensation claims. The restricted cash is to be invested in an interest-bearing account until the restriction is released and cash payments are made for workers' compensation claims. Nature of the Cash Flows Classification Based on: Purpose of the Restriction Cash Flow #1: Set up the restricted cash account (transfer of cash from unrestricted cash to restricted cash) Investing outflow Operating outflow Cash Flow #2: Release from restriction occurs (transfer of cash from restricted cash to unrestricted cash) Investing inflow Operating inflow Cash Flow #3: Payment of workers' compensation claims from unrestricted cash Operating outflow Operating outflow Nature of the cash flows: Cash flows #1 and #2 are classified as an investing activity because the cash flows are similar to the purchase and sale of an investment. Purpose of the restriction: Cash flows #1 and #2 are classified as an operating activity because the cash flows are being linked to the future payment of workers' compensation claims, an operating activity. However, an operating activities classification for cash flows #1 and #2 is contrary to the Master Glossary definition of operating activities, which states, in part, cash flows from operating activities generally are the cash effects of transactions and other events that enter into the determination of net income. Cash flows #1 and #2 do not enter into the determination of net income. Page 15 of 25

16 Example 2: An entity is required by its lender to establish a restricted cash account for the future payment of debt. The restricted cash is required to be invested in an interest-bearing account until the restriction is released and a cash payment is made to pay down debt. Nature of the Cash Flows Classification Based on: Purpose of the Restriction Cash Flow #1: Set up the restricted cash account (transfer of cash from unrestricted cash to restricted cash) Investing outflow Financing outflow Cash Flow #2: Release from restriction occurs (transfer of cash from restricted cash to unrestricted cash) Investing inflow Financing inflow Cash Flow #3: Payment of debt from the unrestricted cash account Financing outflow Financing outflow Nature of the cash flows: Cash flows #1 and #2 are classified as an investing activity because the cash flows are similar to the purchase and sale of an investment. Purpose of the restriction: Cash flows #1 and #2 are classified as a financing activity because the cash flows are being linked to the future payment of debt, a financing activity. However, the nature of cash flows #1 and #2 do not fit into the Master Glossary definition of financing activities, which includes, in part, obtaining resources from owners and providing them with a return and borrowing money and repaying amounts borrowed. Staff Recommendation Subissue 4b 50. Some staff members recommend Alternative A and other staff members recommend Alternative C. Those who support Alternative A believe that: (a) (b) (c) Inherent in the definitions of financing, investing, and operating activities, Topic 230 describes the classification principle as being based on the nature of the cash flows without regard to whether it stems from another item The nature of the changes of the principal balances in restricted cash that affect cash and cash equivalents most closely fits within the definition of investing activities It would not take significant effort or cost to apply. 51. Staff members who support Alternative C acknowledge that including restricted cash with cash and cash equivalents in the statement of cash flows would be a fundamental change to Topic 230. However, they believe this alternative, coupled with a definition of restricted cash, resolves all classification and presentation issues related to restricted cash in the Page 16 of 25

17 statement of cash flows. Additionally, Alternative C provides information about the ultimate cash flows during the period, which is of primary importance to financial statement users. Furthermore, these staff members note that existing disclosure requirements and the statement of financial position will provide users with additional restricted cash information to further facilitate analysis. Subissue 4c Presentation of Cash Payments and Cash Receipts That Directly Affect Restricted Cash 52. At its June 18, 2015 meeting, the Task Force requested that the FASB staff perform additional research on cash payments made directly from restricted cash and cash receipts deposited directly into restricted cash. 53. Sometimes, cash payments are made directly from restricted cash and cash receipts are deposited directly into restricted cash from a source outside the entity (for example, an investor or lender). Stakeholders indicated that they are unclear about how to present and classify cash flows that directly affect restricted cash because restricted cash is not included in the reconciliation of cash and cash equivalents on the statement of cash flows, and there is no specific guidance in GAAP. Therefore, some entities present direct payments made from restricted cash or direct deposits received into restricted cash as line items on the statement of cash flows (that is, those entities gross-up the cash flows) and some entities provide a noncash disclosure. Examples of Cash Payments Made Directly from Restricted Cash 54. Cash payments made directly from restricted cash could relate to operating, investing, or financing activities (for example, workers compensation claims, litigation claims, property and equipment, and repayment of debt). Example of Cash Deposited Directly into Restricted Cash 55. An example of cash that is directly deposited into restricted cash is as follows: an entity issues debt in a bond offering and according to the bond agreement, the proceeds are deposited into an escrow account that is restricted for a specified purpose. A portion of the proceeds are restricted for the immediate payment of existing debt and the remaining portion Page 17 of 25

18 is restricted for future construction expenditures. The entity never received the funds from the bond offering in its unrestricted cash account; rather, the proceeds were sent directly from the investor to the trustee-controlled escrow (restricted) account. 56. If the Task Force reaches a tentative conclusion supporting Alternative C in Subissue 4b, Subissue 4c does not need to be considered. Question for the Task Force 3. How should the changes in restricted cash be presented in the statement of cash flows when cash payments are made directly from restricted cash and cash receipts are deposited directly into restricted cash? Staff Analysis Subissue 4c 57. The staff has identified the following potential alternatives to address Subissue 4c: Alternative A Require noncash disclosures. Alternative B Present cash payments made directly from restricted cash and cash receipts directly deposited into restricted cash in the body of the statement of cash flows. Alternative A 58. Alternative A would provide explicit guidance that cash payments made directly from restricted cash and cash receipts directly deposited into restricted cash should be disclosed as noncash activities, including noncash financing, investing, and operating activities. The staff recognizes that GAAP currently does not require disclosure of other noncash operating activities. 59. Proponents of Alternative A note that Topic 230 states that a statement of cash flows should explain the change during the period in cash and cash equivalents (as defined), and information about all investing and financing activities of an entity during a period that affect recognized assets or liabilities but that do not result in cash receipts or cash payments should be disclosed. Therefore, because restricted cash is not a change in cash and cash equivalents, direct changes in restricted cash that do not affect cash and cash equivalents should not be Page 18 of 25

19 presented in the body of the statement of cash flows. Rather, the information should be disclosed. 60. Proponents of Alternative A also observe that presenting the direct changes in restricted cash grossed up in the statement of cash flows when, by definition, they are not a change in cash and cash equivalents, could set a precedent that similar types of transactions also should be presented grossed up in the statement of cash flows. 61. For the reasons noted above, Alternative A was supported by one public accounting firm, three members of an FASB advisory group (two auditors and one preparer), and three members of another FASB advisory group (one preparer and two users) included in the staff s outreach. 62. Opponents of Alternative A indicate that cash payments made directly from and cash receipts directly deposited into restricted cash represent actual cash flows of an entity and, therefore, it would be misleading to disclose cash flows of an entity as a noncash activity. 63. Several stakeholders included in the staff s outreach observed that applying the existing guidance would lead to a noncash disclosure because the direct changes in restricted cash do not affect cash and cash equivalents. However, those stakeholders expressed concerns that noncash disclosures tend to get overlooked by users, and therefore it might provide better transparency to present the direct changes in restricted cash grossed up in the body of the statement of cash flows. Ultimately, those stakeholders were undecided about which alternative would most effectively address Subissue 4c. Alternative B 64. Alternative B would require that cash payments made directly from restricted cash and cash receipts directly deposited into restricted cash be presented in the body of the statement of cash flows. Alternative B does not address the classification of the cash flows because classification would be determined by existing guidance for the specific cash flow in question or by tentative conclusions reached by the Task Force on Subissue 4b. For example, if a payment of principal on debt was made directly from restricted cash, the cash outflow would be classified as a financing activity, consistent with the guidance that states that cash outflows from financing activities includes repayments of amounts borrowed. Page 19 of 25

20 65. Proponents of Alternative B believe that the cash payments made directly from restricted cash and cash receipts directly deposited into restricted cash are actual cash flows of an entity and are different from the types of transactions described in the noncash investing and financing activities guidance because those noncash investing and financing transactions result in no cash receipts or cash payments. For example, a common noncash investing and financing transaction involves capital expenditures that are financed. Often times, capital expenditures are financed directly by the vendor or by a financial institution that sends the proceeds of the borrowing directly to the seller. Therefore, in the capital expenditure example, the cash proceeds from the financing are never received by the borrower, which is different from the scenario discussed in Subissue 4b. Therefore, the cash payments made directly from restricted cash should be grossed up and presented as a transfer to unrestricted cash (cash inflow) and then as a cash outflow for the payments made directly from the restricted cash account. 66. Proponents of Alternative B state that disclosure of direct cash payments and receipts as a noncash activity could imply that the transactions did not result in actual cash receipts or payments which would be misleading to users. Therefore, proponents indicate that Alternative B would provide better information to financial statement users about an entity s cash transactions and would increase financial statement comparability. 67. Several proponents of Alternative B indicate that there are times when an entity, upon approval from the third party who is restricting the cash, instructs that third party such as a financial institution, to make a direct cash payment from the restricted cash account simply for administrative convenience rather than transferring the funds back into the entity s unrestricted cash account prior to disbursement. Therefore, whether the funds are transferred back to the entity s unrestricted cash account prior to disbursement or the disbursement is made directly from the restricted cash account, the economics are the same. 68. Some proponents of Alternative B analogize restricted cash to investments. Although certain investments do not meet the definitions of and are not included in cash and cash equivalents, their cash flows are an integral part of the statement of cash flows. Therefore, the cash flows associated with the changes in restricted cash should be presented in the body of the statement of cash flows in the same manner as the cash flows of investments. Page 20 of 25

21 69. For the reasons stated above, Alternative B was supported by three public accounting firms, an auditor from an FASB advisory group, and a user. 70. Opponents of Alternative B note that presenting direct changes in restricted cash in the body of the statement of cash flows would be misleading because the changes do not affect cash and cash equivalents. 71. Some stakeholders highlight that, if Alternative B is selected for Subissue 4b (classifying changes of the principal balances in restricted cash based on the purpose of the restricted cash), gross presentation of cash flows made directly from restricted cash could result in reflecting a duplicate cash flow classification, which some people may believe is inappropriate. An example of this fact pattern is illustrated below: Changes in Restricted Cash Account Cash Payments Directly from Restricted Cash Fact Pattern: On January 1, 20X5, an entity is required to set up a restricted cash account (held in escrow) as a result of a court proceeding related to a class action lawsuit. The restricted cash account is restricted for the potential future cash payments to the plaintiffs of the class action lawsuit. The restricted cash account is established by transferring $10 million from the entity's general cash account (unrestricted cash). On June 15, 20X5, the court-appointed trustee of the escrow account makes cash payments to plaintiffs directly from the restricted cash account in the amount of $10 million. The fact pattern also assumes that the entity previously recorded a litigation accrual and an expense, prior to cash payments made to the plaintiffs. Cash Flow #1: On January 1, 20X5, the restricted cash account is established (move money from the unrestricted account to the restricted cash account) in the amount of $10m Cash Flow #2: On June 15, 20X5, cash payments are made to plaintiffs in the class action lawsuit, directly from restricted cash account in the amount of $10m Cash Flow Classification Cash used in operating activities Cash provided by operating activities Journal Entry: Restricted Cash Unrestricted Cash (in millions) Debit Credit $ 10 $ 10 (in millions) (1) Journal Entries: Debit Credit Unrestricted Cash $ 10 Restricted Cash $ 10 Cash used in operating activities Liability Unrestricted Cash $ 10 $ 10 (1) The journal entries are provided in this example to assist the Task Force members in their analysis of this issue and are not meant to suggest that entities need to record journal entries in order to present a gross up of the cash flows. Page 21 of 25

22 Staff Recommendation Subissue 4c 72. The staff thinks that there is merit to both Alternatives A and B because of the reasons provided in previous paragraphs. However, the staff recommends Alternative A primarily because it most closely applies the existing guidance in Topic 230 that states that (a) a statement of cash flows explains the changes during the period in cash and cash equivalents (as defined in the Master Glossary) and (b) information about all investing and financing activities of an entity during a period that affect recognized assets and liabilities but that do not result in cash receipts or cash payments in the period shall be disclosed. The staff recognizes that there is a lack of existing guidance about disclosures of noncash operating activities. However, this alternative would provide explicit guidance that cash flows that directly affect restricted cash should be disclosed as noncash activities, including noncash financing, investing, and operating activities. The staff also has some concern that requiring a gross up of this cash activity could set a precedent and result in entities reaching conclusions that other noncash transactions should be grossed up in the cash flow statement. Consistency Between Subissue 4b and Subissue 4c 73. In Subissue 4b, changes in restricted cash typically occur when restricted cash is established (transfer of cash from unrestricted cash to restricted cash) and when the restrictions are released (transfer of cash from restricted cash to unrestricted cash). Subissue 4c discusses changes in restricted cash that occur when cash payments are made directly from restricted cash and cash receipts are deposited directly into restricted cash from a source outside the entity. 74. The staff recognizes that it may be unclear to stakeholders why the cash flow classification for changes in restricted cash in Subissue 4b could be different from the cash flow classification in Subissue 4c. In Subissue 4b, the changes in restricted cash are simply transfers from one account to another (unrestricted cash to/from restricted cash). In Subissue 4c, the deposits into and disbursements from restricted cash are cash flows with an outside entity. Because the nature of the cash flows in the two subissues are different, it is reasonable to expect that the cash flow classification also would be different. Page 22 of 25