Cash flows do not always fit unambiguously into only one of the three categories: operating, investing and financing. Explain

Answer 1

Ambiguities in Classifying Cash Flows

Cash flows do not always fit unambiguously into only one of the three categories: operating, investing and financing. For example, you might not think of cash received from investments in securities—received in the form of interest and dividends—as coming from operating activities. The logic for this treatment is that interest and dividends appear as revenues in the income statement. Alternatively, you might view cash received from interest and dividends as coming from investing activities. The logic for this treatment is that cash flows related to the purchase and sale of investments in some securities appear as investing activities in the statement of cash flows. U.S. GAAP requires that firms classify cash receipts from interest and dividend revenues as an operating activity, but classify cash flows related to the purchase and sale of investments in securities as an investing activity. IFRS permits firms to classify cash from interest and dividend revenue as operating, investing, or financing activities, provided the classification is consistently applied across periods.

Similar ambiguities arise with interest expense on debt. Should the cash outflow for interest expense appear as an operating activity (to achieve consistency with its inclusion in the income statement as an expense)? Or, should it appear as a financing activity (to achieve consistency with the classification of debt issues and retirements as a financing activity)? U.S. GAAP requires that firms classify cash payments for interest expense as an operating activity. IFRS permits firms to select the classification (operating, or investing, or financing) for cash payments of interest expense, again requiring consistent classification from period to period. Under both U.S. GAAP and IFRS, the issue or redemption of debt is a financing activity. Also, cash dividends appear as a financing activity under both U.S. GAAP and IFRS.

Finally, the distinction is not always clear between certain purchases and sales of securities—are these investing or operating activities?—and increases and decreases in certain short-term borrowings—are these financing or operating activities?