Editor's Note: From time to time this column will call attention to developing accounting issues that companies or their auditors should be aware of and monitor in the coming months.

In practice, financial institutions that use the cost basis of accounting have normally recorded investments in debt instruments at historical cost or amortized cost, except for securities acquired in a trading portfolio. The AICPA's Accounting Standards Executive Committee is working on a project, "Characteristics Distinguishing Investment Activities," that could dramatically change past practice in this area. While attention has been focused on this issue because of the problems of financial institutions, any guidance developed would be transactional in nature and could affect the financial reporting of any company with material investments in debt instruments.

The guidance under consideration would distinguish investment activities in two categories that would be accounted for differently. Debt securities that qualified as investments would continue to be carried at cost or amortized cost, but securities classified as "held- for-sale" would be carried on the lower-of-cost-or-market basis. This would mean that unrealized losses caused by interest rate changes would be recognized in the period they occurred.

Some of the key issues concern the length of time management must intend to hold the securities, e.g., long-term, for the foreseeable future, until maturity, etc., and what conditions or actions would permit disposal of some securities without "tainting" similar remaining securities.

The intent here is not to give a history or a detailed explanation of the issues, but to alert accountants to the potential change in accounting practice for all companies, including financial institutions, with material investments in debt securities.

Interest and Long-Term Bonds in the Cash Flow Statement Under SFAS 95

SFAS 95 states that a company that provides a set of financial statements that presents both financial position and results of operations shall also provide a cash flow statement for each period for which results of operations are provided. The cash flow statement shall explain the change during the period in cash and cash equivalents, and shall classify cash receipts and cash payments as resulting from investing, financing, or operating activities. Under SFAS 95, interest receipts and interest payments are operating inflows and outflows, respectively, whereas receipts from the collection of bond investments at maturity are investing inflows, and payments to retire bonded debt are financing outflows.

This article considers the presentation of interest and long-term bonds in the cash flow statement of a merchandising or manufacturing company. The examination proceeds first from the perspective of the borrower and then from the perspective of the investor. Because interest payments are classified as operating outflows under SFAS 95, the resulting presentation of the retirement of bonded debt at maturity is peculiar and counterintuitive. A more reasonable presentation of the retirement of bonded debt at maturity would result if interest payments were classified as financing outflows. Similarly, because interest receipts are classified as operating inflows under SFAS 95, the resulting presentation of the recovery of bond investment at maturity is also peculiar and counterintuitive. A more reasonable presentation of the recovery of bond investment at maturity would result if interest receipts were classified as investing inflows.

Direct versus indirect Method

There are two methods of deriving cash flow from operations: the direct method; and the indirect method. Under the direct method, the difference between the sum of the operating cash receipts and the sum of the operating cash payments equals cash flow from operations. These amounts may be routinely generated by the accounting system, or they may be derived by adjusting revenues and expenses for changes in related assets and liabilities. For example, operating payments for production could be derived by adjusting cost of goods sold for depreciation and changes in inventories and operating payables. Under the indirect method, cash flow from operations is derived by adjusting net income for: a) the effects of all deferrals of past operating cash receipts and payments, such as changes in inventories, deferred income, and the like, and all accruals of expected future operating receipts and payments, such as changes in operating receivables and operating payables; and b) the effects of revenues and expenses not involving cash, such as depreciation and goodwill amortization, bond discount and premium amortization, as well as transactions whose cash effects are investing or financing cash flows, such as gains or losses from sales of plant and equipment or early extinguishments of debt.

SFAS 95 permits the indirect method but recommends the direct method. There are many reasons for favoring the direct method, but most public- owned companies are expected to use the indirect method. Primarily for this reason, the discussion that follows is largely within the context of the indirect method although the matters discussed are equally applicable under the direct method.

Interest Payments and Interest Receipts

Under SFAS 95, interest payments and interest receipts are classified as operating cash flows. This classification is explicit under the direct method, where interest payments and interest receipts are separate operating cash flows subtracted and added, respectively, to derive cash flow from operations. Under the indirect method, on the other hand, this classification is implicit. Net income is adjusted for bond discount and premium amortization but not for interest expense and interest revenue to derive cash flow from operations.

The FASB acknowledged that a reasonable case could be made for classifying interest payments as financing outflows and interest receipts as investing inflows. It noted that some respondents to the exposure draft argued that interest payments, like dividend payments, are a direct consequence of financing decisions and, therefore, should be classified as financing outflows. These respondents argued that interest and dividend payments are returns on capital provided to creditors and stockholders, respectively, and both should be classified with returns of capital because the distinction between returns of and returns on capital is largely irrelevant in the context of cash flows. Similarly, some respondents argued that interest (and dividend) receipts are a direct consequence of investment decisions and, therefore, should be classified as investing inflows. Indeed, three of the seven FASB members subscribed to these views, and dissented to the issuance of SFAS 95 in part for this reason.

But the FASB also noted that virtually all companies classified interest payments and interest receipts as operating cash flows under APB 19. Additionally, the FASB perceived widespread support for the notion that operating cash flows should, as much as possible, include items whose effects are included in determining net income, in order to facilitate an understanding of the reasons for differences between net income and net cash flow from operating activities. The FASB therefore was not convinced that changing the prevalent practice of classifying interest payments and interest receipts would necessarily result in a more meaningful presentation of cash flows. Rather, SFAS 95 requires that interest payments and interest receipts should be classified as operating outflows and inflows.

SFAS 95 requires disclosure of the amount of interest payments (net of amounts capitalized), either as a separate line item under the direct method or as a supplemental item under the indirect method, so that report users who wish to consider interest payments as financing outflows may do so for their own analytical purposes. It has no comparable requirement to disclose the amount of interest receipts as a supplemental item under the indirect method; it does require disclosure of interest receipts as a separate line item under the direct method.

Bonded Debt

Under SFAS 95, financing inflows include: a) the proceeds from issuing equity instruments; and b) the proceeds from issuing bonds, mortgages, notes, and from other short- and long-term borrowing. Financing outflows include: a) payments of dividends and other distributions to owners, including outlays to reacquire equity instruments; b) repayments of amounts borrowed; and c) other principal payments to creditors who have extended long-term credit. Obviously, the proceeds from issuing bonded debt represents a financing inflow. But because interest paid is classified as an operating outflow under SFAS 95, it follows that the outlay to retire bonded debt represents a financing outflow for the original amount borrowed, an operating outflow for any discount, and an operating inflow for any premium at issuance.

These classifications may be surprising to some readers, largely because they are not explicitly noted in SFAS 95. The pronouncement makes reference to "repayments of amounts borrowed" rather than to "repayments of original amounts borrowed" in its list of financing outflows. But as this article indicates, the allocation of principal payment between operating and financing activities is implicit in SFAS 95, at least as interpreted in informal conversations with some FASB Staff.

Bonds issued at Discount

Bonded debt is issued at a discount if the coupon rate is less than the market rate at date of issuance. The discount is a liability valuation, and is amortized over the life of the bond issue to increase the liability and periodic interest expense. Accordingly, periodic interest expense is more than periodic interest payments by the amount of the discount amortization. For example, assume that on January 1, 19x1, Debtor Corporation issues 13% bonded debt with a face value of $100,000 and a 10 year maturity for $80,000 cash, or at a $20,000 discount. At issuance, the $80,000 proceeds is classified as a financing inflow, equal to the amount actually borrowed. Assuming straight-line amortization over the 10-year bond term for ease of presentation, interest expense each year is $15,000, or $2,000 more than interest payable currently.

In theory, the discount amortization is an increase in the liability that is a separate noncash financing source of funds. Under SFAS 95, however, the discount amortization is treated as a noncash adjustment of interest expense to derive interest paid for the period which, in turn, relates to operating activities. Accordingly, $2,000 is added to net income to derive cash flow from operations under the indirect method. At retirement, the bond discount is fully amortized and the bonds are retired at the $100,000 maturity value. The 100,000 total cash outflow is classified as an $80,000 financing outflow and a $20,000 operating outflow. The $80,000 financing outflow is the repayment of the original amount borrowed, as required by SFAS 95. But because the bonds were issued at a discount, $20,000 of the $100,000 outlay at retirement is for interest, and must be classified as an operating outflow, consistent with the classification of interest payments as operating outflows under SFAS 95. Thus, cash flow from operations decreases by $20,000 as a result of the retirement of bonded debt at maturity ! This presentation is peculiar and counterintuitive. A more reasonable presentation would be to classify the entire $100,000 outlay at retirement as a financing outflow. This more reasonable presentation would result if interest payments were classified as financing outflows rather than as operating outflows.

Bonds issued at Premium

An even more peculiar and counterintuitive presentation of cash flows results upon the retirement of bonded debt issued at a premium. Bonded debt is issued at a premium if the coupon rate is more than the market rate at the date of issuance. The premium is a liability valuation, which is amortized over the life of the bond issue to decrease the liability and periodic interest expense. Accordingly, periodic interest expense is less than periodic interest payments by the amount of the premium amortization.

The presentation in the cash flow statement of bonds issued at a premium is considered within the context of another simple example, as follows. Assume that on January 1, 19X1, Debtor Corporation issues 13% bonded debt with a face value of $100,000 and a 10 year maturity for $110,000 cash, or at a $10,000 premium.

At issuance, the $110,000 proceeds is classified as a financing inflow, equal to the amount actually borrowed. Again assuming straight- line amortization over the 10-year bond term for ease of presentation, interest expense each year is $12,000, or $1,000 less than interest payable currently.

In theory, the premium amortization is a decrease in the liability that is a separate noncash financing use of funds. Under SFAS 95, however, the premium amortization is treated as a noncash adjustment of interest expense to derive interest paid for the period which, in turn, relates to operating activities. Accordingly, $1,000 is subtracted from net income to derive cash flow from operations under the indirect method.

At retirement, the bond premium is fully amortized and the bonds are retired at the $100,000 maturity value. The $100,000 total cash outflow is classified as a $110,000 financing outflow and a $10,000 operating inflow. The $110,000 financing outflow is the repayment of the original amount borrowed. But because the bonds were issued at a premium, the $10,000 difference between the $110,000 amount borrowed and the $100,000 outlay at retirement represents the recovery of interest cost, and must be classified as an operating inflow, consistent with the classification of interest payments as operating outflows under SFAS 95. Thus, cash flow from operations increases by $10,000 as a result of the retirement of bonded debt at maturity ! As noted earlier, this presentation is peculiar and counterintuitive. A more reasonable presentation would be to classify the $100,000 outlay at retirement solely as a financing outflow. This more reasonable presentation would result if interest payments were classified as financing outflows rather than as operating outflows.

Bond investment

Under SFAS 95, investing inflows include: a) receipts from collections or sales of loans made by the entity and of other entities' debt instruments that were purchased by the entity; b) receipts from sale of equity instruments of other entities and from returns of investment in those instruments; and c) receipts from sales of property, plant and equipment and other productive assets. Investing outflows include: a) payments for loans made by the entity and payments to acquire debt instruments of other entities; b) payments to acquire equity instruments of other entities; and c) payments at the time of purchase or soon before or after purchase to acquire property, plant, and equipment and other productive assets. Obviously, the outlay to acquire a bond investment represents an investing outflow. But because interest received is classified as an operating inflow under SFAS 95, it follows that the principal receipt upon the retirement of a bond investment represents an investing inflow for the original amount invested, an operating inflow for any discount, and an operating outflow for any premium at acquisition.

Bonds Acquired at Discount

Bond investments are acquired at a discount if the coupon rate is less than the market rate at the date of acquisition. The bond investment is recorded at cost, and the discount is amortized over the life of the investment to increase the asset and periodic interest revenue. Accordingly, periodic interest revenue is more than periodic interest receipts by the amount of the discount amortization.

For example, assume that on January 1, 19x1, Investor Corporation acquires 13% coupon bonds with a face value of $100,000 and a 10-year maturity for $80,000 cash, or at a $20,000 discount. At acquisition, the $80,000 outlay is classified as an investing outflow, equal to the amount actually invested. Assuming straight-line amortization over the 10-year bond term for ease of presentation, interest revenue each year is $15,000, or $2,000 more than interest receivable currently.

In theory, the discount amortization is an increase in the asset that is a separate noncash investing use of funds. Under SFAS 95, however, the discount amortization is treated as a noncash adjustment of interest revenue to derive interest received for the period which, in turn, relates to operating activities. Accordingly, $2,000 is subtracted from net income to derive cash flow from operations under the indirect method.

At retirement, the bond discount is fully amortized and the bond investment is reported at the $100,000 maturity value. The $100,000 total cash inflow is classified as an $80,000 investing inflow and a $20,000 operating inflow. The $80,000 investing inflow is the receipt of the amount invested. But because the bonds were acquired at a discount, $20,000 of the $100,000 inflow at maturity is for interest, and must be classified as an operating inflow, consistent with the classification of interest receipts as operating inflows under SFAS 95. Thus, cash flow from operations increases by $20,000 as a result of the recovery of bond investment at maturity ! This presentation is peculiar and counterintuitive. A more reasonable presentation would be to classify the entire $100,000 receipt at retirement as an investing inflow. This more reasonable presentation would result if interest receipts were classified as investing inflows rather than as operating inflows.

Bonds Acquired at Premium

An even more peculiar and counterintuitive presentation of cash flows results upon the maturity of a bond investment acquired at a premium. Bond investments are acquired at a premium if the coupon rate is more than the market rate at the date of acquisition. The investment is recorded at cost, and the premium is amortized over the life of the investment to decrease the asset and periodic interest revenue. Accordingly, periodic interest revenue is less than periodic interest receipts by the amount of the premium amortization.

For example, assume that on January 1, 19x1, Investor Corporation acquires 13% coupon bonds with a face value of $100,000 and a 10 year maturity for $110,000 cash, or at a $10,000 premium. At issuance, the $110,000 outlay is classified as an investing outflow, equal to the amount actually invested. Again assuming straight-line amortization over the 10-year investment term for ease of presentation, interest revenue each year is $12,000, or $1,000 less than interest receivable currently.

In theory, the premium amortization is a decrease in the asset that is a separate noncash investing source of funds. Under SFAS 95, however, the premium amortization is treated as a noncash adjustment of interest revenue to derive interest received for the period which, in turn, relates to operating activities. Accordingly, $1,000 is added to net income to derive cash flow from operations under the indirect method.

At retirement, the bond premium is fully amortized and the bond investment is reported at the $100,000 maturity value. The $100,000 total cash inflow is classified as a $110,000 investing inflow and a $10,000 operating outflow. The $110,000 investing inflow is the receipt of the original amount invested. But because the bonds were acquired at a premium, the $10,000 difference between the $110,000 amount invested and the $100,000 principal receipt at maturity represents a reduction of interest receipts, and must be classified as an operating outflow consistent with the classification of interest receipts as operating inflows under SFAS 95. Thus, cash flow from operations decreases $10,000 as a result of the recovery of bond investment at maturity ! As noted earlier, this presentation is peculiar and counterintuitive. A more reasonable presentation would be to classify the entire $100,000 receipt at retirement as an investing inflow. This more reasonable presentation would result if interest receipts were classified as financing inflows rather than as operating inflows.

Evaluation

The peculiar presentation in the cash flow statement of the retirement of bonded debt and the recovery of bond investment at maturity results from the classification of interest payments and interest receipts as operating cash flows under SFAS 95. This, in turn, results from the unfortunate conclusion of the FASB that the prescribed changes from APB 19 to SFAS 95 should be evolutionary in nature. As mentioned previously, the FASB noted that virtually all companies classified interest payments as operating outflows under APB 19, and was not convinced that changing the prevalent practice of classifying interest payments would necessarily result in a more meaningful presentation of cash flows. More generally, the FASB perceived widespread support for the notion that operating cash flows should, as far as possible, include items whose effects are included in determining net income to facilitate an understanding of the reasons for differences between net income and net cash flow from operating activities.

Adherence to this notion results in classifying interest payments and interest receipts as operating cash flows. It reduces the effectiveness of the cash flow statement to distinguish between operating, financing, and investing activities. Indeed, it makes the activity format cash flow statement potentially misleading, by excluding from financing and investing activities cash payments and cash receipts that stem from financing and investing decisions. By classifying interest payments and interest receipts as operating cash flows, the FASB has foregone the opportunity to improve more substantially the quality of financial reporting, by sharpening the distinction between operating, financing, and investing cash flows. It should reconsider the issue.

Hugo Nurnberg

Acknowledgment: The author appreciates the helpful comments of Mark V. Sever (Ernst & Young, Cleveland, Ohio), Clyde P. Stickney (Dartmouth College), and Joyce Strawser (Baruch College, CUNY). Any errors, of course, are the responsibility of the author alone.