Note: Unlike some discussion memos, this example did not require any computations of amounts. You should direct your memo to the appropriate parties and not just copy the headings below and be sure to address the specific issues that the discussion memo asks you to address. Also, this example references authoritative guidance in FASB’s Accounting Standard’s Codification (ASC) and nonauthoritative guidance outside the codification. You are required to cite any authoritative ASC guidance on point and are not required to cite any nonauthoritative guidance, but can do so if you choose. If you choose to cite other guidance as well, you must include appropriate footnote citations to such other guidance.
March 28, 2012
To: The Board of Directors and Audit Committee
From: Mr. Bell, Controller
RE: Cash Flows Statement Treatment of Advances from Customers
The members of the Board of Directors and the Audit Committee have asked me to conduct some research on an accounting issue regarding the presentation of certain cash flows in the statement of cash flows. The question relates to what is the appropriate classification of an advance payment that our company, Business Services, Inc, a management consulting firm, has received from a large customer for services to be purchased in the future under a long-term contract arrangement. We negotiated this advance payment arrangement with our largest customer because the customer is requiring us to devote a large amount of resources to providing future services to them and this would require us to ramp up our hiring to accommodate their service needs. As you are aware, we are considering how to best reflect in the cash flow statement this material customer advance received during the fourth quarter of this year. As we previously have discussed, some concerns have been raised regarding whether such a customer advance for future services should be treated as and operating or a financing cash flow under generally accepted accounting principles (“GAAP”).
The concerns are that because the contract is longer term (two years), the customer advance is not typical of the relatively the short-term advances one often sees from customers, that these advance cash flows are distant in time from when the services will be provided, and also that the advance bears interest. These aspects make the customer advance seem more like a company borrowing under a debt agreement, which would be classified as a financing transaction, than a cash flow collected from a customer in the ordinary course of business. Also, because it is material, there is some concern that treating the advance from the customer as an operating cash flow in the current period would distort the typical pattern of cash flows from customers in the cash flow statement, perhaps giving the impression that the company’s cash flows from customers are higher than they typically are on a recurring basis.
Based on the research I have done it appears that the classification of the customer advance as operating appears to be an appropriate treatment under GAAP applicable to cash flows collected from the sales of a company’s product or services. I believe a key factor in the classification decision to treat the advance as an operating cash flow is that the advance in this case must be repaid in services rather than cash.
As defined in the FASB’s Accounting Standards Codification (ASC) glossary, operating activities include:
“all transactions and other events that are not defined as investing or financing activities. Operating activities generally involve producing and delivering goods and providing services. Cash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income.”
Thus, operating cash flows is something of a residual category, including cash flows that are not appropriately classified in either of the other two classifications.
However, ASC paragraph 230-10-45-16(a) indicates that cash inflows from operating activities include:
Cash receipts from sales of goods or services, including receipts from collection or sales of accounts and both short-and long-term notes receivable from customers arising from those sales.
On the payments side, ASC paragraph 230-10-45-17(b) indicates that cash outflows from operating activities include”
Cash payments to acquire materials for manufacture or goods for resale, including principal payments on accounts and both short- and long-term notes payable to suppliers for those materials or goods.
While not included in the ASC and so not part of the authoritative literature, the Basis for Conclusions (“Basis”) of Statement of Financial Accounting Standards (SFAS) No. 95, which is the source of the codification guidance above, provides some insights into the FASB’s decisions regarding which cash flows from customers to include in operating cash flows, when they are not received at approximately the time of the sale. As discussed in paragraphs 93 through 95 of the Basis, the exposure draft for SFAS No. 95 rejected treating cash flows stemming from installment sales and purchases as operating under the view that only cash flows occurring “soon before or after” the time of sale or purchase should be operating cash flows. Under the Exposure Draft, “[s]ubsequent principal payments on the related notes would have been investing cash inflows or financing cash outflows.”
Commenters on the exposure draft felt that all cash flows related to the purchase or sale of inventory should be operating cash flows regardless of when they were received or paid. The Board ultimately agreed with those commenters and thus SFAS No. 95 provided that all cash collected from customers or paid to suppliers from the sale or purchase of inventory should be classified as operating cash flows.
While the paragraphs in the Basis above discuss purchases and sales of inventory, it seems to be a reasonable interpretation to extend the application of the guidance to a service company, whose primary operations are the sale or purchase of services. As cited above, ASC paragraph 230-10-45-16(a) actually indicates that cash receipts from sales of goods or services, including receipts from collection or sales of accounts and both short-and long-term notes receivable should be treated as operating. If the arrangement were an installment purchase of services, then the answer would appear clear, that is, the principal cash flows received on the installment notes would be treated as operating cash flows. In the company’s situation, the opposite is occurring, the cash flows are occurring in advance of the sale, but the services are not provided until sometime later.
Based on the authoritative guidance in the ASC and the further insights provided by the nonauthoritative guidance in the Basis for Conclusions, I believe that the accounting for advance payments would follow the same principles in the cash flow statement as deferred payments on installment sales. That is, a company that is in the business of selling services should treat cash inflows associated with the sale of services as operating cash inflows “regardless of when they were received or paid.”
The fact that the company received the cash payments for customer services in advance of delivery of the services is not relevant, if the cash payments are in fact payments in advance for services. The fact that the company is also required to pay interest on the advances is similar to installment receivables from the sale of inventory and services. In that case, the fact that the cash is collected years later and with interest does not change the cash flow categorization of the cash received on receivables arising from the sale of goods or services. By similar logic the cash received in advance, although repayable with interest at a later date, if in fact repayable in services and expected to be paid in services, should be treated as an operating cash flow.
In this regard, I believe that it is a very important part of the classification decision that our customer contract provides no alternative mechanism for repaying the advance except for the company’s providing the services required under the contract, except in an event of default on the contract. An event of default is defined as our company being unable to provide the required services to the customer under normal operating conditions. If the contract permitted us to repay the advance in cash or allowed the customer to demand cash absent a default by us, then I think that the classification of the advance as a financing cash flow may be more warranted.
While I believe the accounting guidance in the codification supports treating the customer advance as an operating cash flow, the guidance in the ASC does require another treatment for seller financing arrangements for purchases property, plant and equipment. The guidance cited below suggests that the separation in time of the cash flows from the transfer of the property, plant and equipment may lead to a financing cash flow presentation (rather than investing treatment in that case). ASC Paragraph 230-10-45-13(c) states:
Payments at the time of purchase or soon before or after purchase to acquire property, plant, and equipment and other productive assets, including interest capitalized as part of the cost of those assets. Generally, only advance payments, the down payment, or other amounts paid at the time of purchase or soon before or after purchase of property, plant, and equipment and other productive assets are investing cash outflows. However, incurring directly related debt to the seller is a financing transaction (see paragraphs 230-10-45-14 through 45-15), and subsequent payments of principal on that debt thus are financing cash outflows.
These paragraphs appear to suggest that for purchases of property, plant and equipment (as opposed to inventory) the treatment from the purchaser’s standpoint for payments made after the purchase are financing. The seller financed portion of that transaction would not even appear in the cash flow statement of the purchaser as an investing transaction because it is a “noncash” portion of the investment, but the subsequent cash payments would be treated as financing. I believe that these paragraphs are not relevant to the company’s situation because they relate to transactions involving seller financing of a long-term asset not inventory or services. Also, the guidance provided appears to relate to a purchaser not a seller, the latter of which is what we are.
Summary and Conclusion
To summarize, based on the guidance in the ASC, my conclusion is that that the classification of the cash advance associated with the customer service contract as an operating cash flow is appropriate under GAAP, by analogy to installment sales arrangements for inventory sales. However, I think it is a key point that our customer contract provides no alternative repayment mechanisms, absent default by ourselves, to satisfying the contract, and hence repaying the advance, in services. While I believe this is the appropriate treatment under GAAP, I believe we should discuss this issue with our outside auditors prior to finalizing the decision on how to present these cash flows in the cash flows statement. I look forward to discussing this issue with you further.