I have been teaching undergraduate “Accounting Theory” for the past three years. For reasons that I will explain below, I choose to begin the course by exploring differences between accrual accounting and cash flows; and relatedly, how to analyze a statement of cash flows.
First, you need to know that I love my students. They are diligent, highly teachable, respectful and ambitious. They even laugh at some of my jokes. I could say more about them, like how I think that merely being in their presence at my advanced age helps to keep me feeling young. But what I have already told you is more than enough to convey my initial shock that — even as last semester seniors on the cusp of internships with Big Four firms — hardly anyone knew very much at all about cash flow statement preparation, much less its analysis.
I know that I will be criticized for saying this, but I blame the FASB. I don’t think they care a fig that the mind-numbing and pointless complexity of accounting standards make it impossible to teach our students how to do their jobs well.
As only one of many examples, this week we are reading about the controversies leading to the issuance of SFAS 123R on stock-based compensation. I assigned as background reading the relevant coverage in a bestselling Intermediate Accounting textbook, which the students had used in prior semesters. The overall coverage in these books has expanded so much that they have have practically tripled in size since I was a student. Now, the textbook from which I gave the assignment runs to over 1500 pages; but the entire treatment of stock compensation — including options, restricted stock and purchase plans (ASC 718) — takes up only six of those 1500 pages. Note that one Big Four accounting guide on ASC 718 that I picked at random to download runs to almost 400 pages!
My point is that even the better students don’t have much chance at mastering foundational technical topics like preparation of the statement of cash flows, so long as educators feel compelled to touch every accounting treatment that the student could possibly be tested on when trying to pass the CPA Exam. Intermediate Accounting has become as helpful to one’s future professional life as is making the Olympic swim team by training in a kiddy pool.
Oh well, that was somewhat of a digression. I am writing this post because I really want to talk about what happened in Accounting Theory this year as we covered the statement of cash flows. I added a session to my regular cash flow v. accrual coverage in order to discuss the EITF project dealing with cash flow statement classification issues. And, just one week after that session, we can now chew on proposed ASU EITF-15F, Statement of Cash Flows—Classification of Certain Cash Receipts and Cash Payments (Topic 230).
To prepare for our in-class discussion, I assigned the students the task of being prepared to explain each of the nine issues covered by the handout used for the educational session of the EITF, and to form their own opinions. As it turned out, we only had time to analyze the first issue: the presentation of fees paid to prepay debt.
The EITF’s “educational meeting” handout stated that a prepayment fee represents an approximation of interest that will not be paid, plus penalties and other lender costs. It went on to identify two prevalent views as to its appropriate presentation in the statement of cash flows:
- As an operating activity—A payment represents an adjustment of the debt’s effective interest rate and does not represent repayment of the amount borrowed.
- As a financing activity—A payment is analogous to debt issue costs, which are classified as cash flows from financing activities.
To help the students develop their own opinion as to the merits of each view, I felt that they should understand the economics of debt prepayments, the accounting for prepayments, and whether the EITF materials they reviewed accurately and completely portrayed the issues. I began the session by asking the students to consider an arrangement whereby a borrower would receive $100,000 today in exchange for equal payments to the lender at the end of each year for the next ten years, based on a stated interest rate of 7% per annum. The arrangement also provided that the borrower could settle the loan for the outstanding balance plus $1,000 after the sixth payment. The students were able to easily calculate that the annual payments came to $14,237 and that the balance with four payments remaining would be $48,226.
I next asked the students to assume that market interest rates for similar debt had declined from 7% to 3% over the first six years that the loan was outstanding. Would the borrower create value for its shareholders by prepaying the remaining balance?
Answer: Yes. The present value of the remaining payments at the current market rate of interest is $52,923. One way to finance the repayment would be to borrow $49,226 (i.e., the balance of the debt plus the prepayment “penalty”) at 3%.
Thus far, we showed that prepayment from a strictly financial standpoint is a no-brainer. BUT, if the borrower does choose to prepay, then it will be forced to recognize an accounting LOSS equal to the amount of the prepayment “penalty.”
Two consensus observations then emerged among my students. First, that the EITF mischaracterizes the prepayment cost as a penalty. Penalties are what you pay when one violates a law or a covenant — and gets caught. The prepayment cost, on the other hand, is the borrower’s right, but not an obligation, to pay when it perceives that it is to its advantage to do so; hence, it is more appropriately characterized as the exercise price of an option to prepay.
To further drive this point home to the students, I asked them to go back to the origination date of the loan and to estimate a range of interest rates for a non-prepayable loan (answer: something less than 7%), and a loan that could be prepaid without penalty (answer: greater than 7%). In other words, the borrower negotiated for itself an embedded option along with a loan. Conceivably, a borrower could choose to pay less than 7% for a non-prepayable loan, and use the interest savings to purchase an option from a third party that could require the third party to assume a portion of the remaining four payments.
Second, we concluded that the issue being addressed by the EITF was small potatoes when compared to the potential for value destruction by a flawed* accounting treatment for the loan. How many CFOs of borrowing corporations don’t prepay loans that they obviously should prepay because they would be forced to recognize a loss? Methinks there are many. (Conversely, how many lenders undercharge for granting prepayment options because they are more than happy to record gains when prepayments occur?)
Oh well (again). But, at least our analysis to this point revealed the true nature of the prepayment cash flow: not a penalty, but the exercise price of an option. That should help in responding to the question the EITF has been trying to answer, and I see no indication that the EITF ever considered the issue from the perspective of the true nature of the prepayment cost.
What was the EITF Thinking?
In the proposed ASU, the EITF reported its consensus, for which the FASB has chosen to seek ratification, that the prepayment costs should be classified as financing cash outflows. Although not discussed in their educational materials that I used in class, the proposed ASU also states that transaction costs to retire publicly-traded debt should be treated in the same regardless of the fact that it would be purchased at its market price.
The EITF is wrong on three counts. First, to repeat, a prepayment “penalty” is really the exercise price of an option. This means that the embedded option premium is most appropriately classified in the statement of cash flows on the origination date of the arrangement as an investment outflow. By extension, the exercise price of the option cannot be a financing cash flow. It’s either an operating or an investing cash outflow related to the benefit realized from option exercise; and I really don’t care which one, as the distinction between operating and investing is poorly thought out to begin with.
Second, there is a fundamental difference between early retirement of a private placement of debt at its contractually determined balance, and purchasing one’s own debt from the public at prevailing market prices. The EITF is wrong to apply its thinking on the former seemingly without much additional thought regarding the latter.
Third, the EITF was wrong to have even taken up the issue. Did investors ask for this? I seriously doubt it. Over the thousands of man-hours devoted to this issue by the EITF, the FASB and their support staffs, surely someone had to confront the fact that the accounting itself for debt prepayment costs is full of warts. It took my class barely 60 minutes to realize that better accounting for debt prepayment dwarfs the cash flow presentation issue in its importance.
Indeed, all of the issues taken together in proposed EITF-15F are small potatoes. They aren’t even ‘emerging issues.’ These are all smallish variations in decades-old practices, and it would appear that auditors have finally grown weary of squirmishing over the cash outflows that their clients would prefer to exclude from the operations section. So, they asked the EITF to finally bring it all to some sort of conclusion that issuers wouldn’t hate.
Surely, there are plenty of more consequential inconsistencies in GAAP that investors may care about – but if not, then the EITF should stop meeting until they find one.
* * * * * * * *
For the FASB, the cash-flow elephant in the room remains: to finally, finally require that companies produce a statement of cash flows under the direct method that reports actual cash flows from operations, instead of the backasswards reporting of the accrual components in net income.
*I can’t resist observing that the FASB has made a big deal (and rightly so) about the accounting for an interest rate swap (i.e., a forward contract), but when a contract has an embedded interest rate option, evidently both borrowers and lenders can safely disregard it.