Operating Activities” Please respond to the following:

• From the e-Activity, evaluate the logic of reflecting key person life insurance in the operating activities of the cash flow statement and determine if this presentation is misleading to users of the financial statements. 
• Currently, Financial Accounting Standards Board (FASB) has not provided guidance on the appropriate section for reflecting key person life insurance. As a member of FASB, determine the guidance you would provide for key person insurance in the cash flow statement. Provide your rationale. 

“Free Cash Flow” Please respond to the following:

• Analyze the impact of erroneous classifications in the operating activities section of the cash flow statement on free cash flow and how this distortion can impact the decisions made by financial statement users.
• Assess the importance of free cash flow in a growth company. Provide a brief scenario of a specific type of business that would benefit from free cash flow.

Key-Person Insurance: a Cash-Flow Puzzle

With many companies sitting atop piles of cash and looking for productive ways to use it, buying life-insurance policies on key executives is an increasingly popular tactic.

Although that can be financially effective, it requires companies to make a critical accounting decision for which there is no clear guidance. What they decide can affect operating and free-cash flow and, therefore, influence investor behavior.

Premiums paid on company-owned life insurance policies typically generate a net yield of 0% to 4%, according to Scott Bresnick, an independent sales representative for life insurance products. In other words, for each premium-dollar paid, the cash surrender value of the policy grows by $1 to $1.04. Also, the policies can provide tax-deferred growth and tax-free death benefits, and while in many cases their value is tied in part to stock indices, they often stipulate that for the first few years the policy value can’t decline below the amount of premiums paid.

That means such policies can outperform the paltry returns that companies are currently getting on their cash, especially given that some banks now charge deposit fees that may outweigh the interest on an account’s principal.

As for the accounting issues, some companies record the premiums on their cash-flow statements as a use of cash for operating activities. The most likely rationale for that approach, suggests Charles Mulford, an accounting professor at Georgia Tech University and director of the Georgia Tech Financial Analysis Lab, is that since the companies expense the premium payments (net of any increase in the cash surrender value of the policies) on their income statements, they should also record the use of cash in the operating-activities section of their cash-flow statements.

But that’s faulty thinking, Mulford says. First, while U.S. generally accepted accounting principles say nothing about how to treat corporate-owned life insurance premiums on cash-flow statements, they are classified as an investing use of cash under the Accounting Standards Codification. While there’s no rule, there is an implication that COLI premiums should be designated as investments on cash-flow statements. “Classifying these premiums as an operating use of cash appears to run contrary to the spirit, if not the letter, of GAAP,” says Mulford.

More important, though, classifying premiums under operating activities can either deflate or inflate both operating cash flow and free cash flow — key indicators of a company’s financial health.

The line that appears in the operating-activities section of many cash-flow statements as “change in cash surrender value of insurance,” or similar wording, normally reflects some mix of premiums paid, any company borrowing from or sales of policies, and stock movements.

Depending on whether those factors cumulatively cause the cash surrender value to increase or decrease, operating and free cash flow will also gain or lose. In cases where those cash-flow metrics are dragged down, the company may have contributed by not classifying the premiums as investment activity. In the opposite case, the company in effect has artificially boosted those key metrics, perhaps misleading investors, say both Mulford and Bresnick.

Mulford’s Financial Analysis Lab has just published a report identifying four companies that in their fiscal 2011 financials classified premiums on COLI policies as cash used for operations. Two of the four are multibillion-dollar companies (Darden Restaurants and Jack in the Box) and two are in the range of $135 million to $165 million in revenue (Golden Enterprises and Fisher Communications, respectively).

Changes in the cash surrender value of those companies’ policies during fiscal year 2011 caused the most drag ($1.6 million) on the key cash-flow metrics of Fisher Communications. The other losers were Jack in the Box (a reduction of $1.1 million in its operating and free cash flow) and Golden Enterprises. Darden Restaurants, meanwhile, enjoyed a boost of $13.7 million. (None of the four companies responded to a request to comment for this article.)

Much is Guesswork
It’s apparent that many other companies include such insurance premiums within the operating activities section, because they’re not accounted for in the cash investment section. Beyond that, much is guesswork. “In many cases, you can’t tell from the financials explicitly how they’ve done it,” says Mulford. “You have to infer from their filings, and you can’t always get that inference.”

Classifying premiums as an operating use of cash rather than an investing use can distort reported cash flow and free-cash flow. But GAAP is silent.

More specifically, most companies that include premium payments within operating activities do not actually state how much they paid in premiums. They show the gain or loss in the cash surrender value of their policies, but don’t show how much of that result is attributable to premium payments or the other factors that cause surrender value to fluctuate.

Not only can classifying the premiums within operating activities be misleading to investors, it also can be illogical, Mulford notes. If, for example, $100 in premiums increases cash surrender value by $100 or more, it should clearly be classified as investment. If that $100 increases cash surrender value by only, say, $80 (because the value is tied partly to a stock index), $20 should be classified as operating cash flow and $80 as investment cash flow.

Mulford says the matter doesn’t rise to the level at which a whole new accounting standard is needed, though it’s the kind of smaller issue that the Emerging Issues Task Force of the Financial Accounting Standards Board was created to render opinions on. “It’s a classification issue faced by all CFOs with company-owned life-insurance policies,” he says.

While the task force’s opinions do not have the force of a FASB standard, companies typically follow them once they’re issued. FASB, though, has not yet said whether the committee will look into the premium-classification matter.

Mulford says he first looked at this topic for a book he wrote on cash-flow classifications that was published in 2005, but he didn’t make much of it and basically let it drop.

Recently, though, Bresnick approached him after putting 36 hours of research into the subject. He’d been trying to sell a key-person life-insurance policy to a large technology company. Its finance chief was quite interested, but declined the deal after his tax advisers told him the premiums would have to be classified as operating expense.

Bresnick says he responded, “No, I don’t think so; where the premium generates an equal or greater cash value, it’s an investment.” The answer was still no, so he performed his research and brought the results to Mulford, who got his team working on it within a few weeks.

Mulford was enthusiastic partly because so many companies are buying these policies. It was a common practice until 2004, when new regulations prohibited using the present value of the future proceeds on the policies to offset deferred-compensation liabilities, which was commonly done at the time. For that reason, the market for the products essentially died until about 2010. That’s when life-insurance products began to appear that provided gains in cash surrender values in excess of the return companies could get from money markets.