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 ca.

1. 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

2. 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.

3. 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

4. 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

5. 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.