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1 800 West Peachtree Street NW Atlanta, GA Charles W. Mulford, Director Invesco Chair and Professor of Accounting The Cash Flow Classification of Premiums on Life Insurance Policies EXECUTIVE SUMMARY Generally accepted accounting principles do not specifically address the cash flow classification of premiums on company-owned life insurance policies. Our review of annual financial statement filings with the SEC indicates that many firms are classifying those premiums as an operating use of cash. An operating designation is afforded those premiums even when they serve to increase the cash surrender value of the underlying policies. Such treatment appears to be contrary to the spirit, if not the letter, of GAAP. Moreover, when premiums are paid, it unduly lowers operating cash flow and free cash flow, and could lead to lower assessments of corporate financial health and valuation. Similarly, operating cash flow and free cash flow may be overstated when policy proceeds are classified as operating cash flow. We were able to identify firms who employ an investing classification for life insurance premiums that increase cash surrender values. Such a classification could be characterized as a best-practices approach. The objective of this research report is to raise the awareness of corporate managers, analysts, and investors to the diversity in practice we are witnessing in the classification of life insurance premiums for the purpose of bringing more consistency to practice. Our hope is that regulators such as the FASB, possibly through the Emerging Issues Task Force, will consider it a worthwhile issue to address. March 2012

2 Georgia Tech Financial Analysis Lab Georgia Tech Financial Analysis Lab College of Management Georgia Institute of Technology Atlanta, GA The Georgia Tech Financial Analysis Lab conducts unbiased research on issues of financial reporting and analysis. Unbiased information is vital to effective investment decision-making. Accordingly, we think that independent research organizations, such as our own, have an important role to play in providing information to market participants. Because our Lab is housed within a university, all of our research reports have an educational quality, as they are designed to impart knowledge and understanding to those who read them. Our focus is on issues that we believe will be of interest to a large segment of stock market participants. Depending on the issue, we may focus our attention on individual companies, groups of companies, or on large segments of the market at large. A recurring theme in our work is the identification of reporting practices that give investors a misleading signal, whether positive or negative, of corporate earning power. We define earning power as the ability to generate a sustainable stream of earnings that is backed by cash flow. Accordingly, our research may look into reporting practices that affect either earnings or cash flow, or both. At times, our research may look at stock prices generally, though from a fundamental and not technical point of view. Contact Information Charles Mulford Invesco Chair, Professor of Accounting and the Lab's Director Phone: (404) Maital Dar Ariadna Lopez Website: Graduate Research Assistant and MBA Student Graduate Research Assistant and MBA Student by the College of Management, Georgia Institute of Technology, Atlanta, GA ALL RIGHTS RESERVED. The information contained in this research report is solely the opinion of the authors and is based on sources believed to be reliable and accurate, consisting principally of required filings submitted by the companies represented to the Securities and Exchange Commission. HOWEVER, ALL CONTENT HEREIN IS PRESENTED "AS IS," WITHOUT WARRANTIES OF ANY KIND, EXPRESS OR IMPLIED. No data or statement is or should be construed to be a recommendation for the purchase, retention, sale or short-sale of the securities of the companies mentioned. Technology, Atlanta, GA

3 Companies Named in This Report Page Cobra Electronics Corp. 13 Darden Restaurants, Inc. 8 Fisher Communications, Inc. 7 Golden Enterprises, Inc. 8 Jack In the Box, Inc. 11 Korn/Ferry International, Inc. 18 StellarOne Corp. 16 3M Co. 19 Weyco Group, Inc. 14 Technology, Atlanta, GA

4 The Cash Flow Classification of Premiums on Life Insurance Policies Introduction In accounting for the income effects of company-owned life insurance policies, generally accepted accounting principles are clear. Premiums paid, net of any increase in the cash surrender value of the underlying policies, should be expensed. Where GAAP is less clear, however, leading to significant diversity in practice, is in the cash flow classification of the insurance premiums paid. Many companies report all life insurance premiums paid, even premiums that result in an increase in the cash surrender value of the underlying policies, as operating cash flow. Other firms report the cash paid for insurance premiums that increase cash surrender values as investing cash flow. In this research study we examine and report on the cash flow reporting practices for premiums on life insurance policies. Our objective is to bring more consistency to practice and to identify what we think is a best practices approach to cash flow reporting for life insurance premiums. Cash Flow Classification of Life Insurance Premiums Free cash flow is an important measure of financial performance. It is a source of cash that is available to management for discretionary purposes like debt repayment, dividends, stock buybacks, acquisitions and other investments. Analysts and investors pay close attention to free cash flow as a source of financial health and firm value. While definitions of free cash flow vary, most measure it by subtracting capital expenditures and preferred dividends from the GAAP-defined metric, cash provided by operating activities or operating cash flow. 1 As such, the calculated amount of free cash flow generated by a firm is highly dependent on how operating cash flow is measured. The GAAP definition of operating cash flow can be found in Accounting Standards Codification (ASC) Area 230, The Statement of Cash Flows. The standard defines cash provided by operating activities as follows, 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. 2 No additional clarification on how to classify cash paid for premiums on life insurance policies is given. If company-owned life insurance policies did not provide an investment vehicle in the form of increasing cash surrender values, then an operating designation for premiums on those policies would be consistent with the standard. Policy premiums would be an operating expense, properly deducted from earnings and operating cash flow. However, premiums on life insurance policies are different from other operating expenses in that they can serve to increase the cash surrender value of the underlying policies, providing what is, in effect, an increment to the liquidation value of an investment vehicle. ASC area 230 defines cash provided from or used for investing activities as,... making and collecting loans and acquiring and disposing of debt or equity instruments and property, plant, 1 Some analysts also subtract common dividends from operating cash flow in calculating free cash flow. 2 Financial Accounting Standards Board, Accounting Standards Codification, Area 230 (Norwalk, CT, 2012). Technology, Atlanta, GA

5 and equipment and other productive assets... 3 Under this definition, to the extent that cash disbursements made under life insurance policies increase the cash surrender value of the policies, those disbursements should be considered to be investing activities and reported as such on the statement of cash flows. With this view, investments in cash surrender values of life insurance policies are similar to investments in bonds and other debt instruments or, for some policies, equity securities, which are clearly classified as investing activities in accordance with the ASC. As an aside, ASC , Investments in Insurance Contracts: Subsequent Measurement, does indicate that an increase in the cash surrender value of a life insurance policy should be reported as an adjustment to the premium paid, The change in cash surrender or contract value during the period is an adjustment of premiums paid in determining the expense or income to be recognized under the contract for the period. 4 The standard does not, however, specifically address the cash flow classification of the cash paid that resulted in the increase in cash surrender value. While the ASC does not specifically address the cash flow classification of life insurance premiums, it does refer to the cash surrender value of life insurance policies as investments. For example, in ASC , Investments in Insurance Contracts: Subsequent Measurement, the ASC refers to the cash surrender value of life insurance policies as,... an asset representing an investment in a life insurance contract... 5 By referring to the cash surrender value of a life insurance policy as an investment, the ASC directly implies that cash flows related to increasing or decreasing the value of that cash surrender value should be classified as investing cash flow. As noted, free cash flow is an important measure of cash flow that is available to management for discretionary purposes. In evaluating financial performance, analysts and investors are concerned with how much free cash flow is generated by a firm and how that free cash flow is put to use. Premiums on life insurance policies that increase cash surrender values of life insurance policies are a discretionary use of free cash flow and not an expenditure that is needed to generate that free cash flow. As such, an investing designation as opposed to an operating one would appear to be more appropriate. With an investing classification for premiums paid on life insurance policies that increase cash surrender values, only net premiums, the premiums in excess of the increase in cash surrender value, should impact operating cash flow or free cash flow. Such treatment would be consistent with the expense component of life insurance premiums, which is deducted from revenues in determining net income. Firms that subtract from operating cash flow life insurance premiums that increase the cash surrender value of the underlying policies appear to be unduly reducing operating cash flow and free cash flow. Moreover, they would appear to be doing so in a manner that is contrary to the spirit if not the letter of generally accepted accounting principles. 3 Financial Accounting Standards Board, Accounting Standards Codification, 230 (Norwalk, CT, 2012). 4 Financial Accounting Standards Board, Accounting Standards Codification, , (Norwalk, CT, 2012). 5 Financial Accounting Standards Board, Accounting Standards Codification, , (Norwalk, CT, 2012). Technology, Atlanta, GA

6 In the paragraphs that follow we provide examples of firms that classify the premiums paid on life insurance policies as operating cash flow and firms that classify those premiums as investing cash flow. With such differences in practice, GAAP measures of operating cash flow and related measures of free cash flow are not comparable, making analysis of financial performance more difficult. An Operating Designation for Life Insurance Premiums Our research indicates that many companies report the full premium paid on a life insurance policy as an operating use of cash. They do this by reporting the premium paid as an operating expense but netting against that expense the increase in cash surrender value of the underlying policy. Alternatively, the increase in cash surrender value might be reported as other income. With this practice, net income is reduced by net premium expense. However, in computing operating cash flow, these companies then subtract from net income the increase in cash surrender value, treating it as non-cash income. The net effect is to reduce operating cash flow and free cash flow for the full premium paid. Similarly, for policy proceeds that are included in operating cash flow, operating cash flow and free cash flow are unduly increased. In the paragraphs that follow we provide four representative examples of this practice. The companies cited are Fisher Communications, Inc., Golden Enterprises, Inc., Darden Restaurants, and Jack In The Box, Inc. Fisher Communications, Inc. Fisher Communications states that any cash receipts or payments related to its life insurance policies are reported in the operating section of the cash flow statement. In the notes to its financial statements, Fisher Communications writes, The Company accounts for the cash surrender value of the approximately 70 annuity contracts and life insurance policies using the fair value method. The fair value method requires the Company to remeasure the policies at fair value at each reporting period and the changes are recorded in earnings. Any cash receipts and payments related to the policies are included in the consolidated statement of cash flows within the operating activities section. The carrying value of the annuity contracts and life insurance policies was $17.3 million and $18.9 million as of December 31, 2011 and 2010, respectively. 6 In the operating section of the cash flow statement, the company adjusts net income for changes in the reported amount of the cash surrender value of its policies. In 2010 and 2009, $962,000 and $912,000, respectively, were subtracted from net income, reflecting increases in the cash surrender value. In 2011, $1,617,000 was added to net income in reconciling to operating cash flow, reflecting a reduction in the cash surrender value of the underlying policies. By all appearances, the company expenses the premiums paid on its policies, reducing net income and operating cash flow. Changes in the cash surrender value of the policies, which raise or lower income but provide no additional source or use of cash, are then adjusted out of net 6 Fisher Communications, Inc., Form 10-K Annual Report to the Securities and Exchange Commission, December 31, 2011, p. 85. Technology, Atlanta, GA

7 income in reconciling to operating cash flow. The net effect is to leave the premiums paid on the policies as an operating use of cash. We cannot know from disclosures provided whether the company paid premiums or received proceeds from the policies during To the extent that the company received proceeds that were reported in operations, operating cash flow and free cash flow were increased. The operating section of the company s cash flow statement is provided below. FISHER COMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended December 31, (in thousands) Operating activities Net income (loss) $ 36,435 $ 9,746 $ (9,330) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities Depreciation and amortization 9,564 14,392 13,670 (Gain) loss on extinguishment of senior notes, net (2,965) Deferred income taxes, net (3,960) 4,933 7,190 Amortization of deferred financing fees Amortization of deferred gain on sale of Fisher Plaza (30) Amortization of non-cash contract termination fee (1,461) (1,461) (1,461) Amortization of short-term investment discount (303) Amortization of broadcast rights 10,808 11,877 10,056 Payments for broadcast rights (11,069) (11,963) (10,038) Gain on exchange of assets, net (32) (2,054) (2,569) Loss on disposal of fixed assets destroyed in Fisher Plaza fire 1,482 Loss on disposal of property, plant and equipment Gain on sale of radio station, net (1,062) Gain on sale of real estate, net (4,089) Gain on sale of Fisher Plaza, net (40,454) Loss in operations of equity investees Stock-based compensation 1,580 1,342 1,015 Other 205 Change in operating assets and liabilities, net Receivables (1,596) (2,964) (2,026) Prepaid expenses and other (198) 2,023 (2,260) Cash surrender value of life insurance and annuity contracts 1,617 (962) (912) Other assets 1, Accounts payable, accrued payroll and related benefits and other current liabilities (4,095) 4,170 (2,259) Interest payable (996) (606) (615) Income taxes receivable and payable 22,703 10,571 (8,983) Accrued retirement benefits (511) Other liabilities (3,770) (686) (759) Net cash provided by (used in) operating activities 13,440 39,668 (10,189 ) Source: Fisher Communications, Inc., Form 10-K Annual Report to the Securities and Exchange Commission, December 31, 2011, p. 66. Technology, Atlanta, GA

8 Golden Enterprises, Inc. On its balance sheet at June 3, 2011 and May 28, 2010, Golden Enterprises reports a noncurrent asset for the cash surrender value of life insurance at $934,844 and $1,299,084, respectively, a decline of $364,240. That decline in cash surrender value was reported as an operating source of cash, as seen in the reconciliation of net income to cash provided by operating activities. We could not find reference to the payment of premiums on the company s life insurance policies. Premiums, if any, would have been expensed in calculating net income and would be included in operating cash flow. As with the previous example, Golden Enterprises has increased operating cash flow and free cash flow with proceeds from its life insurance policies. The reconciliation of net income to cash provided by operating activities is presented below. GOLDEN ENTERPRISES, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASHFLOWS For the Fiscal Years Ended June 3, 2011 and May 28, 2010 RECONCILIATION OF NET INCOME TO NET CASH PROVIDED BY OPERATING ACTIVITIES Net income $ 3,014,768 $ 4,209,038 Adjustment to reconcile net income to net cash provided by operating activities: Depreciation 3,174,956 2,485,679 Deferred income taxes 1,329,868 1,013,344 Gain on sale of property and equipment (79,483) (829,618) Change in receivables-net (685,678) (237,108) Change in inventories (94,964) 111,487 Change in prepaid expenses (230,574) 35,537 Change in cash surrender value of insurance 364, ,738 Change in other assets - other (167,256) (177,234) Change in accounts payable 186,036 2,699,930 Change in accrued expenses 138,626 (691,346) Change in salary continuation plan (92,506) (85,188) Change in accrued income taxes (1,103,498) (48,352) Net cash provided by operating activities $ 5,754,535 $ 8,807,907 Source: Golden Enterprises, Inc., Form 10-K Annual Report to the Securities and Exchange Commission, June 3, 2011, p. 18. Darden Restaurants, Inc. Darden Restaurants provides the following disclosure on its company-owned life insurance policies, We have a trust that purchased life insurance policies covering certain of our officers and other key employees (trust-owned life insurance or TOLI). The trust is the owner and sole beneficiary of the TOLI policies. The policies were purchased to offset a portion of our obligations under our non-qualified deferred compensation plan. The cash surrender value for Technology, Atlanta, GA

9 each policy is included in other assets while changes in cash surrender values are included in selling, general and administrative expenses. 7 According to the note, the company nets changes in the cash surrender value of its policies against selling, general and administrative expenses. It would appear that the company expenses as a component of selling, general and administrative expenses the premiums paid on its policies and then nets against this expense any change in the cash surrender value of its policies. Among other assets the company reports the cash surrender value of its trust-owned life insurance policies in the amount of $67,500,000 and $52,800,000, at May 29, 2011 and May 30, 2010, respectively, an increase in cash surrender value of $14,700,000 during In the operating section of the statement of cash flows the company subtracts from net income $13,700,000, for the change in cash surrender value of life insurance. We could not identify the amount of any premiums paid on the company s policies in the disclosures provided. It is possible that the $1,000,000 difference between the actual increase in the cash surrender value of the company s policies, $14,700,000, and the change in cash surrender value reported on the statement of cash flows, $13,700,000, represents premiums paid on the policies that served to increase their cash surrender value. Or, the $1,000,000 difference could be a rounding difference. It does appear to us, however, that to the extent that premiums were paid on the company s policies, those premiums would have been reported as a component of operating cash flows. To gain more clarification, we examined Darden s 2010 Form 10-K Annual Report and found that the actual increase in cash surrender value of the company s policies that year was $17,100,000. Also for 2010, we noted that the increase in cash surrender value reported in the operating section of the statement of cash flows was $7,700,000. Here the difference between the two amounts, $9,400,000, is clearly not due to rounding. Rather, the difference appears to represent premiums paid on the company s policies that increased their cash surrender value and are reported as a component of operating cash flow. That is, while we cannot confirm from the disclosures provided the amount of premiums paid on the company s life insurance policies, it appears that the premiums paid in 2010 were $9,400,000. That year, the increase in cash surrender value of the underlying policies, $17,100,000, can be attributed to $9,400,000 in premiums and $7,700,000 in gains on the policies themselves. The operating section of the company s statement of cash flows is presented below. 7 Darden Restaurants, Inc., Form 10-K Annual Report to the Securities and Exchange Commission, May 29, 2011, p Technology, Atlanta, GA

10 DARDEN RESTAURANTS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS Fiscal Year Ended (In millions) May 29, 2011 May 30, 2010 May 31, 2009 Cash flows - operating activities Net earnings $ $ $ Losses (earnings) from discontinued operations, net of tax (0.4) Adjustments to reconcile net earnings from continuing operations to cash flows: Depreciation and amortization Asset impairment charges, net Amortization of loan costs Stock-based compensation expense Change in current assets and liabilities (79.7) Contributions to pension and postretirement plan (13.2) (0.6) (1.2) Loss on disposal of land, buildings and equipment Change in cash surrender value of trust-owned life insurance (13.7) (7.7) 17.1 Deferred income taxes 28.8 (10.2) 89.5 Change in deferred rent Change in other liabilities (15.4) (14.4) 21.6 Income tax benefits from exercise of stock-based compensation credited to Goodwill Other, net Net cash provided by operating activities of continuing operations $ $ $ Source: Darden Restaurants, Inc., Form 10-K Annual Report to the Securities and Exchange Commission, May 29, 2011, p. 24. Technology, Atlanta, GA

11 Jack In The Box, Inc. In the notes to its financial statements, Jack In The Box writes, Company-owned life insurance We have purchased company-owned life insurance ( COLI ) policies to support our non-qualified benefit plans. The cash surrender values of these policies were $73.3 million and $75.8 million as of October 2, 2011 and October 3, 2010, respectively, and are included in other assets, net in the accompanying consolidated balance sheets. Changes in cash surrender values are included in selling, general and administrative expenses in the accompanying consolidated statements of earnings. 8 The company has included premiums on its life insurance policies in operating expenses and has netted changes in the cash surrender values of its policies against these expenses. Then, in the operating section of the statement of cash flows the company adjusts net income for changes in the cash surrender value of its life insurance policies. These changes in value are reported on the cash flow statement as losses (gains) on cash surrender value of company-owned life insurance. In 2011, 2010 and 2009 the company reported losses (gains) of $1,094,000, ($6,199,000) and $1,910,000, respectively. Note that losses in cash surrender value arise when the values of the underlying policies are tied to the market values of debt or equity securities. Focusing on 2011, the loss of $1,094,000 on cash surrender value increased selling, general and administrative expenses and lowered net income. Given the non-cash character of the loss, it was added back to net income in reconciling to operating cash flow. While we could not find disclosure of the amount of any premiums paid on the policies that year, those premiums would also be expensed, lowering net income and operating cash flow. We also could not find disclosure of where the company reported the cash effects of the decline in the cash surrender value of its policies (To $73.3 million in 2011 from $75.8 million in 2010, or $2.5 million). That decline exceeded the reported loss on the policies of $1,094,000. For clarification of the company s accounting policies for life insurance premiums we looked to its 2010 filing. That year, the actual increase in the cash surrender value of its life insurance policies was $8,900,000. On the statement of cash flows, the company subtracted from net income a gain on the cash surrender value of its policies in the amount of $6,199,000. Here again we could not find explicit disclosure of the premiums paid on the policies. However, it appears that the excess of the $8,900,000 increase in cash surrender value over the $6,199,000 gain on the underlying policies, $2,701,000, could be attributed to premiums paid. By all appearances, these premiums, which were expensed and included in net income, were reported as operating uses of cash. The operating section of the company s statement of cash flows is provided below. 8 Jack In The Box, Inc., Form 10-K Annual Report to the Securities and Exchange Commission, October 2, 2011, p. F-10. Technology, Atlanta, GA

12 JACK IN THE BOX INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) Fiscal Year Cash flows from operating activities: Net earnings $ 80,600 $ 70,210 $ 118,408 Losses from discontinued operations, net ,638 Earnings from continuing operations 80,600 70, ,046 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization 96, , ,830 Deferred finance cost amortization 2,554 1,658 1,461 Deferred income taxes (12,832) (27,554) (15,331) Share-based compensation expense 8,062 10,605 9,341 Pension and postretirement expense 23,845 29,140 12,243 Losses (gains) on cash surrender value of company-owned life insurance 1,094 (6,199) 1,910 Gains on the sale of company-operated restaurants, net (61,125) (54,988) (78,642) Gains on the acquisition of franchise-operated restaurants (426) - (958) Losses on the disposition of property and equipment, net 7,650 10,757 11,418 Impairment charges and other 1,367 12,970 6,586 Loss on early retirement of debt Changes in assets and liabilities, excluding acquisitions and dispositions: Accounts and other receivables (26,116) (8,174) 3,519 Inventories (1,540) 284 7,596 Prepaid expenses and other current assets 19,163 (22,967) 11,496 Accounts payable 1,498 (2,219) (14,975) Pension and postretirement contributions (4,790) (24,072) (26,233) Other (10,891) (27,440) (13,983) Cash flows provided by operating activities from continuing operations 124,260 64, ,324 Cash flows provided by (used in) operating activities from discontinued operations - (2,172) 1,426 Cash flows provided by operating activities 124,260 61, ,750 Source: Jack In The Box, Inc. Form 10-K Annual Report to the Securities and Exchange Commission, October 2, 2011, p. F-5. An Investing Designation for Life Insurance Premiums We were able to identify several companies that report premiums on life insurance policies, to the extent those premiums increase the cash surrender value of the underlying policies, as investing cash flow. Such treatment would appear to be in keeping with generally accepted accounting principles for purposes of cash flow classification. But even if one were to view GAAP for cash flow classification of life insurance premiums as vague and not explicit, the spirit of ASC 230, the area of the accounting standards codification that addresses the statement of cash flows, strongly implies an investing classification. In the paragraphs that follow we provide five representative examples. The companies cited are Cobra Electronics Corp., Weyco Group, Inc., StellarOne Corp., Korn/Ferry International, Inc., and 3M Co. Technology, Atlanta, GA

13 Cobra Electronics Corp. On the balance sheet, under other assets, Cobra Electronics reports cash surrender value of life insurance in the amount of $5,056,000 at December 31, 2011 and $4,891,000 at 2010, respectively, increasing in value by the amount of $165,000 during In 2011, in the investing section of the statement of cash flows, the company reports premiums on the cash surrender of life insurance as a use of cash in the amount of $316,000. Then, in the operating section of the cash flow statement, the company reports a loss on the cash surrender value of its life insurance in the amount of $152,000. That loss in cash surrender value represents the excess of the premiums paid on the policies over the increase in the cash surrender value. That is, $316,000 in premiums paid less the loss in cash surrender value of $152,000, represents the net increase in cash surrender value of $165,000 (after a rounding difference of $1,000). In calculating net income, the company expensed the net premiums paid on the policies, reducing net income, by $152,000 (calculated as the $316,000 premium less the net increase in cash surrender value of $165,000, after the $1,000 rounding difference). When the $152,000 for the loss on cash surrender value was added back to net income in reconciling to operating cash flow, there remained no operating use of cash for the company s life insurance policies. The full premium paid, $316,000, was reported as an investing use of cash. In this case, it would appear that a better approach would have been to split the $316,000 in premiums paid between the operating and investing sections. The portion of the premium that did not result in an increase in the cash surrender value, $152,000, is more of an operating use of cash while the $165,000 increase in cash surrender value is more the investing portion of the premium. The company could have achieved this result by expensing the $316,000 in premium and netting the increase in cash surrender value, $152,000, against this premium in calculating net income, as it did, but with no other adjustment in the operating section of the cash flow statement. Then, it could report the $165,000 increase in cash surrender value resulting from the premiums paid as an investing use of cash. The operating and investing sections of the company s statement of cash flows are presented below. Technology, Atlanta, GA

14 CONSOLIDATED STATEMENTS OF CASH FLOWS Cobra Electronics Corporation Years Ended December 31, 2011, 2010 and 2009 (In Thousands) Cash flows from operating activities: Net earnings (loss) attributable to Cobra $ 3,087 $ 1,332 $ (10,867) Adjustments to reconcile net earnings (loss) to net cash flows from operating activities: Depreciation and amortization 3,805 3,936 3,883 Tax valuation allowance - - 8,382 Deferred income taxes (696) (341) 58 Loss (gain) on cash surrender value (CSV) life insurance 152 (574) (743) Stock-based compensation Loss on sale of assets Non-controlling interests (28) - 2 Changes in assets and liabilities: Receivables (1,377) (83) (3,943) Inventories (6,629) (1,750) 1,613 Other current assets 82 (1,363) (1,881) Income tax refunds 9 1, Other long-term assets (1,160) (643) (520) Accounts payable 152 (1,253) 4,673 Accrued income taxes (439) Accrued liabilities 2,088 (1) (108) Deferred compensation Deferred income (377) Other long-term liabilities 31 (449) 188 Net cash provided by operating activities 589 1,166 1,305 Cash flows from investing activities: Property, plant and equipment (1,154) (1,441) (1,095) Premiums on CSV life insurance (316) (266) (274) Net cash used in investing activities (1,470) (1,707) (1,369) Source: Cobra Electronics Corp., Form 10-K Annual Report to the Securities and Exchange Commission, December 31, 2011, p. 37. Weyco Group, Inc. Within other assets, Weyco Group reports the cash surrender value of life insurance in the amount of $12,055,000 and $11,372,000 at December 31, 2011 and 2010, respectively, an increase of $683,000. In the operating section of the company s statement of cash flows, $527,000 is subtracted in reconciling net income to operating cash flow for Then, in the investing section of the cash flow statement for 2011, the company reports a $155,000 use of cash for life insurance premiums paid. In this example, the cash surrender value of the company s policies increased by $527,000 more than the premiums paid. The company included that $527,000 in income but removed it in reconciling net income to operating cash flow. Finally, the actual premiums paid on the policies, $155,000, which also increased their cash surrender value, was properly reported as an investing use of cash. There is a rounding difference of $1,000. Excerpts from the company s statement of cash flows are presented below. Technology, Atlanta, GA

15 CASH FLOWS FROM OPERATING ACTIVITIES: WEYCO GROUP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS For the years ended December 31, 2011, 2010 and Net Earnings (Dollars in thousands) $ 16,441 $ 14,126 $ 13,070 Adjustments to reconcile net earnings to net cash provided by operating activities Depreciation and Amortization 2,844 2,816 3,041 Bad debt expense Deferred income taxes (343) 503 (18 ) Net foreign currency transaction losses (gains) 197 (400 ) (1,339 ) Stock-based compensation 1,224 1, Pension contribution (1,600) (1,500 ) (1,000 ) Pension expense 2,836 3,248 2,986 Net gains on sale of marketable securities (346) Net (gains) losses on disposal of assets (14) Impairment of property, plant and equipment ,110 Increase in cash surrender value of life insurance (527) (515 ) (507 ) Change in operating assets and liabilities, net of effects from acquisitions Accounts receivable (1,267) (4,642 ) 2,286 Inventories (3,667) (14,889 ) 15,758 Prepaids and other current assets (752) (681 ) (1,153 ) Accounts payable 2,141 1,031 (231 ) Accrued liabilities and other (1,089 ) Accrued income taxes (932) (1,142 ) 3,467 Net cash provided by operating activities 17, ,902 CASH FLOWS FROM INVESTING ACTIVITIES: Acquisition of businesses, net of cash acquired (27,023) (2,638 ) (9,320 ) Purchase of marketable securities (1,179) (22,762 ) (8,073 ) Proceeds from maturities and sales of marketable securities 12,963 6,375 7,273 Proceeds from the sale of assets 14 Life insurance premiums paid (155) (155 ) (155 ) Purchase of property, plant and equipment (8,189) (1,510 ) (1,316 ) Net cash used for investing activities (23,569) (20,690 ) (11,591 ) Source: Weyco Group, Inc. Form 10-K Annual Report to the Securities and Exchange Commission, December 31, 2011, p. 29. Depreciation and amortization were combined for brevity. Technology, Atlanta, GA

16 StellarOne Corp. StellarOne includes income from its bank-owned life insurance policies as a component of noninterest income, increasing net income. The company s breakdown of noninterest income is provided below. Noninterest Income Retail banking fees 15,291 16,237 16,367 Commissions and fees from fiduciary activities 3,386 3,264 2,960 Brokerage fee income 1,560 1,492 1,203 Mortgage banking-related fees 8,186 9,388 7,382 Losses on mortgage indemnifications and repurchases (232) (2,265) (1,098) Gain on sale of financial center Gains (losses) on sale of premises and equipment (76) Impairments of equity securities available for sale - (110) (2,525) Gains on sale of securities available for sale 509 1, Losses on sale / impairment of foreclosed assets (1,149) (1,147) (1,810) Income from bank owned life insurance 1,298 1,296 1,292 Other operating income 2,533 2,899 2,400 Total noninterest income $ 31,466 $ 33,269 $ 26,140 Source: StellarOne Corp., Form 10-K Annual Report to the Securities and Exchange Commission, December 31, 2011, p. 49. In the operating section of the statement of cash flows, the company subtracts from net income the income from its bank-owned life insurance in reconciling net income to operating cash flow. Then, in the investing section of the cash flow statement, the company reports a $10,000,000 premium paid on its life insurance policies as an investing use of cash. This treatment suggests that the cash surrender value of the company s life insurance policies increased during 2011 by $11,298,000 in total. The premium increased the cash surrender value by $10,000,000 and income on the policies in place increased the cash surrender value by an additional $1,298,000. The operating and investing sections of the company s statement of cash flows are presented below. Technology, Atlanta, GA

17 STELLARONE CORPORATION AND SUBSIDIARY Consolidated Statements of Cash Flows For the Years Ended December 31 (In Thousands) Cash Flows from Operating Activities Net income (loss) $ 15,885 $ 9,765 $ (8,530) Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 6,492 6,801 6,283 Amortization of intangible assets 1,651 1,651 1,730 Provision for loan losses 12,700 22,850 37,800 Deferred tax expense (benefit) 2, (3,195) Employee benefit plan expense (benefit) (25) Stock-based compensation expense Losses / impairments on foreclosed assets 1,149 1,147 1,810 Losses on mortgage indemnifications and repurchases 232 2,265 1,098 (Gains) losses on sale of premises and equipment (84) (199) 76 Gain on sale of financial center - (748) - Gains on sale of securities available for sale (509) (1,268) (45) Impairments of equity securities available for sale ,525 Mortgage banking-related fees (8,186) (9,388) (7,382) Proceeds from sale of mortgage loans 424, , ,326 Origination of mortgage loans for sale (406,487) (524,787) (578,347) Amortization of securities premiums and accretion of discounts, net 1,593 1,672 (1,206) Income on bank owned life insurance (1,298) (1,296) (1,292) Changes in assets and liabilities: Decrease in accrued interest receivable Decrease (increase) in other assets 7,995 6,201 (14,797) Decrease in accrued interest payable (156) (1,348) (1,850) Increase (decrease) in other liabilities 1,364 (4,210) (1,976) Net cash provided (used) by operating activities $ 60,318 $ 37,085 $ (8,742) Cash Flows from Investing Activities Proceeds from maturities, calls and principal payments of securities available for sale $ 129,617 $ 127,279 $ 119,045 Proceeds from sales of securities available for sale 13,836 29,469 2,602 Purchase of securities available for sale (231,318) (159,561) (170,614) Proceeds from maturities and principal payments of securities held to maturity Net decrease in loans 43,226 47,732 47,104 Purchase of bank owned life insurance policy (10,000) - - Proceeds from sale of premises and equipment 145 1,014 1,161 Purchase of premises and equipment (3,680) (3,333) (4,163) Proceeds from sale of foreclosed assets 8,030 6,516 2,978 Net cash (used) provided by investing activities $ (50,144) $ 49,541 $ (1,887) Source: StellarOne Corp., Form 10-K Annual Report to the Securities and Exchange Commission, December 31, 2011, p. 49. Technology, Atlanta, GA

18 Korn/Ferry International, Inc. Korn/Ferry International, Inc. reports the cash surrender value of its company-owned life insurance policies net of any borrowings on those policies as a noncurrent asset. The company provides the following description of its accounting policy, Cash Surrender Value of Company Owned Life Insurance Policies, Net of Loans As of April 30, 2011 and 2010, we held contracts with gross CSV of $143.9 million and $136.0 million, respectively. Generally, we borrow under our COLI contracts to pay related premiums. Such borrowings do not require annual principal repayments, bear interest primarily at variable rates and are secured by the CSV of COLI contracts. Total outstanding borrowings against the CSV of COLI contracts were $72.9 million and $66.9 million as of April 30, 2011 and 2010, respectively. At April 30, 2011, the net cash value of these policies was $71.0 million of which $57.6 million was held in trust. 9 The company is clear in its cash flow treatment of the premiums on its life insurance policies. The payments are reported as investing uses of cash in the amounts of $1,702,000, $1,711,000 and $1,781,000, respectively, in 2011, 2010 and The operating and investing sections of the company s statement of cash flows are provided below. In 2011, in the operating section, the company subtracts a gain on cash surrender value of life insurance policies of $6,246,000 from net income in calculating cash provided by operating activities. Then in the investing section for 2011 the company reports premiums on its life insurance policies paid in the amount of $1,702,000. The sum of the gain on cash surrender value of $6,246,000 plus the premiums paid of $1,702,000, or $7,948,000, equals the actual increase in gross cash surrender value of the policies in 2011 (i.e., $143,900,000 in 2011 less $136,000,000 in 2010, adjusted for rounding). Note that cash provided by borrowings against the cash surrender value of the company s life insurance policies in the amount of $6,039,000 in 2011 was reported in the financing section of the statement of cash flows and is not shown here. 9 Korn/Ferry International, Inc. Form 10-K Annual Report to the Securities and Exchange Commission, April 30, 2011, p. 34. Technology, Atlanta, GA

19 KORN/FERRY INTERNATIONAL AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended April 30, (In thousands) Cash flows from operating activities: Net income (loss) $ 58,874 $ 5,298 $ (10,092) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation and amortization 12,671 11,493 11,583 Stock-based compensation expense 15,547 17,729 16,301 Impairment of intangible assets 880 Loss on disposition of property and equipment ,740 Provision for doubtful accounts 7,650 3,340 9,127 (Gain) loss on cash surrender value of life insurance policies (6,246) (9,558) 3,578 Gain on marketable securities classified as trading (7,599) (11,137) Change in fair value of acquisition-related contingent consideration (4,919) Realized loss on available-for-sale marketable securities 5,040 Other-than-temporary impairment on available-for-sale securities, net of unrealized gains reclassified to other income upon the transfer of available-for-sale securities to trading 9,967 Deferred income taxes 5,954 (20,862) (4,354) Change in other assets and liabilities: Deferred compensation 11,716 15,828 (3,085) Receivables (28,140) (33,516) 44,639 Prepaid expenses (6,496) (4,198) (1,340) Investment in unconsolidated subsidiaries (1,862) (91) (2,365) Income taxes payable (1,686) 2,844 (18,909) Accounts payable and accrued liabilities 40,109 (783) (82,236) Other (899) (7,556) 21,577 Net cash provided by (used in) operating activities 95,634 (30,846) 3,171 Cash flows from investing activities: Purchase of property and equipment (27,889) (7,282) (11,947) Purchase of intangible assets (3,481) Purchase of marketable securities (65,964) (4,163) (23,449) Proceeds from sales/maturities of marketable securities 28,618 13,374 19,345 Change in restricted cash (10,007) Cash paid for acquisitions, net of cash acquired and contingent consideration (18,734) (12,900) Payment of contingent consideration from acquisitions (5,795) (2,405) Premiums on life insurance policies (1,702) (1,711) (1,781) Dividends received from unconsolidated subsidiaries 1, ,952 Net cash used in investing activities (81,131) (23,444) (27,780) Source: Korn/Ferry International, Inc., Form 10-K Annual Report to the Securities and Exchange Commission, December 31, 2011, p. F-8. April 30, M Co. 3M Co. nets changes in the cash surrender value of its life insurance policies against premiums paid. Cash flows related to its policies, whether inflows or outflows, are reported as investing cash flow. In its financial statements, 3M Co. writes, Other assets: Other assets include deferred income taxes, product and other insurance receivables, the cash surrender value of life insurance policies, and other long-term assets. Technology, Atlanta, GA

20 Investments in life insurance are reported at the amount that could be realized under contract at the balance sheet date, with any changes in cash surrender value or contract value during the period accounted for as an adjustment of premiums paid. Cash outflows and inflows associated with life insurance activity are included in Purchases of marketable securities and investments and Proceeds from sale of marketable securities and investments, respectively. 10 The operating and investing sections of the company s statement of cash flows are provided below. There are no apparent adjustments to net income for increases or declines in the cash surrender value of the company s policies. It is likely that such adjustments, if any, would be too small to be reported separately on the company s statement of cash flows. Note the inclusion of Purchases of marketable securities and investments and Proceeds from sale of marketable securities and investments in the investing section of the cash flow statement. (Millions) Consolidated Statement of Cash Flows 3M Company and Subsidiaries Years ended December Cash Flows from Operating Activities Net income including noncontrolling interest $ 4,357 $ 4,163 $ 3,244 Adjustments to reconcile net income including noncontrolling interest to net cash provided by operating activities Depreciation and amortization 1,236 1,120 1,157 Company pension and postretirement contributions (582) (618) (792) Company pension and postretirement expense Stock-based compensation expense Deferred income taxes 177 (170) 701 Excess tax benefits from stock-based compensation (53) (53) (14) Changes in assets and liabilities Accounts receivable (205) (189) 55 Inventories (196) (404) 453 Accounts payable (83) Accrued income taxes (current and long-term) (45) 255 (147) Product and other insurance receivables and claims Other net (139) 279 (329) Net cash provided by operating activities 5,284 5,174 4,941 Cash Flows from Investing Activities Purchases of property, plant and equipment (PP&E) (1,379) (1,091) (903) Proceeds from sale of PP&E and other assets Acquisitions, net of cash acquired (649) (1,830) (69) Purchases of marketable securities and investments (4,162) (3,287) (2,240) Proceeds from sale of marketable securities and investments 1,679 1, Proceeds from maturities of marketable securities 1,738 1, Other investing (3) 5 Net cash used in investing activities (2,718) (2,626) (1,732) Source: 3M Co., Form 10-K Annual Report to the Securities and Exchange Commission, December 31, 2011, p The 3M Co., Form 10-K Annual Report to the Securities and Exchange Commission, December 31, 2011, p. 51. Technology, Atlanta, GA

21 Concluding Comments Generally accepted accounting principles do not specifically address the cash flow classification of premiums on company-owned life insurance policies. Our review of annual financial statement filings with the Securities and Exchange Commission indicates that many firms are classifying those premiums as an operating use of cash. An operating designation is afforded those premiums even when they serve to increase the cash surrender value of the underlying policies. Such treatment appears to be contrary to the spirit, if not the letter, of generally accepted accounting principles. Because the Accounting Standards Codification views the cash surrender value of a life insurance policy as an investment, an investing classification for cash payments made to increase that cash surrender value would appear to be more appropriate. We were able to identify firms who employ an investing classification for life insurance premiums. Such classification appears to be more in keeping with the spirit of the Accounting Standards Codification for cash flow classification and could be characterized as a best-practices approach. More specifically, for a policy year in which the premium paid exceeds the increase in cash surrender value, we would recommend that companies expense the premium on life insurance and adjust the expense downward for any increase in cash surrender value on the underlying policies as is currently done in practice. However, on the statement of cash flows we would not make an adjustment in reconciling net income to operating cash flow, in effect reporting the net premium, the premium in excess of the increase in cash surrender value, as an operating use of cash. We would then report the increase in cash surrender value as an investing use of cash. In effect, the premium paid on the policy would be separated into two parts. The portion that represents the premium in excess of the increase in cash surrender value would be reported as an operating use of cash. The portion of the premium that represents an increase in cash surrender value would be reported as an investing use of cash. On the cash flow statement for a policy where the increase in cash surrender value exceeds the premium paid, boosting income, we would subtract from net income the increase in cash surrender value in excess of the premium paid and report as an investing use of cash the full premium paid on the policy. There is the issue of the cash flow classification of redemptions of life insurance policies. We think that an investing classification for proceeds received from life insurance policies is appropriate, provided the redemption amounts do not exceed the cumulative premiums paid on the policies. Such proceeds would be viewed as a return of investment. If amounts redeemed from the policies exceed premiums paid, then those redemption amounts would considered to be a return on investment and an operating designation would appear to be the appropriate classification. Corporate managers as well as financial analysts and investors should be concerned with how life insurance premiums are being classified. When premiums that should be classified as investing cash flow are instead reported as operating cash flow, measures of the all-important operating cash flow and free cash flow metrics are unduly understated, potentially leading to lower assessments of firm value. Similarly, when policy proceeds are included in operations, operating cash flow and free cash flow are likely overstated. The objective of this research report is to raise the awareness of corporate managers, analysts, and investors to the diversity in practice we are witnessing in the classification of life insurance Technology, Atlanta, GA

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