Question

ABC Energy Corp. (the “Company”), an SEC registrant, operates three manufacturing facilities in the United States. The Company manufactures various household cleaning products at each facility, which are sold to retail customers. The U.S. government granted the Company emission allowances (EAs) of varying useable years (i.e., the years in which the allowance may be used) to be used between 2015 and 2030. Upon receipt of the EAs, the Company recorded the EAs as intangible assets with a cost basis of zero, in accordance with the Federal Energy Regulatory Commission (FERC) accounting guidance for EAs. The Company has a fiscal year end of December 31.

As background, in an effort to control or reduce the emission of pollutants and greenhouse gases, governing bodies typically issue rights or EAs to entities to emit a specified level of pollutants. Each individual EA has a useable year designation. EAs with the same useable year designation are fungible and can be used by any party to satisfy pollution control obligations. Entities can choose to buy EAs from, and sell EAs to, other entities. Such transactions are typically initiated through a broker. At the end of a compliance period, participating entities are required to either (1) deliver to the governing bodies EAs sufficient to offset the entity's actual emissions or (2) pay a fine. The Company currently emits a significant amount of greenhouse gases because of its antiquated manufacturing facilities. The Company plans to upgrade its facilities in 2024, which will decrease greenhouse gas emissions to a very low level. On the basis of the timing of the upgrade, the Company currently anticipates a need for additional EAs in fiscal years 2020–2024.

However, upon completion of the upgrade, the Company believes it will have excess EAs in fiscal years subsequent to 2024 because of reduced emissions as a result of the upgrade. The Company currently has forecasted the updates to its facilities will cost approximately $15 million. As the Company operates in a capital intensive industry, analysts and investors focus on a number of important ratios and measures, including working capital, capital expenditures, cash flows from operations, and free cash flow. As a result, the board of directors and management provide forward-looking guidance on these ratios and measures and expend great effort managing these results in light of the Company’s operational needs. The Company entered into the following two separate transactions in fiscal year 2020, which will impact the Company’s results as presented in the statement of cash flows, which the Company prepares under the indirect method.

          1. To meet its need for additional EAs in fiscal years 2020–2024, on April 2,         2020, the Company spent $6.5 million to purchase EAs with a useable year of       2023 from XYZ Manufacturing Corp.

2. In an effort to offset the costs of the April 2, 2019, purchase of 2023 EAs, the Company sold EAs with a useable year of 2026 to DEF Chemical Corp. for $5 million.

Required:

1. What is the appropriate classification in the statement of cash flows in the Company’s December 31, 2020, financial statements for its purchase of 2023 EAs from XYZ Manufacturing Corp.?

2. What is the appropriate classification in the statement of cash flows in the Company’s December 31, 2020, financial statements for its sale of 2026 EAs to DEF Chemical Corp.?

3. Should these cash flows be reported at gross amounts or net amounts in the 2020 statement of cash flows?

Be sure to cite appropriate authoritative support for your answer from the Accounting Standards Codification.

Answer 1

Step-by-step explanation

As per the given scenario,

1. The company bought emission allowances (EAs) for vintage year 2020, in order to offset the emissions during the year 2020-2024. These emission allowances are given by the government to offset the extra emissions which are caused by the manufacturing unit with an objective of preserving the nature. The purchase transaction of these emission allowances will result in benefit to the company in the future years. As they bear future economic benefits for the company, they are classified by the company as intangible assets as per the standards and the norms of the FERC accounting guidance for emission allowances. The cash flow activity of the purchases made would be classified under the investing activities. This occurs because the company has made cash outflow to gain future economic benefits in an asset.

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2. The company is under plans of up-gradation of the manufacturing unit by 2024. The upgraded plant will emit less greenhouse gases and the limits will not be crossed which is set by the law. It will lead to excessive emission allowances with the company. These emission allowances can be sold to another company in need of the same as per the law. During the financial year 2020, the company bought emission allowances for 2020-2024. The company sold emission allowances for the vintage year 2026. Since the company does not own the intangible asset which it has sold i.e. EAs for 2026 vintage year, the company has created a liability. This cash outflow should be categorized under the financing activity because there was no investment in the book yet which was sold to DEF Chemical CorpCompany.

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3. These cash flows should be reported at net amounts in the statement of cash flows for the financial year 2020.