Interest paid - Cash flow from operating or financing activity
December 12, 2016

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Cash flow statement is divided into three sections – cash flow from operations, cash flow from investing activity and cash flow from financing activity. Cash flow from operations is prepared according to direct and indirect method.

As per indirect method:

CFO = Net income + non operating items + noncash items + Change in working capital

It seems very logical that interest paid is a part of financing activity (cost of debt). But the accounting standards have some different opinion on that.

US GAAP categorize interest paid as operating activity and disclose interest paid amount under supplementary information.

As per IFRS, interest paid should be classified in a consistent manner as either operating or financing activities.

Interest paid under operating activity:

Perhaps the reason is, Interest expense(accrued portion) is charged in income statement/net income. Under indirect method, operating activity section begins with net income. Therefore, accrued portion of interest is already included in CFO. Interest is paid to creditor and creditor amount changes due to accrued portion of interest and the payment of interest. Any changes in creditor amount appear in CFO as changes in interest payable/creditors under working capital adjustments. Therefore, difference in interest paid and interest expense (accrued portion) get attuned under working capital change. Thus payment of interest paid is included in CFO because no further adjustments are required.

Maybe the other reason is, debt is employed for operating activity like purchase of property plant equipment or payment of operating expense etc. Therefore, interest paid is reflected as a part of operating activity.

Interest paid under financing activity:

Financing activity includes items relating to raising money for operations. This includes items related to issuance/repayment of debt Sale/repurchase of stock etc. Since, interest is the cost of debt and paid because of debt issuance, therefore it is assumed to be a part of financing activity.

Note: Indian GAAP classify interest paid as financing activity only and thus interest expenses is added back while calculating CFO and CFF is calculated after deducting interest payment.

Disclaimer - It's just an educated guess. I do not work for the FASB or have access to the research, discussions and debates.