[BETA] Fortnightly

Cash flow reporting is more susceptible to manipulation than investors imagined.

Financial results are the prism through which investors view performance in the world of business. Companies may have tens of thousands of employees supplying tangible goods and services to customers, but real and diverse activities are reduced to relatively few numbers when companies are valued.

"Cash flows from operating activities" is a term defined by accountants, and like many terms in accounting, there's some degree of subjectivity involved in applying the definition to the actual preparation of a company's financial statements. That subjectivity opens up the possibility of a lack of clarity in the information being reported-or, perhaps, intentional distortion of that information.

For example, the calculation of operating cash flow or funds from operations, as some call it, can vary from financial analyst to financial analyst, agency to agency, and even from industry to industry.

Wall Street analysts typically use EBITDA (earnings before interest, taxes, depreciation, and amortization) when they focus on a company's cash flow. Unfortunately, calculation of EBITDA varies from company to company. Although the SEC permits companies to report EBITDA in their periodic public filings, provided they include a clear explanation of the differences between it and net income, it may not be included in the generally accepted accounting principles (GAAP) statement of cash flows. In any event, EBITDA is an incomplete measure of sustainable cash flow because it excludes taxes and often includes significant non-cash components of net income.

This problem can be addressed by increasing the level of detail and the quality of discussion of the results presented. The SEC, with a big push from Congress, appears to be following this path.

Whatever improvements in detail and analysis are achieved in future reporting, there will be a significant handicap to overcome: the accountants' definition does not correspond to what non-accountants, even financially literate non-accountants, understand by "operating cash flow."

Some fairly simple changes to the structure of the statement of cash flows would bring more clarity to the transmission of information about sustainable cash flow and more discipline to management's reporting of cash. The simplest change would be to separate changes (normal and abnormal) in working capital from the other items in cash from operating activities. This change would induce better discussion of this item in the Management Discussion and Analysis (MD&A), especially to distinguish business-driven changes in working capital from changes driven by financial condition or extraordinary events.

One additional change would be to allow the statement to separate the effect of out-of-market and other adjustments that, in management's judgment, are required to present a fairer view of sustainable cash flow. This would show that the classification of items between "operating" on the one hand, and "financing" or "investing" on the other, is better thought of as relating to a spectrum rather than belonging to idealized classifications. It would also reduce the temptation to "cheat" by engaging highly structured transactions like Dynegy's prepays. With these additions the statement of cash flows would appear as seen in the box on page 22.

This proposed change