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Business & Money

Cash flow reporting is more susceptible to manipulation than investors imagined.
Fortnightly Magazine - May 15 2003

in the structure of the operating section of the statement of cash flows, along with other supplemental disclosures suggested in this article, would better enable users of financial statements to identify items that are relevant to the determination of a firm's sustainable cash flow from operations. These are fairly simple changes that would enhance the usefulness of the statement of cash flows.

A bigger question is whether the accounting profession needs to take a fresh look at what definition of fund flows (cash, net monetary assets, net working capital, etc.) is most relevant to users of financial statements. Accounting measures always will fail to describe adequately concepts of economic value.

The current GAAP definition of cash flows from operating activities, though, is so far from intuitive expectations as to be misleading, and there are no other well-defined GAAP measurements that can substitute. This situation is further complicated by the fact that, although management can add more detail and analysis to its reporting, the current bias is very much against non-GAAP terminology in reporting. Consequently, we would have GAAP change to allow managers to communicate with financial statement users more effectively or, at the least, not provide statements bearing the GAAP imprimatur that might mislead investors.

In the Eye of the Storm: Cash Flow Anointed King

As the accounting scandals were revealed in 2001 and 2002, financial analysts and investors increasingly turned their scrutiny from the income statement to the statement of cash flows. For several years, academic accounting and financial economic research has found the difference between the two-revenue and expense accruals-to be an important source of net income manipulation. Cash flow from operations, consequently, has come to be seen by many as the preferred basis for evaluation of corporate performance and valuation. After all, it is the basis of the present-value calculation, which is the fundamental concept of firm value.

This increased attention to cash was particularly strong in the merchant energy industry, where mark-to-market (or mark to fair value) accounting seemed to give management license to define income using standards that lacked transparency, and which brought transactions with risky, distant payouts into current income.

As investors' worries increased over the use of "creative accounting" to generate earnings on the Income Statement, they hoped to rely on the statement of cash flows as a less subjective measure of corporate performance than income.

We argue: (1) reliance on operating cash flows has been misplaced in many instances, because the GAAP statement of cash flows (under the Financial Accounting Standards Board [FAS] 95) 1 is more susceptible to manipulation than most investors have imagined; and (2) the architecture of the statement of cash flows is not conducive to transmitting the kind of information investors require or, indeed, to meeting the purposes defined in FAS 95.

The Relevance and Construction of the Statement of Cash Flows Total cash on a company's balance sheet is clear (in the absence of outright fraud), 2 provided there are adequate disclosures that separate cash freely available to the company from restricted cash. Although this is an important piece