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Business & Money

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

markets, they have required vertically integrated, regulated utilities to sell their generating assets. In order to protect retail customers from the near term uncertainty of electricity prices created by the introduction of competition, regulators have sometimes required buyers of the generating assets to provide multi-year contracts with distribution companies (unfortunately, California did not). These contracts have sometimes deliberately been set at below-market rates as part of the political bargain over the terms of moving from regulation to competition, with an offsetting reduction in the cost of the assets acquired.

Even when there is an attempt to follow market prices, the passage of time between the setting of these prices and the closing of the generation divestiture program can be many months, so that prices differ from market at the actual acquisition date.

  1. Financial Accounting Standards Board (FASB). 1987. Statement of Cash Flows. Statement of Financial Accounting Standards No. 95 (FAS 95), Norwalk, CT: FASB.
  2. Fraud is possible. The Wall Street Journal of March 21, 2003, reported that Health South Corp. had apparently deliberately overstated its cash balances by $300 million.
  3. Of course, if the accounting department is doing its job there will be further testing to ensure that the residual is reasonably related to the various components that compose cash from operating activities.
  4. See, for example, Standard and Poor's "Corporate Ratings Criteria" (undated) or Moody's "Financial Ratio Medians For Global Investment Grade Corporates," January 2001.


Case Study: Mirant Cash Flows Mask Drop in Future Earnings

The recent fall in PJM electricity prices has hurt Mirant's ability to generate cash with the PEPCO assets it acquired. Yet the clouded future economic prospects of these plants are nowhere to be found in the statement of cash flows.

In December 2000, Mirant acquired approximately 5,000 MW of generating capacity from Potomac Electric Power Company (PEPCO). PEPCO was then transformed into a distribution company serving retail customers. Mirant was the high bidder in an auction for PEPCO's assets. The terms of the auction included a requirement that the successful bidder agree to sell power back to PEPCO for a four-year period at a fixed price. This was essentially a forward contract obligation.

Both at the time of the bid and at the closing of the transaction the fixed price was significantly below market-in terms of both spot and forward prices over the contract period. The annual amount of the out-of-the market portion of the forward obligation to PEPCO was in the range of $500 million for the four-year period.

Mirant, like any bidder, would have bid a price reflecting its estimate of the value of the power plants less the discounted value of the expected out-of-market component of the forward obligation, presumably using forward prices as the best measure of expected value. The purchase accounting treatment was consistent with this economic valuation: a liability was recorded for the estimate of the discounted present value of the out-of-the market component of the forward contract. The power generating assets were recorded at a value equal to Mirant's purchase price plus the amount of that liability. The result was