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Business & Money

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

that the value of the acquired assets on Mirant's balance sheet should have reflected their market value on the date of acquisition. The essence of the contract was that Mirant was paying PEPCO for assets acquired partially with cash and partially through future power sales to PEPCO at a discount. The amount paid at the time of acquisition of the assets, not the total cost recorded on the balance sheet for those assets, was reported as an investing cash outflow on the Statement of Cash Flows. The non-cash portion of the purchase was presumably included in Mirant's reported non-cash acquisitions at the bottom of its 2000 Statement of Cash Flows as a supplemental disclosure.

In periods subsequent to the acquisition, the power that Mirant sold to PEPCO would have been sold at market were it not for the lower, fixed-price agreement associated with the acquisition. The as-if accounting effect of the sale of power at a fixed discounted price was that power was sold to PEPCO at an amount equal to the forward market price on the date of the acquisition transaction, and a portion (the difference between the forward market and the fixed price) of the proceeds reduced the liability from the acquisition. Mirant actually (and appropriately) recognized revenues equal to the original forward market value of the power delivered to PEPCO, recognized the actual cash received from the sale of power to PEPCO at the fixed price, and decreased the previously recorded liability for the difference.

The sale of power to PEPCO was clearly an operating activity; however, cash was received only for the fixed price amount, not the amount recognized as revenues that reflected the original forward market rates. In the operating section of its Statement of Cash Flows, Mirant was required to make an adjustment subtracting from net income the difference between the revenue recorded and the cash received, or the amount by which the liability was reduced. As a result of Mirant's reporting operating cash flows for the amount received from PEPCO, rather than the amount that could have been received based on the original forward market rates, its reported cash flows from operating activities provided too low an estimate of the assets' ability to generate cash flow on a sustained basis. A remedy for this would be to identify and classify the non-cash adjustment in the operating section of the Statement of Cash Flows in such a way that it would be included in the determination of estimated sustainable cash flows.

There is one more consideration, however, which ought to affect the reporting of this transaction. Both spot and forward electricity prices in PJM have fallen dramatically since Mirant acquired these assets. Mirant's reported net income and cash flow have not been affected by this decline. Net income was effectively hedged through the accounting described above; cash flow was hedged by the forward contract with PEPCO. However, the current and likely future (using forward prices as estimates) ability of the acquired assets to generate cash has dropped dramatically. Unfortunately, it would be very difficult to reflect