Creative cash flow reporting refers to any and all steps used to create an altered impression of operating cash flow and, in the process, provide a misleading signal of a firm’s sustainable cash-generating ability. Steps employed to misrepresent a firm’s sustainable cash-generating ability may employ reporting flexibility within the boundaries of GAAP. Alternatively, steps may be taken that extend beyond the boundaries of GAAP. Finally, amounts may be reported properly as operating cash flow but do not have the sustainable qualities normally expected of operating cash flow. Clearly the adjective “creative” is used here in a pejorative sense. This post provides some overview [with examples] of how cash flow reported in a creative manner misrepresents sustainable cash flow.

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The Motivation Behind Creative Cash Flow Reporting

Managers are well aware of the importance placed by analysts, investors, and creditors on operating cash flow. Cash flow is the life-blood of any organization. A boost in operating cash flow, even as total cash flow remains unchanged, communicates enhanced financial performance. Consider, for example, the hypothetical cash flow statements presented in below figure:
                                                                            Statement 1     Statement 2

Cash provided (used) by operating activities      =  $(14,000)        $ 44,000
Cash (used) by investing activities                     =    (36,000)          (66,000)
Cash provided by financing activities                 =     60,000            32,000
Increase in cash                                                  =   $ 10,000         $ 10,000

 

As reported in both statements, cash on hand increased $10 million.

However:

  • in Statement 1, the company consumed $14 million in cash from operations. Those operating cash needs together with cash needs for investing activities of $36 million were covered with new financing cash flow in the amount of $60 million.
  • In Statement 2, the company generated positive operating cash flow of $44 million.
    The company invested $66 million in the business and obtained $32 million in new financing to help meet its cash flow needs.

 

The company represented by Statement 2 is doing a better job of generating what would appear to be sustainable cash flow. That company is apparently investing more heavily and relying less on new financing to support its operating and investing activities.

What we now know, however, is that the company represented by Statement 2 may be no different from the company represented by Statement 1. For example: proceeds from the sale of investments may have been used to boost operating cash flow. Similarly, proceeds from new borrowings may also have been reported as operating cash flow. The net result is the appearance of improved financial performance.

In the absence of careful scrutiny, this apparent improvement in financial performance might have a positive impact on a firm’s share price, its borrowing costs, and the incentive compensation paid its executives:

  • Share Price Effects – As expectations for sustainable cash flow are increased, so is the present value of that cash flow stream, boosting share-price prospects. Share prices can be influenced to the extent that managers can increase the perception, and not the reality, that their firm is generating more sustainable cash flow. This point was not lost on the executives at companies such as Dynegy, Inc., and Enron Corp. Their managers went to extraordinary lengths to boost operating cash flow in an effort to increase or maintain their share prices. Executives may also have an incentive to report less volatile cash flows, imparting an impression of lower firm risk. The perception of lower risk could move investors to lower their risk-adjusted discount rates. Lower discount rates would boost the present value of future cash flows and potentially raise share prices.
  • Borrowing Cost EffectsInterest and principal on loans are repaid with cash flow. Increases in operating cash flow may translate into perceived improvements in debt-service capacity. The net effect may translate into higher borrowing capacity, lower interest costs, less onerous loan covenants, fewer guarantees, or, possibly, less loan collateral.
  • Incentive Compensation EffectsTo the extent that steps taken to boost operating cash flow translate into higher share prices, managers compensated with stock options will enjoy increased compensation. Beyond such equity-based arrangements, however, some managers may be paid cash bonuses linked directly to improvements in earnings or in operating cash flow. Consider Tyco International, Ltd., a company that has been accused of artificially boosting operating cash flow. As described below, the company’s bonus plan was based, at least in part, on improvements made in operating cash flow: The cash bonus for the Chief Executive Officer and the Chief Financial Officer has two performance based criteria: (i) increase in earnings before non-recurring items and taxes and (ii) improvement in operating cash flow.

 

Adjustments for Sustainable Cash Flow

All of the factors highlighted in this section can and do lead to misleading operating cash flow amounts. These factors consist of:

  • Using GAAP flexibility in cash flow classification
  • Taking actions that extend beyond the boundaries of GAAP
  • Benefiting from nonrecurring sources of operating cash flow
  • Reporting taxes related to non-operating items as operating cash flow

 

Reported operating cash flow should be adjusted for all of these items in determining sustainable cash flow.

 

GAAP Flexibility [Is It Operating or Investing Cash Flow?]

Generally accepted accounting principles are reasonably clear in their definition of operating cash flow. There is, however, considerable flexibility permitted in its calculation. Some firms have demonstrated a willingness to ply this flexibility in an effort to boost amounts reported as operating cash flow. Although such steps raise operating cash flow, they do not increase sustainable cash flow.

Examples of cash flow classified as investing activities include both capital expenditures made to boost future operating cash flows and cash parked in debt and equity securities awaiting future needs. Except for capital expenditures that are included in the calculation of free cash flow, cash provided or used in investing activities is not considered to have the same recurring quality as operating cash flow.

Accordingly, to the extent that creative steps can be taken to boost operating cash inflows by increasing investing cash outflows, an appearance can be communicated of a strengthened cash-generating capability. Two areas for such a cash flow misclassification that are representative of the opportunities afforded by the flexibility found in GAAP are investments classified as trading securities and capitalized operating costs. A third area, acquisitions, can also use investing activities to creatively boost operating cash flow.

 

Creative Cash Flow #1: Investments Classified as Trading Securities

Investments in debt and equity securities may be classified as held for trading purposes or as available for sale. In addition, because they have fixed maturity dates, a third classification, held to maturity, can also apply to debt securities. As the title suggests, trading securities are held to take advantage of very short-term price swings. Holding periods are very short, at times possibly even less than a day. Debt securities that are classified as held to maturity are investments for which a firm has the intent and ability to hold until maturity. The plan is to collect the debt instrument’s principal amount at maturity. All other investments are classified as available for sale, a default classification that can include both short-term and long-term investment positions.

The classification of investments as trading, held to maturity, or available for sale directly affects the classification of cash flows associated with their purchase or sale. When investments are classified as held to maturity or available for sale, the use of cash in their purchase or the proceeds generated by their sale are classified as cash flow from investing activities. In contrast, cash used to purchase or cash provided by the sale of investments classified as trading securities is reported as operating cash flow.

Rules for classifying investments as trading, held to maturity, or available for sale are malleable. This flexibility provides an opportunity for companies to alter reported operating cash flow. For example, cash flows associated with investments in short-term debt instruments classified as held to maturity would be reported as investing cash flow.

However, changing their classification to trading would result in the same cash flows being classified as operating cash flow.

Financial institutions—companies such as banks, insurance companies, and brokerage firms—routinely trade financial instruments. It is part of what they do. Cash flows associated with this activity are properly included with operating cash flow. However, when nonfinancial companies classify investments as trading securities, cash used to purchase the investments or cash provided by their sale does not fit the operating designation. At a minimum, such cash flows are not sustainable and will stop when an investment portfolio has been liquidated.

 

Creative Cash Flow #2: Capitalized Operating Costs

Generally accepted accounting principles offer flexibility in deciding whether certain operating costs are capitalized or expensed. A common example is software development costs. Capitalization of additional costs is required once technological feasibility is reached. However, because of the use of judgment in deciding when that benchmark is attained, there is a high degree of variation across companies in the amounts of software costs being capitalized.

When expensed, software development costs reduce net income and operating cash flow. However, capitalized software development costs are reported as disbursements in the investing section of the cash flow statement and do not reduce operating cash flow. Both earnings and operating cash flow are increased.

When a software company reaches a steady state, where the amortization of software development costs capitalized in prior periods is approximately equal to new costs capitalized in the current period, the earnings effect of capitalization approaches zero. At this point analysts need not be as concerned about the effects on earnings of the company’s capitalization policy. However, even then amounts capitalized continue to be reported as investing uses of cash. Thus, even when there is no earnings effect, capitalization has a cash flow effect, boosting operating cash flow for new amounts capitalized.

The effects of capitalization on operating cash flow are especially apparent when a company changes its capitalization policy.

During 2001, American Software cut in half the percentage of software costs capitalized from approximately 50 percent in 1999 and 2000 to approximately 25 percent. As a result, a larger proportion of software costs incurred were accounted for as direct reductions in operating cash flow, contributing to its decline, even as software development costs incurred were reduced.

 

 
Creative Cash Flow #3: Acquisitions and Operating Cash Flow

When one company acquires another, operating results for the acquired company from the date of acquisition are included with reported amounts for the acquiring company. Thus, an acquisition can serve to boost both reported earnings and operating cash flow. However, beyond these more obvious effects of an acquisition on operating results, there is a lesser-known impact that provides a nonrecurring boost to operating cash flow.

The accumulation through operations of working capital accounts such as accounts receivable, inventory, and prepaid expenses, less accounts payable and accrued expenses payable, serves to reduce operating cash flow. Operating cash flow is increased when these working capital accounts are liquidated.

When working capital is acquired in an acquisition, its cost is reported as an investing and not as an operating use of cash. However, the subsequent liquidation of working capital, even when acquired through an earlier business acquisition, is reported as an operating source of cash. In effect, through an acquisition a company can “acquire” operating cash flow.

Investing activities that can be used to boost operating cash flow within the boundaries of GAAP include short-term investments classified as trading activities, capitalized operating costs, and acquisitions. Financing cash flow includes amounts borrowed and raised through the issuance of capital stock as well as debt repayments, stock buybacks, and dividends. Like cash flow reported in investing activities, financing cash flow is not considered to have the same sustainable qualities as operating cash flow. Flexibility in GAAP can be used to boost operating cash flow that is offset by uses of cash in the financing section.

Xerox’s use of transactions to securitize its finance receivables is another example where cash flow that is ostensibly related to financing transactions is reported as operating cash flow. According to GAAP, proceeds from an outright sale of receivables are reported as operating cash flow. However, when receivables are pledged as security for a loan, any proceeds received are reported as financing activities. The substance of the difference between securitization and pledging transactions is not that great.

 

Creative Cash Flow #4: Increased Vendor Financing

Vendor financing is a form of financing that, in accordance with GAAP, is properly reported as operating cash flow. Consider the cash flow results for Home Depot, Inc. During the company’s fiscal year ended February 3, 2002, operating cash flow increased to $6.0 billion from $2.8 billion during the previous year. Then during its fiscal year ended February 2, 2003, reported operating cash flow remained strong at $4.8 billion. However, contributing significantly to operating cash flow during both years was an outsized increase in accounts payable.

Increases in the length of time taken to settle accounts payable, a vendor financing of sorts, can be an effective corporate finance tool for managing working capital. However, incremental sources of cash generated in this manner are not sustainable.

Overdrafts classified as operating cash flow, securitized accounts receivable, and extended vendor payment terms are three examples of financing-related activities that ply the flexibility of GAAP to boost operating cash flow. More details of these and other similar actions are provided in Chapter 4.
Beyond the Boundaries of GAAP

Some companies move beyond the boundaries of GAAP, reporting as operating cash flow amounts that are clearly nonoperating in nature. In the case of Dynegy, Inc., mentioned earlier, a complex long-term purchase contract for natural gas was used to gain access to $300 million in financing from Citigroup, Inc. The proceeds from that financing, which were borrowed across 9 months and were to be repaid over 51 months, were reported as operating cash flow.

There are many other examples of steps taken by companies beyond the boundaries of GAAP that artificially boost cash flow. Some involve a misclassification between the operating and investing sections of the cash flow statement. Others, like Dynegy, Inc., involve a financing cash flow reported as cash provided by operating activities.

When taken to extremes, many of the same actions that might be viewed as plying the flexibility of GAAP in the classification of cash flow are considered to have moved beyond the boundaries of GAAP. A restatement made to correct prior-period errors in cash flow classification is compelling evidence of a GAAP-boundary violation. Such a restatement may or may not be in response to alleged fraudulent conduct.

 

Creative Cash Flow #5: Capitalized Operating Costs

There are numerous examples of companies breaking GAAP rules through their overzealous capitalization of operating costs. In these instances, firms not only boost reported income incorrectly, but operating cash flow also is increased in error. The increase in operating cash flow occurs because amounts expended are reported as investing and not operating uses of cash.

Dynegy’s use of loan proceeds to boost operating cash flow through its long-term natural gas supply contract with a special purpose entity is an excellent example of misreporting financing cash flow as cash provided by operating activities. Enron Corp. entered into similar transactions, also with Citigroup, Inc., and used financing proceeds to boost operating cash flow. The Securities and Exchange Commission forced Dynegy to restate its cash flow statement. At the time of this writing, a restatement of Enron’s financial statements is pending.

 

Creative Cash Flow #6: Nonrecurring Operating Cash Flow

Even when companies maintain their financial statements within the boundaries of GAAP and do not employ flexibility in the rules to boost operating cash flow, amounts may be reported as operating cash flow that are nonrecurring. In such instances operating sources of cash do not provide the sustainable supply of cash that is normally expected of operations.

For example: a cash collection resulting from a one-time litigation settlement may be included with operating cash flow. Similarly, operating cash payments associated with restructuring events are, in most instances, nonrecurring uses of cash. There are many other examples of nonrecurring operating cash flow.

 

Misleading Cash Flow Classifications under GAAP

Collectively, all steps taken to misrepresent the sustainable nature of operating cash flow are referred to here as creative cash flow reporting. Those steps may be taken within the boundaries of GAAP or beyond those boundaries, or may be the result of nonrecurring sources of operating cash flow. Each of them results in operating cash flow that is not sustainable.

Beyond what is referred to as creative cash flow reporting, there are specific items, especially in the cash flow classification of income taxes, where GAAP state clearly that non-operating items should be included in operating cash flow. Such items may add to or subtract from operating cash flow and create misleading amounts. Taxes and Operating Cash Flow All transactions that result in income or expense, gains or losses, have income tax implications.

According to GAAP, except for one proposed exception, the cash disbursements or receipts related to all such taxes are reported with operating cash flow. An operating designation was chosen because of the complexity and arbitrary nature of allocating taxes to operating, investing, and financing classifications depending on the nature of the underlying item.

When taxes relate to income or expense items included in operations, those taxes should be included in the calculation of operating cash flow. It is a proper grouping of like items. However, when taxes relate to investing or financing items, their inclusion in operating cash flow clouds that measure.

 

Taxes and Investment-Related Gains

For example: on November 15, 2001, Bristol- Myers Squibb Co. sold its Clairol business to Procter & Gamble Co. for approximately $5.0 billion in cash. As a result of the sale the company recorded a pretax gain of $4.2 billion.

Taxes due on the sale totaled $1.7 billion. Bristol-Myers reported the full pretax proceeds from sale, $5.0 billion, in the investing section of its cash flow statement. Taxes due on the sale were deducted from operating cash flow when paid in early 2002. In fact, due primarily to a cash drain resulting from the payment of taxes on the Clairol gain, the company reported negative operating cash flow of $1.1 billion in the first quarter of 2002.

That was down considerably from the positive operating cash flow of $900 million generated during the same period of the previous year. Tax Benefits from Stock Options The exercise of stock options generates a financing source of cash equal to the exercise price on the underlying options. Option holders pay the company an amount equal to the exercise price times the number of options being exercised.

To the company, this is cash received for the sale of stock. It is a financing source of cash and is reported as such on the cash flow statement. When the holders of nonqualified options, typically company officers and employees, exercise their options, the company receives a tax deduction equal to the difference between each option’s exercise price and the market price of the underlying stock times the number of options exercised. The option-related tax deduction can be quite substantial and provide tax benefits, a source of cash, which can run into the hundreds of millions or even billions of dollars.

Consistent with the treatment of taxes generally, tax benefits from stock options are reported as operating cash flow. However, because the sale of stock that gave rise to the tax benefits is a financing event, its related tax benefits are not truly part of operations.

Historically, Microsoft Corp. reported tax benefits from stock options as a financing source of cash. However, Emerging Issues Task Force (EITF) Statement No. 00-15 clarified the cash flow classification of tax benefits from stock options forcing the company to restate its cash flow statements.33 In the restatement, tax benefits from stock options were reclassified to the operating section.

Recently, the FASB proposed that tax benefits received arising from tax deductions related to the exercise of nonqualified stock options that exceed the amount of option-related compensation expense reported on the income statement should be classified as financing cash flow. Such a change in classification would be more in keeping with the financing nature of such tax benefits.