Cash Flow Undergoes Changes, Becomes Relevant

Cash flow and its proper representation in financial statements has gained a lot of respect in recent years, and companies would be wise to give it more than an afterthought going forward.

“Investors are looking for sustainable, ongoing, renewable cash flows,” says Chuck Mulford, director of the Financial Analysis Lab at Georgia Tech and a champion of cash flow reporting. “It’s arguably the best measure we have of a company’s ongoing financial health.”

Mulford

Mulford led a charge in 2004 and 2005 to get companies to pay more attention to how they classify cash flows, which prompted SEC staff to dangle a carrot in front of public companies in early 2006: they could correct sloppy or misleading classifications in their next filing period without restating, or correct them later with a restatement.

That unusual offer—coming on the heels of accounting scandals, corporate collapses, Sarbanes-Oxley and a spike in restatements—set off a flurry of correction activity. Emerging research on the filings that followed now suggests that perhaps problems with cash flow reporting were more dispersed across various items in the cash flow statement than previously believed.

Nicholls

“We weren’t expecting to see so many things getting restated,” says Curtis Nicholls, professor at Bucknell University and a co-author of a soon-to-be-published study on the corrections. “That’s what shocked us as we got into the data.”

Dana Hollie, professor at Louisiana State University and another co-author of the study, says the research suggests companies were overstating operating cash flow by as much as 50 percent. That gives the impression (presumably inaccurate) that a company is generating more of its cash from its core operations, a key concern for investors.

Hollie

“That’s pretty significant,” Hollie says. “You want to know operating cash flows so you can determine if the company can meet its operating expenses and its other liabilities.”

As financial statements go, the cash-flow statement is still a youngster, first required in its current format in the mid-1990s, Mulford explains. Companies are required to classify their cash flows as arising from operating, investing, or financing activities, but the classifications didn’t get much attention or respect for a long time, he says. “The cash flow statement was a stepchild to all the financial statements. It was prepared after everything else was done.”

“It will be hard for companies to revert to their old ways of financial reporting without coming under scrutiny.”

—Dana Hollie,

Professor,

Louisiana State University

Since capital markets were more fixated on earnings and earnings per share, “companies grew sloppy and complacent” about cash-flow classifications, Mulford contends. “If we can make ourselves look better than we really are and no one cares, why not? That may be an overstatement, but not by a lot.”

When Mulford took his deep dive into cash flow statements several years ago, he found some concerns about how companies were classifying cash flows arising from customer financing plans. Many companies, especially major auto makers, were classifying them as operating cash flows when they should have been classified as financing cash flows, he says.

The SEC focused on the issue when it called for corrections in early 2006. Of the companies studied by Nicholls and Hollie, however, only about 12 percent reclassified cash out of operating cash flows for that reason. Nearly as many operating cash flow reclassifications took place around depreciation and amortization (10.5 percent) and discontinued operations (9.3 percent).

CASH FLOW EFFECTS

The following excerpts are from, “The Effects of Cash Flow Statement Reclassifications Pursuant to the Securities and Exchange Commissionrsquo;s One-Time Allowance,” by Dana Hollie, Curtis Nicholls, and Qiuhong Zhao:

IV. Summary and Conclusions

Consistent with the SEC’s concerns, we find that firms generally misclassified cash flows that significantly overstated their net operating cash flows, while significantly understating cash flows related to investing activities. These types of cash flow misclassifications do appear to distort the true operational, financing, and investing activities of the firm. Frequently occurring line-item reclassifications within all cash flow statement categories validate the SEC’s concerns regarding the presentation of dealer floor discontinued operations and plan financing arrangements. However, insurance claim proceeds and beneficial interests in securitized loans do not appear to have impacted overall cash flows to the degree feared by the SEC.

Abstract

The Securities and Exchange Commission (SEC) announced a one-time opportunity for firms with misclassified items within their cash flow statements to correct these errors without having to issue an ‘official’ restatement. This study provides a first-hand account of the impacts of these reclassifications by focusing on prior cash flow reporting practices for firms that adjusted their cash flow statements during this allowance period. We determined what types of firms were affected by this allowance, as well as the types of reclassifications that occurred within key categories (i.e., operating, investing, and financing) of the cash flow statement. Consistent with the SEC’s concerns, we find that firms generally misclassified cash flows that significantly overstated their net operating cash flows while significantly understating their net investing cash flows. We then examine line-items within these categories to determine which were most affected by reclassifications. The most frequently occurring line-item reclassifications were consistent with the SEC’s concerns regarding the presentation of discontinued operations and dealer floor plan financing arrangements. However, insurance claim proceeds and beneficial interests in securitized loans appear to be less problematic than suspected by the SEC. Our findings also indicate that the SEC’s plan was relatively successful, in that these cash flow restatements only exerted a marginally negative effect on the capital market for firms that took advantage of the allowance period.

Source

The Effects of Cash Flow Statement Reclassifications Pursuant to the Securities and Exchange Commission’s One-Time Allowance.

Companies also corrected classifications related to deferred income taxes, accounts receivable, net income, inventory, prepaid expenses, and others. Classifications that hit lines in the operating and financing sections were not as widely dispersed, but certainly not concentrated on stand-alone issues either.

The research even ended up with a large batch of reclassifications that couldn’t be tagged to specific line items. “There are a lot of line items called ‘Other,’” Hollie says. “We don’t really know what was in that, but it was a substantial number.”

Hollie says the erroneous approaches to cash flow classifications appear to have been driven to some extent by industry practices. “Compared to the universe of firms, we saw a lot of reclassifications focused in computers, durable manufacturers, financial institutions, those types of firms,” she says. “They accounted for a large percentage of the corrections.”

That’s not surprising, since companies in a given industry commonly follow each others’ methods and approaches. “Firms were just doing what they always did: ‘The rest of the industry does this, so we do it too,’” Hollie says. “And generally if it’s working to your benefit, it’s not likely people will want to go against the norm. That may have been what was happening here.”

Certainly, the financial crisis and concerns about liquidity have put cash flow under the microscope in a harsh new light. Investors and analysts are poring over cash flow data, looking for signs that suggest a company can remain viable through the turmoil.

“Generally, corporate analysts use the cash flow statement extensively to understand cash flow and to project what future cash flows will be,” says Dina Maher, senior director at Fitch Ratings. “They do quite a bit of modeling of cash flow to understand the sources of various inflows and outflows: what’s an unusual, one-time source of cash flow versus what’s recurring.”

Given the past missteps with cash flows and the current attention to them in today’s economy, businesses won’t have the liberty to take cash flow classifications lightly in the future, Hollie says. “The SEC allowance brought more attention to the statement of cash flows, and it will get more attention going forward,” she says. “It will be hard for companies to revert to their old ways of financial reporting without coming under scrutiny.”