New Study On Cash Flow; Public Debt Rules

Following generally accepted accounting principles, companies may be overstating their operating cash flow and understating their debt—or at least making it tougher for investors to draw their own conclusions, according to recent research by the Georgia Tech Financial Analysis Lab.

Companies have long bundled accounts receivable and sold them to investors in securitized transactions, turning receivables into immediate cash. Financial Accounting Standard No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and its related interpretations provide a roadmap for how that can be done to assure the incoming cash that results from such transactions can be classified not as debt but as operating cash, says Charles Mulford, director of the Georgia Tech research operation.

Mulford says operating cash flow and measures of financial leverage should be adjusted to reflect the effect of securitized receivables. That, he says, would give a better view of a company’s true cash flow from recurring operations and true debt levels. Even with the GAAP-compliant disclosures, however, such a move isn’t always easy, he says.

Mulford

“We’re not saying anyone’s doing anything wrong,” Mulford explains. “Our concern is that investors may not be getting a full, true picture of what companies are doing. It took us an awful lot of digging to see what’s going on, and with a lot of companies we’re just not sure.”

Georgia Tech’s analysis examined 10-Ks filed in 2005 and found that some companies use securitizations to smooth over volatility in their operating cash flow. Other companies, however, showed more volatility in their operating cash flow because of securitizations.

Stripping out the effect of securitizations produced big swings in operating cash flow, according to the report—ranging from a 425 percent increase to a 251 percent decrease for the companies sampled in the research (see box above, right for the study).

The study also revealed significant—although not as dramatically varied—changes in companies’ financial leveraging after adjusting for the effect of securitized receivables. The median increase in leveraging was about 12 percent, the report found.

Cash flow and leveraging metrics are pivotal in a company’s financial performance because they are seen as indicators of a company’s ability to generate sustainable cash flow and have implications for credit analysis.

Mulford says it’s somewhat ironic that regulators and rulemakers repeatedly stress their commitment to make accounting rules more principled and less prescriptive, yet the rules on securitizations are highly prescriptive. “There are some very specific hoops that you have to jump through, and if you don’t jump through every hoop just right, what you really have is a secured debt,” he says.

Still, Mulford doesn’t expect the lab’s research to prompt action by the Financial Accounting Standards Board. “They’ve done their work on this for now,” he says. “They’ve got so much to work on as it is.”

FASB Redefines ‘Public Entity’ For Certain Bond Debtors

The Financial Accounting Standards Board wants to bring private enterprises with public debt increasingly into the “public” fold for purposes of financial reporting.

FASB issued a proposed staff position to amend a number of pieces of accounting literature to redefine “public entity.” The new definition would sweep in certain not-for-profit entities like hospitals, museums, libraries and others that borrow money via conduit municipal bonds. It also would bring in certain for-profit entities that borrow money via industrial revenue or development bonds issued through government bodies.

A conduit municipal bond is an offering by a government body or agency not for its own use, but to be passed along to other entities as permitted by federal tax rules. The government entity initiating the offering has no liability or continuing involvement with the debt once it is passed along to the ultimate debtor.

FASB says in its proposed staff position that “questions have arisen” as to whether the ultimate debtors under such conduit bond arrangements should be considered public entities and subject to the related accounting requirements. The proposed staff position would amend several existing statements, including FAS Nos. 69, 109, 126, 131 and 141, along with some pronouncements still in development, to define such debtors as public entities.

Paul Miller, an accounting professor at the University of Colorado and a former FASB staffer, said the new definition would close a loophole that has allowed borrowers to access public debt without the related disclosures.

Miller

“Some companies are the de facto issuers of bonds that are technically issued by a governmental entity,” he says. “Even though the governmental entity is obligated under the bonds, the conduit company has assumed full responsibility for the interest and principal payments and is de facto the real issuer.”

FASB is open to comment on the proposed definition through July 31.