Cash flow classifications are so flexible that companies are reporting like transactions in different ways, masking true cash flow and exacerbating comparability among companies, according to a new report from the Georgia Tech Financial Analysis Lab.
It’s not a case, however, where companies are pushing the limits of accounting rules to bolster their own results, said Charles Mulford, director of the lab and accounting professor at Georgia Tech. In some cases, companies are taking overly conservative positions in their classifications and making their cash flow look worse than it really is, he said.
Mulford
“At the foundation of this, the rules for classification of cash flow leave so much open to judgment and are so flexible, companies are reporting similar transactions in different ways,” Mulford said. “Anyone looking at financial reports might be misled by a company’s classification of certain items—that the company might be generating more or less free cash flow than it really is.”
Mulford’s study focuses on accounts receivable that are securitized, or sold via off-balance-sheet transactions involving special-purpose entities to third-party investors. Companies typically retain an interest in such receivables and classify the securities as held for trading, available for sale, or held to maturity. The study suggests, however, that collections of retained interests arising from such transactions are in fact operating cash flows and should be considered as such when financial statement users are analyzing cash flow.
Guidance on cash flow classifications would rectify the problem, says Mulford; however, “cash flow classifications are not on the [standard setters’] front burner.” Robert Herz, chairman of the Financial Accounting Standards Board, said at a financial reporting conference hosted last week by Financial Executives International that cash flow is not a priority for FASB. “We see no requirement for clarification or guidance,” on cash flow, he said.
While Mulford says additional guidance is necessary, Ed Ketz, accounting professor at Pennsylvania State University, says the issues deserve more attention from FASB and the Securities and Exchange Commission.
“The real trouble is that the FASB and the SEC allow business enterprises not to consolidate the results of the SPE with their results,” Ketz said. “As such, the FASB and the SEC allows these distortions to occur. The FASB and the SEC should require immediate consolidation of all special-purpose entities,” he said.
Critics of off-balance-sheet accounting for special-purpose entities say SPE results should be consolidated with the parent company’s results to make the true measure of a company’s liabilities more clear to investors. That lack of transparency was one of the factors that contributed to the downfall of Enron.
The study conducted by the Georgia Tech Financial Analysis Lab is above, right, as are related documents and articles.
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