Business & Money
Measuring Corporate Performance: The Perils of Turning To Cash Flow
May 15, 2003
By Raymond Hill, George J. Benston, and Al Hartgraves
Cash flow reporting is more susceptible to manipulation than investors imagined.
Financial results are the prism through which investors view performance in the world of business. Companies may have tens of thousands of employees supplying tangible goods and services to customers, but real and diverse activities are reduced to relatively few numbers when companies are valued.
"Cash flows from operating activities" is a term defined by accountants, and like many terms in accounting, there's some degree of subjectivity involved in applying the definition to the actual preparation of a company's financial statements. That subjectivity opens up the possibility of a lack of clarity in the information being reported-or, perhaps, intentional distortion of that information.
For example, the calculation of operating cash flow or funds from operations, as some call it, can vary from financial analyst to financial analyst, agency to agency, and even from industry to industry.
Wall Street analysts typically use EBITDA (earnings before interest, taxes, depreciation, and amortization) when they focus on a company's cash flow. Unfortunately, calculation of EBITDA varies from company to company. Although the SEC permits companies to report EBITDA in their periodic public filings, provided they include a clear explanation of the differences between it and net income, it may not be included in the generally accepted accounting principles (GAAP) statement of cash flows. In any event, EBITDA is an incomplete measure of sustainable cash flow because it excludes taxes and often includes significant non-cash components of net income.
This problem can be addressed by increasing the level of detail and the quality of discussion of the results presented. The SEC, with a big push from Congress, appears to be following this path.
Whatever improvements in detail and analysis are achieved in future reporting, there will be a significant handicap to overcome: the accountants' definition does not correspond to what non-accountants, even financially literate non-accountants, understand by "operating cash flow."
Some fairly simple changes to the structure of the statement of cash flows would bring more clarity to the transmission of information about sustainable cash flow and more discipline to management's reporting of cash. The simplest change would be to separate changes (normal and abnormal) in working capital from the other items in cash from operating activities. This change would induce better discussion of this item in the Management Discussion and Analysis (MD&A), especially to distinguish business-driven changes in working capital from changes driven by financial condition or extraordinary events.
One additional change would be to allow the statement to separate the effect of out-of-market and other adjustments that, in management's judgment, are required to present a fairer view of sustainable cash flow. This would show that the classification of items between "operating" on the one hand, and "financing" or "investing" on the other, is better thought of as relating to a spectrum rather than belonging to idealized classifications. It would also reduce the temptation to "cheat" by engaging highly structured transactions like Dynegy's prepays. With these additions the statement of cash flows would appear as seen in the box on page 22.
This proposed change in the structure of the operating section of the statement of cash flows, along with other supplemental disclosures suggested in this article, would better enable users of financial statements to identify items that are relevant to the determination of a firm's sustainable cash flow from operations. These are fairly simple changes that would enhance the usefulness of the statement of cash flows.
A bigger question is whether the accounting profession needs to take a fresh look at what definition of fund flows (cash, net monetary assets, net working capital, etc.) is most relevant to users of financial statements. Accounting measures always will fail to describe adequately concepts of economic value.
The current GAAP definition of cash flows from operating activities, though, is so far from intuitive expectations as to be misleading, and there are no other well-defined GAAP measurements that can substitute. This situation is further complicated by the fact that, although management can add more detail and analysis to its reporting, the current bias is very much against non-GAAP terminology in reporting. Consequently, we would have GAAP change to allow managers to communicate with financial statement users more effectively or, at the least, not provide statements bearing the GAAP imprimatur that might mislead investors.
In the Eye of the Storm: Cash Flow Anointed King
As the accounting scandals were revealed in 2001 and 2002, financial analysts and investors increasingly turned their scrutiny from the income statement to the statement of cash flows. For several years, academic accounting and financial economic research has found the difference between the two-revenue and expense accruals-to be an important source of net income manipulation. Cash flow from operations, consequently, has come to be seen by many as the preferred basis for evaluation of corporate performance and valuation. After all, it is the basis of the present-value calculation, which is the fundamental concept of firm value.
This increased attention to cash was particularly strong in the merchant energy industry, where mark-to-market (or mark to fair value) accounting seemed to give management license to define income using standards that lacked transparency, and which brought transactions with risky, distant payouts into current income.
As investors' worries increased over the use of "creative accounting" to generate earnings on the Income Statement, they hoped to rely on the statement of cash flows as a less subjective measure of corporate performance than income.
We argue: (1) reliance on operating cash flows has been misplaced in many instances, because the GAAP statement of cash flows (under the Financial Accounting Standards Board [FAS] 95)1 is more susceptible to manipulation than most investors have imagined; and (2) the architecture of the statement of cash flows is not conducive to transmitting the kind of information investors require or, indeed, to meeting the purposes defined in FAS 95.
The Relevance and Construction of the Statement of Cash Flows Total cash on a company's balance sheet is clear (in the absence of outright fraud),2 provided there are adequate disclosures that separate cash freely available to the company from restricted cash. Although this is an important piece of information to investors, the company's ability to generate ongoing cash flow is, generally speaking, a larger determinant of value.
In defining the purpose of a statement of cash flows, the first objective mentioned by FAS 95 is "to (a) assess the enterprise's ability to generate positive future cash flows." To facilitate this assessment, cash generated or used by operations must be separated from cash generated or used by investing and financing activities.
This required distinction is both an inevitable source of "noise" in the information (because it requires subjective judgments by management) and an opportunity for willful distortion. No investor should believe that focusing on cash is a remedy for the kind of manipulation that, say, WorldCom has admitted to. If current expenses are improperly treated as capital investments to inflate net income, operating cash flow will necessarily be inflated as well.
Even if the distinctions between cash flows from operations and cash flows from investing and financing could be made correctly and were perfectly transparent, other impediments remain to using the Statement of Cash Flows to achieve its primary purpose. Most non-accountants would assume that if a company makes microprocessors, then cash flows from operations is the difference between cash collections from the sale of microprocessors and the cash outflows from making and selling them in the current period. This straightforward expectation is reflected in FAS 95: "Operating activities generally involve producing and delivering goods and providing services."
This information, combined with other data on the company's external environment, would then provide a basis for forecasting the ability of the microprocessor business to generate future cash as well. Calculating cash flows from operations is not, though, as simple as measuring the net cash receipts from making and selling goods and services over a quarter.
To begin with, cash from operating activities is a residual-both in its definition and in the way companies typically compute it. Although FAS 95 directly defines operating, investing, and financing activities, it states: "Operating activities include all transactions and other events that are not defined as investing or financing activities." "Operating cash flows" is the default category. In practice, companies often start with the overall change in cash. Cash changes resulting from financing and investing activities are then determined, since these tend to be events that are relatively easy to identify. The residual is cash from operating activities.3 As a result, the financing and investing components of the statement of cash flows are easier to understand than the operations component, even though it is the most essential component for understanding the value of the enterprise. The fact that cash flow from operating activities includes the results of other events that may not be relevant for inferences about "the enterprise's ability to generate positive future net cash flows" is clearly recognized by credit rating agencies, which make their own alterations to the statement of cash flows to produce non-GAAP "funds from operations" (FF0).4
The Composition of Operating Activities: The Adjustment Quagmire
The "indirect" method virtually all companies use for presenting operating cash flows on the statement further complicates matters. This approach begins with net income, which includes all operating revenues and expenses as well as investing and financing gains and/or losses. Net income is then adjusted, often with a dozen or more items, to arrive at cash flows from operating activities.
While most of these adjustments are understandable to the reader, often some very large adjustments leave the reader less than enlightened. Enron's 10-K filed with the SEC for 2000 illustrates the problems with the indirect method. Enron's net income for the year was $979 million, but it reported significantly larger cash flows from operating activities: $4,779 million. The gap between net income and cash flow has some large components that are easy to understand-depreciation, for example, was $855 million. However, two components-"changes in components of working capital" and "other operating activities"-totaled $2,882 million, or more than half the total gap between net income and operating cash flows. In the single paragraph of the filing's MD&A discussing the statement of cash flows, no explanation is provided for either component, even though the year-on-year change in these two items was $3,708 million.
Although FAS 95 encourages companies to use the direct method, wherein individual items are identified, virtually all publicly traded companies use the indirect method. Typical non-cash adjustment items include:
- depreciation and amortization;
- impairment of goodwill and long-lived assets;
- changes in deferred taxes;
- income from equity in affiliates in excess of dividends received;
- non-cash mark-to-market income from trading activities (especially recently in the energy industry);
- non-cash compensation expense;
- long-term pension and other post-retirement accruals;
- change in working capital; and
- other.
"Other" often (especially for energy companies) includes two items that mask information about sustainable cash flow: adjustments for out-of-market contracts and other types of prepayments. Sometimes, changes in networking capital also are included.
Out-of-Market Contracts: Accounting for Sales Into The Future
When a company acquires a contract to be settled in the future with terms that do not reflect those currently available in the market, GAAP requires that the out-of market component be treated as the outcome of an investing activity. It goes immediately on the balance sheet (as an asset if the out-of-market component is positive and as a liability if negative). The resulting asset or liability is then amortized in the period(s) in which the contract is settled to determine the income from the contract. These adjustments are not, however, applied to the statement of cash flows. Without a similar adjustment to the statement of cash flows, the reported cash flow from the out-of-market contract either overstates (if contract was in the money) or understates (if the contract was out of the money) the cash flow expected from contracts entered into at market prices. For most companies this discrepancy is probably insignificant, but such contracts play a particularly important role in the energy industry, which is characterized by active futures markets for both gas and electricity.
Independent power plants are often bought and sold with long-term contracts to serve a particular customer.
In addition, as some states have made the transition from regulated to competitive markets, they have required vertically integrated, regulated utilities to sell their generating assets. In order to protect retail customers from the near term uncertainty of electricity prices created by the introduction of competition, regulators have sometimes required buyers of the generating assets to provide multi-year contracts with distribution companies (unfortunately, California did not). These contracts have sometimes deliberately been set at below-market rates as part of the political bargain over the terms of moving from regulation to competition, with an offsetting reduction in the cost of the assets acquired.
Even when there is an attempt to follow market prices, the passage of time between the setting of these prices and the closing of the generation divestiture program can be many months, so that prices differ from market at the actual acquisition date.
Endnotes
- Financial Accounting Standards Board (FASB). 1987. Statement of Cash Flows. Statement of Financial Accounting Standards No. 95 (FAS 95), Norwalk, CT: FASB.
- Fraud is possible. The Wall Street Journal of March 21, 2003, reported that Health South Corp. had apparently deliberately overstated its cash balances by $300 million.
- Of course, if the accounting department is doing its job there will be further testing to ensure that the residual is reasonably related to the various components that compose cash from operating activities.
- See, for example, Standard and Poor's "Corporate Ratings Criteria" (undated) or Moody's "Financial Ratio Medians For Global Investment Grade Corporates," January 2001.
Raymond Hill is adjunct senior lecturer; George J. Benston is John H. Harland Professor of Finance, Economics, and Accounting; and Al Hartgraves is professor of Accounting, at Emory University's Goizueta Business School.
Case Study: Mirant Cash Flows Mask Drop in Future Earnings
The recent fall in PJM electricity prices has hurt Mirant's ability to generate cash with the PEPCO assets it acquired. Yet the clouded future economic prospects of these plants are nowhere to be found in the statement of cash flows.
In December 2000, Mirant acquired approximately 5,000 MW of generating capacity from Potomac Electric Power Company (PEPCO). PEPCO was then transformed into a distribution company serving retail customers. Mirant was the high bidder in an auction for PEPCO's assets. The terms of the auction included a requirement that the successful bidder agree to sell power back to PEPCO for a four-year period at a fixed price. This was essentially a forward contract obligation.
Both at the time of the bid and at the closing of the transaction the fixed price was significantly below market-in terms of both spot and forward prices over the contract period. The annual amount of the out-of-the market portion of the forward obligation to PEPCO was in the range of $500 million for the four-year period.
Mirant, like any bidder, would have bid a price reflecting its estimate of the value of the power plants less the discounted value of the expected out-of-market component of the forward obligation, presumably using forward prices as the best measure of expected value. The purchase accounting treatment was consistent with this economic valuation: a liability was recorded for the estimate of the discounted present value of the out-of-the market component of the forward contract. The power generating assets were recorded at a value equal to Mirant's purchase price plus the amount of that liability. The result was 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 this market-change information in the operating section of the Statement of Cash Flows; however, it should be disclosed in the footnotes and in the MD&A to ensure that the reader fully understands cash sustainability in terms of current market conditions. - R.H., G.J.B., and A.H.
New and Improved Cash Flow Statement
- A fair view of sustainable cash flow
- Net income
- Non-cash and non-operating adjustments to net income (excluding purchase accounting and similar adjustments)
- "Basic" cash flow
- Adjustments for out-of-market
contracts (or similar items)
- "Adjusted Basic" cash flow
- Normal Changes in working capital
- Abnormal changes in working capital
- "Total" operating cash flow
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