Compare and contrast the balance sheet, income statement, and cash flow statement. (Note that to compare and contrast these three tools, you will need to define each of them). Then, in your textbook, review the Real World case, focusing on "Putting a Spin on Cash Flows," on page 32. Discuss the following:
• What is the most important segment of a cash flow statement? Why?
• Can the cash flow statement be manipulated? If so, how? If not, why not?
• Are most investors sophisticated enough to interpret a cash flow statement? Should they be?
Putting a Spin on Cash Flows
One of the reasons why cash flow analysis is popular is the difficulty in manipulating, or spinning, cash flows. GAAP accounting principles allow for significant subjective decisions to be made regarding many key areas. The use of cash flow as a metric to evaluate a company comes from the idea that there is less subjectivity involved, and, therefore, it is harder to spin the numbers. But several recent examples have shown that companies can still find ways to do it.
In November 2009, the SEC settled charges against SafeNet, Inc. and some of its former officers, employees, and accountants, in connection with earnings management and options backdating schemes. This case repre- sented the SEC's first enforcement action brought under Regulation G of Sarbox. Of course other companies have spun financial results without legal action. For example, in March 2007, rental car company Avis Budget Group was forced to revise its first quarter 2007 operating cash flow by more than $45 million. The company had improperly classified the cash flow as an operating cash flow rather than an investing cash flow. This maneuver had the effect of increasing operating cash flows and decreasing investing cash flows by the same amount.
Tyco used several ploys to alter cash flows. For example, the company purchased more than $800 million of customer security alarm accounts from dealers. The cash flows from these transactions were reported in the financing activity section of the accounting statement of cash flows. When Tyco received payments from custom- ers, the cash inflows were reported as operating cash flows. Another method used by Tyco was to have acquired companies prepay operating expenses. In other words, the company acquired by Tyco would pay vendors for items not yet received. In one case, the payments totaled more than $50 million. When the acquired company was consolidated with Tyco, the prepayments reduced Tyco's cash outflows, thus increasing the operating cash flows.
Dynegy, the energy giant, was accused of engaging in a number of complex "round trip trades." The round trip trades essentially involved the sale of natural resources to a counterparty, with the repurchase of the resources from the same party at the same price. In essence, Dynegy would sell an asset for $100, and immediately repur- chase it from the buyer for $100. The problem arose with the treatment of the cash flows from the sale. Dynegy treated the cash from the sale of the asset as an operating cash flow, but classified the repurchase as an investing cash outflow. The total cash flows of the contracts traded by Dynegy in these round trip trades totaled $300 million.
Adelphia Communications was another company that apparently manipulated cash flows. In Adelphia's case, the company capitalized the labor required to install cable. In other words, the company classified this labor ex- pense as a fixed asset. While this practice is fairly common in the telecommunications industry, Adelphia capital- ized a higher percentage of labor than is common. The effect of this classification was that the labor was treated as an investment cash flow, which increased the operating cash flow.
In each of these examples, the companies were trying to boost operating cash flows by shifting cash flows to a different heading. The important thing to notice is that these movements don't affect the total cash flow of the firm, which is why we recommend focusing on this number, not just operating cash flow.
We should also note that, for 2008, the total number of financial restatements fell nearly 30 percent from 2007, which had itself experienced a 31 percent decline in restatements from 2006. While this is a positive trend, restate- ments due to cash flow misclassification increased in prevalence over the same period.