Creative Cash Flow Reporting

Creative cash flow reporting refers to any and all steps used to create an altered impression of operating cash flow and, in the process, provide a misleading signal of a firm’s sustainable cash-generating ability. Steps employed to misrepresent a firm’s sustainable cash-generating ability may employ reporting flexibility within the boundaries of GAAP. Alternatively, steps may be taken that extend beyond the boundaries of GAAP. Finally, amounts may be reported properly as operating cash flow but do not have the sustainable qualities normally expected of operating cash flow. Clearly the adjective “creative” is used here in a pejorative sense. This post provides some overview [with examples] of how cash flow reported in a creative manner misrepresents sustainable cash flow.



The Motivation Behind Creative Cash Flow Reporting

Managers are well aware of the importance placed by analysts, investors, and creditors on operating cash flow. Cash flow is the life-blood of any organization. A boost in operating cash flow, even as total cash flow remains unchanged, communicates enhanced financial performance. Consider, for example, the hypothetical cash flow statements presented in below figure:
Statement 1 Statement 2

Cash provided (used) by operating activities = $(14,000) $44,000
Cash (used) by investing activities = (36,000) (66,000)
Cash provided by financing activities = 60,000 32,000
Increase in cash = $ 10,000 $10,000



As reported in both statements, cash on hand increased $10 million.

However:

in Statement 1, the company consumed $14 million in cash from operations. Those operating cash needs together with cash needs for investing activities of $36 million were covered with new financing cash flow in the amount of $60 million.
In Statement 2, the company generated positive operating cash flow of $44 million.
The company invested $66 million in the business and obtained $32 million in new financing to help meet its cash flow needs.


The company represented by Statement 2 is doing a better job of generating what would appear to be sustainable cash flow. That company is apparently investing more heavily and relying less on new financing to support its operating and investing activities.

What we now know, however, is that the company represented by Statement 2 may be no different from the company represented by Statement 1. For example: proceeds from the sale of investments may have been used to boost operating cash flow. Similarly, proceeds from new borrowings may also have been reported as operating cash flow. The net result is the appearance of improved financial performance.

In the absence of careful scrutiny, this apparent improvement in financial performance might have a positive impact on a firm’s share price, its borrowing costs, and the incentive compensation paid its executives:

Share Price Effects - As expectations for sustainable cash flow are increased, so is the present value of that cash flow stream, boosting share-price prospects. Share prices can be influenced to the extent that managers can increase the perception, and not the reality, that their firm is generating more sustainable cash flow. This point was not lost on the executives at companies such as Dynegy, Inc., and Enron Corp. Their managers went to extraordinary lengths to boost operating cash flow in an effort to increase or maintain their share prices. Executives may also have an incentive to report less volatile cash flows, imparting an impression of lower firm risk. The perception of lower risk could move investors to lower their risk-adjusted discount rates. Lower discount rates would boost the present value of future cash flows and potentially raise share prices.
Borrowing Cost Effects - Interest and principal on loans are repaid with cash flow. Increases in operating cash flow may translate into perceived improvements in debt-service capacity. The net effect may translate into higher borrowing capacity, lower interest costs, less onerous loan covenants, fewer guarantees, or, possibly, less loan collateral.
Incentive Compensation Effects - To the extent that steps taken to boost operating cash flow translate into higher share prices, managers compensated with stock options will enjoy increased compensation. Beyond such equity-based arrangements, however, some managers may be paid cash bonuses linked directly to improvements in earnings or in operating cash flow. Consider Tyco International, Ltd., a company that has been accused of artificially boosting operating cash flow. As described below, the company’s bonus plan was based, at least in part, on improvements made in operating cash flow: The cash bonus for the Chief Executive Officer and the Chief Financial Officer has two performance based criteria: (i) increase in earnings before non-recurring items and taxes and (ii) improvement in operating cash flow.

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