Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance

Citation

Uyar, A. (2012), "Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance", Pacific Accounting Review, Vol. 24 No. 2, pp. 235-238. https://doi.org/10.1108/01140581211258498

Described on its back cover as a potential “gold standard in the field of forensic analysis of corporate cash flow”, the aim of this book is “to help the analyst, investor, and creditor uncover sustainable sources of cash flow” (p. 32). Based on the backgrounds of its two authors, it can be considered a product of both academic knowledge and practical experience. Initially, the text directs attention to the ways used to manipulate cash flow by boosting operating cash flows artificially before shifting focus to misclassifications of items among cash flow sections. Next, it provides guidance in preparing proper statement of cash flow; emphasizes the importance of generating sustainable operating cash flow; and finally concentrates on the analysis of cash flow statement and explanation of free cash flow in a very comprehensive manner.

Upfront, it is useful to explain two vital phrases pervading the book: creative cash flow reporting and sustainable cash flow. 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” (p. 18). Sustainable cash flow is “recurring cash and is derived from a company's profitable operations, which is a renewable source” (p. 9).

The book is composed of ten chapters. Each chapter opens with quotes from various sources and ends with a summary and endnotes including the chapter's references. These complementary parts make the book reader‐friendly.

The first chapter emphasizes the merits of cash flow being less subject to manipulation compared to earnings. This notwithstanding, the book demonstrates how operating cash flow may be boosted both within and beyond of the boundaries of generally accepted accounting principles (GAAP) supported by real life examples. The importance of operating cash flow as the main source of cash in meeting discretionary needs is also emphasized.

The second chapter focuses on the historical background and developments which have led to the current format of statement of cash flows; an evolution which has been continuing for over a century. The role of regulatory bodies in this evolutionary process is also explained. As a result of these developments, we see that the Financial Accounting Standards Board (FASB) issued the Statement of Financial Accounting Standards (SFAS) No. 95, “Statement of Cash Flows” in 1987. The end of this chapter draws comparisons between US GAAP's SFAS No. 95 and the International Accounting Standards Board's (IASB) IAS No. 7, as well as between SFAS No. 95 and promulgations of certain other countries.

As pointed out in its title, “Is it operating or investing cash flow”, Chapter 3 deals with the appropriate classification of cash flows under operating or investing sections of the cash flow statement, respectively. Examples of misclassifications that could be made between the operating and investing sections of the cash flow statement are presented. The chapter states that there is no simple rule for classifying where investment‐related cash expenditures will be reported due to industry and company specific situations. Additionally, it provides useful guidelines for the appropriate classification of cash flows between the operating and investing sections for asset acquisitions and sales, restricted cash in a bank account, capitalized operating costs, and investments in debt and equity securities.

Differentiating between cash flows in the operating and financing sections is the subject of Chapter 4. This chapter opens with how companies manipulated statement of cash flows to disguise a financing transaction as an operating transaction. Like the previous chapter, this chapter also provides guidelines for the correct classification of cash flows between operating and financing sections of the statement of cash flow relating to stock options, shareholder loans, minority interest in equity, restricted cash, interest paid, debt issue costs, and dividends paid. In both Chapters 3 and 4, the authors direct the readers' attention to how flexibility in GAAP is plied by managers who have interest in boosting operating cash flow. Finally, both chapters underline the means by which companies mislead analysts by overstepping the boundaries of GAAP.

Chapter 5 outlines the treatment of income taxes in the statement of cash flow. The authors state that SFAS No. 95 pays little attention to income taxes and requires the classification of all tax cash flows within operating cash flow. However, the inclusion of income tax cash flows within operating activities is controversial in cases where they relate to transactions associated with investing and financing activities, such as gains and losses resulting from the sale of investments, property plant and equipment, or the retirement of debt. The authors highlight the potential cash flow impacts of investing and financing gains and losses on the three sections of statement of cash flows. In addition, nonrecurring tax cash flows relating to investing and financing activities are discussed in detail in this chapter, along with relevant examples. The identification and removal of these items from operating activities is deemed necessary for reporting sustainable operating cash flow – a recurrent theme in this book.

Nonrecurring operating cash flow is the focus of Chapter 6. Although GAAP does not define nonrecurring operating cash flow, the authors identify its essential characteristics as being irregular in appearance, irregular in amount, and not associated with core operating activities of the firm. The chapter provides a comprehensive list of nonrecurring operating cash flow items collected from the annual reports of listed companies. Moreover, the authors illustrate nonrecurring items and their location in the statement of cash flow through a number of examples from the annual reports of companies.

Chapter 7 focuses on measuring sustainable or recurring operating cash flow. Investors and creditors need this information in making investment decisions and in evaluating the debt‐paying capacity of debtors. Hence, the chapter begins with an emphasis on recurring earnings and recurring operating cash flow. Then, the measurement of sustainable operating cash flow, which begins with reported operating cash flow, is addressed. Adjustments are then required for both nonoperating and nonrecurring cash flow items.

Chapter 8 seeks to demonstrate how statement of cash flow may be a good indicator of the financial health of companies. In a financially sound company, growth in earnings is expected to be paralleled by growth in operating cash flows over extended periods. Any discrepancy between the two may signal concerns which may require further investigation. Both plausible and less‐benign reasons for such discrepancies are discussed.

Having outlined the fundamentals of preparing a proper statement of cash flow in the preceding chapters, the authors provide a framework for analyzing statement of cash flow in Chapter 9 which is designed to meet the needs of both credit and equity professionals. In the opening section of the chapter, it is shown that improvements in operating cash flow are not necessarily indicative of improvement in financial performance. Improvements in operating cash flows can be accompanied by poor earnings performance as illustrated in the example of Blockbuster, Inc. Hence, sustainability of operating cash flows is questionable unless it is supported by profitable operations.

Chapter 10 is devoted to the development of an understanding of free cash flow, which refers to “cash flow that is available for use with no strings attached” (p. 358). The chapter opens by emphasizing the importance of free cash flow, before directing the reader's attention to uses of free cash flow. Various methods of calculating free cash flow are then presented before the chapter concludes with the treatment of acquisitions in free cash flow computation.

Although the book covers statement of cash flow comprehensively, several criticisms can be directed at its structure and content. First, the table of contents lacks second‐level titles making it difficult to locate specific content. Alternatively, chapter openings might have usefully included these lower‐level titles along with their main titles. Second, the authors could have elaborated on some earlier works regarding operating cash flow formats (Klammer and Reed, 1990), and the potential application of cash flow information in areas such as financial distress prediction (Casey and Bartczak, 1985), fraudulent financial reporting detection (Lee et al., 1999), evaluation of firm performance (Dechow, 1994), and stock return performance evaluation (Rayburn, 1986). Lastly, references are mostly from non‐academic sources displaying a need for more references from scholarly journals.

Despite the above‐mentioned shortcomings, the book is very useful and represents a highly recommended reference work for serious students of cash flow statements including analysts, postgraduate accounting students, academics, sophisticated investors, and creditors. The authors deserve praise for their very important contribution to the accounting literature.