Cooking the Books
Dec 21, 2010
If you have been in business any time at all, you have probably heard the expression "cooking the books." Usually it is said in jest, but sometimes the joke becomes reality as corporate leaders take actions or give directions which are clearly unethical. While creative accounting has merits, actually cooking the books, crosses the line. Recall the behaviors of the leaders of companies such as Enron, Worldcom, Healthsouth and others, behaviors that were so egregious that they demanded intervention by Congress, often not a favorable event for business. One of the principle results was the Sarbanes-Oxley Act of 2002 and the belief by many that government needed to place a tighter reign on the financial reporting of publicly traded companies.
The subject of this article is Cash Flow, specifically on introducing the concept of the monitoring of cash flow such that misreported or misclassified amounts might be identified, thus yielding more meaningful cash flow reporting. In short, the objective is to detect the "cooking of the books."
Why might one be inclined to place more reliance and trust on cash flow verses the other financial statements? The short answer is that it is far more difficult to create a misleading view of cash flow than it is to manipulate the financial information contained in the balance sheet and income statement. While that statement may cause one to suspect deceit, it is actually the vagaries of GAAP that permits manager a great deal of latitude in classifying transactions so that the business might be cast in the most favorable light. This is not to suggest that it is impossible to manipulate the classification of cash inflows and outflows, just that change in cash flow and the balance of the cash account is not a prime candidate for manipulation.
While I have a strong opinion of the validity of the Cash Flow Statement as an extremely useful tool for business owners or managers, I am amazed at how infrequent the Cash Flow Statement is used. I can't help but wonder if one of the reasons for its lack of use is because we "professional accountants" have managed to make it too cumbersome and confusing.
To my simple mind, cash flow is "money coming in" compared with "money going out." Perhaps this is too simple for the accounting profession. We, in the profession, have determined that the flow of cash needs to be categorized further and have chosen the labels of Operating, Investing and Financing, categories which have questionable meaning to the majority of business owners. It is my hope that I can make some progress in demystifying these categories and help business owners achieve a greater level of comfort with the AICPA (American Institute of Certified Public Accounts) endorsed format for the Cash Flow Statement. I will conclude this article with a brief description of the three categories of the sources and uses of cash - Operating, Investing and Financing.
Operating cash flow: Most business owners are familiar with the term "operations" as it applies to their business. Cash flow as provided from operations applies to transactions associated with the generation of net income. Those transactions which affect the current assets and current liabilities sections of the Balance Sheet are also of an operational nature and are usually repetitive in their occurrence. For instance, the purchase of inventory which is paid for with cash is a use of cash, although only Balance Sheet accounts are affected. In comparison, a sale to a customer for which cash is received affects both the Balance Sheet (current assets) and the Income Statement. It may be helpful for the reader to remember that every transaction on the Income Statement must have a corresponding entry on the Balance Sheet and the account affected on the Balance Sheet is virtually always a Current Asset or Current Liability.
Investing Activities: The perspective that may be useful to the reader in understanding Investing Activities is the answer to the question, "How is the money entrusted to the business used to continue the business entity on a long term basis?" An example of the use of cash for an investing activity would by the purchase of durable equipment, plant or property assets. The sale of these assets would be a source of cash. Investing activities only involve the purchase or sale of long term assets and do not affect the income statement.
Financing Activities: The perspective that may be useful in understanding Financing is to consider the question: "Where did the business get the funds in order to establish the business?" The funding may be obtained from the owner, from investors or from a lending institution. Financing activities only affect the long term liabilities and equity section of the Balance Sheet. Financing activities do not impact the Income Statement.
While it may take a little getting used to, classifying the source or use of cash as an Operating Activity, an Investment Activity or a Financing Activity can enable a business owner or manager to quickly understand the application to the success of the business. Was it to used to generate income, affect assets or have an impact on debt/equity?