	2000	2001
Net cash provided by operating activities	$ 70.9	$ 272.1
Net cash (used in) investing activities	(550.5)	(1,304.4)
Net cash provided by financing activities	501.3	1,066.4
Increase in cash and cash equivalents	$ 21.7	$ 34.1

Exhibit 3.3 AmeriCredit Corp., Summarized Statements of Cash Flows, as Restated, Years Ended June 30, 2000 and 2001 ($ millions)

Source: AmeriCredit Corp. Form 10-K annual report to the Securities and Exchange Commission, June 30, 2001, pp. 30 and 31.

	2000	2001
Net cash (used in) operating activities	$ (530.6)	$ (990.4)
Net cash (used in) investing activities	(21.0)	(98.9)
Net cash provided by financing activities	573.3	1,123.4
Increase in cash and cash equivalents	$ 21.7	$ 34.1

The primary reason for the change in AmeriCredit’s cash flow performance was a change in how it classified changes in its automobile finance receivables. Historically, AmeriCredit reported the purchase of automobile finance receivables as an investing use of cash. The proceeds received on the sale of those receivables and the collection of principal on outstanding receivable balances were reported as investing sources of cash. In 2002, the company changed its classification of cash flows associated with the purchase and sale of automobile finance receivables and of collections of principal on them from investing to operations. As a result, in 2000 a use of cash of approximately $602 million ($70.9 million + $530.6 million) was shifted to the operating section of the cash flow statement from the investing section. In 2001, the use of cash shifted to the operating section was over $1.2 billion ($272.1 million + $990.4 million). As a result, in both years the company’s cash flow statements reported a use of operating cash flow.

As part of its restatement, in 2000 and 2001 the company also reclassified a small amount of borrowings out of the operating section of its cash flow statement. Those borrowings, $72 million in 2000 and $57 million in 2001, were reclassified to the financing section. It is because of the reclassification of this borrowing item that financing cash flows reported in Exhibit 3.2, $501.3 million in 2000 and $1,066.4 million in 2001, differ from financing cash flow reported on a restated basis in Exhibit 1.3, $573.3 million in 2000 and $1,123.4 million in 2001.

Should AmeriCredit have changed the cash flow reporting of changes in the balances of its automobile finance receivables for purchases, sales, and collections? It is an interesting question and one that emphasizes the flexibility found in GAAP for cash flow reporting.

Statement of Financial Accounting Standards No. 95, “Statement of Cash Flows,” indicates that investing activities include cash flows associated with the making and collecting of loans.² Thus, banks report loan originations and collections in the investing section of the cash flow statement. Unlike a bank, AmeriCredit does not originate its finance receivables or loans. For the most part, AmeriCredit purchases receivables and resells them.

Increases in loans held for sale at banks are reported as operating uses of cash and not as investing. Proceeds from the sale of such loan packages are reported as operating sources of cash. Thus, AmeriCredit seemingly has changed its cash flow reporting to be more consistent with that of other financial institutions, such as banks, that buy and sell loans.

An operating designation for the purchase and sale of receivables makes sense. It is more of a core operating activity, like the purchase and sale of inventory, whose related cash flows are reported in the operating section.

Household International, Inc., however, provides an interesting contrast. It emphasizes even more the flexibility in GAAP for cash flow reporting. Household International is also in the consumer loan business. Although much of Household’s business entails loan origination, like AmeriCredit, the company also purchases and sells receivables. Yet Household classifies cash flows from its purchase and sale of receivables in the investing section of its cash flow statement.

The AmeriCredit case provides an informative look at the effects of the flexibility in GAAP for cash flow reporting. Without breaking the rules, that flexibility can be used to create a misleading signal about a firm’s ability to generate sustainable cash flow. In other cases, companies may go beyond the boundaries of GAAP. They may improperly report operating cash expenditures as investments, boosting operating cash flow in the process. Consider the unfolding saga of HealthSouth Corp.

As this book is being written, we are reminded each day of the lengths to which some corporate managers may go in an effort to misrepresent their company’s financial performance. During the 1980s and 1990s, HealthSouth grew rapidly, providing outpatient surgical, diagnostic, and rehabilitative health services. In less than 20 years, the company grew from a business start-up to an enterprise with over $4 billion in revenue. Profits and the company’s share price followed right along.

In early 2003, we learned that much of HealthSouth’s financial performance was actually fabricated. Although the facts of the case are still unfolding, it appears that over many years, and under the watch of several different chief financial officers, a systematic fraud was effected. At regular meetings of top corporate officers, before actual results were made public, differences between preliminary estimates of actual earnings and analyst expectations of the company’s results were identified. These differences were referred to as “gaps” or “holes” that needed to be filled before the company went public with its results. Managers then were assigned the task of finding “dirt” to fill the holes so that actual earnings would meet the expectations of analysts. That so-called dirt included fictitious adjustments to increase net revenues and assets and reduce expenses. Fictitious journal entries then were posted to the company’s accounts and, at times, allegedly included the generation of fictitious supporting documentation.³

Net revenues were overstated by understating third-party payor discounts, a contra account, or reduction in revenue. Estimating the amount of such discounts requires considerable judgment and thus is open to manipulation. Overstated assets included property, plant, and equipment. By overstating such assets, operating expenses could be understated, boosting profits. Curiously, cash also was allegedly overstated. How the company was able to misstate cash and not be caught by its auditors is still a mystery. As noted by Dan Guy, a prominent author of auditing textbooks, “I’m shocked that cash is manipulated and overstated, because the darn stuff is so easy to count.”⁴

For our purposes we are particularly interested in the overstatement of property, plant, and equipment. In overstating property, plant, and equipment, HealthSouth also overstated capital expenditures, an investing use of cash, by including operating expenses in their total. By reporting operating expenses as capital expenditures, or increases to property, plant, and equipment, cash expenditures that would have reduced operating cash flow were reported as investing uses of cash. Operating cash flow was correspondingly boosted.

Exhibit 3.4 provides summarized cash flow information as originally reported by HealthSouth. We hasten to point out that the figures presented in the exhibit ultimately will be restated. Yet we wanted to show what the company’s statement of cash flows looked like based on reported amounts.

As seen in the exhibit, in the 1999 through 2001 time period, HealthSouth reported that it was able to generate ample amounts of operating cash flow. Most of that cash was plowed into net new investments, which consisted primarily of capital expenditures. In 2001, operating cash flow exceeded net cash used in investing activities by a significant amount. During that year the company received $215 million from the sale of certain “non-strategic assets.”⁵ In two of the three years presented, 1999 and 2001, the company was able to use cash generated by operations to cover net cash used in investing activities and also to pay down debt and buy back stock. Such transactions are reflected in Exhibit 3.4 as cash (used in) financing activities.

Exhibit 3.4 HealthSouth Corp., Summarized Statements of Cash Flows, Years Ended December 31, 1999, 2000, and 2001 ($ millions)

Source: HealthSouth Corp. Form 10-K annual report to the Securities and Exchange Commission, December 31, 2001, p. 42.

Our point is that on an as-reported basis, HealthSouth’s cash flow statement looks healthy. By allegedly shifting operating expenditures to the investing section, the company was able to boost operating cash flow and portray a stronger picture of health without actually affecting total cash flow. Of course, as noted, other steps were taken, including a misstatement of cash itself. So it is anybody’s guess as to what the company’s real cash flow results looked like. Collectively, it is not difficult to understand how many analysts who use such cash flow numbers to evaluate the quality of the company’s earnings may have been misled.

As seen, operating cash flow can provide misleading signals of a company’s ability to generate sustainable cash flow because of steps taken within the boundaries of GAAP or steps taken that extend beyond the boundaries of GAAP. This chapter looks at both approaches to creative cash flow reporting as they affect classifications of cash flow in the operating and investing sections.

INVESTING CASH FLOW

Companies expend resources on investments to generate returns. Those returns come in the form of income from operations and operating cash flow. Cash expended on investing activities might include the origination of loans that generate interest income. The granting and collecting of loan principal are reported as investing cash activities. Cash interest collected is reported as operating cash flow. Investments in debt and equity securities also are reported as investing cash flow. Purchases of investments are investing uses of cash; proceeds from sale are investing sources. Cash income from those investments, including interest and dividends, are operating cash activities.

Typically the greater portion of cash used in investing activities is in the purchase of property, plant, and equipment. Such disbursements, known more commonly as capital expenditures, provide the asset base from which a company conducts its operations. Cash expended in the purchase of such assets is reported as an investing use of cash. Proceeds from their sale are investing sources of cash. It is important to note that proceeds from sale, whether of investments in securities or of property, plant, and equipment, include recovery of book value plus any gain or less any loss on sale. Thus, gains and losses from sales of investments or property, plant, and equipment are not included in operating cash flow.⁶

The investing section of the statement of cash flows for Intel Corp. is provided in Exhibit 3.5. Note the significance of capital expenditures, referred to here as additions to property, plant, and equipment. Across the three years presented, 2001, 2002, and 2003, the company expended $7,309 million, $4,703 million, and $3,656 million, respectively, on additions to property, plant, and equipment. Other investing activities included cash expended on acquisitions and purchases and sales of available-for-sale investments. In 2003, as additions to property, plant, and equipment declined below prior-year levels, cash expended for new available-for-sale investments totaled $11,662 million and exceeded by a significant amount the $8,488 million in proceeds received from maturities and sales of available-for-sale investments.

Understanding the classification of investing cash flow is important in gaining more insight into how an operating item might be classified as an investing item, or vice versa. Generally, if an expenditure can be characterized as an investment or as the purchase of an asset to be used in operations, an investing classification is appropriate. Assets purchased for sale—that is, inventory—are assigned an operating designation.

Exhibit 3.5 Intel Corp., Investing Section of the Statement of Cash Flows, Years Ended December 29, 2001, December 28, 2002, and December 27, 2003 ($ millions)

Source: Intel Corp. Form 10-K annual report to the Securities and Exchange Commission, December 27, 2003, p. 54.

Restricted Cash

The cash flow classification of restricted cash fits within these general rules. Restricted cash is set aside for a particular purpose. The restriction may be a legal one, for example, a compensating balance where a bank requires that a portion of a bank balance must be set aside to support an existing borrowing arrangement or where proceeds from a borrowing must be employed specifically for the construction of a building. Restrictions also may be informal, such as cash set aside for the payment of a dividend.

Cash flow statement classification of restricted cash depends on the nature of the restriction. For example, the bank of Shopsmith, Inc., required the company to maintain a restricted cash account for use in funding any customer-related, “credit card returns or chargebacks that may occur.”⁷ At March 31, 2002, the company reported $152,000 in restricted cash on its balance sheet. The restriction was lifted during the company’s fiscal 2003, and the entire $152,000 restricted cash balance was reported as operating cash flow.

In contrast, in 2001 Homasote, Inc., received $2,039,286 in proceeds from its insurance carrier for equipment damaged by a fire. The company agreed with its lender that $330,814 of the insurance proceeds should be restricted for replacement of the damaged equipment under the terms of its loan agreement with the New Jersey Development Authority. ⁸ Because it related to equipment, changes in the balance of the company’s restricted cash account were reported in investing cash flow.

Assets Acquired for Use in Operations and for Sale

While expenditures for inventory that is held for sale are reported as operating uses of cash and purchases of assets acquired for use are reported as investing uses of cash, what if merchandise that is acquired for use is also held for sale? A good example is provided by the cash flow reporting practices by companies in the short-term rental business.

Several companies in this industry purchase furniture, appliances, and consumer electronics and hold these assets for sale, for short-term rental, or on a rent-to-own basis. One example is Aaron Rents, Inc.

At Aaron Rents, all rental merchandise is subject to depreciation. Merchandise on lease is depreciated over its estimated useful life. For merchandise that is on hand and available for sale or lease, no depreciation is recorded until an ownership agreement is signed. However, depreciation of the merchandise is begun if an agreement has not been signed after one year.

Through its year ended December 31, 2002, Aaron Rents reported all purchases of rental merchandise as investing uses of cash. This was a curious treatment because there was very little difference between what the company considered to be its merchandise held for sale or lease and merchandise inventory available for sale at any retailer. Aaron Rents might have argued that because it sold its merchandise on a rental contract, its transactions were inherently different from those of other, more traditional retailers. However, in substance, such a rent-to-own agreement might be viewed more as an installment purchase contract. In that light, Aaron Rents’ rent-to-own transaction would be considered the sale of inventory, and an operating designation for the purchase of that inventory would have been viewed as more appropriate.

Interestingly, in 2003, Aaron Rents changed its classification for additions to its rental merchandise pool from an investing to an operating designation. The change made the company’s presentation format more consistent with other firms in the industry. Statements of cash flows for prior years were reclassified to conform to this new presentation. As seen in Exhibit 3.6, the effects of the change on the company’s statement of cash flows and especially on its reported operating cash flow were dramatic.

As noted in the exhibit, Aaron Rents’ change in the cash flow classification for purchases of rental merchandise from an investing to an operating designation was the primary reason for a reduction in operating cash flow from $189.4 million and $221.7 million, as originally reported in 2001 and 2002, respectively, to $66.1 million and $10.1 million, respectively, as reclassified. Financing cash flow was not affected by the reclassification, nor was the overall change in cash.

Demonstrating flexibility in the reporting of cash flow, one company in the rent-to-own industry that continues to classify purchases of merchandise as investing cash flow is Bestway, Inc. In the years ended July 31, 2002 and 2003, Bestway reported operating cash flow of $10,210,071 and $12,110,730, respectively. However, reported among the company’s investing activities were purchases of rental units and equipment for $9,593,006 and $10,565,857 in 2002 and 2003, respectively. If the company were to report purchases of this rental merchandise in the operating section of the statement of cash flows, operating cash flow would be reduced significantly.⁹

Capitalized Operating Costs

Bestway’s cash flow classification of rental merchandise purchases is one example that demonstrates how an investing designation might be afforded a disbursement that otherwise would have been classified as an operating use of cash. Another example is the characterization of operating expenditures as long-lived assets. When operating costs are capitalized, or reported as assets, the cash expenditure made often is reported as an investing use of cash. We have already seen examples of this in Chapter 1, where American Software, Inc., reported capitalized software development costs as investing uses of cash. As the company reduced the proportion of software costs capitalized, its operating cash flow declined as greater amounts of software costs incurred were reported in the operating section. Although it is a more extreme case, HealthSouth Corp. also demonstrates how capitalization decisions can boost operating cash flow.

Exhibit 3.6 Aaron Rents, Inc., Operating and Investing Cash Flows, Years Ended December 31, 2001, and 2002, as Originally Reported and as Reclassified ($ millions)

Source: Aaron Rents, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, Item 8, and December 31, 2003, Item 8.

		2001	2002
As Originally Reported:
Net cash provided by operating activities		$189.4	$ 221.7
Net cash (used in) investing activities:
	Net additions to property, plant and equipment	(28.2)	(25.2)
	Net additions to rental merchandise	(122.4)	(211.0)
	Other investing activities	(12.1)	(14.0)
Net cash (used in) investing activities		(162.7)	(250.2)
Net cash provided (used in) financing activities		(26.7)	28.5
Increase (decrease) in cash		$ 0	$ 0
As Reclassified:
Net cash provided by operating activities		$ 66.1	$ 10.1
Net cash (used in) investing activities:
	Net additions to property, plant and equipment	(27.3)	(24.6)
	Other investing activities	(12.1)	(14.0)
Net cash (used in) investing activities		(39.4)	(38.6)
Net cash provided (used in) financing activities		(26.7)	28.5
Increase (decrease) in cash		$ 0	$ 0

Investments in Debt and Equity Securities

Beyond assets used in operations, investments in debt and equity securities also are classified as investing cash flows. If these investments are characterized as investments in trading securities, however, then cash expended in their purchase and proceeds from their sale are reported as operating cash flow.

In Chapter 1 we looked at Nautica Enterprises, Inc. Traditionally, the company classified investment securities as available for sale. Cash expended in making investments was reported as an investing use of cash. Around the time the company carried a substantial sum in its portfolio, it changed the classification of its investments to a trading designation. Over the next few years as it liquidated its investment portfolio, the cash proceeds generated were reported as operating sources of cash.

No Simple Rule

The purpose of these examples is to give background and perspective to the classification of investing cash flows. On the surface, GAAP for classifying investing cash flow is reasonably straightforward. Cash expended for loans, investments in securities, except for trading investments, and purchases of property, plant, and equipment are reported as investing cash flow.

However, beyond this simple expression of investing activities, there is no simple rule for predicting consistently where investment-related cash expenditures will be reported. Certainly balance sheet classification plays a role. Everything else being equal, cash expenditures resulting in assets classified as noncurrent tend to be reported as investing uses of cash. Purchases of buildings and equipment fit this rule well. However, even this simple rule will not work consistently.

For example, investments in marketable securities classified as current, excluding trading investments, still will be reported as investing cash flow. On the other end of the spectrum are investments in noncurrent assets reported as operating cash flow. Consider the case of Pre-Paid Legal Services, Inc.

Pre-Paid Legal Services, Inc., sells what are effectively insurance policies to cover the need for future legal services. The company refers to its policies as memberships. For an annual fee, members are afforded legal representation through a network of independent law firms that are under contract with Pre-Paid Legal Services. At the time a membership is sold, an advance is made, with certain limitations and restrictions, to the sales agent for approximately three years’ worth of commissions to be earned on the sale.

As of December 31, 2000, Pre-Paid Legal Services reported capitalized commission advances, which it titled membership commission advance receivables, of $156.1 million. Of this total, $45.6 million was reported as a current asset and $110.5 was reported as a noncurrent asset. At the time, these capitalized costs represented 63 percent of the company’s total assets.¹⁰ Starting in 2001, the company changed its accounting for membership commission advances and began expensing them. The financial statements for 2000 and prior years were restated, and membership commission advance receivables were removed from the balance sheet.

Interestingly, even though the majority of amounts reported as membership commission advances were noncurrent assets that were amortized against income, the company reported commission advance payments as operating uses of cash. Thus, the restatement and the company’s new accounting policy for membership commission advances reduced earnings and assets reported on the balance sheet. However, the accounting change did not impact the cash flow statement.

Beyond balance sheet classification, industry-wide practices are also important in cash flow classification. For example, capitalized software development costs are generally, but not always, reported as investing uses of cash.

Yet even beyond these classification guidelines, there remains an unexplained component where cash flow reporting practices are company specific and can lead to unexpected results. Such unexpected cash flow reporting practices attest to the inherent flexibility of GAAP for cash flow reporting.

GAAP FLEXIBILITY: IS IT OPERATING OR INVESTING CASH FLOW?

Given the flexibility that exists in GAAP for cash flow reporting, managers who have an interest in doing so can ply that flexibility to boost operating cash flow. The objective is to put a more positive spin on operating results.

Several examples related to the cash flow classification of operating and investing items are provided next. Some of the examples are designed to help the reader better understand how cash flows are reported. Others are provided because we found them to be both interesting and potentially misleading.

Capitalized Operating Costs: A Closer Look

When it is determined that costs incurred will benefit future periods, those costs are capitalized or reported as assets. The capitalized costs are then amortized or systematically written off with an expense charge against earnings in the future periods that benefit from these expenditures. In this way, benefits derived in the form of revenues or cost savings are charged with an expense for those costs.

In recent years, GAAP have reduced the kinds of costs that firms may capitalize. For example, start-up costs, which consist of costs related to such one-time activities as opening a new facility, introducing a new product or service, commencing activities in a new territory, or pursuing a new class of customer, may no longer be capitalized. Also, the Securities and Exchange Commission (SEC) has restricted when advertising costs known as direct-response advertising may be capitalized. Direct-response advertising consists of costs incurred to elicit sales to customers who can be shown to have responded specifically to that advertising. Such costs may be capitalized when persuasive historical evidence permits formulation of a reliable estimate of the future revenue that can be obtained from incremental advertising expenditures. The SEC has interpreted capitalization guidelines for such costs in a limited way. Companies in new, evolving, and unstable industries may not capitalize such costs. This was learned by America Online, Inc., a company that in 1996 was required to take a special $385 million pretax charge to write down direct-response advertising costs that had been capitalized previously. ¹¹

Yet even with newer limitations, numerous kinds of costs may be, and in some cases must be, capitalized. Some relate to firms across all industries, including, for example, capitalized interest costs, where capitalization is required when certain conditions are met. Others are costs incurred within specific industries, including software development and motion picture development costs.

This section looks at the cash flow classification of several different kinds of capitalized costs. In particular, our interest is in determining whether these costs are reported as operating activities or investing activities in the statement of cash flows.

Customer Acquisition Costs

Although the costs carry different names, many companies in varying industries incur costs related to increasing their customer base. Qwest Corp. describes customer acquisition costs in this way:

Customer Acquisition Costs. We defer the initial direct costs of obtaining a customer to the extent there is sufficient revenue guaranteed under the arrangement to ensure the realizability of the capitalized costs. Deferred customer acquisition costs are amortized over the longer of the contract or the expected life of the customer relationship. ¹²

Qwest’s policy describes the nature of these costs well. Customer acquisition costs consist of incremental direct costs incurred in adding new customers. For example, such costs may include direct-response advertising. They also may include commissions paid to sales personnel, similar to the membership-commission advances paid by Pre-Paid Legal. Administrative costs incurred in signing up new customers may be included with customer acquisition costs as well.

Pre-Paid Legal describes its accounting policy for such administrative costs, which it capitalizes, in this way:

Member and Associate Costs. Deferred costs represent the incremental direct and origination costs the Company incurs in enrolling new Members and new associates. . . . Deferred costs for enrolling new members include the cost of the Membership kit and salary and benefit costs for employees who process Membership enrollments. Deferred costs for enrolling new associates include training and success bonuses paid to individuals involved in recruiting the associate and salary and benefit costs of employees who process associate enrollments. Such costs are deferred to the extent of the lesser of actual costs incurred or the amount of the related fee charged for such services.¹³

The company carries these capitalized costs in both the current and noncurrent asset sections of the balance sheet. Classification depends on the amortization period for the capitalized costs, which, in turn, is linked to the term of the related new membership.

Subscriber Acquisition Costs

Pegasus Communications Corp. provides direct broadcast satellite and cable television services. The company refers to the costs incurred in signing up new customers as subscriber acquisition costs and describes its accounting policy for these costs in this way:

These costs consist of the portion of programming costs associated with promotional programming provided to subscribers, equipment related subsidies paid to distributors and applicable costs incurred by us, installation costs and related subsidies paid to dealers, dealer commissions, advertising and marketing costs, and selling costs.¹⁴

The company expenses these costs. However, it capitalizes certain subscriber acquisition costs that it capitalizes, as described next.

We also have subscription plans for our DIRECTV programming that contain minimum service commitment periods. These plans have early termination fees for subscribers should service be terminated by subscribers before the end of the commitment period. Direct and incremental subscriber acquisition costs associated with these plans is deferred in the aggregate not to exceed the amounts of applicable termination fees. . . . Direct and incremental subscriber acquisition costs consist of equipment costs and related subsidies not capitalized as fixed assets, installation costs and related subsidies, and dealer commissions.¹⁵

These costs are amortized over a 12-month period and are carried on the balance sheet as current assets.

Policy Acquisition Costs

Customer acquisition costs typically are capitalized in the insurance industry, where they are referred to as policy acquisition costs. Miix Group, Inc., which provides professional liability insurance products to the medical profession, describes its accounting method for policy acquisition costs in this way:

Deferred Policy Acquisition Costs. Policy acquisition costs (primarily commissions and premium tax expenses), that vary with and are directly related to the production of business, are capitalized and amortized over the effective period of the related policies. ¹⁶

Miix Group does not classify its balance sheet into current and noncurrent asset sections. The company simply reports assets in a single section of its balance sheet. Accordingly, deferred policy acquisition costs are not separated from current assets, such as cash or accounts receivable, or noncurrent assets, such as goodwill or property, plant, and equipment. Nonetheless, given that their amortization period generally extends beyond one year, they should be considered to be long-lived in nature.

Aetna, Inc., a health-insurance provider, expenses acquisition costs related to its pre-paid health and health indemnity contracts. The company does, however, capitalize acquisition costs related to its long-term care policies. Those costs are carried in other long-term assets on the company’s balance sheet.

Direct-Response Advertising

The primary line of business of CPI Corp. is to operate portrait studios within Sears, Roebuck & Co. retail stores. Certain of the costs incurred by the company in marketing its services to consumers are capitalized as direct-response advertising. The policy is described in this way:

The Company expenses costs involved in advertising the first time the advertising takes place, except for direct-response advertising, which is capitalized and amortized over its expected period of future benefits.

Direct-response advertising consists of direct mail advertisements, which include coupons for the Company’s products, and of certain broadcast costs. The capitalized costs of the advertising are amortized over the expected period of future benefits following the delivery of the direct mail in which it appears.

Total advertising reported as a capitalized cost for direct-response advertising and classified with other assets for 2001 and 2000 was $1.3 million and $1.2 million, respectively. ¹⁷

The capitalized direct-response advertising costs of CPI Corp. are carried with other assets, a noncurrent asset, on the company’s balance sheet.

Direct-response advertising is very important to companies in the direct-to-consumer catalog sales business. Consider this disclosure made by Lillian Vernon Corp.

Catalog costs are deferred and amortized over the estimated productive life of the catalog, generally three months. Such deferred costs are considered direct-response advertising . . . and are reflected as long-term assets in the accompanying balance sheets.¹⁸

Lillian Vernon, which uses catalogs to market miscellaneous merchandise, including gift, household, kitchen, and gardening products, incurs direct-response advertising costs when it mails catalogs to consumers. Although the company notes that a three-month amortization period is used for such costs, capitalized catalog costs are reported as a noncurrent asset on its balance sheet.

In its membership shopping and time-share sales programs, Cendant Corp. also incurs advertising costs that are considered to be direct-response advertising. As described in the next note, however, the company generally expenses such costs as incurred:

Advertising costs, including direct response advertising related to membership and timeshare sales programs, are generally expensed in the period incurred.¹⁹

Cash Flow Classification of Customer Acquisition Costs The discussion in the previous section reveals that customer acquisition costs include a wide range of expenditures carrying different names. Depending on the company and the industry, such titles as customer acquisition costs, subscriber acquisition costs, policy acquisition costs, and direct-response advertising are used. The costs are all designed to add to a company’s customer base.

Among the many companies surveyed, capitalization of customer acquisition costs was common but not universal. There was, however, no consistency in the balance sheet treatment of assets resulting from cost capitalized. Some companies reported them as current assets and others as noncurrent assets. Companies that did not classify their balance sheets simply reported unamortized customer acquisition costs among their listed assets.

Although differences were noted in the balance sheet treatment of capitalized customer acquisition costs, there was little disagreement in the cash flow treatment of these costs. Regardless of the balance sheet classification employed, capitalized customer acquisition costs were reported as an operating use of cash. On this item we found consistent treatment. As seen in the case of Cendant Corp., operating treatment also was afforded direct-response advertising costs that were expensed as incurred.

Tyco International, Ltd. and Purchased Customer Accounts

Tyco International, Ltd., historically touted its financial strength as evidenced by its ability to generate what it termed free cash flow, defined by the company as “cash generated by operations, minus dividends and capital expenditures.”²⁰ In fact, at one point, the company’s chief financial officer told investors to “forget reported earnings and instead focus on cash-flow generation as a percentage of net income, to ‘show that our quality of earnings is good.’”²¹

The company, with operations in security and fire-protection services, among other areas, would spend significant amounts each year adding to its customer base. Although not disclosed in its regulatory filings, the company admitted in response to analyst questions that during 2001 it spent some $830 million buying roughly 800,000 individual customer contracts for its security-alarm business from a network of 2,300 independent dealers. These dealers were agents of Tyco who sold security services on the company’s behalf. They did not, however, work as employees of the company but as independent contractors.

Had the independent dealers worked for Tyco, costs incurred in adding customer accounts would have been a form of customer acquisition cost. The company would have faced the question of whether to capitalize some portion of these costs. However, whether capitalized or not, expended amounts would have reduced operating cash flow and the company’s definition of free cash flow.

Tyco, however, classified cash payments made to acquire customer contracts from its independent dealers as acquisitions. They were reported in the investing section of the cash flow statement. As acquisitions, these cash payments did not reduce the company’s free cash flow. Other intricacies of the company’s accounting for purchased customer accounts boosted free cash flow even further.

As alleged, Tyco might pay $1,000 for a hypothetical customer account that generated $30 per month in revenue for security monitoring. The company would not write a check for $1,000, however. Instead it would deduct $200 as a connection fee and pay the dealer $800 for the new account. That $200 was accounted for as a reduction in operating expenses, which boosted net income.²²

Thus, even though Tyco was out of pocket $800 for the purchase of this hypothetical customer account, it reported $200 of up-front income and operating cash flow. That operating cash flow was actually the company’s own money. It was the difference between what was reported as a $1,000 acquisition and the actual $800 that was paid to acquire the account. No wonder the company reported so much operating and free cash flow. On an operating cash flow basis, new accounts were effectively without cost and added immediately to cash flow results.

After intense scrutiny was focused on these questionable actions, the company changed its accounting for acquired customer accounts and its definition of free cash flow. As Tyco noted, “In determining free cash flow under this new definition, the Company will include the effect of spending on ADT dealer account acquisitions,”²³ Indications were that this change would reduce free cash flow during 2003 by about $750 million, or approximately 27 percent.²⁴

Capitalized Interest

We normally think of interest as being expensed as incurred. However, when an asset requires an extended period of time to get it ready for its intended use, interest incurred during that preparation time should be capitalized, that is, added to the cost of the asset. ²⁵

An extended period of time to prepare an asset for its intended use might entail the construction period for a property or equipment item. Examples include the construction of a building or other real estate project and the manufacture of aircraft or cruise ships, all intended for a company’s own use. It might also entail assets intended for sale or lease that are constructed as discrete projects. Examples here include residential homebuilding and other real estate projects, barreled whiskey, and tobacco inventories.²⁶

Interest to be capitalized represents avoidable interest, that is, the interest that could have been avoided if the asset were not constructed. When specific borrowings can be identified with a particular project, then interest incurred on those borrowings during the construction period should be capitalized. If specific borrowings do not cover the entire funding requirements of the project, then interest incurred on other borrowings should be capitalized based on a weighted average interest rate. That interest rate is applied to average expenditures accumulated on a project during a reporting period over and above the amount of any specific borrowings related to the project. Interest capitalization ceases when an asset is ready for use or sale.

Delta Air Lines, Inc., capitalizes interest on aircraft and ground facilities that are under construction. Consider this disclosure about the company’s accounting policy for capitalized interest:

We capitalize interest on advance payments for the acquisition of new aircraft and on construction of ground facilities as an additional cost of the related assets. Interest is capitalized at our weighted average interest rate on long-term debt or, if applicable, the interest rate related to specific asset financings. Interest capitalization ends when the equipment or facility is ready for service or its intended use.²⁷

For assets that are classified as property, plant, and equipment, capitalized interest is part of the asset’s cost and adds to depreciation expense over its useful life. For discrete inventory projects, capitalized interest adds to inventory cost and increases cost of goods sold upon sale. Thus interest capitalization shifts the timing of expense from when the interest is incurred until later when the associated asset is depreciated or sold.

In terms of cash flow, when interest is expensed as incurred, it is reported as an operating use of cash. In contrast, depending on whether it is capitalized into property, plant, and equipment or inventory accounts, capitalized interest may be reported as an investing item or an operating item. When assets whose cost includes capitalized interest are added to property, plant, and equipment, the amount of interest capitalized is reported as part of capital expenditures in the investing section of the cash flow statement. When added to discrete inventory projects, capitalized interest is reported as an operating use of cash.

Disclosures of capitalized interest vary depending on the nature of the company and materiality of the interest that has been capitalized. Most companies that are adding capitalized interest to property, plant, and equipment accounts report the amount of interest capitalized during a reporting period in a simple footnote comment. Delta, for example, provided this disclosure:

Capitalized interest totaled $12 million, $15 million and $32 million for the years ended December 31, 2003, 2002 and 2001, respectively.²⁸

Companies with more material amounts of capitalized interest, especially where interest becomes a component of inventory, tend to provide more extensive disclosures of capitalized interest. Consider KB Home.

KB Home capitalizes interest into its inventory of homes, lots, improvements, and land under development. In its annual report the company provided a summary of interest incurred and expensed and of interest capitalized into inventory. Summarized data taken from that disclosure for 2001, 2002, and 2003 are provided in Exhibit 3.7.

During the three years ended November 30, 2001, 2002, and 2003, KB Home capitalized $62.0 million, $68.4 million, and $95.0 million, respectively, of interest incurred into inventory. Although amounts capitalized will await sale to be transferred to expense in the form of cost of goods sold, total interest incurred reduced operating cash flow when paid.

Software Development Costs

For software companies that sell, lease, or license new software applications, costs incurred in developing that software are expensed until technological feasibility is reached. At that point, and until the software is available for distribution, software development costs incurred are capitalized. Technological feasibility is defined as the point at which all of the necessary planning, designing, coding, and testing activities have been completed to the extent needed to establish that the software application can meet its design specifications. Once technological feasibility is reached, the software company has a more viable product and a higher likelihood of being able to realize its investment in the software through future revenue.²⁹ Because the financial realizability of software development can be assessed more readily than spending on more traditional research and development projects, accounting standards embrace capitalization of software development costs. As noted by a financial executive in a software company, “The key distinction between our spending and R&D is recoverability. We know we are developing something we can sell.”³⁰

PeopleSoft, Inc. describes its accounting policy for software development costs in this way:

The Company accounts for the development cost of software intended for sale in accordance with Statement of Financial Accounting Standards No. 86, “Accounting for Costs of Computer Software to be Sold, Leased, or Otherwise Marketed” (“SFAS 86”). SFAS 86 requires product development costs to be charged to expense as incurred until technological feasibility is attained. Technological feasibility is attained when the Company’s software has completed system testing and has been determined viable for its intended use.

Exhibit 3.7 KB Home, Interest Incurred, Expensed, and Capitalized into Inventory, Years Ended November 30, 2001, 2002, and 2003 ($ millions)

Source: KB Home, Form 10-K annual report to the Securities and Exchange Commission, November 30, 2003, p. 69.

It would seem that waiting until system testing has been completed before technological feasibility is reached is rather late in the software development process. However, as long as a software firm has a detailed program design or a detailed step-by-step plan for completing the software, software costs may be capitalized once the detailed program design is complete and high-risk development issues have been resolved.

There is one additional limit on whether software development costs may be capitalized and by how much: the software’s expected commercial viability. Capitalized software costs may not be greater than the expected net realizability of the software product once it is commercialized. Accordingly, even if a detailed program design is prepared, costs may not be capitalized when commercial viability of the product is questioned.

In practice, these various decision points and constraints on capitalization mean that substantial flexibility is afforded software firms for deciding whether software development costs are to be capitalized. Development of a detailed program design early in the software-writing process, assuming the product is expected to be commercially viable, can result in an increase in the proportion of software development costs capitalized. Postponement of a detailed program design means that capitalization must await system testing. Consider this policy statement from PeopleSoft, Inc.

The time between the attainment of technological feasibility and completion of software development has been short with immaterial amounts of development costs incurred during this period. Accordingly, the Company did not capitalize any development costs in 2002 or 2001. . . .

Apparently the company did not complete a detailed program design. As a result, technological feasibility was postponed until system testing was finished. That stage was sufficiently late in the software development process that any remaining development costs were immaterial. As a result, the company capitalized no software development costs.

As a result of management judgment and GAAP flexibility, capitalization practices vary significantly across the spectrum of software companies. In a research paper, Ely and Waymire examined the software capitalization practices of a sample of 342 software firms in 1998. Of this sample of firms, 175 firms expensed all software development costs incurred. The remaining 167 firms capitalized at least some portion, averaging 26 percent of software costs incurred.³¹

Analysts have understandable concern regarding the proportion of software costs capitalized by a firm. Capitalization boosts earnings. Later, when capitalized amounts are amortized, earnings are reduced. When amounts capitalized exceed software costs amortized, the net effect on earnings is a positive one and is offset with an increase in net capitalized software costs on the balance sheet. The risk is that these capitalized costs will not be realized and a future write-down may be needed.

The effects on earnings of a software firm’s capitalization policy are minimized when amortization of software costs equals new amounts capitalized. At this steady state, analysts’ concerns about a firm’s capitalization policy are somewhat assuaged. The continuing effects of a firm’s capitalization policy on operating cash flow still exist, however.

Most companies report capitalized software development costs as an investing use of cash. There are exceptions, however. Consider, for example, the cash flow data presented for Activision, Inc., in Exhibit 3.8.

Unlike most of its peers, Activision classifies capitalized software development expenditures as operating uses of cash. It is a conservative treatment. The company could boost operating cash flow markedly by following other software firms and reporting capitalized software development expenditures as investing uses of cash.³²

Software costs that are expensed as incurred are also operating uses of cash. Thus, not only are there differences across firms in the amount of software costs capitalized, there are significant differences in the cash flow treatment of software costs. Accordingly, even when new software costs capitalized equal amounts amortized and the effects on earnings of a firm’s capitalization policy are minimal, software capitalization continues to boost operating cash flow when capitalized costs are reported as investing uses of cash. Consider A.D.A.M., Inc., for example.

A.D.A.M, Inc., produces health-related educational software. During the year ended December 31, 2002, the company generated a net loss of $1,530,000. On a cash flow basis, however, the company’s performance was better. Reported operating cash flow during 2002 was $1,022,000.

A.D.A.M.’s accounting for software development costs had little effect on its earnings during 2002. Software development costs capitalized were $527,000; amounts amortized were $599,000. Capitalized software development costs were, however, reported as an investing use of cash. Had they been reported in the operating section, operating cash flow would have been correspondingly reduced.

Capitalized Internal-Use Software Development Costs Beyond the software firms, all companies are subject to capitalization rules when developing software for internal use. Here the accounting rules also allow managers considerable leeway in deciding the amount of software costs to capitalize. In particular, costs incurred in developing software for internal use are to be capitalized once the preliminary project stage is complete. At that point, the company has completed its conceptual formulation, design, and testing stage. Also, by that time a software vendor has been chosen, if one is to be used. Costs are capitalized until the project is completed. Capitalized costs are reported as long-lived assets and are amortized over their expected economic life.³³ Amounts capitalized appear as investing uses of cash versus an operating designation if the costs were not capitalized.

Exhibit 3.8 Activision, Inc., Operating Cash Flow and Capitalized Software Development Expenditures, Years Ended March 31, 2001, 2002, and 2003 ($ millions)

^a Includes purchased intellectual property licenses. Source: Activision, Inc., Form 10-K annual report to the Securities and Exchange Commission, March 31, 2003, p. F-5.

DeVRY, Inc., provided the next disclosure for internal-use software development costs incurred:

The Company capitalizes certain internal software development costs that are amortized using the straight line method over the estimated lives of the software not to exceed five years. Capitalized costs include external direct costs of materials and services consumed in developing or obtaining internal-use software and payroll and payroll related costs for employees who are directly associated with the internal software development project. Capitalization of such costs ceases no later than the point at which the project is substantially complete and ready for its intended purpose. Capitalized software development costs for projects not yet complete, which are included as Equipment in the Land, Buildings and Equipment section of the Consolidated Balance Sheets, were $6,862,000 and $2,381,000 as of June 30, 2002 and 2001, respectively.

The company reports capitalized internal-use software development costs in the investing section of its cash flow statement. During 2002, a total of $4,481,000 ($6,862,000 - $2,381,000) in costs were capitalized. Were these costs expensed, operating cash flow would have been reduced by approximately 4 percent.

Film Production Costs

Producing a modern motion picture can be an expensive undertaking. Just the compensation paid to an actor might run $20 million or more if top-line talent, such as Tom Hanks, Julia Roberts, or Tom Cruise, is sought. And that compensates only a single actor. Other production costs include costs to obtain an original screenplay or for film rights to books or stage plays and to adapt those works to a screenplay; compensation of other cast members, directors, producers, extras, and other staff; costs of set construction and operations, wardrobe, and accessories; costs of sound synchronization; on-location rental facilities; postproduction costs such as music, special effects, and editing and an allocation of corporate overhead for individuals or departments with significant responsibility for film production. Because the costs incurred create an asset that is acquired for the purpose of benefiting future periods, those costs are capitalized. Once capitalized, film production costs then are amortized to expense as film revenues are generated.

Because capitalized film production costs benefit future periods, they are a long-lived asset, similar to property, plant, and equipment. In general, motion picture production firms do not classify their balance sheets. That is, assets are not separated into current and noncurrent categories. Nonetheless, because of an amortization period that extends beyond one year, capitalized film production costs should be considered to be long-lived assets.

Given their long-lived nature, one would expect that capitalized film production costs incurred during a reporting period would be classified as investing uses of cash on the cash flow statement. Yet GAAP requires motion picture companies to report capitalized film production costs as an operating and not as an investing use of cash.³⁴ As an example, consider Metro-Goldwyn-Mayer, Inc.

MGM incurred losses in both 2001 and 2002. In its year ended December 31, 2002, the company’s net loss from continuing operations was $142.2 million. That loss was actually larger than the previous year, when the company reported a loss of $55.7 million from continuing operations. On an operating cash flow basis the company’s performance also worsened during 2002. That year MGM used $88.8 million in cash from operations while generating positive cash from operations of $3.8 million in 2001.

Charged against operating cash flow in 2002 was $468.1 million in film production costs that MGM termed “additions to film costs, net.” That amount actually was up from $391.6 million in 2001. Interestingly, had the company reported its capitalized film costs as an investing activity, operating cash flow would have been little changed in 2002 from 2001, even though its net loss had grown markedly.

Exhibit 3.9 presents selected balance sheet, income statement, and cash flow information for MGM. Note the lack of classification of assets on the balance sheet. Also note how much more operating cash flow the company apparently would have generated had capitalized film development costs been reported as investing uses of cash.

Exhibit 3.9 Metro-Goldwyn-Mayer, Inc., Selected Financial Statement Information, Years Ended December 31, 2001, and 2002 ($ millions)

ource: Metro-Goldwyn-Mayer, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, pp. 57, 58, and 60.

		2001	2002
From the balance sheet:
Assets:
	Cash and cash equivalents	$ 2,698	$ 593,131
	Short-term investments	—	6,488
	Accounts and contracts receivable, net	458,010	590,637
	Film and television costs, net	2,035,277	1,870,692
	Investments in and advances to affiliates	845,042	620,132
	Property and equipment, net	38,837	41,397
	Goodwill	516,706	516,706
	Other assets	26,594	29,791
Total assets		$3,923,164	$4,268,974
From the income statement:
	Loss from continuing operations	$ (142,247)	$ (55,740)
From the cash flow statement:
	Net cash provided by (used in) operating activities	$3,815	$ (88,779)
	Additions to film costs, net included in operating cash flow	$ (391,633)	$ (468,083)

Consistent with GAAP, other motion picture studios also report capitalized film production costs as operating uses of cash. Included are such firms as Pixar and Fox Entertainment Group, Inc., as well as smaller firms including Film Roman, Inc., and Lions Gate Entertainment Corp.

The cash flow classification practices of capitalized film production costs by motion picture companies contrast with the treatment afforded software development costs. In both cases, expenditures create long-lived assets that benefit future periods, similar to property, plant, and equipment. Those capitalized costs are amortized over the future periods benefited. Yet while cash flow classification practices in the software industry have led most firms to report cash expenditures for software development as investing uses of cash, the motion picture companies classify costs incurred for the development of motion pictures as operating uses of cash. These are industry practices that point to the care that must be taken by readers of financial statements in understanding exactly what is included in operating cash flow.

Oil Exploration Costs

Depending on whether oil exploration costs are capitalized, they may be reported as operating or investing cash flow. Under what is termed the full-cost method, oil exploration firms may capitalize all costs incurred in exploring for reserves. Costs even may be capitalized on wells that prove to be nonproductive provided those costs can be realized from future revenues to be derived from the firm’s global reserves. Consider this disclosure provided by Anadarko Petroleum Corp.:

The Company uses the full cost method of accounting for exploration and development activities as defined by the SEC. Under this method of accounting, the costs for unsuccessful, as well as successful, exploration and development activities are capitalized as properties and equipment. This includes any internal costs that are directly related to exploration and development activities but does not include any costs related to production, general corporate overhead or similar activities.³⁵

The company includes capitalized exploration expenditures with its property, plant, and equipment accounts. Capitalized amounts are reported as investing uses of cash.

Under what is termed the successful-efforts method, oil exploration costs generally are expensed. Development costs, consisting of costs to drill and equip successful wells, are capitalized, but are charged to expense if proved reserves ultimately are not found. Consider this disclosure from Amerada Hess Corp., a successful-efforts firm:

The Corporation uses the successful efforts method of accounting for oil and gas producing activities. Costs to acquire or lease unproved and proved oil and gas properties are capitalized. Costs incurred in connection with the drilling and equipping of successful exploratory wells are also capitalized. If proved reserves are not found, these costs are charged to expense. Other exploration costs, including seismic, are charged to expense as incurred. Development costs, which include the costs of drilling and equipping development wells, are capitalized. ³⁶

Unlike capitalized oil exploration costs, which are reported as investing uses of cash, oil exploration costs that are charged directly to expense reduce operating cash flow. Accordingly, companies that employ the full-cost method will report higher operating cash flow than companies that use the successful-efforts method. That higher operating cash flow will continue even when earnings are later reduced for the amortization of capitalized exploration costs.

Cost Capitalization Summary

A vast array of operating costs may be capitalized. For purposes of cash flow analysis, it is important to determine whether such capitalized costs are being reported as operating or investing uses of cash. That cash flow classification will depend on the nature of the cost item, the company’s industry, and management discretion.

Generally, capitalized costs that are added to the property, plant, and equipment category of the balance sheet are reported as investing uses of cash. Costs that are capitalized into inventory or other current operating accounts typically are reported as operating uses of cash. However, as we saw with firms in various industries, for example, software and motion picture production, such distinctions are not always accurate. Accordingly, it is important to examine carefully the operating and investing sections of the statement of cash flows together with related footnotes to determine how capitalized costs have been classified on the cash flow statement.

Investments in Securities

When investments in debt securities are classified as held to maturity, or when investments in debt or equity securities are classified as available for sale, the purchase amount of the investment or the proceeds from its sale are classified on the cash flow statement as investing cash flow. In contrast, cash paid to purchase or proceeds received from the sale of investments in debt or equity securities held for trading purposes is reported as operating cash flow. Dividends and interest received from investments, whether classified as held to maturity, available for sale, or trading, are included in operating cash flow.

Companies take positions in trading securities for the purpose of profiting from short-term swings in price. For example, debt securities might be purchased in the morning with the expectation of selling them in the afternoon because of an expected positive impact on price caused by an anticipated decline in interest rates during the day.

The trading desks of financial institutions regularly take short-term trading positions in debt and equity securities. An operating designation for the cash flow related to such investments is appropriate because trading activities comprise an important line of business for these firms. Consider SunTrust Banks, Inc. For the years ended December 31, 2001, 2002, and 2003, the bank generated trading profits and commissions of $95.7 million, $103.2 million, and $109.9 million, respectively. These profits comprised 4.7, 5.7, and 5.8 percent, respectively, of the bank’s pretax income for the years indicated.³⁷

An operating designation for the cash flow associated with short-term investments is not appropriate, however, when purchases and sales of short-term investments are not part of an active trading business. Although certain short-term investments might meet the nominal definition of trading securities—that is, investments made with the objective of generating profits on short-term swings in price—such investments often are not fundamentally trading positions. This is especially true for many nonfinancial companies where marketable securities often are used to carry excess cash balances. Classifying such investments as trading positions results in the reporting as operating, cash flows that are clearly investment-related. At a minimum, their inclusion in operating cash flow clouds that important measure with cash flows that are inherently nonrecurring.

Consider Acacia Research Corp. In the year ended December 31, 2001, a portion of the company’s investments in high-grade corporate bonds, commercial paper, money market accounts, and other marketable securities were classified as held for trading purposes. That year, the cash used for the purchase of these investments, $4.1 million, was reported as an operating use of cash. Then in 2002, the company sold these investments and reported the proceeds from sale, $4.1 million, as an operating source of cash. Both amounts were inherently nonrecurring and helped to detract from the sustainable nature of operating cash flow.

Attesting to the nonrecurring nature of cash flows related to purchases and sales of investments classified as trading securities, consider WHX Corp. For the nine months ended September 30, 2001, the steel company reported operating cash flow of $89.6 million, up from $41.2 million for the same period in 2000. If an investor thought that improvements in operating cash flow for 2001 represented actual improved operating performance, he or she would have been disappointed. Included in the company’s operating cash flow for 2001 was cash provided from the sale of short-term investments classified as trading securities in the amount of $69.3 million. Three months later, for the year ended December 31, 2001, the company reported that it consumed operating cash flow of $46.9 million. That is a big swing in operating performance in only three months. A major reason for the apparent reversal of fortune was the fact that the company’s year-end operating cash flow was reduced by $64.6 million for the purchase of short-term investments net of margin borrowings.

In each of the three years ended December 31, 2000, 2001, and 2002, Nstor Technologies incurred losses. The company also reported that it consumed cash from operations in the amount of $9.4 million, $10.3 million, and $451,000 in 2000, 2001, and 2002, respectively. However, helping to improve the company’s operating cash flow performance in 2001 and 2002 were the proceeds from the sale of marketable securities. In 2001 the company reported an operating source of cash in the amount of $1 million from the sale of marketable securities. In 2002, operating cash flow provided by the sale of securities totaled $3.1 million. A clearer picture of the company’s operating cash flow performance would exclude these investment proceeds.

There are numerous other examples of companies that have included the purchase and sale of short-term investments in the operating section of the cash flow statement. For example, in 2000 and 2001, the automotive division of Ford Motor Co. reported an operating source of cash from the sale of trading securities in the amount of $6.9 billion and $1.1 billion, respectively. Then in 2002, the division consumed operating cash flow by purchasing trading securities in the amount of $6.2 billion. Also, as reported in Chapter 1, in 2001 Nautica Enterprises, Inc., boosted operating cash flow by approximately 57 percent by classifying short-term investments as trading securities. Finally, Curtiss-Wright Corp. reported that it generated $41.5 million of operating cash flow during the year ended December 31, 2002; however, $89.0 million of operating cash flow was provided from the proceeds of sale of trading securities.

We cannot say that any of these companies purposefully classified short-term investments as trading securities as a way of artificially manipulating operating cash flow. We do know that the classification rules for short-term investments offer ample opportunity for such manipulation if corporate managers were so inclined.

Notes Receivable

Amounts due from customers, accounts receivable, are reported as a component of operating cash flow. A sale made on open account boosts net income but does not provide operating cash flow until the related account receivable has been collected.

A question arises, however, when customers are offered more formal payment terms in the form of notes receivable. Are the resulting receivables, often referred to as financing receivables, components of operating cash flow, or should they be reported as investing activities? If an increase in financing receivables is reported as a use of cash in the investing section of the cash flow statement, then cash flow provided by operations would be reported correspondingly at a higher amount.

SFAS No. 95, “Statement of Cash Flows,” notes the problematic classification but concludes that such receivables are components of operating cash flow. Quoting from the statement:

A somewhat difficult classification issues arises for installment sales . . . for which cash inflows . . . may occur several years after the date of the transaction. . . .The Board agreed that all cash collected from customers or paid to suppliers from the sale or purchase of inventory should be classified as operating cash flows.³⁸

In the telecom equipment industry, Motorola, Inc., offers its customers extended payment terms. The resulting long-term finance receivables, which the company includes with other assets on its balance sheet, ballooned to $2.5 billion at December 31, 2000, and that was after subtracting an allowance for uncollectible accounts in the amount of $239 million. Attesting to difficulty the company had in collecting these receivables, by December 31, 2002, the allowance for uncollectable accounts had been increased to $2.3 billion, leaving a net receivable balance included in other assets of $381 million.

Consistent with GAAP for such customer-based receivables, Motorola classifies changes in the balances of these receivables in operating cash flow. Increases in the balance, resulting from uncollected sales, reduce operating cash flow; decreases in the balance, resulting from collections of the receivables, increase operating cash flow.

Also in the telecom industry, Qualcomm uses long-term receivables to finance customer purchases. At September 30, 2002, the company reported finance receivables of $831 million, after subtracting an allowance for doubtful receivables of $51 million. Those balances were after a write-off during 2002 of $622 million in finance receivables from Globalstar L.P. Like Motorola, Qualcomm reports changes in its finance receivables in the operating section of the cash flow statement.

Nortel Networks Corp. also provides its customers a financing arrangement in the form of what it refers to as long-term receivables. These receivables have been a problem for the company, leading it to reserve 80 percent of their book value at December 31, 2001, and 95 percent of their book value at December 31, 2002. Notwithstanding such credit problems with its customers, the company has continued to extend new customer credit using this financing arrangement and has reported some collections.

In the last few years, the cash operating performance of Nortel Networks has declined. In the years ended December 31, 2000, and 2001, the company reported cash provided by continuing operations of $824 million and $425 million, respectively. In 2002, the company consumed cash from continuing operations of $589 million.

Confounding the reported operating cash flow, however, is the company’s approach to reporting its long-term receivables. Changes in the balances of these receivables have been reported consistently as investing and not operating cash flow. Had the company reported changes in its long-term receivables as operating cash flow, its operating cash flow performance still would show a decline; however, the size of that decline would have been changed significantly.

More specifically, if long-term receivables had been reported in the operating section of the cash flow statement instead of the investing section, an increase in their balance would have caused operating cash flow in 2000 and 2001 to appear to be much worse. In contrast, a slight decline in the balance of long-term receivables would have resulted in a small improvement in operating cash flow in 2002. Consider the findings reported in Exhibit 3.10.

As seen in the exhibit, if Nortel had reported long-term receivables in the operating section of the cash flow statement instead of the investing section, cash provided by continuing operations would have been $466 million, $191 million, and a use of cash of $554 million, respectively, for the years ended December 31, 2000, 2001, and 2002. These adjusted operating cash flow amounts are in contrast to the cash sources of $824 million and $425 million and the use of cash of $589 million, respectively, as originally reported.

In contrast to Nortel Networks, and consistent with Motorola and Qualcomm, Lucent Technologies, Inc., reports all of its customer-based receivables in the operating section of the cash flow statement. However, like many companies, Lucent sells its receivables through a securitization financing facility. Although such sales of receivables are properly reported in the operating section of the cash flow statement, initial securitization transactions and increases in amounts securitized provide nonrecurring boosts to operating cash flow. We address the topic of securitized receivables in Chapter 4.

Nortel is not alone in classifying financing receivables as investing cash flow. Outside the telecom industry, Harley-Davidson, Inc., follows a similar approach. Harley’s finance arm, Harley-Davidson Financial Services, Inc., offers wholesale and retail financial services to its dealer network. The financial services company provides wholesale financing of dealer inventory through a floor-plan arrangement. Retail financing provided by the entity covers customer purchases of inventory from the dealer.

Exhibit 3.10 Nortel Networks Corp., Summarized Statements of Cash Flows, Years Ended December 31, 2000, 2001, and 2002 ($ millions)

Source: Nortel Networks Corp. Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, p. F-5.

All of Harley’s finance receivables, wholesale and retail, are reported in the investing section of the cash flow statement. For the retail accounts, an investing classification would appear to be appropriate because these are not receivables from Harley’s customers but rather the customers of Harley’s customers, that is, the retail purchasers. Harley invests its cash flow in these receivables. However, an operating designation would appear to be more appropriate for the finance receivables from Harley’s customers, the dealers.

The bulk of Harley’s receivables are in the form of these finance receivables. At December 31, 2001, and 2002, the company reported finance receivables of $1,036 million and $1,446 million, respectively. Of these amounts, the wholesale finance receivables totaled $568.3 million and $707.9 million at 2001 and 2002, respectively. At these same dates, accounts receivable, which primarily represents open amounts due from foreign motorcycle dealers, were $118.8 million and $108.7 million, respectively.

In the year ended December 31, 2002, Harley Davidson reported operating cash flow of $779.5 million, up from $756.8 million in 2001. Had the company classified its wholesale receivables as operating as opposed to investing cash flow, operating cash flow actually would have declined to $639.9 in 2002 from $645.4 million in 2001.³⁹

Sales-Type Lease Receivables

Closely related to finance receivables are lease receivables arising from sales-type leases. Sales-type leases afford an up-front profit component to a manufacturer or a dealer as well as a source of finance income to be earned over the lease term. An operating cash flow designation would appear to fit such lease receivables, just as an operating designation is proper for certain finance receivables.

Xerox Corp. offers financing to its customers by selling equipment through sales-type lease arrangements. The resulting lease receivables together with finance receivables arising from installment sales arrangements are reported in the operating section of its cash flow statement. In contrast, Cisco Systems Corp. classifies its sales-type lease receivables as investing cash flow.

The position taken by the FASB in SFAS No. 95—that collections on receivables from customers, even long-term installment receivables, are to be reported as operating cash flow—has not resulted in consistent treatment across reporting companies. Although our research indicates that operating cash flow is the classification of choice by most public companies, a nontrivial number of firms use an investing classification.

Other Investing Activities

Insurance Settlements

Few Americans will forget the anthrax scare that gripped the nation soon after the September 11, 2001, bombing of the World Trade Center in New York. At the center of the developments was American Media Operations, Inc., based in Boca Raton, Florida. An employee of the company died from inhalation anthrax. On October 7, 2001, authorities closed the company’s building when anthrax was discovered on a computer keyboard there.

The company’s insurance carrier ultimately provided reimbursement for its losses. Some of the insurance proceeds were designed to cover the costs of maintaining the contaminated facility before it could be disposed of. Other proceeds were designed to cover the cost of a replacement building.

For the year ended March 31, 2003, American Media reported the insurance proceeds received to replace its contaminated facility as a source of cash in the investing section of its cash flow statement. Such treatment is appropriate and is tantamount to the cash flow treatment that would be afforded a sale of the building for cash. There is a certain symmetry here where cash received for an old building and cash paid for a new one would appear as an investing source of cash and an investing use of cash, respectively.

There are, however, numerous examples of companies that have reported similar insurance settlements for damaged or destroyed items of property, plant, and equipment as operating cash flow. One representative example is Gulfport Energy Corp.

Gulfport Energy Corp. experienced significant losses as a result of Hurricane Lili, which struck the Gulf Coast of Louisiana in 2002. The company described the event in this way:

Hurricane Lili hit the southern gulf coast of Louisiana on October 3, 2002 with estimated sustained winds over 120 miles per hour and a 9-foot tidal surge. The eye of the hurricane came on shore directly East of Gulfport’s WCBB field. The storm caused significant damage to the Company’s production facilities and the WCBB field.

Gulfport’s insurance carrier agreed to pay it $3.5 million to restore production to the damaged oil field. The company received $1 million of this reimbursement in 2002; it received the remaining $2.5 million during the first quarter of 2003.

Gulfport reported the cash received to reimburse it for the sustained damages as an operating source of cash. Cash paid to replace the damaged production facilities was reported as an investing use of cash. As a result of the hurricane, the company’s operating cash flow was boosted temporarily.

The boost to Gulfport’s operating cash flow results for the first quarter of 2003 was significant. In the quarter ended March 31, 2003, Gulfport reported operating cash flow of $6.5 million, which was up significantly from the $658,000 in operating cash flow reported for the same period in 2002. However, contributing to the company’s significant improvement in operating cash flow during the first quarter of 2003 was receipt of the $2.5 million from its insurance carrier. That same quarter, Gulfport reported in the investing section of its cash flow statement the disbursement of $536,000 in cash for progress payments on replacement production facilities.⁴⁰ Thus, as reported, the net effect of the hurricane was to boost operating cash flow offset with an increase in investment spending. An investing classification for the insurance proceeds received for the replacement of destroyed equipment would appear to have been more appropriate.

Cash Surrender Value of Life Insurance

The cash surrender value of life insurance offers interesting flexibility in classifying cash flows between the operating and investing sections of the cash flow statement. Corporations may take out life insurance policies on corporate personnel to help defray the costs associated with an unexpected loss. Policies that are ordinary life or limited payment life have a cash surrender value, an investment of sorts, that the company may liquidate or borrow against in the future.

Insurance premiums paid, net of the increase in an underlying policy’s cash surrender value, are operating uses of cash. The increase in a policy’s cash surrender value would be reported as an investing use of cash. If the increase in a policy’s cash surrender value exceeds any premium paid, the full amount of the premium would be reported as an investing use of cash. Moreover, on an indirect-method statement of cash flows, because the increase in cash surrender value over the premium paid increased net income but did not provide any cash, a subtraction would be needed in reconciling net income to operating cash flow.

Collections of cash surrender value through policy cancellations or through borrowings would be reported as investing sources of cash. Borrowing against a policy is more a return of a company’s investment than incremental debt financing.

During the year ended December 31, 2002, increases in the cash surrender value of life insurance at Albany International Corp. apparently were greater than the premiums paid on its policies. That year, premiums paid on the company’s life insurance policies were reported as investing uses of cash. In addition, the company subtracted from net income the increase in the cash surrender value of its policies in excess of the premiums paid. This latter item was needed because the increase in cash surrender value had boosted net income but did not provide a corresponding amount of operating cash flow.

Consider also the cash flow treatment of cash surrender value of life insurance at Dyna Group International, Inc. During the year ended December 31, 2002, the company reported an increase in the cash surrender value of its policies as an investing use of cash. This treatment is consistent with the view that the policies are an investment. That same year, however, Dyna Group also reported a decrease in the cash surrender value of its life policies as an operating source of cash. That is, the company showed a decrease in cash surrender value as an operating source of cash and an increase in cash surrender value as an investing use of cash.

Unfortunately, the company did not disclose what the decrease in cash surrender value represented. If the company used the cash surrender value on certain policies to cover any premiums due, then an operating designation, which reflects the noncash nature of the underlying premium-related expense, would appear to be appropriate. If, however, the decrease in cash surrender value represented any cash taken out of the policy, then an investing designation of the cash received would have been more in keeping with the underlying nature of the cash received. The company did not respond to our request for clarification.

A Book Overdraft and Investing Cash Flow

As is discussed in Chapter 4, a company may have prearranged for its bank to provide automatic short-term financing to cover any checks presented for payment in excess of available cash balances. With such overdraft protection, the firm would need to carry little or no cash in low-yielding checking accounts. At the end of a reporting period the company would report a book overdraft, a current liability, for the excess of outstanding checks over bank cash balances. Over a reporting period, a change in the balance of a firm’s book overdraft would constitute cash flow from financing activities.

In its 2000 report, Amgen reported the existence of book overdrafts. In this case, however, the company would transfer funds from a short-term investment account to cover any checks presented for payment. Amgen described the arrangement in this way:

Under the Company’s cash management system, the bank notifies the Company daily of checks presented for payment against its primary disbursement accounts. The Company transfers funds from short-term investments to cover the checks presented for payment. This system results in a book cash overdraft in the primary disbursement accounts as a result of checks outstanding. The book overdraft, which was reclassified to accounts payable, was $101.2 million and $43.9 million at December 31, 2000 and 1999, respectively.

Amgen reported the change in its book overdraft in operating cash flow. During 2000, the balance in book overdrafts increased $57.3 million, resulting in an operating source of cash. Because the company covered its book overdrafts with transfers from a short-term investment account, an investing classification would appear to have been more appropriate.

Acquisitions and Operating Cash Flow

Increases through operations in such working capital accounts as accounts receivable, inventory, and prepaid expenses, less accounts payable and accrued expenses payable, are reported as operating uses of cash. The liquidation through operations of such working capital accounts is reported as an operating source of cash.

An increase in working capital resulting from an acquisition is reported as an investing use of cash and not as an operating use. However, the subsequent liquidation of working capital acquired as part of a business acquisition still is reported as an operating source of cash. As a result, a company can use an acquisition to give operating cash flow a short-term boost that exceeds the amount that one might expect from the simple addition of the operating cash flow of two combining companies.

As discussed in Chapter 1, during the years ended December 31, 1999, and 2000, AutoNation, Inc., expended a cumulative $1.2 billion on acquisitions. Among the assets purchased in the acquisitions was approximately $500 million in inventory that was reported as an investing use of cash.

During 2001, the company liquidated a substantial portion of its inventory, providing $544.7 million in operating cash flow. However, offsetting that operating cash flow was a reclassification of the company’s floor-plan notes payable to the operating section of the cash flow statement from the financing section. A reduction in those notes that accompanied the inventory reduction in 2001 consumed $514.4 million in operating cash flow.

During the year ended December 31, 2002, Advanced Power Technology, Inc., reported a net loss of $3.7 million. That disappointing performance was after reporting net income of $1.8 million in 2001. Operating cash flow at the company, however, improved markedly during 2002. That year cash provided by operations improved to $5 million from only $1.1 million during 2001. During 2002 Advanced Power reported an investing use of cash in the amount $26.6 million for acquisitions. One should expect that operating cash flow may have been boosted temporarily. Indeed, in a refreshingly candid statement the company did note in its 2002 Management’s Discussion and Analysis that “a large portion of cash from operations resulted from a lowering of the inventory levels at our newly acquired companies.”⁴¹

To better see how acquisitions affect operating cash flow, consider the next example, which was constructed using assumed amounts. During 2005, Operations Co. purchases $100 of inventory as part of operations. During 2006 the purchased inventory is sold for $100 and cash is collected. In contrast, during 2005, inventory at Acquisitions Co. increases by $100 as part of an acquisition. During 2006, the acquired inventory is also sold for $100 and cash is collected. No other transactions took place at either company during 2005 or 2006. The two companies operated at break-even in both years. Exhibit 3.11 presents the cash flow statements for Operations Co. and Acquisitions Co. in 2005 and 2006.

As seen in the exhibit, inventory purchased by Operations Co. during 2005 was reported as a use of cash in the operations section of the cash flow statement. Acquisitions Co. also purchased inventory during 2005 but did so as part of a corporate acquisition. As a result, the increase in inventory was reported as an investing use of cash. For both companies, the sale of inventory in 2006 resulted in an operating source of cash.

In calculating operating cash flow, the statement of cash flows reports an increase in inventory net of the effects of acquisitions. As seen in the exhibit, even though inventory at Acquisitions Co. increased by $100 during 2005, that increase in inventory was reported as an investing use of cash. Thus, the change in inventory on the balance sheet would not equal the change in inventory reported in the operating section of the statement of cash flows.

Companies that complete acquisitions on a regular basis routinely report changes in working capital accounts in the operating section of the statement of cash flows that do not equal the change in those same accounts when calculated using the beginning and ending balance sheets. Consider again the case of Advanced Power Technology, Inc., presented in Exhibit 3.12.

In reviewing the exhibit, it can be seen that during 2002, as reported on the balance sheet, working capital related to operations, in particular, accounts receivable, inventories, prepaid expenses, and other current assets, less accounts payable and accrued expenses increased $3,708,000. In the absence of an acquisition, the increase in working capital related to operations would be reported as an operating use of cash. During the same period, however, the operating section of the company’s cash flow statement indicates that working capital related to operations, net of the effects of acquisitions, actually declined by $3,164,000. Such a decline in working capital related to operations is an operating source of cash. Acquired components of working capital were transferred to the investing section of the cash flow statement from the operating section.

Exhibit 3.11 Contrasting Cash Flow Classifications for Inventory Purchases

Exhibit 3.12 Advanced Power Technology, Inc., Balance Sheet and Cash Flow Statement Excerpts, Years Ended December 31, 2001, and 2002 ($ thousands)

Source: Advanced Power Technology, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, pp. F-2 and F-5.

A measure of the amount of operating working capital purchased in the company’s acquisitions is the difference between the use of cash, $3,708,000, implied by the increase in these accounts as reported on the balance sheet, and the source of cash, $3,164,000, indicated by their decline as reported on the statement of cash flows. The total difference between the two amounts, a use of cash of $3,708,000 and a source of cash of $3,164,000, is $6,872,000 ($3,708,000 + $3,164,000) and serves as an estimate of the amount of operating working capital purchased in its acquisitions.⁴²

In the year of an acquisition, operating cash flow is increased at an unsustainable rate because it consists of the operating cash flow of two combining companies. Prior-year results do not reflect combined amounts. However, operating cash flow can be increased further through the liquidation of acquired operating working capital. That was the case at Advanced Power, where the company noted that operating cash was boosted in 2002 through the liquidation of inventory added through acquisitions. The company was not breaking any accounting rules. The acquisitions simply offered an opportunity to gain a short-term boost to operating cash flow.

Another way that acquisitions might be used to boost operating cash flow is by artificially limiting the operating cash flow of a target firm during the period between the announcement of a deal and when it closes. Consider Tyco International, Ltd.

During the late 1990s and the early part of this decade, the financial performance of Tyco International was one to be envied. The company’s sales and earnings grew markedly and with them its stock price. Yet many analysts were unconvinced that the company’s earnings were real, alleging that aggressive practices were used to boost its results. However, management of the company often pointed to its strong operating cash flow as a sign that the company’s earnings were of high quality.

An important component of Tyco’s business model was growth through acquisition. In at least one year the company consummated over 100 separate acquisitions. Such a stream of acquisitions gave the company ample opportunity to boost operating cash flow in an unsustainable manner. A boost to operating cash flow in this way would not attest to high earnings quality but rather could be associated with a proclivity to manage operating cash flow much like earnings might be managed.

In a story in Fortune we received an inside look into how the company allegedly used its acquisitions to boost operating cash flow.⁴³ In one acquisition in 1999, Tyco agreed to purchase Raychem Corp. As reported in Fortune, according to certain former employees of Raychem, in the period after the deal was announced in May but before it closed in August, Tyco managers converged on Raychem’s headquarters with specific instructions. These managers were instructed to accelerate the payment of open accounts and hold back the deposit of cash receipts. Such actions would minimize accounts payable and maximize accounts receivable, reducing Raychem’s operating cash flow. Then after the deal closed, when Raychem’s operating cash flow became that of Tyco, Raychem managers would be expected to deposit the undeposited checks. That would boost Tyco’s operating cash flow. Of course, any disbursements to vendors would reduce operating cash flow. However, because payment on these accounts was accelerated earlier, there was less of a drag on operating cash flow.

Tyco’s alleged cash flow actions were certainly not in the interests of the company’s shareholders. What shareholders lost was the time value of money.

When companies complete acquisitions, operating cash flow typically will receive an unsustainable boost. Operating cash flow for two companies will be combined as if it were the operating cash flow of one. The cash flow statements of previous years will not be restated, meaning that they cannot be used for comparison purposes. In addition, acquisitions offer an opportunity to boost operating cash flow further by providing increases to operating working capital, reported as investing uses of cash, which can later be liquidated, providing an operating cash source. Acquisitions also can be used to boost operating cash flow by limiting the operating cash flow of a target between the time a deal is announced and when it closes.

Careful scrutiny of the cash flow statement of a target, if available, in the years and quarters leading up to an acquisition should help to isolate any boost provided to operating cash flow of the combined entity. An unexpected decline in the operating cash flow of a target in the period leading up to the acquisition may indicate that operating cash flow has been “shifted” to the combined entity.

What would be especially helpful to financial statement users would be a requirement for companies to report on a pro-forma basis operating cash flow for a company assuming an acquisition had been in effect for all years presented in an annual report. Analysts then would be in a better position to compare current-year operating cash flow for the combined entity with that of prior years. Such a disclosure requirement would provide pro-forma information similar to that currently required for revenue and net income when an acquisition is made.

BEYOND THE BOUNDARIES OF GAAP

Generally accepted accounting principles offer considerable flexibility in the classification of cash flow between the operating and investing categories. Although one or more of the examples provided may appear to involve misclassification, most were not deemed to be a sufficiently material GAAP violation to warrant restatement. However, other examples of violations of GAAP in the classification of cash flows between the operating and investing categories have been sufficiently material to warrant restatement. Comptronix Corp. is one such example.

A Carefully Crafted Charade

Few financial frauds involved the extensive detail that surrounded the deceit at Comptronix Corp. During the period 1989 to 1992, management at the small Alabama-based electronics manufacturer took a variety of steps to boost profits and net assets. Inventory was increased and cost of sales was reduced to boost gross profit. To better hide fake inventory, amounts were shifted to property, plant, and equipment and reported as capital expenditures. Fake invoices were prepared to support the equipment purchases. Fictitious sales, supported with phony invoices and accounts receivable, were recorded to boost revenue.

Outsiders did not discover the fraud at Comptronix. Rather, management confessed to its existence. What helped to hide the fraud from view was management’s careful attention to cash flow. Managers at Comptronix knew that analysts would be looking for growth in operating cash flow to accompany the growth reported in sales and profits. It is a warning sign to analysts when growth in operating cash flow lags profit growth. Thus, the company had to demonstrate actual collections of its fictitious sales and phony accounts receivable. By adding this piece to the puzzle, the fraud could be better sustained. But how does one collect nonexistent accounts receivable and show cash flow in the process? In the case of Comptronix, what was needed was a special arrangement with the company’s bank.

To show fictitious cash flow, management at Comptronix wrote checks to what were likely fictitious vendors for nonexistent purchases of equipment. These checks were taken to the local bank and, although not endorsed by the vendors, were credited to their respective bank accounts. However, because Comptronix was also supposedly owed money by these same vendors, the checks were then charged against the vendors’ accounts and credited back to Comptonix’s bank balance .⁴⁴ Whew!

When asked about this unusual arrangement, a spokesperson for the bank said that the deposit arrangement was used for a legitimate business purpose when a customer of Comptronix was also a vendor to the company. In those cases, a special account was used to reconcile the difference.

What this deposit arrangement meant was that the company could report operating cash inflows for collections on customer accounts and investing cash outflows for purchases of new equipment. Operating inflows were offset with investing outflows—a natural development for a growth company. Moreover, these cash flows could be reported without changing the balance in cash reported on the balance sheet. It was the perfect arrangement and meant that Comptronix’s fraud could be kept under wraps for a longer period of time.

Capitalized Operating Costs

Misstatements of cash flow that involve the operating and investing sections and extend sufficiently beyond the boundaries of GAAP to warrant restatement often entail capitalized operating costs. Earlier in this chapter, HealthSouth Corp. was mentioned as a prominent example. The lessons learned from that fraud are of sufficient merit to warrant a closer look.

At HealthSouth, regular operating expenses were capitalized or added to property, plant, and equipment. Examples include sponsorship of “the Erie Otters junior-league hockey team in Pennsylvania” and others such as “newspaper advertisements.”⁴⁵ The individual expenses that were capitalized were small in amount, typically $4,999 and less, so that the auditors would be less likely to examine them. When the auditors did ask for documentation, management prepared fake invoices to support the purchases. In the end, over $1 billion was transferred to property, plant, and equipment in this manner, meaning that over 200,000 entries for bogus purchases had to be made.

HealthSouth’s moves boosted operating cash flow by reclassifying operating expenditures to the investing section. We have seen similar actions on numerous occasions. For example, Chambers Development Co., Inc., maintained target profit margins by transferring to its landfill development costs, a component of property, plant, and equipment, operating expenses that exceeded some predetermined level .⁴⁶ The steps taken to boost earnings and operating cash flow at Chambers Development were followed rather closely at WorldCom.

In terms of absolute dollar amounts, the financial fraud at WorldCom probably will set a high water mark for years to come. While the fraud involved billions of dollars of misreported earnings, one particular scheme, the capitalization of operating costs, boosted pretax earnings and operating cash flow by approximately $3.8 billion. What WorldCom capitalized were “charges paid to local telephone networks to complete calls.”⁴⁷ Such expenditures are clearly related to operations and should have been expensed as incurred, reducing net income and operating cash flow. Instead, the company reported them as capital expenditures or increases to property, plant, and equipment.

Misclassified Investment Proceeds

The example of the Project Nahanni transaction entered into between Enron Corp. and Citigroup, Inc., provided in Chapter 1 is a good example of an erroneous classification of an investing source of cash as operating. Through this project Enron borrowed $500 million and used the proceeds to purchase Treasury securities. The securities were then sold, providing $500 million of operating cash flow. The proceeds of sale should have been reported as investing cash flow. According to the court-appointed examiner in Enron’s bankruptcy, Project Nahanni was “designed solely to permit Enron to record $500 million in cash flow from operating activities.”

Another example of misclassified investment proceeds relates to the investment disposition made by Hewlett-Packard Co. reported in the opening section of this chapter. Hewlett-Packard erroneously included $144 million in proceeds from the sale of an investment in operating cash flow and was forced to restate its cash flow statement. As a result of the restatement, operating cash flow in the quarter ended January 31, 2003, was reduced to $647 million from the $791 million originally reported.

SUMMARY

This chapter examines misclassifications of operating and investing cash flow. Nine key points were raised:

1. Due to flexibility within the boundaries of generally accepted accounting principles, operating cash flow may provide misleading signals regarding a company’s ability to generate sustainable cash flow.

2. Flexibility in GAAP notwithstanding, some companies extend their reporting practices beyond the boundaries of GAAP and use investing items to exaggerate operating cash flow.

3. Investing cash flow consists of cash employed by investments in and cash generated by liquidations of positions in debt and equity securities and investments in property, plant, and equipment. Income on those investments is reported as operating cash flow.

4. Capitalized operating costs are often, but not always, reported as investing cash flow. Examples include interest capitalized into property, plant, and equipment, capitalized software development costs in most cases, and capitalized oil exploration costs. Recurring examples of capitalized costs reported as operating cash flow include customer acquisition costs, interest capitalized on discrete inventory projects, and capitalized film production costs.

5. Investments in debt and equity securities, classified as held to maturity or available for sale, are reported as investing cash flow. Investments in securities classified as trading are reported as operating cash flow.

6. Changes in customer-related long-term receivables typically are reported as components of operating cash flow. However, there are exceptions noted in practice.

7. The cash flow classification of insurance settlements tends to be consistent with the underlying insured item.

8. Acquisitions can give nonrecurring boosts to operating cash flow as acquired operating-related working capital accounts are liquidated.

9. Some of the more egregious examples of the misclassification of cash flow that extend beyond the boundaries of GAAP entail improperly capitalized operating costs.

NOTES

1 Associated Press Newswires, March 13, 2003.

2 Statement of Financial Accounting Standards Board, SFAS No. 95, Statement of Cash Flows (Norwalk, CT: FASB, 1987).

3 Details provided in a U.S. Department of Justice Press Release, “Former HealthSouth Chief Financial Officer Agrees to Plead Guilty in Probe of Corporate Fraud Conspiracy” (Washington, DC: Department of Justice, March 19, 2003).

4 J. Weil, “Did Ernst Miss Key Fraud Risks at HealthSouth?” The Wall Street Journal, April 10, 2003, p. C1.

5 HealthSouth Corp., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2001, p. 42.

6 Numerous other examples of investing cash flow items can be found in Chapter 2.

7 Shopsmith, Inc., Form 10-K annual report to the Securities and Exchange Commission, March 31, 2003, p. 11.

8 Homasote, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, footnote 11.

9 Bestway, Inc., Form 10-K annual report to the Securities and Exchange Commission, July 31, 2003, p. 26.

10 Pre-Paid Legal Services, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2001, Item 8.

11 Accounting and Auditing Enforcement Release No. 1257, In the Matter of America Online, Inc., Respondent (Washington, DC: Securities and Exchange Commission, May 15, 2000).

12 Qwest Corp., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2001, p. 33.

13 Pre-Paid Legal Services, Form 10-K annual report to the SEC.

14 Pegasus Communications Corp., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, pp. F-15-F-16.

15 Ibid., p. F-16.

16 Miix Group, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, p. F-9.

17 CPI Corp., Form 10-K annual report to the Securities and Exchange Commission, February 2, 2002, p. 46.

18 Lillian Vernon Corp., Form 10-K annual report to the Securities and Exchange Commission, February 23, 2002, p. F-7.

19 Cendant Corp., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, p. F-14.

20 M. Maremont, “Tyco Hails Its Cash Flow, but a Close Look Shows That Accounting for It Can Be Complex,” The Wall Street Journal, March 5, 2002, p. C1.

21 Ibid.

22 Ibid.

23 Tyco International, Ltd., Form 8-K Current Report to the Securities and Exchange Commission, March 13, 2003, Exhibit 99.1.

24 M. Maremont, “Tyco Says It Is Likely to Change Its Main Cash-Flow Definition.” The Wall Street Journal, February 3, 2003, p. C13.

25 SFAS No. 34, Capitalization of Interest (Norwalk, CT: FASB, December 1979).

26 Discrete inventory projects exclude inventories that are routinely manufactured or otherwise produced in larger quantities on a repetitive basis.

27 Delta Air Lines, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, p. F-16.

28 Ibid.

29 SFAS No. 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed (Norwalk, CT: FASB, August 1985).

30 D. Kieso, J. Weygandt, and T. Warfield, Intermediate Accounting (Hoboken, NJ: John Wiley & Sons, 2001), p. 623.

31 K. Ely and G. Waymire, Application of Software Cost Capitalization: Does It Fulfill the Intent? Working Paper (Atlanta, GA: Georgia Institute of Technology, March 11, 2003).

32 Another example of a company that reports capitalized software development expenditures as operating uses of cash is Take Two Interactive Software, Inc.

33 American Institute of Certified Public Accountants, Statement of Position No. 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use (New York: AICPA, 1998).

34 American Institute of Certified Public Accountants, Statement of Position No. 00-2, Accounting by Producers or Distributors of Films (New York: AICPA, 2000).

35 Anadarko Petroleum Corp., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, p. 44.

36 Amerada Hess Corp., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, p. 23.

37 SunTrust Banks, Inc., 2003 annual report, December 31, 2003, pp. 59 and 89.

38 SFAS No. 95, paras. 93-95.

39 Wholesale finance receivables were reported at $456.9 million, $568.3 million, and $707.9 million, respectively, at December 31, 2000, 2001, and 2002. If the increase in these wholesale receivables, $111.4 million in 2001 and $139.6 million in 2002, were treated as operations-related, it would reduce operating cash flow.

40 Gulfport Energy Corp., Form 10-Q quarterly report to the Securities and Exchange Commission, March 31, 2003, p. 7.

41 Advanced Power Technology, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, p. 16.

42 Other factors, for example, the effects of exchange rate fluctuations on the working capital accounts of foreign subsidiaries, can complicate the calculation.

43 H. Greenberg, “Does Tyco Play Accounting Games?” Fortune, April 1, 2002. p. 83.

44 Although unclear from available case documentation, it would appear that to avoid detection, Comptronix would have had to set up phony accounts at the bank for fictitious vendors.

45 C. Mollenkamp, “An Accountant Tried in Vain to Expose HealthSouth Fraud.” The Wall Street Journal, May 20, 2003, p. A1.

46 Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 764, In the Matter of Richard A. Knight, CPA, (Washington, DC: SEC, February 27, 1996).

47 J. Sandberg, D. Solomon, and R. Blumenstein, “Disconnected: Inside WorldCom’s Unearthing of a Vast Accounting Scandal Internal Auditor Discovered An Unorthodox Treatment of Long-Distance Expenses.” The Wall Street Journal, June 27, 2003, p. A1.