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The New Demands of Cash Flow Reporting.

Tougher approaches by the regulatory and investment communities will require companies to improve their analysis and forecasting.

Recently, the financial and regulatory communities have shown renewed interest in flow reporting requirements. Consider the following comments and actions:

* Robert A. Howell, a visiting professor of accounting at Dartmouth College's Tuck School of Business and senior partner of The Howell Group, says, "Accounting has gotten to be such a manipulated thing. Cash is real."

* Investment banking firm Bear Stearns Cos. Inc. suggests that for the majority of industry groups, investors have already begun to assess companies on their cash earnings.

* The Financial Accounting Standards Board (FASB) recently issued Statement of Financial Accounting Concepts No. 7, Using Cash Flow Information and Present Value in Accounting Measurements, and is now publishing new standards building on these concepts at a torrid pace (for the FASB).

The key question is whether a company's financial reporting systems and staff are equipped to deal with new demands for cash flow analysis. Though it can be a simple exercise to prepare a cash flow statement for a current period, it is more difficult to accurately forecast cash flow at the level of detail now required.

Issued in 1987, FAS 95, Statement of Cash Flows, established the current standards for cash flow reporting. It superseded 1971's APB Opinion No. 19, Reporting Changes in Financial Position, and requires a statement of cash flows as part of a full set of financial statements for all business enterprises in place of the statement of changes in financial position.

FAS 95 requires that a statement of cash flows should classify cash receipts and payments according to whether they stem from operating, investing or financing activities. This statement encourages enterprises to report cash flow from operating activities directly, by showing major classes of operating cash receipts and payments (the direct method). For example:

* Net cash provided from operating activities (payments received from customers, payments made to employees, etc.)

+ Net cash used in investing activities (payments received for sale of facility, capital expenditures, etc.)

+ Net cash provided by financing activities (borrowings, stock issuance, dividends paid, etc.)

* Equals Change in Cash

These are fairly easy to construct on a backward-looking basis because all amounts are known. However, management and regulatory bodies are becoming more interested in forecasting these items. To properly forecast cash flow, managers need to answer questions such as: How much cash will be collected from customers in the future? What capital purchases are expected? What dividends will need to be paid in the future? In which currencies will these amounts be paid or collected? What exchange rates should be used? These are tough questions to answer, and detailed modeling of assumptions ("what if' analysis) is crucial to determining the right answers. Once these inputs have been agreed upon and modeled, management can make better decisions on where to invest a company's limited resources.

Answering these questions will help companies comply with new accounting regulations. Issued in February 2000, Statement of Financial Accounting Concepts No. 7, Using Cash Flow Information and Present Value in Accounting Measurement, provides a framework for using future cash flows as the basis for accounting measurements. It provides general principles that govern the use of present value, especially when the amount and timing of future cash flows are uncertain. The issuance of concepts statements is a rare event, indicating a fundamental shift in thinking that will find its way into future financial accounting statements that all publicly traded companies must follow.

Two such statements are Statement No. 141, Business Combinations, and Statement No. 142, Goodwill and Other Intangible Assets. Issued July 20, 2001, these new rules for business combinations, goodwill and intangibles suggest analysis of historical and future cash flows to determine asset valuation (see "The Merger Game Changes," page 22).

A recently released Bear Stearns Cos. Inc. guidebook, "Goodbye, Goodwill: Assessing the Impact of the New Accounting Rules," goes beyond most research to provide a detailed industry-by-industry examination of how the FASB's ruling will affect virtually every company in Bear Stearns' universe of coverage. Each industry analyst was asked to compile a wide range of statistical data in order to illustrate: 1) The impact of the accounting change on reported (i.e., GAAP) earnings and earnings growth rates; 2) how it affects returns on assets and equity; and 3) the likelihood of goodwill write-offs under new impairment tests.

In addition, Bear Stearns analysts point to some potential outcomes that may surprise investors. According to their research, the revised accounting rules could noticeably affect the valuations and price performances of stocks that are traditionally valued on a price/earnings basis, as the market adjusts to the changes in reported earnings per share.

The FASB's new approach is certainly more complicated than amortization. Under the new goodwill and intangible-asset measurement standards, companies generally must perform an impairment test yearly for each reporting unit. (A reporting unit is the same as an operating segment -- that term is used in paragraph 10 of FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related Information -- or one level below an operating segment, referred to as a component.) It's a two-step test that first determines whether the book value of the reporting unit's acquired assets exceeds the unit's so-called fair value -- typically measured through discounted cash-flow estimates. If fair value is lower than book value, the company then must determine whether the fair value of the unit's goodwill is less than the goodwill's book value, which would necessitate recognizing an impairment loss.

By late August, at least 11 publicly traded companies, including Corning Inc. and Verisign Inc., have or will probably need to write off more than $1 billion each as a result of the new rules. The present values of future cash flows from each company's acquisitions have simply not supported the book values of the acquisition's goodwill. However, other publicly traded companies, like Airgas Inc., have been able to recapture previously charged goodwill amortization by adopting the new rules. For instance, Airgas booked a larger profit for the June 2001 quarter after retroactively adopting Statement of Financial Accounting Standard 142. In a statement, it said it decided to adopt early because it believed the new standard better reflects the dynamics of its business.

What sort of cash flow is analyzed to determine the discounted cash flow and present value? To Howell, the statement of cash flows is "an abomination [that is] useless to a manager." Instead, he suggests focusing on "cash earnings" and "free cash flow" -- recognizing that managers and investors need to know how much cash a business produces and expects to produce over and above what's needed to operate it. This focuses on the real concerns of the business: producing cash and creating value.

In a recent study of 25 blue-chip stocks across industries, Howell found that most were severely overvalued at today's prices and that current free cash flows cannot support most companies' current market prices. Additionally, the rate by which cash flows would have to grow, in perpetuity, to support market prices seems very unlikely for many companies.

Again, the key question is whether a company's financial reporting systems and staff are equipped to deal with new demands for cash flow analysis. Attempting to perform this sort of detailed and complex analysis in a spreadsheet, for example, will be difficult. Ultimately, it will lead to poor decisions and potentially inaccurate financial statements.

Transactional general ledger systems do not provide the environment for running "what if" analyses and are almost impossible to use as forecasting tools. But companies having good analytical applications will be able to respond quicker and more accurately than those that don't. A high-performing analytical application will enable forecasting cash flows at the right level of detail, quickly change assumptions to model different outcomes, provide audit detail for present-value calculations and accommodate any sort of cash flow viewpoint -- traditional or new. Financial managers at all levels should evaluate their existing financial systems to be sure they are ready to handle the future of cash flow reporting.

Michael Malwitz is product marketing manager at Hyperion, the financial software firm.
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Author:Malwitz, Michael
Publication:Financial Executive
Date:Oct 1, 2001
Previous Article:Far Beyond Technology.

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