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The new dilemma of cash versus earnings.

The new dilemma of cash versus earnings Conventional wisdom says that cash flow must eventually translate into reportable earnings. The author explains how the OPEB exposure draft blows holes in that assumption. To get business and Wall Street investment evaluation standards in sync again, the FASB needs to eliminate the "transitional amount" concept. How does one reconcile the investment evaluation process of Wall Street with the investment evaluation process of business? This dilemma, which has long troubled me, has taken on increased importance as a result of the FASB exposure draft on other postemployment benefits (OPEB). Let me explain.

Wall Street uses its investment evaluation process to judge business performance and make stock buy/sell recommendations. Such recommendations impact the ultimate stock price of a company. Business uses its investment evaluation process to make monetary and capital investments aimed at maximizing return on assets and at convincing Wall Street that a given stock is worthy of a premium price versus the overall stock market.

On the surface, these two goals seem similar and compatible. Business simply has to show Wall Street how successful its investments have been over time, and both parties will have succeeded in their mission--Wall Street in identifying a solid investment opportunity for its clients and business in commanding a premium stock price for its shareholders. It seems so simple, right? Wrong.

Not everything is as it appears in today's complex accounting environment. Even though Wall Street and business seem to have similar goals, the analytical tools used by each party to accomplish these goals are quite different.

Wall Street focuses primarily on reported earnings. Practically nothing is as important to Wall Street (except takeover/restructuring rumors) as quarterly and annual earnings per share. Such earnings are Wall Street's bread and butter, the statistic from which the majority of other key statistics flow--such as price-to-earnings ratio and return on equity. Business, on the other hand, focuses its investment decisions primarily on discounted cash flow. As any MBA student knows, investment decisions are designed to achieve a present value cash flow return in excess of the business' cost of capital.

In summary, Wall Street utilizes reported earnings (and projections of future reported earnings) to make investment evaluations, and business utilizes cash flow projections to make investment evaluations. Clearly, these two statistics are different. However, are they mutually exclusive, or are they somehow compatible?

Conventional wisdom says they are compatible. Conventional wisdom says that, over a reasonable time period, cash and earnings are equivalent for a given investment. Cash flow eventually must translate into reportable earnings. Also, conventional wisdom tells us that accrual basis accounting is vastly superior to cash basis accounting. Accrual basis accounting makes it possible to summarize all revenues and expenses applicable to a given time period in that time period, despite when the actual cash flow occurred or will occur. In this way, an outside party (Wall Street) can determine objectively whether a business is really succeeding--and not be lulled into a false sense of security by early cash flow gains that will be completely eliminated in future periods.

A misguided assumption? Now, the above concepts and rationale appear quite logical. Wall Street seems to be utilizing the proper tools to do its job. However, the entire concept is held together by one important assumption, which seems to get lost in the shuffle. And this assumption is at the very heart and sould of Wall Street's investment analysis process. It is that cash flow eventually translates into reportable earnings.

To date, I have been fairly comfortable (although not completely satisfied) with this method of reconciling the investment evaluation process dilemma posed earlier. The ever-important assumption that cash flow eventually translates into earnings is somewhat difficult for an accountant to embrace, given deferred income tax accounting and pension accounting under the FASB's Statement 87. But it is an assumption I was willing to live with in order to try to understand Wall Street's behavior. The problem is that, just as I was willing to accept this concept, along came the FASB's OPEB project.

The OPEB exposure draft issued in February of 1989 blows holes--indeed, rather large holes, given the magnitude of the amounts involved --into Wall Street's assumption that for a given investment cash flow translates into earnings over a reasonable period of time. As mentioned, certain "holes" have existed in the cash-equals-earnings concept for quite some time, but those holes, unlike the hole created by OPEB, do not present investment dilemmas like the following.

What happens when a business is faced with an investment opportunity that is a "loser" from a cash-flow perspective (i.e., it doesn't generate sufficient cash flows to meet the cost-of-capital rate) but is a "winner" from a reported-earnings perspective? This was not a likely question before OPEB, but it is a very real scenario under the current exposure draft. Let's examine the following assumptions about a hypothetical company: * XYZ company's OPEB "transitional amount" is $100 million. Annual cash outlays for OPEBs are $20 million per year. * XYZ company does not have any tax-advantaged methods for prefunding the OPEB obligation. Any amounts funded would not be tax deductible, nor would investment earnings accrue tax free. * Assumed after-tax interest rates are 5 percent. * XYZ company will amortize its OPEB "transitional amount" over 15 years. * Tax rates are 34 percent. * XYZ company's cost of capital is 15 percent. The investment option is a straight-forward one. Should XYZ company prefund its OPEB obligation?

From a cash-flow perspective, the answer is obvious. For an after-tax investment of $100 million, XYZ company can generate only $13.6 million in net present value cash. The return of 13.6 percent is well below the company's 15 percent cost of capital. Under traditional investment evaluation techniques, this investment would be rejected.

However, under the OPEB exposure draft and utilizing the unique "transitional amount" amortization concept, the fate of the investment is not quite so clear. While the company can generate only $18.1 million in after-tax cash flow from the investment, it can generate $84.1 million in after-tax reportable earnings over the next 15 years. This net present value return of 38.5 percent is well in excess of the 15 percent cost-of-capital rate. So much for the assumption that cash translates into earnings.

It is important to note, of course, that for XYZ company to realize this 15-year earnings benefit, it is necessary for the $100 million cash contribution ($66 million after deferred taxes) to be expensed in the year of payment. Be aware, however, that under FASB Technical Bulletin 87-1 (Accounting for a Change in Method of Accounting for Certain Postretirement Benefits), such expense would be classified as a "cumulative effect of a change in accounting principle," whereas the 15-year earnings benefit would be classified as operating earnings. Additionally, it is well documented that the stock market does not penalize share price for a one-time earnings decrement as a result of a cumulative effect accounting change.

Given the above scenario, how should the XYZ company respond? Finance professors all over the country are shouting that the answer is clear: do not make the investment. After all, investing in projects below the cost of capital will reduce shareholder value. But in this case, is that true? Will shareholder value really be hurt? Will Wall Street reward or punish such an investment given the beneficial impact on reported earnings?

Astute corporate controllers are beginning to realize this investment dichotomy. If the investment increases earnings per share over a long period of time (despite not achieving the necessary cash flow), why not make the investment? After all, the ultimate goal of all voluntary investments is to achieve reported earnings. If an investment can achieve earnings without cash flow, is that wrong?

I believe the intellectually honest answer to the above question is yes--it is wrong. Reported earnings without cash is not a worthy goal of business. Shareholders cannot buy groceries with reported earnings. Business cannot pay salaries or suppliers with reported earnings. Business needs cash to survive. However, in today's real world of corporate raiders, LBOs, and forced restructurings, it is clear that business also needs reported earnings and the related P/E ration premium in order to survive. Therefore, the dilemma and the paradox.

An unpleasant solution It is not an easy decision for any businessman to have to make. It is not a decision I would want to make. It is not a decision which should have to be made. Yet, it is a very real decision that many companies will have to face if the FASB's current OPEB exposure draft is adopted.

True accounting theory aficionados will argue that, in the long term, OPEB cash flow will translate into OPEB expenses. However, this will be true only in a "going-out-of-business" scenario. Fortunately, for the vast majority of businesses, such a situation will not occur, or will not occur until the very long term--30, 40, 50, or more years into the future. So, no matter how sophisticated the business, it is difficult to make decisions today to benefit earnings under a "going-out-of-business" scenario.

Accounting rules should reflect economic reality--that is good. Accounting rules should not influence economic reality--that is bad. Unfortunately, in the creation of the "transitional amount" concept, the FASB has crossed the boundary between good and bad--because the concept can result in a poor investment decision being perceived as a good investment decision--the very threat accrual accounting should avoid.

We cannot blame business for this problem. After all, we cannot expect business to behave rationally--and for the good of the macro-economy--if the accounting rules that hold business accountable reward irrational behavior.

The solution to this dilemma is quite simple, albeit unpleasant. Eliminate the "transitional amount" concept. There is no reason why the OPEB accounting change (if a change is even necessary--an idea that has yet to be publicly debated) cannot be made through a cumulative effect adjustment. This non-cash earnings "hit" would be apparent to the people on Wall Street and appropriately ignored.

This recommendation may not make me popular with my fellow accountants in industry. However, it will allow me to sleep a little better at night, knowing that the ever-important assumption that cash flow eventually translates into earnings remains reasonably intact, thereby allowing me to reconcile Wall Street's investment evaluation process with that of business. And, after all, isn't that why we are all working so hard every day? John F. Kelly Manager, External Reporting Anheuser-Busch Companies
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Copyright 1989, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:the affect of the Federal Accounting Standards Board's proposed Overview of Post-Employment Benefits on reportable earnings
Author:Kelly, John F.
Publication:Financial Executive
Date:Jul 1, 1989
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