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SEC Acts to Curb Cash Flow Shenanigans

Once thought to be rock-solid, cash flow statements deserve a second look, a new study finds.

An operating cash flow statement has long been considered a reliable barometer of a firm's financial health and less susceptible to creative accounting than its cousins the income statement and the balance sheet. Turns out, that belief is sometimes wrong.

Research out of Georgia Tech's business school has found that a number of prominent companies routinely miscategorize money due from vendors, such as members of their distribution network. Typically, firms record the IOUs as part of their cash flow from investments rather than as reductions to their operating cash flow. Earlier this year, the Securities and Exchange Commission forced seven well-known companies to amend their financials in response to the study.

Harley-Davidson, Caterpillar, and General Motors were among the companies affected by the ruling. Their 2002 and 2003 financials classified money owed to them by dealerships as an outstanding investment, meaning that the operating cash flows they reported were artificially high. Harley's 2003 cash flow was 29% lower after the restating; Caterpillar's tumbled by a staggering 372%.

What does this mean for growing private companies? A lot depends on your future ambitions. If you intend to sell your company to a public firm or intend to go public yourself some day and if you help your customers finance purchases, then you should make sure your accountants follow the Financial Accounting Standards Board's definition of operating cash flow.

You may be especially vulnerable if your company ties profit sharing specifically to cash flow, as more and more firms are doing these days, because that fact alone could tempt someone on your management team to massage the numbers. "Every company wants to show as strong a cash flow as possible," says Charles Mulford, the author of the Georgia Tech report, but you should always "use common sense in classifying what truly is an operating activity."

Last updated: Jun 1, 2005


Darren Dahl is a contributing editor at Inc. magazine, which he has written for since 2004. He also works as a collaborative writer and editor and has partnered with several high-profile authors. Dahl lives in Asheville, North Carolina.

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