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Wall Street Journal |
Outside Audit
By MICHAEL RAPOPORT
September 1, 2006; Page C3
Consider this proposition: The choice of one little preposition can mean a big
difference in how much cash a company appears to be generating.
The fine distinction is the difference between return "on" investment and return "of" investment. Many companies are making a choice that, while not at all an impropriety, has the effect of making them look less capable than they really are in expanding their main operations. And that choice gets baked into the cash-flow statements closely watched by large investors.
Specifically, these companies are misclassifying the cash dividends and distributions they receive from their investments in other companies.
At some companies, like General Mills Inc., the misclassification can mean that tens of millions of dollars should be added to operating cash flow, according to Charles Mulford and Eugene Comiskey, two accounting professors at the Georgia Institute of Technology. At least one company, Schnitzer Steel Industries Inc., would have nearly doubled its operating cash flow last year if the distributions were handled the right way, according to a report by the professors.
It is a tricky area, said Prof. Mulford, who also oversees Georgia Tech's Financial Analysis Lab, which published the report.
Accounting rules say that when a company receives a cash return on an equity investment such as a joint venture, that money is like a dividend and should be recorded under operating cash flow, the most important and scrutinized part of the cash-flow statement. The distribution is being paid out of the earnings the investment is generating -- literally a return "on" investment.
But when the money a company earns from another company is less than the distribution paid to it by that company, that means the joint venture or other investment entity had to dip into its capital to return some of the funds that were originally invested in order to pay the distribution. In that case, it is a return "of" investment, and accounting rules call for that sort of distribution to be counted under the less-significant category of investing cash flow. Professional investors pay less heed to investing cash flows, figuring that it is more important for a business to be good at expanding its main operations rather than investing money on the side.
Profs. Mulford and Comiskey examined 107 companies that receive distributions from equity investments and found that 13 place all of their distributions under investing cash flow. Yet at each of the 13, the equity-investment earnings were higher than the distributions, suggesting that the distributions were a return on investment and thus should be under operating cash flow. (Total cash flow remains the same no matter how the cash is classified.)
For instance, General Mills reported receiving $83 million in dividends from several international joint ventures in fiscal 2005, and the food maker counted that money under investing cash flow. But because that amount was less than the income the company reported from the joint ventures, the $83 million belongs under operating cash flow, according to the Georgia Tech report. Such a reclassification would have lifted General Mills's operating cash flow by nearly 5%.
Thomas Forsythe, a General Mills spokesman, said that the company is confident it reports its financials "as required under U.S. GAAP," or generally accepted accounting principles.
The matter affects small companies, too. Universal Security Instruments Inc., which makes smoke alarms, had $1.1 million in distributions in its last fiscal year from a Hong Kong joint venture. That amount was less than Universal Security reported in joint-venture earnings, but the company still put the distributions under investing cash flow. The company would have seen an increase in operating cash flow to $2.9 million from its reported $1.8 million if its distributions had been counted properly, according to the Georgia Tech report.
Harvey Grossblatt, the company's chief executive, said that "philosophically" he agrees with the professors' stance but added that the company's auditors have repeatedly indicated that investing cash flow is the proper treatment for the distributions.
Schnitzer Steel Industries, on the other hand, decided to redo its cash-flow statements for the past three fiscal years to move its joint-venture distributions from investing to operating cash flow. The original placement under investing cash flow was "an error in classification," the company said in its restatement Wednesday. While the changes for fiscal 2004 and 2003 were minor, for 2005 the revised operating cash flow jumped 99%, to $146.3 million from the originally reported $73.5 million.
Greg Witherspoon, Schnitzer's chief financial officer, said the company, which announced its intention to restate in July, hadn't been aware of the Georgia Tech report and made its decision independently. He noted that the restatement doesn't affect the company's reported earnings, income statements or balance sheets.
Write to Michael Rapoport at Michael.Rapoport@dowjones.com
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