Question

Hi Archie. You made a very interesting observation in your posting regarding restatement issues with specific statements. It might be interesting to explore this a little bit more. We typically think of the income statement when we hear of a financial restatement, but it’s certainly possible for other statements to be impacted. Let’s examine the statement of cash flows. We know that the change in cash during the period should reconcile with the change that we see in cash between the comparative balance sheets. However, it’s up to management to classify the cash flows as operating, investing, and financing activities. Class, why might management be tempted to shift or manipulate the cash flows reported in each category? Brandy

Answer 1

A cash flow statement consists of three parts, namely,

## the operating activities section which details about the cash inflows & outflows from regular operations, like cost of goods sold , other selling & administrative expenses incurred,salaries & tax payments ,as well as changes to working capital due to customer collection &vendor payments & other similar increase or decrease to current assets or current liabilities--that are necessary for regular operations.

## the inveting activities section--detailing about purchase & sale of fixed assets & investments,ie. Capital expenditures & also business acquisitions

## the financing section that explains cash used in/ generated from - issuing stocks.bonds & retirement/repurchase of the same. Dividends paid , other borrowings/repayment.

The net cash used by/generated from the above three activities, during the year , explains the reason matched by figures, the flow of cash during that year , within the organisation.

The managements are tempted to shift or manipulate the cash flows reported in each category, mainly because of the enthusiasm to show better operating performance ,given the investing & financing cash flows .

It is because the investors are more concerned with the operational efficiency of the management,under the given resoruces.

For example, the management may resort to the following , while switching cash flows between categories:

1. Selling of receivables , by factoring ,ie. At heavy discount costs to company, will look as an operating cash inflow to the company, while it may be argued that it is also a financing cash inflow.

2. Borrowing finance by selling/ using inventory as collateral, again is often considered an operating cash inflow , whereas, there is a strong argument for it to be a financing option.Also, it saves on interest expense --an outflow under operating section.

3. Likewise, capitalising normal operating expenses & shifting as an investment cash outflow, both increases operating cash flow (due to depreciation add-back) & also shows this as an outflow in a different section.

4. Some companies , treat the COGS of its retail trade as perfect assets , which will then decrease expenses in the operating section, thus posting a good cash from operations.The investors need to check about the consistency of the management's pratice, in this regard.

The above are some instances , where interchange can post better operating performance of the company & the management is tempted to try out these, as most often, performance incentives of the managers are linked to /or mesaured by the operational efficiency ---read over & compared to peers or previous year.

In addition, there is the need to maintain the current investors' loyalty & also to entice potential investors.

All the above make the managements to post presentable numbers .