As critics, we have been asked by others in frustration, "Is there anything in GAAP financial statements that you guys consider to be useful?" Up until now, our smug answer has always been, "Only the cash balance!"Alas, it turns out we were wrong ... .

A BIZARRE SITUATION

Our attention was recently drawn to the 10-K filed by a well-known public firm that will remain anonymous in appreciation for the cooperation we received from its personnel. To be sure, the management is totally responsible for what is going on, although we aren't sure whether its place in our spotlight arises from a conscious effort to deceive or from blind obedience to an outmoded accounting rule that produces misleading results.

What we observed is a well-out-of-the-mainstream practice that clearly overstates the company's available cash balance by a huge amount. Specifically, management reports its outstanding checks among its current liabilities, instead of deducting them from the cash balance. To give an idea of the scale, the outstanding check balance in the most recent 10-K was one-third of the reported multi-million-dollar cash balance.

The consequence is a balance sheet that overstates the cash that's really on hand. Besides raising doubts about this management's ethics, we see their deficient reporting practice as another reason to keep Rule 203 exceptions in the literature and to encourage managers and auditors to exercise this privilege.

BOTH SIDES OF THE STORY

In tracking down the story, we spoke with representatives from the company and its Big Four audit firm. As expected, the latter would not talk to us, but politely suggested we speak with their client.

When we got through to a company official, we learned that they write checks every day against a "zero-balance" account at one bank that they automatically cover in the morning with a transfer from another account. What is unique is that the transfer is made from another bank. The result is a very temporary and carefully planned overdraft situation that is created and deliberately left in place overnight.

The company representatives claimed that they follow the auditor's explicit guidance on how to account for these technical, but unreal, overdrafts. Through a narrow and literal interpretation of very old GAAP that never contemplated such an arrangement, their outstanding checks are reported as a spurious liability based on the arcane rule that positive and negative checking account balances with different banks are not to be offset.

We're convinced that this hairsplitting probably never made sense, and surely doesn't today when it's possible to click a mouse and instantly move cash between banks, even those separated by thousands of miles. We suspect the rule was designed originally to protect auditors by reflecting a technical legal restriction, without considering the possibility that it would obscure the real overall cash situation.

What matters to statement users is a company's net amount of available cash, without regard to its precise bank location on the balance sheet date. Thus, when a check is mailed or wired, the aggregate cash balance should go down. Of course, if all overdrafts were to ever exceed all positive balances, that net amount should appear as a liability and the cash balance should be zero. This company was in this situation two years ago, but reported a cash balance on the left side of the balance sheet and an even larger liability for "outstanding checks" on the right.

This bizarre practice creates the appearance that it has cash on hand and a current liability to be settled sometime in the future. This result is misleading, because the liability was paid off the next day. We think nothing, absolutely nothing, justifies claiming that this treatment provides users with useful information. The defense that the practice is GAAP-compliant is tissue-thin and unpersuasive. It looks like old-fashioned window dressing to us, and we can't make ourselves believe that it is accidental.

THE PLOT THICKENS

To make matters worse, the distortion spills over to the cash-flow statement. There we found that the change in the outstanding checks' "liability" is not included in the operating cash flow section as a modification to net income, as one would expect. Instead, management reports the change in the financing section as a source (when the balance decreases) or a use (when it increases).

Just think that one through: by writing checks for operating activities through a zero-balance account, management reports a financing outflow or inflow! This treatment simply defies common sense.

The real deal

Here are six inarguable realities:

1. The relevant measure of cash is not affected by these inter-bank transfers;

2. The cash balance on the balance sheet doesn't equal the real cash balance;

3. The current liabilities are overstated;

4. Cash generated by operations is misstated;

5. Cash generated or spent on financing activities is misstated; and,

6. Users are left scratching their heads as to what really happened.

There are two competing explanations for this bad accounting. Most graciously, management and the auditors may have acted in blind obedience to a Pitifully Old and Obsolete Principle (POOP) that was created eons ago. If so, their flaw is shared with a great many others, in that they have not considered how compliance degrades the statements' quality. Shame on them for being oblivious.

A less gracious (but more plausible) explanation is that management knows exactly what it's doing and hopes it can fool the capital markets. If so, even more shame on them, and the auditors as well.

THE MAGNITUDE

Just in case you might think we're excited about a one-time occurrence or a decades-old tradition, past 10-K reports show that the company initiated this reporting practice about six years ago. The first section of the accompanying schedule (see box) illuminates the error's significance by presenting the relationship between the reported and de facto cash balances in percentages. In particular, note that the real cash balance was substantially less than the reported amount in all five years, even to the point of being overdrawn at the end of 2006.

The second section shows what happened to the reported operating cash flow. One could argue that the difference in operating cash flow isn't significant. We disagree, because cash flow is considered bedrock information that should be free from manipulation. Also, these differences (as much as 5 percent in two years) arise from only a few hours' delay in transferring cash from one bank to another. It's balderdash that a non-event like that could create such large differences in a key performance indicator.

OUR POINTS

To reiterate, this management and its auditors can be faulted at the least for not paying attention to the consequence of their to-the-letter compliance with an archaic guide, and, at the worst, for using that ancient rule to purposely mislead financial statement users. In either case, shame on them, and we hope this column leads them to change their policy.

A much bigger fish to fry is that we have once again demonstrated the importance of keeping Rule 203 exceptions in the authoritative literature. The Financial Accounting Standards Board's 2005 exposure draft on the GAAP hierarchy asserts that compliance with published standards will always lead to providing relevant and reliable information. We use this case to pound yet another nail in the coffin of that misbegotten platitude.

Indeed, this case provides persuasive evidence that practical and political compromises adopted in the heat of long-past controversies live on well beyond any usefulness they may have ever had.

GOT CASH?

Much to our bemusement, we now add cash to our examples of where GAAP is not any good, including such things as inventory, depreciation, goodwill, research and development, treasury stock, convertible bonds, combinations, pensions, leases, and employee options.

These and many more practices simply do not provide useful information. They should be eliminated so that this company, and any others like it, will be liberated from the shackles of perhaps once well-intended but now bad GAAP.

Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors' views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.

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