I had a great conversation with my dad last night that I though was worth sharing.
In the late 1990s my father and a couple of other acccounting PhDs published an academic paper in Accounting Horizons of a study of which the null hypothesis was:
Over the long term the cash flow of a company should equal its net income.
They went back 30 years using Compustat data and reconstructed GAAP cash flow [Note, GAAP cash flow is a fairly recent convention and was not used at the time of beginning of the study.)
Their conclusion was very interesting insofar as the null hypothesis was proven to be not true.
Their finding were.
GAAP cash flow reported tended to be highly overstated because (in order of impact):
- Periodic adjustments and reclassifications to fixed assets and associated depreciation were substantial over time.
- Amortization of goodwill was random to the point of meanlessness.
- The inclusion of working capital in cash flow was erroneous to the extent that current assets both have dynamic valuations (as in inventory) and often was a contract-indecator to the viability of the operation.
The last point was most interesting to me since I’ve been around long enough to see outsized adjustments to the other two.
Dad was quick to point out that cash flow under GAAP was improved if a company just decided to slow down payment to trade creditors – hardly an indicator of good working capital management.
The article made quite a splash in academic circles and the community pressed the FASB to reconsider GAAP cash flow reporting – which they never have brought up for review.
In summary he thinks GAAP cash flow reporting is highly flawed and, on any one reporting period, is very unreliable as a measure valuation.
Just his two cents.