February 15, 2002

FLOYD NORRIS

Can Investors Believe Cash Flow Numbers?

WASHINGTON -- You can't fake cash flow."

Well, actually, you can.

As corporate America became better at managing earnings in the 1990's — normally using tactics that corporate officials regarded as proper but sometimes pushing on to methods that auditors knew would outrage the Securities and Exchange Commission if it found out about them — investors reassured themselves that if they only looked at cash flow, they would be safe.

Now we know that accountants rose to the challenge. If investors wanted to see operating cash flow, well, by jiggery, they would see it. Cash flow mirages are crucial parts of what went on at Enron (news/quote) and Global Crossing.

Enron found ways to borrow money and report the cash as if it were real operating cash flow. The S.E.C. will decide whether Enron found clever ways around accounting rules, or whether it flouted the rules. Either way, investors were misled.

At Global Crossing, the company traded capacity with other fiber optics companies. In reality, almost nothing happened, but both companies involved in a swap were able to report revenue without offsetting expenses. They treated their purchases as capital investments. So the companies reported profits and operating cash flows. Global Crossing was careful to structure the transactions so that the money it spent would not show up in its cash flow number.

Global Crossing's accounting appears to be within the rules — so long as the transactions were not shams. Whether or not they are viewed that way will probably be the major issue the S.E.C. will face in determining if fraud charges are warranted. But for investors, the big issue is that they did not know just how unreal the cash flow was.

A few months ago, politicians who said anything about accounting rules were lobbying to weaken them. The argument, put forth by corporate lobbyists, was that tough rules would scare investors and drive down stock prices. Yesterday, both the House and Senate held hearings on accounting standards, with legislators clamoring for action to end abuses and reassure those same investors that the numbers are not fake. Edmund Jenkins, the chairman of the Financial Accounting Standards Board, promised quick action to close one loophole that Enron used, the one that let it keep many partnerships out of sight of investors.

It is becoming possible to hope that many good reforms will come from the Enron mess. One of the more outrageous things that auditing firms do is sell opinions to investment bankers, who use them to market strange transactions that are designed to squeeze around accounting rules. With such a letter, a company can put pressure on its own auditor to sign off on dubious accounting.

But yesterday, Robert K. Herdman, the S.E.C.'s chief accountant, called for a ban on such letters. That would be one important step toward making auditors remember that their real client is the public that is asked to rely on their certification of financial statements — not some investment banker offering a fat fee for a friendly opinion.

The reforms now coming, if not fatally weakened in back-room compromises, promise to make it much more difficult to fake numbers, whether of cash flow or profits. And auditors, having watched Arthur Andersen's reputation crumble, are likely to show new vigilance. The lasting effect of Enron may be very positive.