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Talk about an overreaction.
When regulators pushed some big companies earlier this year to revise how they account for vendor financing, Caterpillar Inc. (CAT) was among those hardest hit. The heavy-equipment giant slashed $14 billion off its previously reported operating cash flow as a result.
But now, a soon-to-be-released report suggests Caterpillar may have cut too much - $13 billion too much, in fact. This isn't just some idle speculation: The report comes from the same outfit whose work is credited with prompting regulators to look into the vendor-financing issue in the first place.
The report from the Georgia Tech Financial Analysis Lab shows that Caterpillar differs from many other companies in how it accounts for "retained interests" - the instruments that represent the stake a company continues to hold in a pool of receivables even after it sells them. That difference accounts for $13 billion of the $14 billion reduction in its 2002-03 operating cash flow that Caterpillar announced in February. The report suggests the company should have accounted for them in a way that wouldn't have required such a huge reduction.
Caterpillar's situation illustrates the complexity of accounting rules and how cash-flow accounting can be open to uncertainty and interpretation. It also demonstrates once again that operating cash flow may not necessarily be the "real," hard-and-fast performance measurement some investors believe it to be.
"I think they were erring on the side of over-conservatism," said Charles Mulford, the Georgia Institute of Technology accounting professor who heads the lab. Caterpillar's accounting, he said, is "technically accurate, but so conservative as to be misleading."
Rusty Dunn, a Caterpillar spokesman, said the company would have no comment.
SEC Guidance
This saga began last year, when Mulford's lab issued a report on how companies account for the receivables - money owed to the company - that are generated when they provide financing help to their dealers to help them buy the company's products. Many companies had put these receivables under the investing part of the cash-flow statement, but the lab argued they belonged instead under operating cash flow - a move which in many cases would have dramatically reduced that key measurement of the company's financial health.
The Securities and Exchange Commission agreed with the lab and pushed some large companies to revise their previously reported cash-flow numbers. Several companies, including General Motors Corp. (GM), Ford Motor Co. (F) and General Electric Co. (GE), did so last winter.
But Caterpillar suffered the biggest hit, cutting its 2002 operating cash flow by $6.3 billion and its 2003 figure by $7.7 billion. At the time, the company said that was partly due to retained interests, which companies sometimes keep in a pool of receivables when they're sold as a means of offering extra collateral to investors who buy them.
But the lab's new report argues there's a big flaw in what Caterpillar did. Essentially, the company moved its issuance of the receivables from investing to operating cash flow - and, since more receivables equals lower cash flow, that moved a negative item onto the operating side, pushing it lower. But the company didn't move its collections on the retained interests out of investing cash flow - it left them there.
In other words, Caterpillar moved the side of the transaction that lowered its cash flow, when it loaned money to its dealers. But it didn't move a major countervailing positive item - its subsequent collections that effectively repaid part of the loans. The result was a big negative impact on operating cash flow, without the positive impact from the other side of the transaction that should have helped offset it.
At the time, Caterpillar said accounting rules required it to keep the retained interests under investing cash flow. In its annual report, the company said the retained interests are considered held-to-maturity securities - meaning the company doesn't plan to sell them any time soon - and so they have to be kept under investing instead of operating.
Companies Have Choice
The new report from Georgia Tech, however, argues it's not that simple:
Companies do have a choice for how to classify retained interests, the report says, and most of the other companies it surveyed put them in operating cash flow. (Besides Caterpillar, the only company covered in the report that puts them in investing cash flow is Bluegreen Corp. (BXG), where an official couldn't be reached for comment.) Because everything stems from an operating transaction - the sale of products - it's most appropriate to classify the collection on the retained interests as operating cash flow, the report says.
If Caterpillar had done that, it would have lessened the negative impact of the revision by $5.9 billion for 2002 and $7.1 billion for 2003. That means that overall, Caterpillar's response to the SEC's prodding would have been to lessen 2002 operating cash flow by only $411 million and 2003 by only $548 million - a total of $959 million. That's a far cry from $14 billion. Accounting for the retained interests in the way Caterpillar did also reduced its 2004 operating cash flow by $5.7 billion, according to the report.
"I don't think the intent of GAAP is to show retained interests as investing cash flow," Mulford said, referring to generally accepted accounting principles.
An SEC spokesman declined to comment on the retained-interests issue or the new report.
Ultimately, the issue may not make a huge difference in the way investors view Caterpillar's finances. When the company announced its revision earlier this year, it noted that while the operating cash flow for the entire company was changing, the operating cash flow figures Caterpillar reports for its individual manufacturing and financing units - which the company says investors care most about - weren't affected.
Mulford stressed that Caterpillar's overreaction doesn't mean his lab's initial conclusion about the need to reclassify vendor financing on the cash-flow statement was wrong. Caterpillar "went too far" in reacting to legitimate concerns, he said. "We're not backtracking."
And while the lab didn't find many companies other than Caterpillar who were classifying retained interests in a way the report views as incorrect, Mulford said there may be more out there. It's hard to tell, he said, because companies' disclosure of retained interests and how they're categorized isn't great.
"I think there's confusion on the part of reporting companies," he said.
Michael Rapoport is one of four "In the Money" columnists who take a sophisticated look at the value of companies and their securities and explore unique trading strategies.
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