Cashflow Reporting in the Presence of Overdrafts

755 Ferst Avenue 404-894-4395 Atlanta, GA 30332 http://www.dupree.gatech.edu/faculty/finlab/lab.shtml Dr. Charles W. Mulford, CPA, Director Invesco Chair and Professor of Accounting charles.mulford@mgt.gatech.edu Kerianne Maloney Graduate Research Assistant gtg335k@mail.gatech.edu Cashflow Reporting in the Presence of Overdrafts Executive Summary Numerous companies maintain cash overdraft balances. These seemingly innocuous accounts can have material effects on reported amounts of cash and operating cash flow. In this report we survey reporting practices for overdrafts and draw attention to cases where analysts may be misled. January, 2003

Cash Flow Reporting in the Presence of Overdrafts Financial Reporting and Analysis Lab DuPree College of Management Georgia Institute of Technology Atlanta, GA 30332-0520 Financial Reporting and Analysis Lab The DuPree College of Management Financial Reporting and Analysis Lab conducts unbiased stock market research. Unbiased information is vital to effective investment decision-making. Accordingly, we think that independent research organizations, such as our own, have an important role to play in providing information to market participants. Because our Lab is housed within a university, all of our research reports have an educational quality, as they are designed to impart knowledge and understanding to those who read them. Our focus is on issues that we believe will be of interest to a large segment of stock market participants. Depending on the issue, we may focus our attention on individual companies, groups of companies, or on large segments of the market at large. A recurring theme in our work is the identification of reporting practices that give investors a misleading signal, whether positive or negative, of corporate earning power. We define earning power as the ability to generate a sustainable stream of earnings that is backed by cash flow. Accordingly, our research may look into reporting practices that affect either earnings or cash flow, or both. At times our research may look at stock prices generally, though from a fundamental and not technical point of view. Contact Information Charles Mulford. Invesco Chair, Professor of Accounting and the Lab's Director. Phone: (404) 894-4395 Email: charles.mulford@mgt.gatech.edu Michael L. Ely. MBA, Financial Analyst. Phone: (404) 894-9473 Email: michael.ely@mgt.gatech.edu Katie Hudson. Graduate research assistant and MBA student. Kerianne Maloney. Graduate research assistant and MBA student. Andrew Moses. Graduate research assistant and MBA student. Website: http://www.dupree.gatech.edu/faculty/finlab/lab.shtml 2002 by the DuPree College of Management, Georgia Institute of Technology, Atlanta, GA 30332-0520. ALL RIGHTS RESERVED. The information in this research report was based on sources believed to be reliable and accurate, consisting principally of required filings submitted by the companies represented to the Securities and Exchange Commission. However, no warranty can be made. No data or statement is or should be construed to be a recommendation for the purchase, retention, or sale of the securities mentioned. Cash Flow Reporting in the Presence of Overdrafts, January, 2003. 2

www.dupree.gatech.edu/faculty/finlab/lab.shtml Companies Named In This Report Page Airborne, Inc. 5,6 AMC Entertainment, Inc. 5,13-14 Amgen, Inc. 5,10-12 Aviall, Inc. 5,8-9 Beazer Homes, USA, Inc. 5,7-8 Boeing Corporation 5,6 Electric Lightwave Inc. 5 Hershey Foods Corporation 5,6 Hunt Corp. 5 Kendle International Inc. 5 Linens N Things, Inc. 12-13 Medsolutions, Inc. 5 Mim, Corp. 9-10 National R.V. Holdings, Inc. 5 Paving Stone Corporation and Subs. 5 Peabody s Coffee, Inc. 5 Pennford Corp. 5 Perini Corporation 5 Railworks Corp. 5 Speizman Industries Inc. and Subsidiaries 5 Strategic Distribution Inc. 5 Cash Flow Reporting in the Presence of Overdrafts, January, 2003. 3

Cash Flow Reporting in the Presence of Overdrafts Cash Flow Reporting in the Presence of Overdrafts Introduction Cash-balance overdrafts arise when checks written and presented for payment exceed available bank balances. It is not uncommon for companies to have overdraft protection arrangements with their banks whereby short-term financing is provided to cover checks presented for payment. Indeed, an overdraft arrangement can play a role in effective cash management as a means of minimizing the opportunity cost of carrying funds in low-yielding bank accounts. At period's end, even though an overdraft has been covered resulting in a positive bank balance, the existence of outstanding checks will result in a book overdraft - a negative cash balance. Generally accepted accounting principles (GAAP) call for the reporting of such an overdraft balance as a current liability. Reclassifying an overdraft balance to a liability results in an increase in the reported cash balance from a negative amount to zero. At times, the amounts of these reclassifications can be significant. Analysts who are unaware of such reclassifications may be misled into thinking that more on-hand cash is available than is actually the case. Also, while GAAP calls for the reporting of changes in overdraft balances as financing sources and uses of cash, many companies report them as operating cash flows. The end result may be an improper assessment of a firm's ability to generate sustainable cash flow. This report provides accounting guidance for overdrafts and statistics on the extent to which cash overdrafts are reported and their materiality to existing cash balances. Also provided are measures of the extent to which the operating cash flow designation for changes in overdrafts is employed versus a more appropriate financing classification. Frequency of Overdraft Reporting We began our study by gathering evidence on the frequency with which companies report overdraft balances. We sampled 2,571 10-K annual report filings spread across the fiscal 2001 filing year. In particular, we were looking for evidence of the disclosure of overdrafts either in the footnotes, the balance sheet, or in the statement of cash flows. In the sample, 100 companies, or 3.9% disclosed the existence of overdrafts of a sufficiently material amount to warrant disclosure. Some examples of the overdrafts noted in fiscal 2001, together with a few interesting examples from 2000 are provided in Exhibit 1 below. Quick Stat.: 3.9% of 10-K filings sampled reported the existence of material overdrafts Cash Flow Reporting in the Presence of Overdrafts, January, 2003. 4

www.dupree.gatech.edu/faculty/finlab/lab.shtml Exhibit 1 presents reported cash balances, cash overdrafts, and net cash balances, for a sample of companies noted in our survey of overdraft reporting. In the exhibit, the Reported Cash Balance column is the amount of cash and cash equivalents reported on the balance sheet for the fiscal year noted. The Cash Overdraft Balance column is the year-end amount of overdrafts disclosed in the footnotes or as a liability on the balance sheet. The Net Cash Balance was computed by subtracting the overdraft balance from the reported cash balance. Net cash reflects the actual onhand amount of cash and cash equivalents in the absence of any overdraft financing. Exhibit 1. Cash Balances and Cash Overdrafts Reported Cash Balance Cash Overdraft Balance Company Year Ended Net Cash Balance AIRBORNE INC. 12/31/00 $ 40,390,000 $ 51,738,000 ($ 11,348,000) AMC ENTERTAINMENT, INC. 03/28/02 219,432,000 31,751,000 187,681,000 AMGEN INC. 12/31/00 226,500,000 101,200,000 125,300,000 AVIALL INC. 12/31/01 2,526,000 7,500,000 (4,974,000) BEAZER HOMES USA, INC. 09/30/01 41,678,000 20,100,000 21,578,000 BOEING CORPORATION 12/31/01 633,000,000 351,000,000 282,000,000 ELECTRIC LIGHTWAVE INC. 12/31/00 10,318,000 6,965,000 3,353,000 HERSHEY FOODS CORP. 12/31/00 31,969,000 22,500,000 9,469,000 HUNT CORP. 12/03/00 23,878,000 4,100,000 19,778,000 KENDLE INTER. INC. 12/31/00 6,709,000 1,234,000 5,475,000 MEDSOLUTIONS, INC. 12/31/01 0 145,500 (145,500) NATIONAL R.V. HOLD., INC. 12/31/01 22,000 608,000 (586,000) PAVING STN. CORP. & SUBS. 12/31/01 35,439 326,936 (291,497) PEABODY S COFFEE, INC. 03/31/02 7,307 48,495 (41,188) PERINI CORPORATION 12/31/01 9,512,000 2,626,000 6,886,000 RAILWORKS CORP. 12/31/00 7,263,000 1,164,000 6,099,000 SPEIZMAN IND. INC. & SUBS. 06/30/01 0 1,438,466 (1,438,466) STRATEGIC DISTRIB. INC. 12/31/00 1,869,000 2,495,000 (626,000) Source: Company filings with SEC. Cash Flow Reporting in the Presence of Overdrafts, January, 2003. 5

Cash Flow Reporting in the Presence of Overdrafts In reviewing Exhibit 1, consider the results for Airborne, Inc. Because the company's cash overdraft balance exceeds its cash balance at December 31, 2000, its net cash balance is a negative amount at year-end. However, because the overdraft balance is not separately stated on the company s balance sheet, but is instead included in its account payable balance, its negative cash balance is not evident from the company's financial statements. A review of the financial statement footnotes is necessary to reveal the effect of the overdraft balance on its reported amount of cash. As reported in the notes: Cash The Company has a cash management system under which a cash overdraft exists for uncleared checks in the Company's primary disbursement accounts. The cash amount in the accompanying financial statements represents balances in other accounts prior to being transferred to the primary disbursement accounts. Uncleared checks of $51,738,000 and $43,246,000 are included in accounts payable at December 31, 2000 and 1999, respectively. In the case of Boeing Corp., the cash overdraft balance at year-end does not exceed its reported cash balance. Overdrafts comprise 55.5% of the company's reported cash balance. Here again, a review of the footnotes is necessary to reveal the effect of the overdraft balance on reported cash. As reported in the notes (in millions): Accounts Payable and Other Liabilities Accounts payable includes $351 and $441 as of December 31, 2001 and 2000, attributable to checks written but not yet cleared by the bank. Hershey Foods Corp. s cash overdrafts comprise 70.4% of its reported cash balance, as revealed in the footnotes to its financial statements: Short-term debt As a result of maintaining a consolidated cash management system, the Corporation maintains overdraft positions at certain banks. Such overdrafts, which were included in accounts payable, were $22.5 million and $20.4 million as of December 31, 2000 and 1999, respectively. Overdrafts and the Statement of Cash Flows Under GAAP, changes in overdraft balances - sources of cash from increasing overdraft balances or uses of cash for reducing them - should be reported as financing activities on the statement of cash flows. Statement 95, Statement of Cash Flows, does not make specific reference to the cash flow classification of overdrafts. The Statement is, however, clear in noting that outside sources of cash in the form of borrowed amounts are to be classified as financing activities. Because cash is not on-hand to fund an overdraft balance, an outside source, a financing, is needed. Bolstering this view, in a speech delivered to the Twenty-Third Annual National Conference on Current SEC Developments in 1996, Christine Q. Davine, Associate Chief Accountant, Division of Corporation Finance of the SEC noted, Cash Flow Reporting in the Presence of Overdrafts, January, 2003. 6

www.dupree.gatech.edu/faculty/finlab/lab.shtml "Registrants are reminded to evaluate the criteria in SFAS 95 for classifying each cash receipt and payment in the appropriate category... Cash overdrafts should be reported as financing activities." 1 In some instances, companies may use funds transferred from company-owned investment accounts to cover overdrafts. In such cases, an investing cash-flow classification for changes in overdrafts, though importantly, not an operating designation would appear to be in order. Such guidance notwithstanding, not all companies report changes in overdrafts outside the operating section of the cash flow statement. In fact, among our sample of companies reporting the existence of overdrafts, 16% included changes in overdrafts as operating cash flow while 61% reported overdrafts in the financing section. The remainder, 23% of our sample, did not provide sufficient information to determine where overdrafts had been classified in the statement of cash flows. Quick Stats.: 16% of sample reported overdrafts in operating cash flow 61% of sample reported overdrafts in financing cash flow In analyzing performance, it is important to be clear on how overdrafts have been classified on the statement of cash flows. When overdrafts are included in operating cash flow, analysts may overestimate the amount of sustainable cash flow being generated. Given the nontrivial number of firms classifying overdrafts as operating cash flow, there is ample opportunity for analysts to be misled. Consider the case of Beazer Homes USA, Inc. In the year ended September 30, 2001, the company reported that it used $29.4 million in operating cash flow. That year, however, an increase in overdrafts provided $20 million. Thus, the company's operating cash performance would have been worse in the absence of overdraft financing. In its performance for 2002, Beazer was more profitable than in 2001 and was more successful in generating operating cash flow. In addition to an increase in earnings, contributing to its operating cash that year were an increase in trade accounts payable versus a decline the previous year, a decrease in other assets, and an increase in the tax benefits from stock transactions. The company disclosed no change in overdrafts The operating section of Beazer's cash flow statement is presented in Exhibit 2. Note the clear disclosure of changes in overdrafts and their effects on operating cash flow. 1 American Institute of Certified Public Accountants 1996 Twenty-Third Annual National Conference on Current SEC Developments, taken from http://www.sec.gov/news/speech/speecharchive/1996/spch080.txt (accessed 10/28/02). Cash Flow Reporting in the Presence of Overdrafts, January, 2003. 7

Cash Flow Reporting in the Presence of Overdrafts Exhibit 2. Financial Statement Excerpts, Beazer Homes USA, Inc. Operating Section, Consolidated Statements of Cash Flows (in thousands) For the year ended: 2002 2001 2000 Cash flows from operating activities: Net income $ 122,634 $ 74,876 $ 43,606 Adjustments to reconcile net loss to net cash (used)/provided by operating activities: Depreciation and amortization 9,453 9,253 6,852 Loss on early extinguishment of debt -- 1,202 -- Deferred income tax benefit (6,613) (7,906) (3,792) Tax benefit from stock transactions 12,235 3,837 -- Changes in operating assets and liabilities, net of effects from acquisitions: Increase in accounts receivable (13,601) (15,814) (1,671) Increase in inventory (152,990) (153,668) (97,104) Decrease/(increase) in other assets 15,611 (1,023) 4,589 (Decrease)/increase in trade accounts payable 23,481 (26,676) 28,571 (Decrease)/increase in other liabilities 48,300 65,397 11,083 Change in book overdraft -- 20,095 (11,219) Other changes 954 4,849 359 Net cash (used)/provided by operating activities $ 59,464 $ (25,578) $ (18,726) Source: Company filings with SEC. Other companies were less forthcoming in their disclosures of the effects of overdrafts on operating cash flow. Consider, for example, Aviall, Inc. In 2000, Aviall, Inc. reported that it generated $7.7 million in operating cash flow. The cash flow statement did not, however, provide direct evidence of the effects of overdrafts. The company did disclose in a note that overdrafts were included in accounts payable. According to the note, during 2000, those overdrafts increased $15.2 million, providing that amount of operating cash flow. The note is reproduced below: Cash and cash equivalents The Company considers all highly liquid, interest-bearing instruments with an original maturity of three months or less to be cash equivalents. The Company reclassifies cash overdrafts to accounts payable. Cash overdrafts included in accounts payable were $19.7 million and $4.5 million at December 31, 2000 and 1999, respectively. To confirm the inclusion of overdrafts in operating cash flow, we tied the change in accounts payable from the balance sheet, which, according to the company, included cash overdrafts, to its change in the operating section of the cash flow statement. Cash Flow Reporting in the Presence of Overdrafts, January, 2003. 8

www.dupree.gatech.edu/faculty/finlab/lab.shtml In 2001, Aviall reported that it used $93.4 million in operating cash flow. That year, overdrafts declined from $19.7 million to $7.5 million, consuming $12.2 million in cash from operations. The company made the following disclosure in the notes to its financial statements for 2001: Cash and cash equivalents The Company considers all highly liquid, interest-bearing instruments with an original maturity of three months or less to be cash equivalents. The Company reclassifies cash overdrafts to accounts payable. Cash overdrafts included in accounts payable were $7.5 million and $19.7 million at December 31, 2001 and 2000, respectively. As is common for quarterly filings, the company provided no disclosure of overdrafts in the quarterly statements for the period ended September 30, 2002. Exhibit 3. Financial Statement Excerpts, Aviall, Inc. Operating Section, Consolidated Statements of Cash Flows (in thousands) Year ended December 31, 2001 2000 1999 OPERATING ACTIVITIES: Net earnings $ 2,759 $ 11,628 $ 9,703 Gain on disposal of discontinued operations (322) (1,062) (4,588) Unusual items 9,787 -- 6,029 Extraordinary item 1,026 -- -- Depreciation and amortization 11,630 9,232 6,775 Compensation expense on restricted stock Awards 437 371 104 Deferred income taxes 1,477 5,684 2,709 Tax benefit from exercise of stock options -- 23 128 Changes in: Receivables 7,234 (20,643) (3,395) Inventories (112,613) (26,319) (24,880) Accounts payable (15,942) 31,594 3,448 Accrued expenses 1,054 (196) (5,213) Other, net 85 (2,644) (2,800) Net cash (used for) provided by operating Activities $ (93,388) $ 7,668 $ (11,980) Source: Company filings with SEC. Consider also the effects of overdrafts on the operating cash flow of Mim Corp. as presented in Exhibit 4. Cash Flow Reporting in the Presence of Overdrafts, January, 2003. 9

Cash Flow Reporting in the Presence of Overdrafts Exhibit 4. Financial Statement Excerpts, Mim, Corp. Operating Section, Consolidated Statements of Cash Flows (in thousands) Nine Months Ending Sept. 30, 2002 Three Months Ending March, 30, 2002 Three Months Ending March, 30, 2001 Fiscal period Net income $ 14,303 $ 5,207 $ 3,483 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 4,544 1,343 1,416 TennCare reserve adjustment (851) (851) (980) Issuance of stock to employees 109 Provision for losses on 941 169 305 receivables Changes in assets and liabilities, net of acquired assets: Receivables, net 5,264 (4,463) (5,479) Inventory (2,268) (2,185) (1,296) Prepaid expenses and other current assets (1,305) (158) 283 Accounts payable 56 1,482 930 Claims payable (2,721) 4,956 8,788 Cash overdrafts -- 9,698 -- Payables to plan sponsors 2,046 (1,946) (3,423) Accrued expenses and other current liabilities (1,900) (321) 86 Non-current liabilities -- -- (232) Net cash provided by operating activities $ 18,218 $ 12,931 $ 3,881 Source: Company filings with SEC. For the fiscal quarter ending March 31, 2002 Mim clearly disclosed the effects of overdrafts on operating cash flow. That quarter, an increase in cash overdrafts of $9.7 million provided Mim with 75.0% of its operating cash flow. For the nine months ending September 30, 2002, however, Mim did not report the effects of cash overdrafts on operating cash flow. That is, the line item "cash overdrafts" was actually deleted from the cash flow statement. Such presentation indicates that either cash overdrafts were covered or effectively repaid in ensuing quarters or the effects of overdrafts were combined with another line item on the statement of cash flows. Like so many other companies, Amgen, Inc. includes its bank overdraft balance at year-end in accounts payable. As reported in the notes to the company's financial statements for the year ended December 31, 2000: Cash Flow Reporting in the Presence of Overdrafts, January, 2003. 10

www.dupree.gatech.edu/faculty/finlab/lab.shtml The company considers cash equivalents to be only those investments that are highly liquid, readily convertible to cash and which mature within three months from date of purchase. Under the Company s cash management system, the bank notifies the Company daily of checks presented for payment against its primary disbursement accounts. The Company transfers funds from short-term investments to cover the checks presented for payment. This system results in a book cash overdraft in the primary disbursement accounts as a result of checks outstanding. The book overdraft, which was reclassified to accounts payable, was $101.2 million and $43.9 million at December 31, 2000 and 1999, respectively. At December 31, 2001, Amgen did not disclose the existence of overdrafts. That year, the company's cash note was amended to the following: The Company considers cash equivalents to be only those investments which are highly liquid, readily convertible to cash, and which mature within three months from date of purchase. Amgen did not separately report the effects of overdrafts in its cash flow statement. However, in 2000, because the change in accounts payable on Amgen s statement of cash flows agreed with the change in accounts payable reported on the balance sheet, which included overdraft balances, it is apparent that Amgen had included cash overdraft activity in the operating section of its cash flow statement. The operating section of Amgen's cash flow statement is provided in Exhibit 5. Exhibit 5. Financial Statement Excerpts, Amgen, Inc. Operating Section, Consolidated Statements of Cash Flows (in thousands) Year Ended December 31, 2001 2000 1999 Cash flows from operating activities: Net income $ 1,119,700 $ 1,138,500 $ 1,096,400 Depreciation and amortization 265,900 211,800 176,800 Tax benefits related to employee stock Options 244,500 376,600 151,600 Loss / (gain) on equity investments 7,400 (31,800) -- Other non-cash expenses 87,700 29,700 -- Deferred income taxes (148,300) 6,600 9,800 Loss of affiliates, net 2,700 23,900 16,800 Cash provided by (used in): Trade receivables, net (123,000) 23,000 (92,300) Inventories (85,500) (120,900) (73,500) Other current assets (31,500) (51,400) (9,000) Accounts payable (6,500) 59,800 (38,200) Accrued liabilities 147,100 (31,200) (11,500) Net cash provided by operating activities $ 1,480,200 $ 1,634,600 $ 1,226,900 Cash Flow Reporting in the Presence of Overdrafts, January, 2003. 11

Cash Flow Reporting in the Presence of Overdrafts Source: Company filings with SEC. At December 31, 2000, 44.7% of Amgen s cash balance consisted of cash overdrafts. Further, an increase in cash overdrafts contributed $57.3 million to Amgen s operating cash flow for that year. Although Amgen may have maintained an overdraft balance at December 31, 2001, the company did not disclose the details of the amount or the accounts in which the overdrafts were included. Thus, both the reported cash balance at December 31, 2001 and the operating cash flow for the year ending December 31, 2001 may be materially affected by the presence of overdrafts, but such effects cannot be determined from the financial statements alone. As an example of a company that includes overdrafts in financing cash flow, consider AMC Entertainment, Inc. The company reports the existence of overdrafts with the following footnote disclosure: Under the Company's cash management system, checks issued but not presented to banks frequently result in overdraft balances for accounting purposes and are classified within accounts payable in the balance sheet. The amount of these checks included in accounts payable as of March 28, 2002 and March 29, 2001 was $31,751,000 and $35,157,000, respectively. The cash flow statement clearly reports the change in overdrafts in financing cash flow, as seen in Exhibit 6. Exhibit 6. Financial Statement Excerpts, AMC Entertainment, Inc. Condensed Consolidated Statements of Cash Flows (in thousands) Year Ended March 28, 2002 and March 29, 2001: March, 2002 March, 2001 Net cash provided by operating activities $ 100,649 $ 43,458 Net cash used in investing activities (144,510) (91,933) Cash flows from financing activities: Net borrowings (repayments) under Credit Facility (270,000) (60,000) Proceeds from issuance of 9 7/8% Senior Subordinated Notes due 2012 172,263 - Net proceeds from sale of Common Stock 100,800 - Net proceeds from Preferred Stock Issuance 230,022 - Proceeds from financing lease obligations 881 19,135 Principal payments under capital and financing lease obligations and other (2,638) (2,755) Change in cash overdrafts (3,406) 6,520 Change in construction payables 6,264 1,816 Deferred financing costs and other (4,865) - Net cash (used in) provided by financing activities 229,321 (35,284) Effect of exchange rate changes on cash and equivalents (103) (1,471) Cash Flow Reporting in the Presence of Overdrafts, January, 2003. 12

www.dupree.gatech.edu/faculty/finlab/lab.shtml Net increase (decrease) in cash and equivalents 185,357 (85,230) Cash and cash equivalents at beginning of year 34,075 119,305 Cash and cash equivalents at end of year $ 219,432 $ 34,075 Source: Company filings with SEC. Since AMC Entertainment, Inc. has appropriately reported the effects of overdrafts in its financing cash flow, operating cash flow results have not been distorted. Conclusion The presence of overdraft balances at year-end can affect the presentation of both the balance sheet and statement of cash flows. Because overdraft balances are typically classified as liabilities, the reported balance in cash can be misleading. Moreover, if changes in overdraft balances are improperly reported in the operating section of the cash flow statement, reported operating cash flow does not clearly reflect sustainable cash flow. Given the number of companies maintaining overdraft balances and the potentially material effect such overdrafts can have on cash balances and operating cash flow, a complete financial analysis should consider their impact. However, because disclosure is somewhat spotty, verification with management of the existence of cash overdrafts may be in order. Cash Flow Reporting in the Presence of Overdrafts, January, 2003. 13