Cash Flow Classification-As Long as It's on the Statement, Does It Matter Where?

Helen was uneasy. Even though her company's top tax managers, Gene and Jamie, seemed comfortable with the cash flow classification and the tax savings plan proposed by the company's international Certified Public Accounting (CPA) firm, Helen's gut feeling told her it was wrong (Steffy, 2013). Still in her twenties, and much younger than her tax managers, was she just being silly to have doubts, or did it really matter where a cash flow appeared on the cash flow statement as long as it was on there? Helen was a CPA, but so were Gene and Jamie. And, as long as her superiors and the CPA firm embraced the plan as legitimate, did it really matter if she had doubts about the economic substance underlying the transactions? When the idea was presented, Helen, Gene, and Jamie were excited to hear about the plan proposed by their CPA firm. Helen's company had come under close scrutiny by financial analysts because of a widening gap between its net income and cash flow from operating activities. Much of the gap was caused by the company adopting "mark-to-market" accounting. Helen's company was heavily involved with energy trading. "Mark-to-market" accounting was required for these types of contracts. Under this accounting method, the contracts were presented on the company's balance sheet at market value. If the contract increased (decreased) in value, an unrealized gain (loss) would be recorded even though there was no corresponding cash flow. These unrealized gains (losses) appeared on the income statement, thus increasing (decreasing) net income. Most of the contracts had increased in value, which resulted in unrealized gains, and thus increased net income without a corresponding increase in cash flow (SEC, 2002). Their CPA firm had assured Helen, Gene, and Jamie about the legitimacy of the transactions. In fact, one of the accounting firm's clients was already using the plan. The client was a prestigious company, one of the largest in the United States (Sharkey, 2013). The plan was structured in a way that significantly increased cash flows and reduced income taxes. The CPA firm established guidelines that should be followed, such as avoiding certain hedging transactions, in order for the project to be in accordance with generally accepted accounting principles (GAAP). This proposal, which was named "Project Alpha, " appeared to be just what the company needed to appease financial analysts (SEC, 2003). As time went on, however, Helen became more anxious about the project although it was created by one of the most well-known CPA firms in the world. She was a team player and loyal to the company. Helen began working for the company right out of college (Sharkey, 2013). "Project Alpha" was complex and involved some of the company's affiliates and outside lenders. The fees paid for the project were substantial, $35.8 million. The following figure graphically shows these intercompany transactions. An affiliate called NGAI borrowed $310 million from a syndicate of lenders. NGAI used these funds to purchase another affiliate named DMT for $307 million. In exchange for this purchase, NGAI had a nine-month, 99 percent limited partnership interest in DMT. Helen's company (HC) held the other 1 percent as a general partner. Of the funds received, DMT sent $300 million to HC, payable back to DMT on demand. At the same time, another affiliate, ABG, entered into a five-year agreement with DMT to sell energy contracts (SEC, 2002). [FIGURE OMITTED] During the first nine months, ABG sold the contracts to DMT at a discount. DMT then sold the contracts on the open market at a profit. From these gains, DMT gave NGAI approximately $300 million to enable NGAI to pay back the loans to the syndicate of lenders. During the remaining term of the five-year agreement, DMT agreed to purchase energy contracts from ABG at above market prices to enable ABG to recoup the losses incurred during the first nine months. …