We’ve all heard the expression that “cash is king.” This well-worn phrase often is used when assessing the financial health or investment prospects of a firm. Those of you that have followed the Grumpies for a while, may recall a past rant on how companies increasingly “manage” reported cash balances and cash flows (see What’s Up With Cash Balances?). In that diatribe, we described the games that global financial managers now play with cash to overstate performance, as well as the competence decline in entry-level accountants in the auditing and reporting of cash. Unfortunately, things have not improved during the past three years from either an academic OR a real world perspective.
First, the bad news from the classroom front. A month ago, I surveyed my summer graduate students (Master of Accounting candidates) on their undergraduate accounting/auditing education in the area of cash. These students, most of whom attended well-regarded bachelor degree programs, almost unanimously reported that their accounting instructors devoted little or no time to cash or related controls (e.g., bank reconciliations, etc.), and none had even heard of a proof of cash. When it came to cash disclosures, the results were equally troubling. None had ever been exposed to cash policy disclosures or the notion of restricted cash balances. Obviously, cash is NOT king to some of my ivory tower accounting colleagues…
Surely, it can’t be this bad in the real world, right? WRONG! The recent fascination with corporate inversions, transactions in which U.S. companies make overseas acquisitions to reduce their tax burden on income earned abroad, has drawn this grumpy old accountant’s attention to yet another potentially misleading disclosure…this time one associated with “trapped cash.” Trapped cash generally refers to corporate cash balances held in wholly-owned foreign subsidiaries.
The Bigger Sin: “Trapped Cash” or Non-Payment of Taxes?
So what’s the problem? To avoid U.S. taxation of foreign income earned abroad, companies commonly assert that they have no intention of returning the “trapped cash” associated with foreign earnings to the United States. Here are a couple of examples from three well-known tax minimizers:
My beef is not with their obvious and well-publicized tax avoidance practices, but rather that they report “trapped cash” balances as unrestricted cash in their consolidated balance sheets. Clearly, such cash balances are not available for general corporate use as intimated by Google above, therefore the use of these liquid assets is restricted to the jurisdiction where the cash resides. Consequently, restrictions on “trapped cash” and related assets should be reported in the financial statements, and 10Q and 10K disclosures expanded to enhance reporting transparency.
But do companies clearly and fully disclose this restriction? You guessed it…NO! After all, such transparency would negatively affect their financial optics in at least two ways. First, liquidity ratios would be negatively impacted if companies reported restricted “trapped cash” balances as non-current instead of current assets in the balance sheet. Additionally, operating cash flows (OCF) might be negatively impacted by my proposed restricted cash treatment, since increases in restricted “trapped cash” balances would be classified as investing activities, NOT operating activities in the statement of cash flows. Given that OCF are relied upon for a variety of valuation exercises (e.g., stock price calculations, impairment tests, etc.), the incentives for managers to ignore this restricted cash disclosure issue are clear.
Vincent Ryan summed up these disclosure risks nicely in Offshore Corporate Profits Pose Hidden Risks:
GAAP and “Trapped Cash”
So what do generally avoidable accounting principles (my definition of GAAP) say about this issue? Not surprisingly, very little. ASC-305 is generally silent on the restricted cash issue but does cite Securities and Exchange Commission Regulation S-X, Rule 5-02.1 as a resource for restricted cash disclosure. According to the SEC (key points highlighted):
Separate disclosure shall be made of the cash and cash items which are restricted as to withdrawal or usage. The provisions of any restrictions shall be described in a note to the financial statements. Restrictions may include legally restricted deposits held as compensating balances against short-term borrowing arrangements, contracts entered into with others, or company statements of intention with regard to particular deposits; however, time deposits and short-term certificates of deposit are not generally included in legally restricted deposits.
For the “trapped cash” issue, Rule 5-02.1 seems clear and on point. Given the stated intention of corporate tax minimizers NOT to repatriate earnings or related assets, clearly the cash is restricted. Foreign subsidiary cash balances should be reported in a separate balance sheet account, and the nature of the restriction disclosed in a note to the financial statements (not just a one-liner buried in the 10-K management, discussion, and analysis). And remember, removing these restricted cash balances from cash and cash equivalents will also affect reported OCF!
Scope of the “Trapped Cash” Problem?
As the following table for 2013 (prepared in millions and based on firm 10-K data) suggests, for at least five global technology companies the “trapped cash” disclosure problem (and repatriated earnings issue) is far from insignificant. Note that all of the companies reported cash and cash equivalents lumped together with short and long-term marketable securities.
Apple has by far the largest amount of total cash and securities “restricted” to its foreign subsidiaries at $111.3 billion (75.84 percent of total cash and securities and 53.77 percent of total assets). However, both Oracle and Microsoft report cash and security balances where over 90 percent are “held” in foreign subsidiaries. Of the five companies, only Oracle discussed the “trapped cash” issue in the cash policy note to its 2013 10-K:
Surprisingly, two companies (Apple and Microsoft) report that approximately half their total assets (53.77 percent and 48.87 percent, respectively) are cash and securities held in foreign subsidiaries! Maybe a “restricted asset” disclosure is in order…just a thought.
And that’s not all…let’s not forget that a reclassification of “trapped cash” to a non-current asset classification will impact OCF. Three of the five companies discussed above (Apple, Google, and Oracle) may have potentially overstated their 2013 OCF due to increases in “trapped cash” during the past fiscal year. If we apply the percentage of total cash and securities held in foreign subsidiaries (from the above table) to total reported cash and cash equivalents, we can estimate the cash held in foreign subsidiaries at the end of 2013 and 2012. The below table reflects these assumptions.
Increases in “trapped cash” cannot be considered operating inflows due to their restriction. Therefore, they are really investing cash inflows. Consequently, any increase in “trapped cash” should be reversed out of reported OCF. The above table suggests fairly significant possible overstatements of OCF for these three companies.
Are Current “Trapped Cash” MD&A Disclosures Enough?
Not if transparency is the goal! Investors need much more information about the nature and scope of this cash restriction, and its potential impact on liquidity and OCF. At the very least, increased disclosure would eliminate our need to estimate the impact of “trapped cash” on the balance sheet and statement of cash flows. So here are a couple of grumpy suggestions on how to improve transparency:
- Eliminate manager incentives to play the “trapped cash” and “unremitted foreign earnings” games. Yes, that will require some significant tax law changes, which in turn requires that our Congress works together. Well, I guess you can scrap this idea…what was I thinking?
- The SEC should be more aggressive in enforcing registrant compliance with Regulation S-X, Rule 5-02.1. Specifically, companies should reclassify their “trapped cash” balances into non-current asset restricted cash categories in their balance sheets. Also, the SEC is clear that restrictions must be described in a note to the financial statements, not simply buried in the MD&A. And of course, the statement of cash flows would require that any changes in “trapped cash” be reported as investing cash flows.
- Finally, for companies with significant “trapped” cash and securities balances, the SEC should consider expanded MD&A disclosures that provide detail on cash and security balances by category, as well as unremitted earnings, by foreign jurisdiction.
So, there you have it. While cash may indeed “be king,” the “trapped cash” disclosures of large global companies are far from royal. The sad truth is that there is no good reason why cash reporting has to be this complex, if we could get our tax house in order. Perhaps Kurt Vonnegut said it best:
This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.