Show stockholders the money! (Forward Observer).(cash flow better indicator of value)

In the wake of last year's corporate scandals, politicians tried to boost the confidence of investors by improving the so-called Generally Accepted Accounting Principles (GAAP) that public companies use to report their earnings to the Securities and Exchange Commission. They have taken a dangerously misguided approach.

As my AEI colleague Peter Wallison wrote recently, the problem with current earnings statements isn't their accuracy but their adequacy: "GAAP financial statements, even when competently audited, do not, by themselves, furnish ... reliable information to investors."

There is, however, an alternative to GAAP: It is called cash. If you run your own business, what do you truly care about? The money that comes in the door and the money that goes out the door. That movement of money is called "cash flow," and it is the classic method of figuring what an asset is worth. The value of any business is determined by the cash it will generate over its future life. Cash flow, rather than audited earnings, ought to determine value. As a saying that goes back to at least 1890 puts it, "Earnings are an opinion; cash flow is a fact."

So it's troubling that the main legislative response to the scandals (the Sarbane-Oxley law), plus new SEC measures, have concentrated on earnings-adding new rules, plugging loopholes, and forcing both auditors and corporate managers to swear up and down that the numbers are right. Instead, regulators should remind investors that earnings are only one--often misleading--way to describe the health of a business.

Take Enron. If you'd had a chance to look at its cash statements, you might have suspected something was fishy long before 2001. Between 1998 and 2000, Enron suffered an outflow of $4 billion in cash--while claiming double-digit earnings growth.

Or consider WorldCom. In a recent paper, financial consultant Richard Bassett noted that on the day before WorldCom revealed it had overstated GAAP earnings by $3.9 billion, its stock sold for just 83 cents--down from $75 in 1999. Investors had ...