ACCOUNTING SIGNS IN LATE CYCLE TOP 10: SECURITIZATION GAMES

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1 MACRO RESEARCH Accounting & Tax Policy Portfolio Strategy Quantitative Analysis March 18, 2016 ACCOUNTING SIGNS IN LATE CYCLE TOP 10: SECURITIZATION GAMES This is the first report on the Top 10 accounting items to watch for in a late cycle environment. Over the coming weeks, we will publish a new topic each Friday. When uncertainty is more prevalent and growth becomes harder to come by, managements often become more aggressive when reporting to investors. Companies may choose accounting policies or undertake transactions that hide or skew their true economic impact. This week, we examine how accounts receivable securitizations impact reported cash flows and financial ratios. Aggressive Revenue Recognition: Masked by A/R Sales. We expect companies to become more aggressive in their revenue recognition policies in an uncertain macro environment (e.g. recognizing sales earlier or extending / loosening credit terms). Traditionally, the best way to spot these tactics is through changes in days sales outstanding or A/R turnover. A/R sales and securitizations have the impact of keeping the balance sheet amount of receivables artificially low, skewing these metrics. Therefore, the receivable balances should be adjusted for sold, but uncollected, receivable balances when calculating DSOs for analytical purposes. Receivable Sales May Boost Cash Flow Outside of the Normal Cash Collection Process. Many companies utilize accounts receivable sales / securitizations as a cost effective financing tool. However, when these transactions receive off-balance sheet treatment, they may create the appearance of unsustainably strong cash flow generation. When receivables are initially sold and removed from the balance sheet, cash flow is pulled forward from future periods outside of the normal operating cycle of the business. Adjusting Cash Flow for A/R Securitizations. We believe the economics of receivable sales truly reflect a financing decision and should be analyzed as such. Within this report, we discuss and show how to use company disclosures of uncollected securitized receivable balances to analytically adjust operating and financing cash flows. Chris Senyek, CFA, CPA Adam Calingasan, CFA, CPA Chip Miller, CFA, CPA Chris Van Doren (646) (646) (646) (646) csenyek@wolferesearch.com acalingasan@wolferesearch.com cmiller@wolferesearch.com cvandoren@wolferesearch.com This report is limited solely for the use of clients of Wolfe Research. Please refer to the DISCLOSURES located at the end of this report for applicable disclosures. WolfeResearch.com Page 1 of 6 Accounting & Tax Policy

2 ACCOUNTS RECEIVABLE SALES MASKS AGGRESSIVE REVENUE RECOGNITION One of the tried and true detection metrics for aggressive revenue recognition is the level of and changes in days sales outstanding. Growth in DSOs may indicate the company is recognizing revenue earlier than it has historically or has perhaps loosened credit standards. However, a company that initiates or increases the use of A/R securitizations may skew days sales outstanding as a reliable indicator of cash collections from customers. As the accounts receivable amounts are sold and removed from the balance sheet, the calculation and growth in any days outstanding number will not accurately reflect these sales and will be artificially low unless adjusted by the uncollected receivable balance. Many lower credit rated companies utilize accounts receivable (A/R) sales as a form of low-cost financing where the interest rate is typically based on short-term LIBOR or commercial paper rate. There are a variety of monikers used in describing A/R sales in company disclosures, including securitizations, factoring programs, secured financing facilities or off-balance sheet facilities. At best and if used properly, these accounts receivable sales can be cost effective financing tools. At worst and if used improperly, they boost current period operating cash flows at the expense of future cash flows. Additionally, as mentioned above A/R sales will also mask deterioration in DSOs and less conservative revenue recognition policies. We have found accounts receivable sales to be most prevalent among industrials, information technology, and consumer discretionary companies. As an example below, consider Crown Holdings. The company has a securitization program for its accounts receivable, which it has increased usage of over the last several years. In fact, the company discloses that increased A/R sales in 2015 benefitted days sales outstanding by 5 days. Accounts Receivable Securitization Accounting Impacts Crown Holdings ($ millions) Receivables decreased from $1,031 in 2014 to $912 in 2015 primarily due to increased securitization and factoring, declining raw material costs and the impact of foreign currency translation, partially offset by the impact of the Empaque acquisition. Days sales outstanding for trade receivables improved from 36 in 2014 to 33 in 2015 primarily due to a benefit of 5 days related to increased securitization and factoring of receivables. The Company uses receivables securitization and factoring facilities in the normal course of business as part of managing its cash flows. The Company accounts for transfers under its securitization facilities as sales because the Company sells full title and ownership in the underlying receivables and has met the criteria for control of the receivables to be considered transferred. At December 31, amounts securitized or factored were as follows: Accounted for as secured borrowings $ 10 $ 19 Accounted for as sales Note: Emphasis added. On the following pages, we discuss how securitizations skew operating cash flow and obfuscate aggressive revenue recognition, as well as how to analytically adjust for the these transactions. We encourage analysts to view securitizations in the context of the company s specific facts and circumstances. To that end, we would be skeptical of a company using accounts receivable securitizations with no apparent need for the proceeds (cash and no debt on the balance sheet). WolfeResearch.com Page 2 of 6

3 SECURITIZATION ACCOUNTING IMPACTS SALE VS. BORROWING HAVE SAME ECONOMICS Exact structures will vary, but generally, securitization transactions will be accounted for either as secured loans or sales. If a secured loan, the company records an increase of cash and debt on its balance sheet. The receivables remain on the company s balance sheet. On the cash flow statement, the loan proceeds received from the financial institution are shown as cash inflows from financing activities. Second, a company may factor or securitize accounts receivable, which is very similar to a secured borrowing, but may have different accounting impacts. If the transaction receives sale treatment under the accounting rules, the receivables will be removed from the balance sheet and recorded on the cash flow statement as an operating cash inflow. The two potential treatments of an A/R sale / secured borrowing transaction are summarized below: Accounts Receivable Securitization Accounting Impacts Accounting Treatment Balance Sheet Impact Cash Flow Impact Secured Borrowing Receivables remain on balance sheet No operating cash flow impact Liability recorded Financing cash inflow Sale Receivables removed from balance sheet Operating cash inflow No liability recorded No financing cash flow impact Source: Wolfe Research Accounting & Tax Policy Research. Regardless of the actual accounting treatment the securitization receives under GAAP (irrespective of the non-recourse nature of receivable sales), we believe that, economically, the transaction is a financing decision and should analytically be treated as such. The incoming cash flow is occurring outside the normal cash flow collection process. ADJUSTING DAYS SALES OUTSTANDING FOR SECURITIZATIONS Continuing our Crown Holdings example, we adjust days sales outstanding by including the offbalance sheet uncollected receivables balance as if they were not sold and remain on balance sheet. As the company has increased it s factoring of receivables in recent years, the trend in DSOs is significantly different compared to the unadjusted amount. Adjusting DSOs for Accounts Receivable Securitization Crown Holdings ($ millions) For a more accurate assessment of DSOs, include offbalance sheet uncollected receivables in the calculation. Note: DSOs = Avg. Receivables / Sales * Sales 8,762 9,097 8,656 8,470 Receivables - As reported Off-balance sheet uncollected receivables Adjusted receivables 1,460 1,467 1,232 1,197 Unadjusted DSOs Adjusted DSOs WolfeResearch.com Page 3 of 6

4 HOW SECURITIZATIONS SKEW REPORTED CASH FLOWS AND HOW TO ANALYTICALLY ADJUST Below, we illustrate the cash flow statement impacts from an accounts receivable securitization transaction that receives sale treatment, continuing the Crown Holdings example. Generally, the impact of a securitization program will be buried within the footnotes described as something akin to the uncollected receivable balance or amounts utilized. This balance of uncollected receivables is the amount of accounts receivable that has been sold to, but not collected by, the third party (bank or securitization trust). While disclosure of the uncollected receivables balance has improved in recent years, it is still spotty across all companies. Crown Holdings discloses the amount (as shown for 2014 and 2015 on page 2) in a table captioned amounts securitized or factored. To estimate the annual impact of receivables sold on cash flow, we would calculate the year-over-year change in the disclosed uncollected receivable balance. Typically, this amount would be netted within the changes in Accounts Receivable balance that is shown in the working capital changes line item in the operating section of the cash flow statement. In order to adjust the cash flow statement for the impact of the securitizations, the change in uncollected balance (amount utilized ) would be used to reduce (in the case of an increase in the utilized balance) or add to operating cash flow. To adjust, operating cash flow should be reduced by the change in the uncollected receivables balance. Correspondingly, financing cash flow is adjusted by the same amount. Assuming the uncollected accounts receivable balances have increased yearover-year, there is a negative adjustment to operating cash flow (from the change in the uncollected balance) and a positive adjustment to financing cash flow. Continuing our Crown Holdings example, we simply adjust the operating cash flow by these amounts, as shown below. Adjusting Cash Flow for Accounts Receivable Securitization Crown Holdings ($ in millions) Net impact on operating cash flow from receivables sold as opposed to collected in ordinary course of business Reclassify changes in utilization of securitization programs from operating cash flow to financing cash flow Uncollected Receivables Y/Y Change Income (loss) from cont. operations Add: Non-cash items Changes in accounts receivable (51) Net changes in other working cap Reported operating cash flow Adjustment: Remove securitization impact (101) (267) (36) Adjusted operating cash flow % Change in Operating Cash Flow -11% -29% -4% Reported financing cash flow (306) Adjustment for securitization Adjusted financing cash flow (270) WolfeResearch.com Page 4 of 6

5 IMPACT OF A/R SALES MOST PREVALENT IN YEAR 1 & INCENTIVIZES CONTINUED USE Below, we illustrate the long-term impact of an off-balance sheet A/R sale on reported cash flow. Assume that in Year 1 the company sells $100 of receivables and the uncollected receivable balance at year-end remains $100. In this scenario, the company has created an artificial boost to reported operating cash flow by pulling forward collections on A/R from subsequent periods. The company can continue to do this in Years 2 & 3 as it increases the use of its securitization program (e.g. Uncollected Accounts Receivable Balance increases). In Years 4 through 6, the amount of the new A/R securitizations slows, so as the accounts receivable are repaid and the securitization unwinds, operating cash flow is reduced. Accounts Receivable Securitization Change in Uncollected Balance Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 A Uncollected Accounts Receivable Balance B Change in Uncollected Balance (100) (150) C Operating Cash Flow (prior to A/R sales) B + C Reported Operating Cash Flow As shown above, the overstatement of cash flow from operations from an accounts receivable securitization typically is most significant in the first period of the securitization and when usage of the program is accelerating. However, investors often do not learn of new utilization of accounts receivable securitization facilities until reading through 10-Qs or 10-Ks. Once companies begin securitizing receivables, the incentive to continue growing the outstanding balance is substantial. As securitization facilities are unwound in Years 4 through 6 in our example above, reporting operating cash flow is lower than it would otherwise have been absent the securitization. Therefore, for analytical purposes, we adjust operating cash flow for the change in the uncollected receivable balance, as shown below: Accounts Receivable Securitization Analytical Adjustments Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 A Uncollected Accounts Receivable Balance B Change in Uncollected Balance (100) (150) C Operating Cash Flow (prior to A/R sales) B + C Reported Operating Cash Flow B Analytical Adjustment (100) (150) (300) (150) D Adjusted Operating Cash Flow WolfeResearch.com Page 5 of 6

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