ACCOUNTING SHENANIGANS ON THE CASH FLOW STATEMENT

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1 Financial Reporting & Analysis ACCOUNTING SHENANIGANS ON THE CASH FLOW STATEMENT Reading

2 Learning Outcomes Stretching out payables Financing of payables Securitization of receivables Using stock buybacks to offset dilution of earnings 2

3 CASH FLOW MANIPULATION Accounting shenanigans can artificially boost reported operating cash flow or present unsustainable cash flows. One of the ways to misrepresent a firms cash generating ability is to classify financing activity as operating activity. Management has the discretion over the timing of the cash flows and also where to report cash flows. Analysts should investigate the quality of a company s cash flow and should determine whether increases in operating cash flow are sustainable or not. 3

4 WAYS TO MANIPULATE THE CASH FLOW STATEMENT STRETCHING ACCOUNTS PAYABLES Companies usually slow down the rate of payments to their vendors to improve reported operating cash flow. A firm can temporarily increase operating cash flow by stretching accounts payable and any year over year improvement in operating cash flow may be unsustainable. The extension of payables can be identified by monitoring Days Sales in Payables(DSP). It is calculated by dividing accounts payable by COGS and multiplying the result by number of days in the period. Days Sales in Account Payable = Accounts Payable COGS * No. of Days 4

5 WAYS TO MANIPULATE THE CASH FLOW STATEMENT.. Financing of Payables In this case a firm uses a third party usually a financial institution to pay the vendor in the current period. This arrangement allows the firm to manage the timing of the reported operating cash flows. The firm then pays back the third party in subsequent period. When the account payable is due, financial institution makes payment to the vendor on firms behalf and firm takes account payable to short term debt. Decrease in accounts payable decreases operating cash flow and increase in short term debt increases financing cash flow. When firm repays the financial institution, the firm reports the outflow of cash as financing activity and not an operating activity. 5

6 WAYS TO MANIPULATE THE CASH FLOW STATEMENT.. Securitization of Receivables It occurs when companies package their receivables that have a longer term and high credit quality and transfer them to a financial institution. By securitizing its accounts receivable rather than waiting to collect from the customer, a firm can accelerate operating cash flow into the current period. When receivables are securitized the firm recognizes gain in some cases and this is result of difference between the book value and fair value of the receivables. Estimates like default rate, discount rate and prepayment rate can affect the gains. Some firms include the gains as revenue and some report the gains as a part of non operating income. 6

7 WAYS TO MANIPULATE THE CASH FLOW STATEMENT.. Using stock buybacks to offset dilution of earnings Firms repurchase stock to offset the dilutive effect of the exercise of employee stock options. When analyzing the true earnings power of a company as measured by cash flows it becomes essential to consider the cash expended to buy back stock to offset dilution. Cash received from the exercise of the option and the outflow of cash from the share repurchase are both reported as financing activities in the cash flow statement. This cash flow should be subtracted from the operating cash flow in order to calculate the true free cash flow the company generated. 7