accounting shenanigans on the cash flow statement ift notes

Accounting Shenanigans on the

Cash Flow Statement 2014 Level I Financial Reporting and Analysis

IFT Notes for the CFA® exam

Accounting Shenanigans on the Cash Flow Statement Irfanullah.co

Copyright © Irfanullah Financial Training. All rights reserved.

Contents

1. Introduction ....................................................................................................................................... 3

2. Dispelling the Myth about Cash Flows ........................................................................................... 3

3. Stretching Out Payables ................................................................................................................... 3

4. Financing of Payables ...................................................................................................................... 4

5. Securitization of Receivables........................................................................................................... 5

6. Tax Benefits from Stock Options .................................................................................................... 6

7. Stock Buybacks to Offset Dilution .................................................................................................. 7

Summary ............................................................................................................................................... 7

Next Steps ............................................................................................................................................. 8

This document should be read in conjunction with the corresponding reading in the 2014 Level I

CFA® Program curriculum.

Some of the graphs, charts, tables, examples, and figures are copyright 2013, CFA Institute.

Reproduced and republished with permission from CFA Institute. All rights reserved.

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or

quality of the products or services offered by Irfanullah Financial Training. CFA Institute,

CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute.



1. Introduction

Traditionally, investors have used the income statement and balance sheet to base their

investment decisions. Companies have exploited this knowledge to engage in aggressive

accounting practices (accelerate revenue recognition, deferred expenses to name a few) to inflate

earnings. When evaluating a company, investors should scrutinize the quality of cash flows, and

not just the income statement. The cash flow statement, however, is not immune to manipulation.

This reading describes the numerous ways in which a cash flow statement can be manipulated.

2. Dispelling the Myth about Cash Flows

There is a perception that the cash flow statement cannot be manipulated but that is not true.

Cash flows can be manipulated by misclassifying CFO, CFI or CFF. If you recall, in the case of

Enron, cash flows that should have been classified as CFF were shown as CFO.

3. Stretching Out Payables

One of the simplest ways to improve operating cash flow is by delaying payment to suppliers.

The reason could be that the company is struggling to generate cash, or they may call it a prudent

cash-management strategy. Any benefits from such a policy will only be short-lived as vendors

will pressurize the company to make more timely payments. So, the boost to operating cash flow

is also only temporary.

Extension of payables can be identified by monitoring days sales in payables (DSP). As DSP

grows, operating cash flow increases.

DSP = Number of day in period/payables turnover

Payables turnover = purchases/average payables

(If purchases data is not available, then COGS can be used.)



Worked Example 1:

In period 1, COGS was 50 and average accounts payables were 46. In period 2, COGS was 60

and average accounts payables were 50. Assuming 90 days per period what can we say about the

rate of payments to suppliers?

Solution:

Let’s begin with period: Payables turnover = 50/46 = 1.09; DSP = 90/1.09 = 82.8

Period 2: Payables turnover = 60/50 = 1.2; DSP = 90/1.2 = 75

DSP has decreased from 82.8 days in period 1 to 75 days in period 2. This means the company

has expedited payments to suppliers. Faster payment will lead to a decrease in operating cash

flow.

Worked Example 2:

In year 1, COGS was 50 and average accounts payables were 40. In year 2, COGS is expected to

increase to 60. Which of the following changes in accounts payables will most likely increase the

operating cash flow? (Try to solve this problem before reading the solution.)

A. 30% decrease

B. 20% increase

C. 30% increase

For operating cash flow to increase, DSP should increase. This means that payables turnover

(COGS / Average Payables) should decrease. Given the data, COGS is expected to increase 20%

(from 50 to 60). For the payables turnover to decrease, the average payables must increase by

more than 20%.

4. Financing of Payables

This is a more complicated version of stretching out payables and happens when a company uses

a third-party financial institution like a bank to pay its vendors in the current period, with the



company paying back the bank in the future. Think of it like a short-term loan for a company’s

payables. Why does a company finance its payables? To boost its operating cash flow in a

period. Let’s look at an example below:

A company wants to boost operating cash flows in period 1 and expects high cash flows in

period 2. How does it increase operating cash flows in period 1? By asking a bank to pay its

suppliers. The accounts payable is classified as a short-term loan.

Under normal circumstances, the company would have had to pay its suppliers. The cash used to

pay suppliers would have decreased the operating cash flow. In period 2, the company pays off

the loan. Through this exercise the company has manipulated the timing of operating cash flows.

5. Securitization of Receivables

Securitization of receivables is a practice of packaging the receivables of a company and selling

this pool of receivables to a financial institution for cash. The customers who owed the company

(in the form of receivables) now pay the financial institution. The cash received from the sale

boost cash flow from operations (CFO). Non-financial companies use this method to boost their

CFO. The diagram below explains the concept of securitization of receivables:

The cash received from the sale of receivables will increase the CFO temporarily; the boost to

CFO is unsustainable.

Period 1: company wants to boost

operating cash flows

Period 2: company expects high

cash flows

Company A/R Financial

Institution Cash



When the receivables are securitized, if the accounts receivable is sold for higher than book

value, a gain is recorded. U.S. GAAP does not stipulate where the gain on sale of receivables

should be reported – revenues, selling, general or administrative expenses (SG&A), or non-

operative income. If it is reported as

Revenue – it is the most aggressive way of recording gain.

Offset to SG&A – intermediate way.

Non-operating income – most conservative way of recording gain.

6. Tax Benefits from Stock Options

Many companies do not take a deduction on their tax return when stock options are granted.

However, when stock options are exercised, companies do take a deduction on tax returns. The

deduction is equal to the difference between the fair market value of the stock received on

exercise and the exercise price.

Let’s assume the exercise price of a stock option is $25 and the actual price of the stock at the

time of exercise is $30. This difference of $5 is shown as an expense (tax deductible). This

would, in turn, lower earnings before taxes (EBT) and lower taxes payable. Since tax is an

operating cash flow, lower tax payment means higher CFO. Operating cash flow is often greatest

when stock prices are high. When a stock is doing well, its options are exercised resulting in

higher tax benefit, and higher CFO. The tax benefit and its impact on CFO are unsustainable in

the long term.

When options are exercised, the company issues more stock and hence equity also goes up.

Analysts should study the cash flow statement, stockholders’ equity statement, and notes to the

financial statements to understand the number of options exercised and its impact on operating

cash flow for the period.



7. Stock Buybacks to Offset Dilution

When a company issues stock to raise capital, it is considered a financing activity (CFF). When a

company buys back stocks, it is also considered a CFF activity.

But, if the buyback is due to a large number of stock options being exercised, should it be

considered CFF or CFO? As we saw in the previous section, when a stock’s price increases,

employees exercise stock options. This would increase the number of outstanding shares and

dilute the earnings per share (EPS). To counter the negative effect on EPS because of stock

options, companies buy back their own shares in the open market. The cash outflow for stock

buyback is recorded as a CFF. Analysts must, however, consider stock buyback as an operating

cash flow. This is because the stock buyback is related to employee stock options which are a

form of compensation. Employee compensation is clearly an operating activity; hence, cash out

flows related compensation should reduce CFO.

Summary

Manipulating the cash flow statement is more difficult than manipulating earnings but it is still

possible. Some of the ways in which cash flows can be manipulated are:

• Stretching out payables which gives a one off boost to CFO

Might be prudent cash flow management or the company might be struggling

This strategy is not sustainable and suppliers might tighten credit

An analyst should keep an eye on days sales payable

• Financing of payables: use bank loans to payoff A/P; hence using financing to pay-off an

operating cash flow; pay the bank loan later

• Securitization of receivables: sales receivables gives CFO a boost but this is a one-time gain

• Companies give senior management stock options. When these options are exercised there is

tax deduction which improves CFO. Stock buybacks are categorized as CFF even when the

buyback is due to employee stock options being exercised; this cash flow should really be

categorized as CFO.



Next Steps

Solve the practice problems in the curriculum.

Solve the IFT Practice Questions associated with this reading.

Review the learning outcomes presented in the curriculum. Make sure that you can perform

the implied actions

accounting shenanigans on the cash flow statement ift notes

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