Manipulating Operating Cash Flows
Accounting Standards Might Change for the Better, But People Do Not
The majority of investors are already well aware of the concept of quality of companies’ earnings. By the same token, in the wake of some of the worst corporate governance scandals in the U.S. and elsewhere in the world, the investment community has also become acutely aware that balance sheets and income statements can easily be manipulated and thus may no longer provide an accurate picture of a company.
Consequently, more and more investors no longer rely on reported earnings and opt for other metrics, some of which are non-GAAP (Generally Accepted Accounting Principles), such as order backlogs, double-booked revenues, etc., and some of which are GAAP-required, such as the statement of cash flows.
Manipulating the Cash Flow Statement
Granted, focusing the analysis of a company on its statement of cash flows is bound to be beneficial to investors. After all, the cash flow statement offers no-frills insight into the company’s fiscal performance, as well as its realistic financial position. However, this does not mean that cash flow statements are completely shenanigans-free.
There are a number of ways that the cash flow statement can be manipulated, including:
- stretching out account payables;
- financing account payables;
- securitizing account receivables;
- offsetting dilution with stock buybacks, etc.
Stretching Out Account Payables
This is one of the simplest methods of manipulating cash flow statements. All a company’s management has to do is to pay its vendors at a much slower rate. In the good old times, stretching out account payables was considered the first signal a company’s operations were struggling to generate cash.
Today, however, this method is often explained as prudent cash management (?). As a result of delaying payments to vendors, a company’s operating cash flows may appear stronger, boosting, in the process, the company’s retained earnings. All the while, something completely different may be afoot.
Financing Account Payables
A more complex version of stretching out account payables is financing of the same. When a company borrows money from a third party at interest to pay its vendors, the company is effectively financing its account payables through some sort of an interest-bearing arrangement.
Securitizing Account Receivables
A particularly popular, and equally dangerous, way of manipulating the statement of cash flow is by securitizing account receivables. Companies often “package” their receivables, especially those that are collectible further in the future and which have higher credit rating.
These “packages” are then transferred to financial institutions, or variable interest entities (VIEs). If a VIE is not likely to file for bankruptcy, then under GAAP, packaged future receivables are deemed as sold and their sale proceeds can be immediately booked as cash flows from operations. Of course, this is a faulty premise because had it not been for the securitization, those account receivables would not even be cashed in for quite some time.
Offsetting Dilution through Stock Buybacks
When a company buys back its own shares in open market transactions, both the operating and financing cash flows are impacted.
Many companies have been buying their own stocks as a result of stock option activities. Excluding the recent volatility in the stock markets, since 2003 stocks have been enjoying a bull market. Many cheaply acquired options were exercised along the way, too, resulting in increased numbers of shares outstanding.
If companies did nothing to offset new shares generated by en masse exercising of in-the-money options, the dilutive effects would adversely impact the companies’ earnings. Consequently, to offset dilution, many companies opted for aggressive stock buybacks.
On an income statement, exercising stock options leaves minimal impact. However, on the statement of cash flows, option exercises generate tax benefits to those companies whose options have increased in value. In contrast, expensing cash for stock buybacks is considered as cash outflows from financing activities.
As a result, the higher the option exercises, the higher the operating cash inflows from tax benefits. Furthermore, whatever cash is dispensed for stock buybacks, it is recorded as financing cash outflows. Notably, analysts are interested in cash flows from operations. However, tax benefits from option exercising may provide a skewed picture as to the strength of a company’s cash flows from operations.
Although analyzing cash flows offers a much better insight into a company’s performance than earnings, cash flows are far from being perfect metrics. Granted, investors would do well to incorporate assessing the quality of a company’s cash flows into their analysis, provided they never forget that management today is often highly motivated and quite capable of intelligent accounting shenanigans intended to conceal a company’s potentially shaky operations.
Source: “Accounting Shenanigans on the Cash Flow Statement,” by Marc A. Siegel, The CPA Journal, March 2006.
