Understanding Cashflow Shenanigans (Part-3)

Understanding the details of Cashflow Shenanigans (Part-3)

Shuchi. P. Nahar
Link to Part-1: https://myweekendspot.blogspot.com/2020/01/catch-trend-its-all-about.html

Link to Part-2: https://myweekendspot.blogspot.com/2020/01/checklist-to-understand-recording-of.html
This blog is in the series of my previous three blogs. This blog will help an individual to understand the manipulation done in cash flow statement and help an investor to analyze the statements and be wary of cash flow shenanigans.

With so many recent financial frauds going undetected, investors are increasingly questioning the value of the accrual-based figures shown on the Statement of Income. Time and time again, companies have duped investors by recording revenue too soon or hiding expenses. Some sophisticated investors claim that they realize that earnings can be manipulated and therefore put more faith in the “purer” cash flow from operations.

While that’s certainly a step in the right direction, be extra careful to look both ways as you cross the proverbial street from accrual based earnings to the cash flow numbers. The reasons for exercising
this caution will become abundantly clear as you read through this part of the blog.
A particularly important metric that investors rely upon to assess both a company’s ability to generate cash and its “quality of earnings.”
Before digging into the specific techniques, it is important to have a firm grasp of accrual versus cash-based accounting as well as the structure of the Statement of Cash Flows (SCF). Accounting rules mandate that a company report its earnings performance using the accrual basis.

Investors do not consider the three sections of the Statement of Cash Flows equally important. Rather, they regard the Operating section as the “favored son” because it presents cash generated from
a company’s actual business operations (i.e., cash flow from operations).

Robin Hood Tricks

Think of these intra-period geography games as “Robin Hood” tricks: stealing from the rich section of the Statement of Cash Flows and giving to the poor one. In most cases, the “poor” section will be

the Operating section, which investors follow much more closely, and the “rich” sections will be the Investing and Financing sections, which investors tend to ignore.

As you will see, these Robin Hood tricks are actually quite simple and more common than you might imagine. It is not that difficult for companies to concoct a reason to move the good stuff (cash inflows) to the most important Operating section, and send the bad stuff (cash outflows) to the less important Investing and Financing sections.

Techniques to Shift Financing Cash Inflows to the Operating Section

1. Recording bogus CFFO from a normal bank borrowing
2. Boosting CFFO by selling receivables before the collection date
3. Disclosures about selling receivables with recourse
4. Inflating CFFO by faking the sale of receivables
5. Changes in the wording of key disclosure items in the financial reports
6. Providing less disclosure than in the prior period
7. Big margin expansion shortly after an inventory write-off

Second clever way in which management may inflate operating cash flows is by pushing some of the “bad stuff” (i.e., the outflows) from the Operating section to another place on the Statement of Cash Flows. To find these outflows that management loves to bury in the Investing section, even though they seem more like operating-related outflows. And we’ll discuss the following three primary techniques that companies use to shift these operating cash outflows to the Investing section.

Techniques to Shift Normal Operating Cash Outflows to the Investing Section.

1. Inflating CFFO with Boomerang Transactions

2. Improperly Capitalizing Normal Operating Costs

Recording Normal Operating Costs as a Capital Asset Rather Than as an Expense. 

3. Recording the Purchase of Inventory as an Investing Outflow

Warning Signs: Shifting Normal Operating Cash Outflows to the Investing Section

• Inflating operating cash flow with boomerang transactions
• Improperly capitalizing normal operating costs
• New or unusual asset accounts
• Jump in soft assets relative to sales
• Unexpected increase in capital expenditures
• Recording purchase of inventory as an investing outflow
• Investing outflows that sound like a normal cost of business
• Purchasing patents, contracts, and development-stage technologies. 

Techniques to Inflate Operating Cash Flow Using Acquisitions or Disposals

1. Inheriting Operating Inflows in a Normal Business Acquisition.

The cash flow shifting tricks in this chapter have many similarities to the ones we discussed in the previous chapter they represent shifts between the Operating and the Investing sections.
However,we focus solely on shifts that are related specifically to acquisitions and disposals. The first two techniques in this chapter involve shifting Operating cash outflows to the Investing section.

2. Acquiring Contracts or Customers Rather Than Developing Them Internally. 

Treat CFFO Differently for Acquisitive Companies. Since acquisitions create an unsustainable boost to CFFO, investors should not blindly rely on CFFO as a barometer of performance.
Use free cash flow after acquisitions to assess cash generation at acquisitive companies.

3. Boosting CFFO by Creatively Structuring the Sale of a Business

Warning Signs: Inflating Operating Cash Flow Using Acquisitions or Disposals

• Inheriting Operating cash inflows in a normal business acquisition
• Companies that make numerous acquisitions
• Declining free cash flow while CFFO appears to be strong
• Acquiring contracts or customers rather than developing them internally
• Boosting CFFO by creatively structuring the sale of a business
• New categories appearing on the Statement of Cash Flows
• Selling a business, but keeping the related receivables.

Techniques to Boost Operating Cash Flow Using Unsustainable Activities

1. Boosting CFFO by Paying Vendors More Slowly

To grow your cash flow again next year, you would have to push two months’ worth of payments into

the following January. Your “delay payments” lifeline may be a helpful cash-management strategy, and there is certainly nothing wrong with holding your money a month longer. In the same way, it is completely appropriate for a company to take longer to pay back its vendors and reap the immediate cash-management benefits.

2. Boosting CFFO by Collecting from Customers More Quickly

Another way in which companies can generate a nonrecurring , CFFO boost would be to convince customers to pay them more quickly. This certainly would not be considered a bad thing, and it may even speak well of a company’s significant leverage over its customers. However, as in our discussion about stretching out payables, companies cannot continue to collect at a faster and faster rate every quarter in perpetuity. As a result, the growth in CFFO that results from accelerated collections should be deemed unsustainable.

3. Boosting CFFO by Purchasing Less Inventory

Well, when the company had another CFFO-improving trick up its sleeve: purchasing less inventory.

When companies lowered its inventory levels simply by not restocking shelves after goods had been sold. In other words, the company just did not purchase as much inventory from vendors as in previous years.

4. Boosting CFFO with One-Time Benefits

when companies make it very easy for investors to understand that the income from this settlement was nonrecurring and unrelated to its normal operations; it was reported “below the line” as non-operating income.

Warning Signs: Boosting Operating Cash Flow Using Unsustainable Activities

• Boosting CFFO by paying vendors more slowly
• Accounts payable increasing faster than cost of goods sold. 
• Increases in other payables accounts
• Large positive swings on the Statement of Cash Flows
• Evidence of accounts payable financing
• New disclosure about prepayments
• Offering customers incentives to pay invoices early
• Boosting CFFO by purchasing less inventory
• Disclosure about the timing of inventory purchases
• Dramatic improvements in CFFO
• CFFO benefit from one-time items.

“Cash Flow Shenanigans,” addresses a relatively new and troubling phenomenon: management’s propensity to use Cash Flow Shenanigans to give a company the misleading appearance of having

strong operating and free cash flow.

The blog also presents strategies that investors can use to detect Cash Flow Shenanigans and to adjust the reported numbers to remove these unsustainable boosts.

Disclaimer: The information provided on Shuchi Nahar’s Weekend Blog is for educational purposes only. The articles  may contain external links , references and compilation of various publicly available articles. Hence all the authors are given due credit for the same. All copyrights and trademarks of images belong to their respective owners and are used for Fair Educational Purpose only.

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