Shenanigans on the
Cash Flow Statement
2014 Level I Financial Reporting and Analysis
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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.
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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.
Extension of payables can be identified by monitoring days sales in payables (DSP). As DSP
grows, operating cash flow increases.
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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:
Lets 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
Copyright Irfanullah Financial Training. All rights reserved.
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company paying back the bank in the future. Think of it like a short-term loan for a companys
payables. Why does a company finance its payables? To boost its operating cash flow in a
period. Lets 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:
A/R
Company
Financial
Institution
Cash
The cash received from the sale of receivables will increase the CFO temporarily; the boost to
CFO is unsustainable.
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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 nonoperative income. If it is reported as
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.
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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 stocks 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:
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.
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Next Steps
Review the learning outcomes presented in the curriculum. Make sure that you can perform
the implied actions
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