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

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.

Copyright Irfanullah Financial Training. All rights reserved.

Page 2

Accounting Shenanigans on the Cash Flow Statement

Irfanullah.co

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.)
Copyright Irfanullah Financial Training. All rights reserved.

Page 3

Accounting Shenanigans on the Cash Flow Statement

Irfanullah.co

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.

Page 4

Accounting Shenanigans on the Cash Flow Statement

Irfanullah.co

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.

Period 1: company wants to boost

operating cash flows

Period 2: company expects high

cash flows

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.

Copyright Irfanullah Financial Training. All rights reserved.

Page 5

Accounting Shenanigans on the Cash Flow Statement

Irfanullah.co

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

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.
Lets 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.

Copyright Irfanullah Financial Training. All rights reserved.

Page 6

Accounting Shenanigans on the Cash Flow Statement

Irfanullah.co

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 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:

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.

Copyright Irfanullah Financial Training. All rights reserved.

Page 7

Accounting Shenanigans on the Cash Flow Statement

Irfanullah.co

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

Copyright Irfanullah Financial Training. All rights reserved.

Page 8