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Financial Reporting & Analysis

ACCOUNTING SHENANIGANS ON
THE CASH FLOW STATEMENT
Reading - 34

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Learning Outcomes
Stretching out payables
Financing of payables
Securitization of receivables
Using stock buybacks to offset dilution of earnings

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CASH FLOW MANIPULATION
Accounting shenanigans can artificially boost reported
operating cash flow or present unsustainable cash flows.

One of the ways to misrepresent a firms cash generating


ability is to classify financing activity as operating activity.

Management has the discretion over the timing of the cash


flows and also where to report cash flows .

Analysts should investigate the quality of a companys cash


flow and should determine whether increases in operating
cash flow are sustainable or not.
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WAYS TO MANIPULATE THE CASH FLOW STATEMENT

STRETCHING ACCOUNTS PAYABLES


Companies usually slow down the rate of payments to their
vendors to improve reported operating cash flow.
A firm can temporarily increase operating cash flow by
stretching accounts payable and any year over year
improvement in operating cash flow may be unsustainable.
The extension of payables can be identified by monitoring Days
Sales in Payables(DSP).
It is calculated by dividing accounts payable by COGS and
multiplying the result by number of days in the period.

Accounts Payable
Days Sales in Account Payable = * No. of Days
COGS

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WAYS TO MANIPULATE THE CASH FLOW STATEMENT..

Financing of Payables
In this case a firm uses a third party usually a financial institution to
pay the vendor in the current period .
This arrangement allows the firm to manage the timing of the
reported operating cash flows.
The firm then pays back the third party in subsequent period.
When the account payable is due , financial institution makes
payment to the vendor on firms behalf and firm takes account
payable to short term debt.
Decrease in accounts payable decreases operating cash flow and
increase in short term debt increases financing cash flow.
When firm repays the financial institution , the firm reports the
outflow of cash as financing activity and not an operating activity.

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WAYS TO MANIPULATE THE CASH FLOW STATEMENT..

Securitization of Receivables
It occurs when companies package their receivables that have a
longer term and high credit quality and transfer them to a
financial institution.
By securitizing its accounts receivable rather than waiting to
collect from the customer , a firm can accelerate operating cash
flow into the current period.
When receivables are securitized the firm recognizes gain in
some cases and this is result of difference between the book
value and fair value of the receivables .
Estimates like default rate , discount rate and prepayment rate
can affect the gains.
Some firms include the gains as revenue and some report the
gains as a part of non operating income.

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WAYS TO MANIPULATE THE CASH FLOW STATEMENT..

Using stock buybacks to offset dilution of earnings


Firms repurchase stock to offset the dilutive effect of the
exercise of employee stock options.
When analyzing the true earnings power of a company as
measured by cash flows it becomes essential to consider the
cash expended to buy back stock to offset dilution.
Cash received from the exercise of the option and the outflow
of cash from the share repurchase are both reported as
financing activities in the cash flow statement .
This cash flow should be subtracted from the operating cash
flow in order to calculate the true free cash flow the company
generated .

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