34. Accounting Shenanigans On The Cash Flow Statement
Cash flow manipulation :
Stretching Accounts Payable :
A firm can temporarily increase operating cash flow by simply stretching accounts payable; that is, delaying payments to its suppliers. However, stretching payables is not a sustainable source of increased cash flows, since the firm’s suppliers may eventually refuse to extend credit because of the slower payments. One way to determine whether a firm is stretching is payables is to examine the number of days in accounts payable.
Financing Accounts Payable :
Delaying the cash flows associated with payables can also be accomplished by entering into a financing arrangement with a third party, usually a financial institution. Such an arrangement allows the firm to manage the timing of the reported operating cash flows.
When the account payable is due, a financial institution makes payment to the supplier on behalf of the firm, and the firm reclassifies the account payable to short-term debt. At this point, operating cash flow is lower and financing cash flow is higher, but total cash flow is still unaffected. Finally, when the firm repays the financial institution, the firm reports the outflow of cash as financing activity and not an operating activity. Ultimately, the firm delayed the outflow of cash. Of course, the financial institution will charge a fee to handle the arrangement.
Securitizing Accounts Receivable :
Firms can immediately convert accounts receivable to cash by borrowing against the receivables or by selling or securitizing the receivables.
When receivables are securitized, they are usually transferred to a bankruptcy remote structure known as special purpose entity (SPE). The SPE pools the receivables together and sells securities representing an interest in the pool. A securitization is treated just like a collection; that is, the inflow of cash is reported as an operating activity in the cash flow statement because the transaction is reported as a sale.
Accelerating operating cash flow by securitizing receivables is not sustainable because the firm only has a limited amount of accounts receivable.
Securitizing accounts receivable may also affect earnings. When the receivables are securitized, the firm can recognize a gain in some case. This gain is the result of differences between the book value and fair value of the receivables at the time of securitization.
GAAP is silent on where the gains from securitizations should be reported in the income statement.
Repurchasing stock to offset dilution :
When a firm’s stock options are exercised, shares must be issued. The higher the stock price relative to the exercise price, the more shares that must be issued by the firm. As the shares are issued, earnings per share are diluted (reduced).
Firms often repurchase stock to offset the dilutive effects of stock option exercise. The cash received from the exercise of the option and outflow of cash from the share repurchase are both reported as financing activities in the cash flow statement. Because there is a tax benefit when options are exercised, exercise increases operating cash flow.
For analytical purposes, the net cash outflow for share repurchases to avoid dilution should be reclassified from financing activities to operating activities to better reflect the substance of the transaction. Since employee stock options are part of the compensation, an analyst should subtract the cash outflow from operating cash flow to recognize the true cash cost of options-based compensation.
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