Accounting Shenanigans on the Cash Flow Statement
Metrics Might Change, but Corporate Behavior Does Not

By Marc A. Siegel

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In the wake of recent high-profile scandals, the landscape is beginning to change. The majority of investors are now keenly aware of the concept of quality of earnings. It is now fairly common knowledge in the investment community that corporate management can in various ways manipulate earnings as reflected on the income statement. As a result, certain investors shun reported earnings and instead focus more attention on other metrics to evaluate the operational health of a business. Some metrics are non-GAAP, such as backlog, same-store sales, and bookings. Many analysts have also embraced cash flow measurements. These analysts believe that, notwithstanding the fraud at Parmalat Finanziaria SpA, cash cannot be manipulated. But this, too, is a misconception. While quality of earnings is now a buzzword, it may be another 10 years before it is as widely understood that the quality of cash flows is just as valid a concern.

Most conceptual definitions of materiality include the concept of factors that affect an investment decision. As Wall Street analysts have lost faith in earnings-based metrics in the wake of Enron, WorldCom, and others, many have gravitated toward the cash flow statement. Companies are regularly evaluated on the basis of free cash flow yield and other measures of cash generation. The focus of audits must change in order to devote more attention to the cash flow statement; the users of financial statements demand it.

Dispelling the Myth About Cash Flows

Investors’ increased focus on the cash flow statement is beneficial. Analyzing the cash flow statement is integral to understanding a company’s financial performance and position because it often provides a check to the quality of the earnings shown in the income statement. Certain accounting shenanigans can, however, either artificially boost reported operating cash flow or present unsustainable cash flows. The increased scrutiny has alerted people to how some companies mask declines in operating cash flow. For example, after WorldCom’s reverse-engineering subterfuge, many have learned to look for excessive capitalization of cash expenditures. Others now scrutinize the cash flow statement for nonrecurring sources of cash, such as the receipt of an income tax refund. Certain complex situations can arise that cause reported cash flow from operations to appear higher than it would have otherwise.

As the investment community begins to focus on this metric, auditors should adapt as well. Auditors have little to work with, however; only SFAS 95, Statement of Cash Flows, specifically addresses the cash flow statement, and only 15 paragraphs within SFAS 95 discuss the appropriate categorization of cash expenditures within the cash flow statement. On the other hand, a plethora of authoritative guidance surrounds the calculation and presentation of earnings. The following examples show how companies can employ certain techniques (many of which are within GAAP) to show improved reported cash flows.

Stretching Out Payables

The simplest thing that companies can do to improve reported operating cash flow is to slow down the rate of payments to their vendors. Extending out vendors used to be interpreted as a sign that a company was beginning to struggle with its cash generation. Companies now “spin” this as a prudent cash-management strategy. Another consequence of this policy is to boost the reported growth in cash flows from operations. In other words, reported operating cash flows can be improved due solely to a change in policy to slow the payment rate to vendors. If analysts or investors expect the current period improvement to continue, they may be mistaken; vendors will eventually put increasing pressure on the company to pay more timely. Therefore, any benefit may be unsustainable or, at minimum, 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). This metric is calculated as the end-of-period accounts-payable balance divided by the cost of goods sold and multiplied by the number of days in the period. As DSP grow, operating cash flows are boosted. As Exhibit 1 shows, General Electric Corporation began stretching out its payables in 2001 and therefore received boosts to operating cash flow. The figures show, however, that while the company received a significant benefit to cash flows from operations in 2001, that benefit began to slow in subsequent periods, indicating that GE will probably be unable to continue to fuel growth in operating cash flow using this method. Interestingly, GE modified some executive compensation agreements to include cash flow from operations as a metric on which management is evaluated.

Financing of Payables

A more complicated version of stretching out payables is the financing of payables. This occurs when a company uses a third-party financial institution to pay the vendor in the current period, with the company then paying back the bank in a subsequent period. An arrangement between Delphi Corporation and General Electric Capital Corporation shows how seemingly innocuous ventures can affect operating cash flows. The arrangement allowed Delphi to finance its accounts payable through GE Capital. Specifically, GE Capital would pay Delphi’s accounts payable each quarter. In return, Delphi would reimburse GE Capital the following quarter and pay a fee for the service.

This agreement provided Delphi with a means to change the timing of its operating cash flows. In the first quarter of the venture, Delphi did not have to expend any cash with respect to accounts payable to vendors. The impact to operating cash flows can be seen in Delphi’s accounting for the agreement with GE Capital. After GE Capital paid the amounts due from Delphi to its vendors, Delphi reclassified these items from accounts payable to short-term loans due to GE Capital. Delphi did this in a quarter in which cash flows were seasonally strong and it had access to the accounts-receivable securitization facilities. The reclassification resulted in a decrease to operating cash flow in that quarter, and an increase in financing cash flows. In the subsequent quarter, when Delphi paid GE Capital, the cash outflow was accounted for as a financing activity because it was a repayment of a loan. Normally, cash expenditures for accounts payable are included in operating activities. Therefore, because of the arrangement, Delphi was able to manage the timing of reported operating cash flows each period because the timing and extent of the vendor financing (and offsetting receivables securitizations) was at the discretion of company management.

Another example shows that the accounting profession has been slow to adapt to these types of transactions. During 2004, three companies in the same industry—AutoZone, Pep Boys, and Advance Auto Parts—all financed payments to vendors through a third-party financial institution. In other words, similar to Delphi above, the financial institution paid the vendors on behalf of the respective automotive company. Subsequently, the company paid back the bank, thereby slowing down its rate of payment to the vendors and boosting its operating cash flow. While each of these auto parts companies used a similar process for financing payables, each reflected it differently on its cash flow statement. Interestingly, two of these companies had the same auditor. This disparity in accounting treatment made analysts’ comparisons of free cash flow yields for each of these companies irrelevant.

The lesson here is that auditors should ask questions whenever financial intermediaries are inserted in between parties that usually have no financial intermediary.

Securitizations of Receivables

A particularly significant item that could obfuscate both true cash flows and earnings is the securitization of receivables. Securitizations of receivables occur when companies package their receivables, most often those that have a longer term and higher credit quality, and transfer them to a financial institution or a variable interest entity (VIE). If the VIE is bankruptcy-remote (i.e., creditors cannot attach the assets of the VIE if the VIE sponsor files for bankruptcy), then GAAP indicates that the receivables have effectively been sold and the proceeds received should be reflected in the operating section of the cash flow statement.

The issue relates to nonfinancial companies, which are in effect able to boost reported operating cash flow by deciding how much and when to securitize accounts receivable. To the extent that proceeds received from the securitizations increase, any reported improvement in cash flow from operations should be considered unsustainable, because there is a limit to how much a company can securitize.

An interesting corollary to the impact on operating cash flow from securitizations is the impact on earnings. Specifically, in many cases companies can report gains when long-term accounts receivable are securitized. This occurs because the book value of the receivables at the time they are securitized does not include all the future interest income that is to be earned, yet the entity purchasing the receivables will have to pay for that interest. As a result, in this simplified example, because the amount received for the receivables is greater than the book value, a gain is generated. The amount of the gain can be affected as well by a variety of management assumptions, such as the expected default rate of the receivables securitized, the expected prepayment rate, and the discount rate used.

GAAP does not prescribe where on the income statement this gain is to be recorded. While one company may report the gain on sale of the receivables within revenues (the most aggressive approach), another might record it as an offset to selling, general, or administrative expenses. Another company might report the gain “below the line” in other nonoperating income. Marriott Corporation used to record the gain on securitizations of timeshare notes receivables within revenue. Specifically, in 2000, Marriott reported a gain on sale of $20 million within revenue from the securitization of these receivables. In 2001, the company reflected a $40 million gain on sale within revenues, helping to boost both reported revenues growth and pretax earnings growth. In 2002, Marriott’s gain on sale was $60 million, again included in revenues, which further fueled reported revenues and earnings growth. In 2003, however, the gain on sale was flat at $60 million. Perhaps coincidentally, Marriott changed its accounting for these gains in 2003 and reported the gains on sale for all years presented as a component of “other” (nonoperating) income.

Tax Benefits from Stock Options

Most companies currently follow Accounting Principles Board (APB) Opinion 25, which generally allows companies to avoid recording stock options as an expense when granted. Current IRS rules do not allow a company to take a deduction on its tax return when options are granted. At the time the stock option is exercised, however, the company is permitted to take a deduction on its tax return for that year reflecting the difference between the strike price and the market price of the option. On the external financial statements reported to investors, that deduction reduces (debits) taxes payable on the balance sheet, with the corresponding credit going to increase the equity section (additional paid-in-capital). Exhibit 2 shows the growing benefit that Cisco Corporation’s operating cash flow received from this tax benefit.

A question developed over how to classify this tax benefit (reduction of the taxes payable) on the cash flow statement. Some companies had been including it as an addback to net income in the operating section of the cash flow statement; others included it as a financing activity. FASB’s Emerging Issues Task Force (EITF) Issue 00-15, released in July 2000, specifically indicated that a reduction in taxes payable should, if significant, be shown as a separate line item on the cash flow statement in the operating section (i.e., as a source of cash). [SFAS 123(R), Share-Based Payment, which requires options to be expensed, also relegates the excess tax benefit to the financing section of the cash flow statement. SFAS 123(R) takes effect for fiscal years beginning after June 15, 2005.] If the company does not disclose the tax benefit in the operating section or in the statement of changes in stockholders equity, then EITF 00-15 provided that the company should disclose any material amounts in the notes to the financial statements. The tax benefit is sometimes disclosed only in the annual statement of stockholders equity, rather than as a separate line item in the operating section of the cash flow statement for investors to analyze.

To the extent that operating cash flow is affected by a growing impact from the tax benefit on stock options, an investor should question whether the reported operating cash flow growth is in fact sustainable and is indicative of improved operations. In fact, the boost to operating cash flow is often greatest in a period when the stock price has increased. In other words, when the stock is performing well, more stock options are exercised, resulting in a higher tax benefit, which is included as a source of operating cash flow, implying improving growth of operating cash flow. Because companies in the technology sector use stock options to a higher degree, these entities may require more-careful scrutiny. (This is an issue, however, only when a company has taxable income and the taxes that it would have paid are avoided by this tax benefit. If a company has a loss, there is no boost to operating cash flow.) Analysts and investors should thoroughly review the cash flow statement, the stockholders equity statement, and the notes to the financial statements to glean the volume of options exercised during the period, and the related tax benefit included as a source of operating cash flow.

Stock Buybacks to Offset Dilution

A second issue related to stock options that affects reported cash flows is the buyback of company stock. A large number of companies have, in recent periods, been buying back their own stock on the open market. In a majority of cases, this activity is due to stock-option activity. Specifically, as stock prices generally increased in 2003, many of those who held stock options exercised those relatively cheap options. If companies did nothing to offset the larger number of outstanding shares that existed as a result of the growing number of in-the-money options, earnings per share would be negatively affected. Management of such companies therefore face a choice: They can allow earnings per share to be diluted by the growing share count or they can buy back company stock to offset that dilution.

From an accounting standpoint, the impact of options on the income statement is usually minimal, as discussed above. On the cash flow statement, the tax benefit of option exercises is a source of operating cash flow, benefiting those companies whose option exercises grow. Cash expended by a company for the buyback of corporate stock, however, is considered a financing activity on the cash flow statement. Consequently, as option exercises grow, so does the boost to operating cash flows for the tax benefit, but the outflows for stock buybacks to offset dilution of earnings are recorded in the financing section of the cash flow statement.

Interestingly, as a company’s stock price rises, more options are generally exercised and the company must buy back more stock at the ever-higher market prices. In some cases, the entire amount of cash flow generated by operations in recent periods could be expended to buy back company stock to offset the dilution from in-the-money options. (See Cisco’s cash flow statements in Exhibit 2.) Therefore, when analyzing the true earnings power of a company as measured by cash flows, it is important to consider the cash expended to buy back stock to offset dilution. This cash outflow should be subtracted from the operating cash flow in order to calculate the true free cash flow the company generated in the period in question.

Other Means

Many other means exist by which companies can influence the timing or the magnitude of reported free cash flows. Increasing the use of capital lease transactions as a way to acquire fixed assets obfuscates free cash flow because capital expenditures may be understated on a year-over-year basis. The accounting for outstanding checks and financing receivables are additional examples. In fact, General Motors and others have restated prior years’ reported cash flow results in order to reflect the SEC’s increased scrutiny of finance receivables. The restatement amounted to a downward revision of almost half of the reported operating cash flow.

Some companies have pointed analysts toward different metrics, such as operating cash flows, which are believed to be a more transparent indicator of a company’s performance. The quality of a company’s cash flows must be assessed, as highly motivated and intelligent management teams have created new ways to obfuscate the true picture of a company’s operations. Auditors must be aware of the new focus by users of financial statements on operating cash flows, and adjust their work accordingly in order to provide the most value to the public.