Financial Shenanigans – Chapter 10: Shifting Financing Cash Inflows to the Operating Section

By Howard M. Schilit and Jeremy Perler

Today I am continuing my in-depth review of Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports. This is an ongoing process, so send me your feedback as to how I can provide you with more value in reviewing these books (send me an email here or leave a comment below).

You can read the other parts of this review here. Stay tuned each Saturday and Sunday for the next parts of this review.

Part Three: Cash Flow Shenanigans

Investors and analysts usually focus on cash flows from operations (CFO), since these are thought to be the most relevant to the company's ongoing operations (after all, investing and financing activities are usually less frequent) and are the basis for valuing a company that is a going concern. The consequence of this is that companies tend to focus their effort on making CFO appear as strong as possible.

Chapter 10: Cash Flow Shenanigan No. 1: Shifting Financing Cash Inflows to the Operating Section

The first cash flow shenanigan that the authors profile is moving cash inflows from financing into the operating section. These are particularly egregious, in that it seems companies caught doing this have little excuse for their behaviour (these don't seem to fall into a grey area; they are simply wrong!). The authors show three ways that companies can accomplish this. I'll show the methods, and then ways investors can detect these frauds.

1. Recording bogus CFO from a normal bank borrowing

When companies borrow money, the resulting cash inflow falls under Cash Flows from Financing (CFF). Some companies either don't quite understand this concept, or purposely mischaracterize the cash flow, because it ends up on their Statement of Cash Flows under CFO.

In 2000, Delphi entered into a repurchase agreement (“Repo”), which involves transferring an asset to a lender at one price (say, $100), and agreeing to repurchase the asset at a specified later date at another, slightly higher price (say, $104). This is a standard business activity clearly used as a form of collateralized borrowing. The difference ($4) is interest, and the original $100 receives is a loan to be repaid (if defaulted upon, the lender has the asset). Despite this, Delphi recorded it as a CFO inflow for the quarter!

2. Boosting CFO by selling receivables before the collection date

Companies frequently sell the receivables that they generate (either by “factoring” the receivables with a bank, or by “securitizing” the receivables by turning them in a security which is then sold). The underlying economics of doing this are the same as getting a loan. However, the accounting rules say collecting receivables is CFO, not CFF, so by factoring receivables a company is essentially collecting all of the receivables up front.

This has the effect of boosting CFO. The problem here is that in many cases, companies are justified in selling their receivables. However, it is important to consider the type of business, and the magnitude of these sales relative to CFO. If the company factors their receivables on a regular basis, and the inflows generally trend with revenues, then there is less to worry about than the situation where a company, after several periods chooses to factor their receivables all at once, showing a massive increase in CFO. For the investor, you are advised to take the increase with a grain of salt!

3. Inflating CFO by faking the sale of receivables

This is the same situation as above, but the company retains the risk of collecting the receivables. This is obviously collateralized borrowing and should be treated as CFF, not CFO. Companies will often disclose the new risk of collecting on the receivables in the risk disclosures in their annual report.

How to Detect these Frauds:

Key methods (These should be part of your process for analyzing companies!):

1. Track the different line items on the Statement of Cash Flows over time and look for anomalies that may signify something strange
2. Do a side-by-side comparison each year of changes in risk disclosures (Microsoft Word allows for comparing documents, highlighting the differences). I've begun doing this and I've been shocked by the differences I've found.

Also,

1. Where companies disclose new financing arrangements, pay attention to the form of the financing and watch for large unexplained swings in revenue (which flows down to net income which is where CFO begins)
2. Consider whether the company factors its receivables (this would be disclosed as a financing arrangement), and whether this is done on a regular or irregular cycle. Watch for large jumps in inflows from receivables being reduced, and normalize this over a period of time)

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Talk to Frank about Financial Shenanigans

Related posts:

1. Financial Shenanigans – Chapter 6: Shifting Current Expenses to a Later Period
2. Financial Shenanigans – Chapter 9: Shifting Future Expenses to an Earlier Period
3. Financial Shenanigans – Chapter 8: Shifting Current Income to a Later Period