Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports
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.
Chapter 13: Cash Flow Shenanigan No. 4: Boosting Operating Cash Flow Using Unsustainable Activities
For companies that are really desperate to change the appearance of their Statements of Cash Flows, there exist a number of opportunities that only work once. These are essentially pushing the problem off until later, as they cannot be reproduced after they are exhausted, and do not lead to recurring benefits. The authors point out four of these unsustainable activities. I'll show the methods, and then ways investors can detect these frauds.
1. Boosting CFO by paying vendors more slowly
When companies pay their vendors more slowly, they increase their accounts payable, and maintain the cash for a longer period of time. This works, until it doesn't. Eventually vendors must be paid, so when a company stretches its payments to the last possible day, that initially makes CFO appear to be higher than it is, but in later periods they cannot push the payments any further. The result is that the company stretches its vendor relationships (and may even incur late payment penalties or give up early payment discounts) for the sake of boosting CFO.
The authors point to Home Depot, which extended its Days' Payables Outstanding from 22 to 34 under Robert Nardelli. Nardelli looked brilliant for generating so much more free cash flow than his predecessor, but this only works to a point.
2. Boosting CFO by collecting from customers more quickly
Companies can boost their CFO by changing their payment terms with customers, requiring payment earlier than in the past. This has the effect of reducing accounts receivable (and thus Days' Sales Outstanding) which (like increasing accounts payable) has the effect of reducing working capital (Current Assets – Current Liabilities). Reductions in working capital lead to apparently improved CFO, however this is done in an unsustainable manner. In the optimal case, all customers would pay cash up front (or in advance), but clearly this only stretches to a point.
3. Boosting CFO by purchasing less inventory
Reducing inventory on hand has the effect of decreasing working capital (since inventory is a current asset), which inflates CFO. However, obviously this only works to a point – the point at which the company is utilizing just in time delivery for everything, inventory can be reduced no further.
4. Boosting CFO with other one-time benefits
The above three shenanigans are the most common one-time CFO boosts. However, there is no limit to the number of one-time items that may show up under CFO or the income statement (which leads to net income, the starting point of calculating CFO). Investors will have to watch for unusual one-time changes, and the best way to do this is to track each line item over time and identify big swings.
How to Detect these Frauds:
Key methods (These should be part of your process for analyzing companies!):
- Track Days' Payables Outstanding, Days' Sales Outstanding and Days' in Inventory over time and note apparent shifts in payment policies. These three items are used to calculate the Cash Conversion Cycle, which is an important metric for many businesses and should be calculated and tracked. Note my write-up about Dell's DELL awesome Cash Conversion Cycle here.
- Track the different line items on the Statement of Cash Flows over time, and note big swings. It may help to adjust for swings to get a clearer picture of the free cash flow that the company generates in a sustainable manner.
- Watch for swings in soft liabilities like “other payables” that might indicate the company is pushing tax payments or payroll forward.
Also,
- Watch for new disclosures about Prepayments (“due to an increase in customer prepayments”) related to the discussion of Accounts Receivable increases (in the notes to the Statement of Cash Flows).
- Watch for disclosures about offering discounted terms for early payment. This will also affect the gross margin, as these discounts would affect COGS, so you might uncover this shenanigan by investigating changes in the gross margin.
Author Disclosure: This book was provided by the publisher
Talk to Frank about Financial Shenanigans
Related posts:
- Financial Shenanigans – Chapter 5: Boosting Income Using One-Time or Unsustainable Activities
- Financial Shenanigans – Chapter 12: Inflating Operating Cash Flow Using Acquisitions or Disposals
- Financial Shenanigans – Chapter 10: Shifting Financing Cash Inflows to the Operating Section
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