Financial Shenanigans – Chapter 11: Shifting Normal Operating Cash Outflows to the Investing Section

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 11: Cash Flow Shenanigan No. 2: Shifting Normal Operating Cash Outflows to the Investing Section

There are three ways companies can shift normal operating cash outflows into the CFI section. I'll show the methods, and then ways investors can detect these frauds.

1. Inflating CFO with Boomerang Transactions

Boomerang schemes involve selling something to a party and agreeing to repurchase the same asset. These can be legitimate transactions, but sometimes they can be used to shift cash flows around on the Statement of Cash Flows. In doing this, companies will record the cash flow received the the original sale as an operating inflow, and then record the cash used to repurchase the asset as an investing outflow.

The authors give the example of Global Crossing, which built an undersea fiber-optic network. The company sold future capacity, treating the cash inflow as CFO. Then they purchased capacity back from those same parties and treated it as CFI.

2. Improperly Capitalizing Normal Operating Costs

By capitalizing expenses, companies treat the expense as if it created an asset that should be depreciated over time. We looked at this in the review of chapter 6 which involved shifting current expenses into the future. This impacts the Statement of Cash Flow in that the normal operating expense (which affect Net Income, the starting point for CFO) is now treated as a capital expenditure which falls under CFI. Thus, CFO is higher than it should be, and CFI (which many people overlook, or at least treat as less important) is lower than it should be. However, free cash flow (CFO – Capital Expenditures) is unaffected, so investors that follow FCFs (this should be you!) won't be fooled by this shenanigan!

3. Recording R&D or the Purchase of Inventory as an Investing Outflow

Companies are sometimes tempted to treat their inventory purchases as investing cash outflows. For example, Netflix NFLX treated its DVDs as capital expenditures which it would then amortize over a period of time. Strangely, they did this despite the fact that Blockbuster was penalized by the SEC in 2005 for doing the same thing!

Additionally, companies are frequently confused as to how research and development expenses should be treated. GAAP accounting rules say that cash paid to acquire the output of R&D (designs, patents, etc) are capital expenditures and thus CFI, whereas cash paid to develop the same things internally is treated as normal operating expenses and should affect CFO.

How to Detect these Frauds:

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

1. Create a common-sized balance sheet (all items as a percent of total assets) and track changes over time  to identify assets growing faster than the rest of the balance sheet.
2. Follow free cash flow (CFO – Capital Expenditures) over time, as this eliminates the opportunity to improperly capitalize.
3. Always read the notes that explain the Statement of Cash Flows (“Supplemental Cash Flow Information”) which give insight that can help identify shenanigans.

Also,

1. Be alert for Boomerang Transactions, where the company's disclosures say things like “$100 was received from customers who purchased $100 of goods from us” or “$100 from customers to whom the company made substantial commitments during the period.” Be especially wary of growth in soft asset accounts (e.g. “Other Assets”)
2. If you are suspicious of how a company is accounting for its inventory purchases or R&D, compare how its competitors accounting policies differ. Consider whether the company's policies reflect the underlying economics.

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Related posts:

1. Financial Shenanigans – Chapter 10: Shifting Financing Cash Inflows to the Operating Section
2. Financial Shenanigans – Chapter 6: Shifting Current Expenses to a Later Period
3. Financial Shenanigans – Chapter 9: Shifting Future Expenses to an Earlier Period