Financial shenanigans

- Cash flow misrepresentation

cash flow shenanigans to

manipulate OCF
Cf No. 1: Shifting financing cash
inflows to the operating section
Cf No.2: Shifting normal operating
cash outflows to the Investing
section
Cf No.3: Inflating operating cash flow
using acquisitions or disposals
Cf No.4: Boosting operating cash flow
using unsustainable activities
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Benefits derived by using CF

Shenanigans
Boosting of OCF, the most studied
number giving signs of the
operational strength of the company
and earnings quality
To cover-up underlying
weakness/cash crunch and portray
strong liquidity position

CF No. 1: Shifting financing cash

inflows to the operating section
Recording bogus CFFO from a normal bank borrowing (Case
Delphi Corporation, pg 199- Sham sale of inventory to bankloan raised on pledge of inventory recorded as sales boosting
revenue and CFO)
Boosting CFFO by selling Receivables before the collection date
Sale of receivable to banks/Financial Institutions, though an
appropriate scheme, should be viewed with caution if company is
significantly resorting to sale of receivables, as this may signal pile-up
of uncollectible receivables that have been sold
Usually it is on recourse basis and does not signify improvement in
OCF on account of operating transaction (Case Cardinal Health and
Sanmina-SCI Corporation, pg 203 and 205)
In CMA, we add bills discounted to bank borrowing and receivables to
get the actual picture of Days sales outstanding (DSO) and nullify the
positive impact on CFO and show it correctly as Cash flow from
Financing activity
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Example
Reporte
d

2010

201
1

Bank
50
borrowing

80

Adjusted 2010

201
1

Bank
50
borrowing

80+
100

Receivabl
es

Receivabl
es

201
0

2011

100

90

201
0

2011

100

90+
100

Example In 2011, XYZ company sold 100 million of Receivables

to bank
Impact on Operating cash flow +10
Impact on Financing cash flow +30

If we adjust as per CMA, the real impact can be seen

Impact on Operating cash flow (90)
Impact on Financing cash flow +130
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CF. No. 1
Inflating CFFO by faking the sale of
receivables
Case Peregrine Systems, pg 207

Indicators
Ideally if net income grows CFO should also move in same direction;
closely check all items of Cash flow from operating activities to see which
item is causing excessive cash drain. This could signal if earning
manipulation done
On other hand, if Net income is deteriorating and an overtly positive OCF
reported, check for cash-inflows that is causing this variation. Possible
arrangements could be
Sale of receivables
Delay in payment of creditors; this will increase the OCF, however is it due to
normal credit policy change for long-term or does it signify cash crunch

Read notes to accounts and Management Discussion and Analysis

(MD&A) section carefully to see if any material sales receivable
transactions entered into, regularity of such transactions and to what
extent (as a % of total receivables)
Also keep this in mind while modeling future period Receivables position
Refer to Rating agencies reports
Reference check with banks in case of Multiple banking arrangements (Refer RBI
Circular Loans and Advances)
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CF No.2: Shifting normal operating

cash outflows to the Investing section
Inflating CFFO with Boomerang transactions
Improperly capitalizing normal operating costs
Recording the purchase of inventory as an
investing outflow

CF No.2: Shifting normal operating

cash outflows to the Investing section
Inflating CFFO with Boomerang transactions
Boomerang schemes involve selling something to a party and
agreeing to repurchase the same asset (e.g. sale and leaseback
transactions) or other services/products e.g. INR 100 million
received from customers who purchased 100 million of goods
from us
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
from original sale as an operating inflow, and then record the
cash used to repurchase the asset as an investing outflow
Case Global Crossing, pg 215 (sold future capacity and
booked revenue too soon and classified it as CFO, then they
purchased some capacity from those parties, treating it as
Financing cash outflow)
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CF No.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
This impacts the Statement of Cash Flow as
the normal operating expense (which affect Net Income, the starting
point for CFO) is now treated as a capital expenditure which falls
under cash flow from Investing (CFI)
OCF 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 (OCF Capital Expenditures) is unaffected,
so investors that follow Free cash flows will be better informed

Recording the purchase of inventory as an investing

outflow
Case Netflix Inc. and Blockbuster Inc (pg. 220)

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Indicators
Understand the boomerang transactions by reading notes
carefully
Talk to management/Finance officer of the company, understand true
economics behind the transaction and way it is recorded in the books
While modeling the numbers keep this in mind, such transactions can
be of non-recurring nature. Blindly taking a growth rate for reported
figures will lead to misleading projections
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
Calculate and stress on free cash flow generation capability over time
(OCF Capital Expenditures) rather than OCF, as this eliminates the
opportunity to improperly capitalize
Always read the notes that explain the Statement of Cash Flows
(Supplemental Cash Flow Information) which give insight that can
help identify shenanigans
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CF No.3 Inflating OCF Using Acquisitions

or Disposals
Inheriting operating inflows in a normal business
acquisition
Companies that have acquisitive tendencies grow more
rapidly than companies taking the organic route
The result of acquisition of another company on cash flow
statement is
Cash paid for acquiring net assets of the company is shown as cash
flow from investing activities
Cash from operations of acquirer company is benefited as a result of
acquisitions
Company that is growing organically will incur operating cash outflows
(payments for producing and marketing products) in order to create CFFO
inflows (receipts from customers).
However, a company that is growing by acquiring other businesses generates
growth without the stigma of those initial CFFO outflows
Due to the above reasons, companies that grow through acquisitions often
appear to have stronger CFFO than companies that grow organically

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CF No. - 3

This technique was used by Tyco and WorldCom to boosts

their OCF and hide their weak organic growth, by indulging
into acquisition spree every year
Tyco acquired some 700 companies between 1999-2002 for c. USD
29 billion

Such serial acquirers receive improved OCF year-on-year

thus concealing the underlying weakness of the business
Though a correct accounting treatment, while analyzing
such acquisitive companies stress should be laid on Free
cash flow after acquisition to get the correct picture of cash
generation at acquisitive companies
OCF minus capital expenditures minus cash paid for
acquisitions
While modeling the combined company, see the individual
companies financials before combination (Standalone
basis) to assess the strength of business scenario
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Acquiring Contracts or Customers Rather

Than Developing Them Internally
Tyco for its electronic security monitoring business
sourced customers in 2 ways
through its own direct sales force and
through an external network of dealerships
The dealers allowed Tyco to outsource a portion of its sales force.
They were not on Tycos payroll, but they sold security contracts,
and Tyco paid them about USD 800 for every new customer

Tyco misleadingly recorded this normal customer

solicitation cost (just as sales commission) as cost of
acquisition of contracts under Cash flow from
investing activities
Thus Tyco reported higher CFO by using this gimmick
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Acquiring Contracts or Customers

Rather Than Developing Them Internally
Tyco further engineered this scheme and led to serious
Dealer connection fee sham transaction. The
scheme was designed as
For every contract Tyco purchased from a dealer, the dealer
would be required to pay an up-front USD 200 dealer
connection fee
The dealers were not happy about this new fee, so Tyco
raised the price at which it would purchase new contracts by
the same USD 200from USD 800 to USD 1,000.
The net result though the same as earlier (Tyco was still
paying a net of USD 800 the reporting further wrongly
boosted the OCF)
by USD 200 per contract as cash inflow from dealer connection fee
USD 1,000 per contract was recorded as CFI
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Boosting OCF by Creatively structuring the

Sale of a Business
Tenet Healthcare, that owns hospitals and medical centres,
creatively structured the sale of hospitals when it was in
need of liquidity (pg. 239)
It retained the Receivables from the assets side and sold
rest of the assets to the other party. By doing this
Tenet restructured the cash inflow from investing activities to OCF
(If tenet would have sold all assets including receivables, the
cash inflows would have been recorded as cash from investing
activities)
However by retaining Receivables on its books, Tenet managed to
boost the OCF which resulted as collection of cash from customers
Though structuring of transaction would make business sense,
Analysts should not believe that this was a sustainable source of
OCF

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Indicators
Beware of companies that make
numerous acquisitions as they would
be inheriting operating cash inflows
rather than normal business
generation
Declining free cash flow while OCF
appears to be strong

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Techniques to Boost Operating Cash

Flow Using Unsustainable Activities
Boosting OCF by paying vendors more slowly
Look at the Creditors payment period and creditors
as a % of COGs to get the right picture
This OCF boost can be one-time or accepted by
vendors during recession period and there is a limit
to stretching the payments to vendors every
quarter or year
This provides an unsustainable or non-recurring
boost to OCF

Boosting OCF with one-time benefit (Case- Sun

Microsystems, pg 252)
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Sources
Financial Shenanigans by Howard M. Schilit and
Jeremy Perler
Accounting Standards issued by ICAI
Research papers from Journal of Accounting
The Serious Fraud Investigation Office (SIFO)
http://www.watchoutinvestors.com - Site formed
by Ministry of Corporate Affairs, Government of
India, Investor protection and education fund and
SEBI
http://www.watchoutinvestors.com/compindex.as
p?findword=A
list of companies alleged on different grounds
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