Cash Flow Problems: A/R Securitization, Capitalizing Expenses And More

The Statement of Cash Flows was long considered to tell a much truer tale of how a company was faring than the Statement of Profit and Loss.  The numbers were considered to be cleaner, and after all, the statement tells how much cash is on hand, right?  Well right, but as companies have shown time and time again in recent years, there are ways, some of them perfectly legal, to make cash flow look better than what it actually is.  How?  It isn’t hard.  It just takes a little “aggressive” accounting.  While many companies still like to keep their accounting practices on the conservative side, the aggressive line can be pushed quite a ways without breaking any laws.  This can be done by choosing a less than conservative way to handle certain accounts and practices.  For example:

Accounts Payable

This account should be pretty cut and dry, unless you look a little deeper.  In general, the larger accounts payable is, the larger operating cash flow is.  This is because the cash that would pay these bills has been retained.  The way a company accounts for outstanding checks can throw a kink in this truth however.  If a company writes checks to pay several payable accounts, but does not deduct them from cash until they are cleared, then the operating cash flow could be inflated.

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An example of this is found with Aviall.  In 2000 they showed positive operating cash, but the first note in the 10-K revealed that there was a large chunk of this cash tied up in outstanding checks.  In fact, when all of those checks were deducted from cash, operating cash was actually negative.

Another way accounts payable can be used to beef up operating cash is to finance them.  For example, in years past, Delphi Automotive PLC (NYSE:DLPH) financed their payable through a third party, General Electric Company (NYSE:GE) Capital.  General Electric Company (NYSE:GE) Capital paid Delphi’s vendors, and they in turn, paid GE Capital. Other companies, such as The Pep Boys – Manny, Moe & Jack (NYSE:PBY), Advance Auto Parts, Inc. (NYSE:AAP), and AutoZone, Inc. (NYSE:AZO) have been known to do the same.  There is nothing inherently wrong with this, but it can make things in the realm of operating cash flow appear better than they actually are.  Payables can be reclassified to short-term or long-term debt, and the cash output is slowed down exceptionally, thus reducing the amount taken out of operating cash at once.

A/R Securitization

This is also known as selling receivables, and it can actually be a viable cash management move, if collections is an issue.  In fact, if it is done in generally the same way each year, the impact on cash flow is minimal.  However, there are two reasons why this could raise a cash flow red flag.

First, if selling receivables is new for the company, it could be an effort to bridge or mask struggling cash flow.  Collecting all of that cash at once, though less than they would get otherwise, as they sell at a discount, would increase operating cash significantly.   For example, Oxford Industries, Inc. (NYSE:OXM), in 2001, reported that their operating cash almost doubled from the previous year.  At first glance this looks as if operations picked up considerably.  However, a closer look via the notes to the financial statement reveals that the increase was from an increase in collections due to securitization.  They did absolutely nothing wrong, but anyone who took the Cash Flow Statement at face value would definitely get only a part of the story.

Capitalizing Expenses

Operating expenses are deducted from operating cash flow, thus reducing the amount of operating cash on hand reported.  Some more aggressive accounting practices capitalize some of these expenses however, which lands them in the “Cash from Investing Activities” portion of the statement, rather than the operating portion.  The end result is that operating cash is higher, cash from investments is lower, but the final total cash flow number is the same as it would be either way.  The problem is that for the purposes of most that use the report, operating cash is what matters.  They look at this number to determine how much cash the company generates in the course of normal operations.  If operating expenses have been capitalized, then this number is skewed.  This is a lesson that was learned by the world during the WorldCom fiasco.  While not always a fraudulent practice, it depends on which expenses are capitalized, the reasoning behind them, and whether or not the accounting is revealed in the notes.

Securities Trading

Generally Accepted Accounting Principles, or GAAP, allow for cash from securities trading to be recording in the operating section of the cash flows statement.  These activities are not, in most cases, activities that occur during the normal course of business.  In the case of the first quarter report of 2001 for WHX, for example, the Cash Flow Statement reported operating cash of $6.3 million.  The details revealed, however, that $4.76 million was the result of short-term investments and borrowing to finance more.   This is cash that did not result from steel making or the making other products.  Subtracting this amount gives a much clearer picture of true cash flow from operations.

The moral of the story is, there are ways for the Cash Flow Statement to be manipulated to look better than it really is on the surface, and it does not take fraud to do so.  The key is to go beyond the face.  Look at more than the bottom line.  Look at the details, read the notes, and ask questions that may reveal practices that show one-time gains or cover weak performance.  The burden is on the reader when it comes to reading financial statements, including the Statement of Cash Flows.