Book 3 FRA - Accounting Shenanigans on CFS Flashcards
Analyze and describe the following ways to manipulate the cash flow statement: stretching out payables; financing of payables; securitization of receivables; and using stock buybacks to offset dilution of earnings.
**Stretching Accounts Payable. **Transactions with suppliers are usually reported as operating activities in the cash flow statement. A firm can temporarily increase operating cash flow by simply stretching accounts payable; that is, delaying payments to its suppliers. By delaying payment,
the firm effectively receives no-cost financing. However, stretching payables is not a sustainable source of increased cash flows, since the firm’s suppliers may eventually refuse to extend credit because of the slower payments.
Financing Accounts Payable. Delaying the cash flows associated with payables can also be accomplished by entering into a financing arrangement with a third party, usually a financial institution. Such an arrangement allows the firm to manage the timing of the reported operating cash flows. When the account payable is due, a financial institution makes payment to the supplier on behalfofthe firm, and the firm reclassifies the account payable to short-term debt. The decrease in accounts payable decreases operating cash flow, and the increase in short-term debt increases financing cash flow. At this point, operating cash flow is lower and financing cash flow is higher, but total cash flow is still unaffected. The firm might time the arrangement so that the lower operating cash flow is offset by higher operating cash flows from other sources, such as seasonal cash flows or cash flows from receivable sales or securitizations. In effect, the firm times the operating cash outflow to occur when other operating cash inflows are higher.
Finally, when the firm repays the financial institution, the firm reports the outflow of cash as a financing activity and not an operating activity. Ultimately, the firm has delayed the outflow of cash. Of course, the financial institution will charge a fee (interest) to handle the arrangement.
Securitizing Accounts Receivable. Firms can immediately convert accounts receivable to cash by borrowing against the receivables or by selling or securitizing the receivables. When a firm borrows with its receivables as collateral, the inflow of cash is reported as a financing activity in the cash flow statement.
When receivables are securitized, they are usually transferred to a bankruptcy remote structure known as a special purpose entity (SPE).
**Repurchasing Stock to Offset Dilution. **When a firm’s stock options are exercised, shares must be issued. The higher the stock price relative to the exercise price, the more shares that must be issued by the firm. As the shares are issued, earnings per share are diluted (reduced).
Firms often repurchase stock to offset the dilutive effects of stock option exercise. The cash received from the exercise of the option and the outflow of cash from the share repurchase are both reported as financing activities in the cash flow statement. Because there is a tax benefit when options are exercised, exercise increases operating cash flow.
