Financial Shenanigans Cashflows

8/18/2019 Financial Shenanigans Cashflows

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Financial shenanigans- Cash fow misrepresentation

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2/19

cash fow shenanigans to

manipulate OCF

• C No. 1: Shiting nancing cashinfows to the operating section

• C No.2: Shiting normal operatingcash outfows to the Inestingsection

• C No.!: Infating operating cash fowusing ac"uisitions or #isposals

• C No.$: %oosting operating cash fowusing unsustaina&le actiities

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%enets #erie# &' using CF

Shenanigans

• %oosting o OCF( the most stu#ie#num&er giing signs o theoperational strength o the compan'

an# earnings "ualit'

• )o coer-up un#erl'ingwea*ness+cash crunch an# portra'

strong li"ui#it' position

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4/19

CF No. 1: Shiting nancing cashinfows to the operating section

• ,ecor#ing &ogus CFFO rom a normal &an* &orrowing Case /elphi Corporation( pg 100- Sham sale o inentor' to &an*-loan raise# on ple#ge o inentor' recor#e# as sales &oostingreenue an# CFO

•

%oosting CFFO &' selling ,eceia&les &eore the collection #ate – Sale o receia&le to &an*s+Financial Institutions( though an

appropriate scheme( shoul# &e iewe# with caution i compan' issignicantl' resorting to sale o receia&les( as this ma' signal pile-upo uncollecti&le receia&les that hae &een sol#

– suall' it is on recourse &asis an# #oes not signi' improement in

OCF on account o operating transaction Case Car#inal 3ealth an#Sanmina-SCI Corporation( pg 24! an# 245

– In C67( we a## &ills #iscounte# to &an* &orrowing an# receia&les toget the actual picture o /a's sales outstan#ing /SO an# nulli' thepositie impact on CFO an# show it correctl' as Cash fow romFinancing actiit'

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89ample

• 89ample In 2411( ;< compan' sol# = 144 million o ,eceia&lesto &an*

–

Impact on Operating cash fow >14 – Impact on Financing cash fow >!4

• I we a#?ust as per C67( the real impact can &e seen

– Impact on Operating cash fow 04

– Impact on Financing cash fow >1!4

5

Reported

2010 2011

2010

2011

%an*&orrowing

54 @4 ,eceia&les

144 04

Adjusted 2010 2011

2010

2011

%an*&orrowing

54 @4>144

,eceia&les

144 04>144


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CF. No. 1

• Infating CFFO &' a*ing the sale oreceia&les – Case Aeregrine S'stems( pg 24B


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In#icators

• I#eall' i net income grows CFO shoul# also moe in same #irectionDclosel' chec* all items o Cash fow rom operating actiities to see whichitem is causing e9cessie cash #rain. )his coul# signal i earningmanipulation #one

• On other han#( i Net income is #eteriorating an# an oertl' positie OCF

reporte#( chec* or cash-infows that is causing this ariation. Aossi&learrangements coul# &e – Sale o receia&les

– /ela' in pa'ment o cre#itorsD this will increase the OCF( howeer is it #ue tonormal cre#it polic' change or long-term or #oes it signi' cash crunch

• ,ea# notes to accounts an# 6anagement /iscussion an# 7nal'sis6/E7 section careull' to see i an' material sales receia&letransactions entere# into( regularit' o such transactions an# to whate9tent as a o total receia&les – 7lso *eep this in min# while mo#eling uture perio# ,eceia&les position

– ,eer to ,ating agencies reports

– ,eerence chec* with &an*s in case o 6ultiple &an*ing arrangements ,eer ,%ICircular Goans an# 7#ances

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8/19

CF No.2: Shiting normal operatingcash outfows to the Inesting section

• Infating CFFO with %oomerang transactions

• Improperl' capitaliHing normal operating costs

• ,ecor#ing the purchase o inentor' as an

inesting outfow

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9/19

CF No.2: Shiting normal operatingcash outfows to the Inesting section

• Infating CFFO with %oomerang transactions – %oomerang schemes inole selling something to a part' an#

agreeing to repurchase the same asset e.g. sale an# lease&ac*transactions or other serices+pro#ucts e.g. IN, 144 millionreceie# rom customers who purchase# =144 million o goo#srom usJ

– )hese can &e legitimate transactions( &ut sometimes the' can&e use# to shit cash fows aroun# on the Statement o CashFlows

– In #oing this( companies will recor# the cash fow receie# the

rom original sale as an operating infow( an# then recor# thecash use# to repurchase the asset as an inesting outfow

– Case Klo&al Crossing( pg 215 sol# uture capacit' an#&oo*e# reenue too soon an# classie# it as CFO( then the'purchase# some capacit' rom those parties( treating it as

Financing cash outfow 0


10/19

CF No.2

• Improperl' capitaliHing normal operating costs – %' capitaliHing e9penses( companies treat the e9pense as i it

create# an asset that shoul# &e #epreciate# oer time

– )his impacts the Statement o Cash Flow as• the normal operating e9pense which aLect Net Income( the starting

point or CFO is now treate# as a capital e9pen#iture which allsun#er cash fow rom Inesting CFI

• OCF is higher than it shoul# &e( an# CFI which man' peopleoerloo*( or at least treat as less important is lower than it shoul# &e

• 3oweer( Free cash fow OCF Capital 89pen#itures is unaLecte#(so inestors that ollow Free cash fows will &e &etter inorme#

• ,ecor#ing the purchase o inentor' as an inestingoutfow – Case Netfi9 Inc. an# %loc*&uster Inc pg. 224

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Indicators

• n#erstan# the &oomerang transactions &' rea#ing notescareull' – )al* to management+Finance oMcer o the compan'( un#erstan# true

economics &ehin# the transaction an# wa' it is recor#e# in the &oo*s

– hile mo#eling the num&ers *eep this in min#( such transactions can

&e o non-recurring nature. %lin#l' ta*ing a growth rate or reporte#gures will lea# to mislea#ing pro?ections

– Create a common-siHe# &alance sheet all items as a percent o totalassets an# trac* changes oer time to i#enti' assets growing asterthan the rest o the &alance sheet

– Calculate an# stress on ree cash fow generation capa&ilit' oer time

OCF Capital 89pen#itures rather than OCF( as this eliminates theopportunit' to improperl' capitaliHe

– 7lwa's rea# the notes that e9plain the Statement o Cash FlowsSupplemental Cash Flow InormationJ which gie insight that canhelp i#enti' shenanigans

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12/19

CF No.! Infating OCF sing 7c"uisitionsor /isposals

• Inheriting operating infows in a normal &usinessac"uisition – Companies that hae ac"uisitie ten#encies grow more

rapi#l' than companies ta*ing the organic route

– )he result o ac"uisition o another compan' on cash fowstatement is• Cash pai# or ac"uiring net assets o the compan' is shown as cash

fow rom inesting actiitiesJ

• Cash rom operations o ac"uirer compan' is &enete# as a result oac"uisitions Compan' that is growing organicall' will incur operating cash outfows

pa'ments or pro#ucing an# mar*eting pro#ucts in or#er to create CFFOinfows receipts rom customers.

3oweer( a compan' that is growing &' ac"uiring other &usinesses generatesgrowth without the stigma o those initial CFFO outfows

/ue to the a&oe reasons( companies that grow through ac"uisitions oten

appear to hae stronger CFFO than companies that grow organicall' 12


13/19

CF No. - !

• )his techni"ue was use# &' )'co an# orl#Com to &ooststheir OCF an# hi#e their wea* organic growth( &' in#ulginginto ac"uisition spree eer' 'ear )'co ac"uire# some B44 companies &etween 1000-2442 or c. S/

20 &illion

• Such serial ac"uirers receie improe# OCF 'ear-on-'earthus concealing the un#erl'ing wea*ness o the &usiness

• )hough a correct accounting treatment( while anal'Hingsuch ac"uisitie companies stress shoul# &e lai# on Freecash fow ater ac"uisition to get the correct picture o cash

generation at ac"uisitie companies OCF minus capital expenditures minus cash paid for

acquisitions

While modeling the combined company, see the individualcompanies nancials before combination (Standalonebasis to assess the strength of business scenario

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Acquiring Contracts or Customers RatherThan Developing Them Internally

• )'co or its electronic securit' monitoring &usinesssource# customers in 2 wa's – through its own #irect sales orce an#

– through an e9ternal networ* o #ealerships

• )he #ealers allowe# )'co to outsource a portion o its sales orce. )he' were not on )'cos pa'roll( &ut the' sol# securit' contracts(an# )'co pai# them a&out S/ @44 or eer' new customer

• )'co mislea#ingl' recor#e# this normal customersolicitation cost ?ust as sales commission as cost o

ac"uisition o contracts un#er Cash fow rominesting actiities

• )hus )'co reporte# higher CFO &' using this gimmic*

1$


15/19

7c"uiring Contracts or Customers,ather )han /eeloping )hem Internall'

• )'co urther engineere# this scheme an# le# to serious/ealer connection ee sham transactionJ. )hescheme was #esigne# as

– For eer' contract )'co purchase# rom a #ealer( the #ealer

woul# &e re"uire# to pa' an up-ront S/ 244 #ealerconnection eeJ

– )he #ealers were not happ' a&out this new ee( so )'coraise# the price at which it woul# purchase new contracts &'the same S/ 244Prom S/ @44 to S/ 1(444.

–

)he net result though the same as earlier )'co was stillpa'ing a net o S/ @44 the reporting urther wrongl'&ooste# the OCF• &' S/ 244 per contract as cash infow rom #ealer connection ee

• S/ 1(444 per contract was recor#e# as CFI

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16/19

Boosting C! "y Creatively structuring the#ale o$ a Business

• )enet 3ealthcare( that owns hospitals an# me#ical centres(creatiel' structure# the sale o hospitals when it was innee# o li"ui#it' pg. 2!0

• It retaine# the ,eceia&les rom the assets si#e an# sol#rest o the assets to the other part'. %' #oing this – )enet restructure# the cash infow rom inesting actiities to OCF

I tenet woul# hae sol# all assets inclu#ing receia&les( thecash infows woul# hae &een recor#e# as cash rom inestingactiities

– 3oweer &' retaining ,eceia&les on its &oo*s( )enet manage# to

&oost the OCF which resulte# as collection o cash rom customers – )hough structuring o transaction woul# ma*e &usiness sense(

7nal'sts shoul# not &eliee that this was a sustaina&le source oOCF

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17/19

In#icators

• %eware o companies that ma*enumerous ac"uisitions as the' woul#&e inheriting operating cash infows

rather than normal &usinessgeneration

• /eclining ree cash fow while OCF

appears to &e strong

1B


18/19

)echni"ues to %oost Operating CashFlow sing nsustaina&le 7ctiities

• %oosting OCF &' pa'ing en#ors more slowl'

– Goo* at the Cre#itors pa'ment perio# an# cre#itorsas a o COKs to get the right picture

– )his OCF &oost can &e one-time or accepte# &'en#ors #uring recession perio# an# there is a limitto stretching the pa'ments to en#ors eer'"uarter or 'ear

– )his proi#es an unsustaina&le or non-recurring

&oost to OCF

• %oosting OCF with one-time &enet Case- Sun6icros'stems( pg 252

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19/19

Sources

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• Financial Shenanigans &' 3owar# 6. Schilit an# Qerem' Aerler

• 7ccounting Stan#ar#s issue# &' IC7I

• ,esearch papers rom Qournal o 7ccounting

• )he Serious Frau# Inestigation OMce SIFO

• http:++www.watchoutinestors.com - Site orme#&' 6inistr' o Corporate 7Lairs( Koernment oIn#ia( Inestor protection an# e#ucation un# an#S8%I

• http:++www.watchoutinestors.com+compin#e9.aspRn#wor#7 list o companies allege# on #iLerent groun#s
http://www.watchoutinvestors.com/http://www.watchoutinvestors.com/compindex.asp?findword=Ahttp://www.watchoutinvestors.com/compindex.asp?findword=Ahttp://www.watchoutinvestors.com/compindex.asp?findword=Ahttp://www.watchoutinvestors.com/compindex.asp?findword=Ahttp://www.watchoutinvestors.com/

Financial Shenanigans Cashflows

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