Spring 2009 NBA 5060

Lecture 7 – Cash Flow Analysis and Earnings Manipulation

1. What to look for in a statement of cash flows

2. Why is detecting earnings manipulation important? Economic consequences of accounting ‘irregularities’

3. A model for detecting earnings manipulation

For Next Class: We will be discussing the JFF case. Also, consider how you would forecast sales growth for CBRL over the next 1 to 2 years and over the long-term.

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Analyzing the statement of cash flows

In addition to a profitability analysis, which focuses primarily on earnings (income statement) and invested capital (balance sheet), it is useful to examine the cash flows of the company. This type of analysis can tell us, for example:

Primary sources of cash Primary uses of cash Quality of reported earnings Life cycle of the firm and expected growth

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Key questions to ask using the statement of cash flows:

1. Cash Flow Adequacy

Is the cash from operations consistently positive? If not, why not?

2. Quality of Earnings

Is the reported net income backed up by cash?

Total Accruals to Assets ( TATA )=Net Incomet - Cash From Operations tTotal Assetst

Where the numerator is referred to as total accruals. A positive TATA ratio (i.e. greater than 0) is often problematic, especially if the firm has negative earnings. A TATA ratio of less than –10% is usually a good sign, especially if the company has positive earnings.

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3. Main uses of cash

What has the company been investing in? How heavily? Are they growing through acquisitions or internal growth?

Primarily: (1) supporting operations (i.e. negative CFO). (2) investments in PPE (internal growth)(3) acquisitions (external growth)(4) Non-operating investments

Although R&D or advertising represent investments as well, you will not find these explicitly listed on an indirect statement of cash flows.

4. Main sources of cash

Is cash from financing positive or negative? What are the means of financing? What are the implications of financing choices for operating cash flow or for shareholder wealth? What do financing activities signal about future growth opportunities?

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5. Company growth dynamics

Not every company with negative CFO is in trouble. The relative size of a company’s CFO, CFI, and CFF is related to growth dynamics.

Relation of income and cash flows and the product life cycle

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Operations

Investing

Revenue growth

Net Income

+

0

-

+

0

-

Introduction Growth Maturity DeclineFinancing

Reading and Interpreting the Statement of Cash Flows – CBRL

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Reading and Interpreting the Statement of Cash Flows

Company A ______________

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12/31/2004 12/31/2005 12/31/2006

Net Income (642.4) (666.7) (718.9) Depreciation & Amort. 145.9 144.6 167.6 Amort. of Goodwill and Intangibles 1.3 1.3 1.3 Other Amortization 18.5 30.2 41.3 (Gain) Loss From Sale Of Assets - - (4.5) (Gain) Loss On Sale Of Invest. - - 76.6 (Income) Loss on Equity Invest. - 0.5 23.2 Stock-Based Compensation 2.0 6.0 68.0 Provision & Write-off of Bad debts 3.2 8.3 15.2 Other Operating Activities 157.3 75.5 112.4 Change in Acc. Receivable (8.4) (35.4) (37.5) Change in Acc. Payable 57.4 125.8 (102.2) Change in Unearned Rev. 98.5 208.3 66.1 Change in Other Net Operating Assets 91.5 (65.0) (170.8) Cash from Ops. (75.2) (166.7) (462.1)

Capital Expenditure (169.9) (179.8) (275.0) Sale of Property, Plant, and Equipment - - 7.2 Invest. in Marketable & Equity Securt. - (25.3) - Other Investing Activities 133.6 (1.0) 3.4 Cash from Investing (36.3) (206.1) (264.4)

Long-Term Debt Issued 533.3 100.0 800.0 Short Term Debt Repaid (103.0) - - Long-Term Debt Repaid (232.6) (47.9) (499.8) Issuance of Common Stock 236.8 319.6 6.4 Repurchase of Preferred - - (24.0) Other Financing Activities (23.4) (5.8) (48.8) Cash from Financing 411.1 366.0 233.8

Net Change in Cash 299.6 (6.9) (492.8)

For fiscal year ended

(Amounts in Millions)

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Reading and Interpreting the Statement of Cash Flows

Company B ______________

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12/31/2005 12/31/2006 12/31/2007

Net Income (1,261.0) (601.0) 676.0 Depreciation & Amort. 890.0 900.0 785.0 Amort. of Goodwill and Intangibles 121.0 146.0 - (Gain) Loss From Sale Of Assets (78.0) (65.0) (157.0) Asset Writedown & Restructuring Costs 640.0 426.0 336.0 (Income) Loss on Equity Invest. (12.0) - - Net Cash From Discontinued Ops. 28.0 - (37.0) Other Operating Activities 250.0 (103.0) (988.0) Change in Acc. Receivable 228.0 157.0 161.0 Change In Inventories 306.0 271.0 108.0 Change in Other Net Operating Assets 96.0 (175.0) (569.0) Cash from Ops. 1,208.0 956.0 315.0

Capital Expenditure (472.0) (379.0) (259.0) Sale of Property, Plant, and Equipment 130.0 178.0 - Cash Acquisitions (984.0) (3.0) (2.0) Divestitures - - 2,676.0 Invest. in Marketable & Equity Securt. 22.0 (21.0) (7.0) Cash from Investing (1,304.0) (225.0) 2,408.0

Long-Term Debt Issued 2,520.0 765.0 177.0 Short Term Debt Repaid (126.0) (11.0) - Long-Term Debt Repaid (1,672.0) (1,557.0) (1,363.0) Issuance of Common Stock 12.0 - 6.0 Common Dividends Paid (144.0) (144.0) (145.0) Other Financing Activities (57.0) - 44.0 Cash from Financing 533.0 (947.0) (1,281.0)

Foreign Exchange Rate Adj. (27.0) 20.0 36.0 Net Change in Cash 410.0 (196.0) 1,478.0

For fiscal year ended

(Amounts in Millions)

Economic Consequences of Earnings Manipulation

Example: Cendant Corporation

Cendant Corporation to Restate Earnings

April 15, 1998--Cendant Corporation (NYSE:CD) today reported that, in the course of transferring

responsibility for the Company's accounting functions from former CUC International, Inc. personnel to former HFS Incorporated accounting personnel and preparing for the reporting of first quarter 1998 results, it has discovered potential accounting irregularities in certain former CUC business units which are part of Cendant's Alliance Marketing Division (formerly the Membership segment).

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Accordingly, Cendant said it expects to restate annual and quarterly net income and earnings per share for 1997 and may restate certain other previous periods related to the former CUC businesses. Based on presently available information, the effect on 1997 results is expected to be a reduction to net income prior to restructuring and unusual charges of approximately $ 100 to $ 115 million and earnings per share by about 11 to 13 cents, respectively.

In 1997, the Company had previously reported net income prior to restructuring and unusual charges of $ 872 million and earnings per share of $ 1.00. Cendant said that the potential accounting irregularities are limited to certain former CUC businesses, which accounted for less than one third of Cendant's net income in 1997. It said all its current businesses continue to perform strongly and that its anticipated percentage growth of earnings per share in 1998 over restated 1997 appeared achievable.

Cendant expects to meet or exceed the currently forecasted Wall Street consensus estimate of 25 cents per share for the first quarter of 1998. However, since 1997 earnings per share will be reduced by about 11 to 13 cents, the Company anticipates that 1998 full-year earnings expectations will be reduced from current levels by approximately the same amount. Henry R. Silverman, President and CEO, said: "Cendant remains a strong and highly liquid company. Our businesses are very healthy and growing, but we're growing off a lower base than we had been previously led to believe by certain members of the former CUC management." The Company also stated it remains committed to completion of the previously announced American Bankers, National Parking Corporation and Providian Insurance transactions. The Company said that upon discovering the potential accounting irregularities, it, together with its counsel, Skadden, Arps, Slate, Meagher & Flom LLP, assisted by auditors, immediately began an intensive investigation.

As a result of the discovery and information developed to date, Cendant has taken a number of actions: It has informed the appropriate regulatory authorities; The Audit Committee of the Board of Directors has engaged Willkie Farr & Gallagher as special legal counsel, and Willkie Farr has engaged Arthur Andersen LLP to perform an independent investigation; The Company has assigned all accounting, finance, financial reporting, budget, systems and control functions to the former HFS finance staff; and The Company has asked counsel to explore litigation against certain officers of the former CUC as well as other potential defendants. In addition, the Company will take appropriate action, including immediate terminations, with respect to those individuals whom the investigation establishes have had any involvement in or knowledge of the potential accounting irregularities.

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Why do we care about earnings manipulation?

e.g. Cendant Corp (see article)

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$20 drop in price per share, a loss of $16B in market cap.

A Model for Detecting Earnings Manipulation

Beneish (1999) examines characteristics of known manipulators (firms subject to SEC enforcement actions) and uses these characteristics to develop a model that distinguishes manipulators from non-manipulators.

The Beneish model includes four ratios that capture effects of manipulation and four ratios that capture preconditions (incentives) for manipulation:

FactorEffect or

Precondition? IntuitionDSRI (Days sales in receivables)* Effect

Booking fictitious sales

GMI (Gross margin index)* Precondition

Deteriorating product market performance

AQI (Asset quality index)* Effect

Capitalizing costs that should be expensed

SGI (Sales growth index)* Precondition

Cap market pressure to maintain high sales growth

DEPI (Depreciation index)*

EffectStretching useful lives

SGAI(SG&A index) Precondition

Increased advertising to stem falling demand

TATA (Total accruals to total assets)*

EffectDistortions in accruals from manipulation

LVGI (Leverage)Precondition

Avoid violating debt covenants

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A Model for Detecting Earnings Manipulation

Beneish (1999) estimates the model with a probit regression and then validates the model by using it to predict manipulators from a combined sample of manipulators and non-manipulators

Factor CalculationSample Averages

Manipulators ControlDSRI (Days sales in receivables)*

%Rect/%Rect-1

%Rec=AR/Sales 1.46 1.03

GMI (Gross margin index)*

%GMt-1 / GMt

%GM=(sales-cogs) / sales 1.19 1.01

AQI (Asset quality index)*

1-[(CA+PPE)/TA]t / 1-[(CA+PPE)/TA]t-1 1.25 1.04

SGI (Sales growth index)*

Salest / Salest-1

1.61 1.13

DEPI (Depreciation index)*

Dep/(Dep+PPE)t-1 / Dep/(Dep+PPE)t 1.08 0.97

SGAI(SG&A index) %SGAt / %SGAt-1 1.04 1.05

TATA (Total accruals to total assets)*

As defined prev. 0.031 0.018

LVGI (Leverage) (LTD+CL / TA) t / (LTD+CL / TA) t-1 1.11 1.04

The full model:M = - 4.840 + .92*DSRI +.528*GMI + .404*AQI + .892*SGI + .115*DEPI

- .112 SGAI + 4.679*TATA - .327*LVGI

If the M-score is greater than –1.78 then we classify the firm as a possible manipulator.

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M-score Worksheet (you need to input the relevant data)

The Full Beneish model for earnings manipulation detection(Based on Eight Variables) Input data in shaded green cellsINPUT VARIABLES 2008 2007Net Sales 2,384,521 2,351,576CGS 744,275 706,095Net Receivables 13,484 11,759Current Assets (CA) 220,639 200,281PPE (Net) 1,045,240 1,018,982 Company:Depreciation 57,689 56,908 Cracker BarrelTotal Assets 1,313,703 1,265,030SGA Expense 127,273 136,186Net Income (before Xitems) 162,065 116,291CFO (Cash flow from operations) 124,510 96,872Current Liabilities 274,669 330,533Long-term Debt 787,775 764,494

DERIVED VARIABLESOther L/T Assets [TA-(CA+PPE)] 47824 45767

DSRI 1.131GMI 1.017

AQI 1.006SGI 1.014

DEPI 1.011SGAI 0.922TATA 0.029LVGI 0.934

M = -4.84 + .920 DSRI + .528 GMI + .404 AQI + .892 SGI + .115 DEPI -.172 SGAI + 4.679 TATA - .327 Leverage

M-score (8-variable model) -2.17

Note: if M < -1.78, firm does not have characteristics of a manipulator

You can download this excel template on the course home page mscore.xls

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M-score Worksheet (you need to input the relevant data)

The Full Beneish model for earnings manipulation detection(Based on Eight Variables) Input data in shaded green cellsINPUT VARIABLES 2000 1999Net Sales 100789 40112CGS 94517 34761Net Receivables 10396 3030Current Assets (CA) 30381 7255PPE (Net) 15459 13912 Company:Depreciation 855 870 Enron Corp.Total Assets 65503 33381SGA Expense 3184 3045Net Income (before Xitems) 979 1024CFO (Cash flow from operations) 4779 1228Current Liabilities 28405 6759Long-term Debt 8550 7151

DERIVED VARIABLESOther L/T Assets [TA-(CA+PPE)] 19663 12214

DSRI 1.365GMI 2.144

AQI 0.820SGI 2.513

DEPI 1.123SGAI 0.416TATA -0.058LVGI 1.354

M = -4.84 + .920 DSRI + .528 GMI + .404 AQI + .892 SGI + .115 DEPI -.172 SGAI + 4.679 TATA - .327 Leverage

M-score (8-variable model) -0.54

Note: if M < -1.78, firm does not have characteristics of a manipulator

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The Usefulness of the M-Score Model: Evidence from Beneish and Nichols (2008)

Table 1. Recent High-Profile Fraud Cases Detected by PROBM (M-Score)This table reports the 20 highest profile fraud cases as reported by auditintegrity.com. Firms are flagged as manipulators if PROBM exceeds -1.89 at any time during the period in which either the SEC alleges the firm committed financial reporting violations or the firm publicly admits to such violations.  Year flagged refers to the first year the firm is flagged by the PROBM model as a manipulator. Year discovered refers to the year in which the fraud was first publicly revealed in the business press. Market cap lost denotes the change in market capitalization during the three months surrounding the month the fraud was announced (i.e., months -1,0,+1). Market cap lost (%) denotes the market capitalization lost during the three months surrounding the fraud announcement month as a percentage of market capitalization at the beginning of month -1.

Flagged as Year Year Market Cap Market CapCompany Name manipulator? Flagged Discovered Lost ($B) Lost (%)

Adelphia Communications Yes 1999 2002 4.82 96.8%American International Group, Inc. N/A - FinancialAOL Time Warner, Inc. Yes 2001 2002 25.77 32.2%Cendant Corporation Yes 1997 1998 11.32 38.1%Citigroup N/A - FinancialComputer Associates International, Inc. Yes 2000 2002 7.23 36.4%Enron Broadband Services, Inc. Yes 1998 2001 26.04 99.3%Global Crossing, Ltd Yes 1999 2002 (Delisted due to bankruptcy)HealthSouth Corporation No 2002 2.31 57.3%JDS Uniphase Corporation Yes 1999 2001 32.49 61.0%Lucent Technologies, Inc Yes 1999 2001 11.15 24.7%Motorola N/A – Abetted AdelphiaQwest Communications International Yes 2000 2002 9.84 41.8%Rite Aid Corporation Yes 1997 1999 2.83 59.1%Sunbeam Corporation Yes 1997 1998 1.28 58.8%Tyco International No 2002 37.55 58.2%Vivendi Universal No 2002 1.28 27.9%Waste Management Inc Yes 1998 1999 20.82 63.6%WorldCom Inc. - MCI Group No 2002 1.03 69.8%Xerox Corporation No 2000 7.73 43.8%

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