Financial shenanigans

Continuation to the First Review

In the previous review, we only discussed the earnings manipulation shenanigans. That is, how
and when the management of the company uses it. In the second review, we will look upon the
other two Financial Shenanigans namely Cash flow shenanigans and Key metrics shenanigans.
We all should know that; investors also equate net earnings with CFFO and are upset when CFFO
lags behind net earnings. The emergence of certain benefit exploitation suggests high net incomes
together with low CFFOs. Organizations are conscious of the interest of investors about the CFFO
segment and pass cash flows to the major operations portion while forwarding cash outflows to
finance and investment sections. The author highlights four cash flow shenanigans in this book
namely (1) Shifting Financing Cash Inflows to the Operating Section (2) Shifting Normal
Operating Cash Outflows to the Investing Section (3) Inflating Operating Cash Flow Using
Acquisitions or Disposals (4) Boosting Operating Cash Flow Using Unsustainable Activities
Firstly, the author discusses “Shifting Financing Cash Inflows to the Operating Section”.
Following are the four methods/techniques the management of the company can use to shift cash
inflows to the operating section of the cash flow statement (1): Recording Bogus CFFO from a
Normal Bank Borrowing (2). Boosting CFFO by Selling Receivables Before the Collection Date
(3). Inflating CFFO by Faking the Sale of Receivables
Firstly, “recording Bogus CFFO from a Normal Bank Borrowing”: In this, a business can borrow
from a bank a short-term loan and set up its stock as collateral (which could be seized if the
company is unable to repay the loan). The corporation would report the earned money as a lending,
i.e. an increase in cash flow from financing activities, and raise the balance sheet cash and
liabilities (loan payable). Alternatively, however, the client should report the transaction as an
inventory transfer, not reporting the transaction in a manner consistent with the parties ' economics
and purpose. The author gives the example of Vitesse Semiconductor, who also admitted that it
obtained cash from a bank for the selling of receivables and not for lending. The suspected scheme
involved Vitesse at the end of each quarter selling receivable accounts many of which related to
uncollectable or fraudulent revenue to Silicon Valley Bank, to make it appear that Vitesse's
receivable accounts remained relatively stable. The threat of loss from these receivables was never
really offloaded by Vitesse, however, since the bank retained the right to demand that Vitesse
purchase these receivables.
Secondly “boosting CFFO by Selling Receivables Before the Collection Date”. In this, Companies
may convert receivables into money even though the consumer still has to pay by seeking a willing
buyer, often a bank, and transferring to it the ownership of certain receivables. In return, the client
pocks a cash payment for the total amount of receivables, less a commission. Some of the warning
signs the author has given to investor are: The investor should be wary of businesses that do not
provide information to investors and are not clear about their selling of receivables. It could be an
alert that the cash flow report is dressed by the window, or an imminent cash flow crunch.
Moreover, See the cash flow report unexpectedly swing. Look for huge increases in cash flows
from a particular source, e.g. receivables–look at the percentage change in cash inflow from that
source over the last period, and how high a percentage of total cash inflow is. Reflect not only on
how much CFFO has grown, but also on how it has grown, and figure out what is the primary
growth factor.
Thirdly, “Inflating CFFO by Faking the Sale of Receivables”. In this, if a company sells the debts
in exchange for cash to a bank, but the possibility of collection loss stays with the company which
needs to return the cash back to the bank on debts not received, then the link economies are more
similar to the collateralized loan, and they should be viewed as cash flows for funding. However,
the economic reality of the situation could be ignored by a company and recorded as a sale of
receivables and operating cash inflow. Some of the warning signs the author has given to the
investors are: Look for changes in disclosure each half, particularly in the most important sections
of the filings. Most analysis platforms and word processing applications have word reference or
blackline capabilities, where it is not as tedious as it sounds to analyze all filings side by side.
Moreover, be vigilant when an organization discloses less than in the previous period.
The author then focuses his attention towards the second cash flow shenanigan which is “Shifting
Normal Operating Cash Outflows to the Investing Section” In this the author discusses three
methods the management of the company can use to manipulate cash flows namely (1) Inflating
CFFO with Boomerang Transactions (2). Improperly Capitalizing Normal Operating Costs (3).
Recording the Purchase of Inventory as an Investing Outflow.
Firstly, the author discusses “Inflating CFFO with Boomerang Transactions”. In this, the investor
should watch for boomerang transactions (purchase and selling by the same party); check out 10
K and 10Q filings for their reports. Companies are not going to speak specifically about boomerang
transactions, but there are specifics about these transactions, particularly when they are large in
size. Once you've seen one, it's imperative to dig around and understand the arrangement's true
economics, and seek further disclosure. Evaluate the transaction's economics and understand how
it contributes to the results of the company. Consider whether the company has deliberately
avoided or complicated reporting–you may not want to understand how its payment is boomerang
transactions work.
Secondly, the author discusses “Improperly Capitalizing Normal Operating Costs”. In this, the
investor should be beware of free cash flow as though CFFOs are overvalued, but FCFs may not
be affected, because it is a calculation of cash flow after capital expenditure. Moreover, remember
that capital expenditure has increased suddenly. Also remember that soft assets have jumped when
compared to sales.
Thirdly, the author discusses “Recording the Purchase of Inventory as an Investing Outflow.”. In
this, the economics of buying goods to be sold to consumers indicates that they should be listed
on the cash flow statement as business operation. However, these transactions are known by some
businesses as outflow investments. Moreover, in the comparison of rivals it is possible to consider
variations in accounting policies, e.g. if a company buys DVD in investing cash outflows, the
CFFO of a company that purchases DVD in operating cash outflows cannot be compared, without
making an adjustment. In addition to this, the investor should pay attention to companies that
purchase goods and then rent those goods to clients. Instead of throwing them into the operational
money outflows, they should capitalize on the products they have bought to rent.
After discussing the first two cash flow shenanigans, the author focuses his attention on the third
shenanigan which is “Inflating Operating Cash Flow Using Acquisitions or Disposals”. The author
highlights three methods the management of the company can use to manipulate cash flows namely
(1) Inheriting Operating Inflows in a Normal Business Acquisition (2). Acquiring Contracts or
Customers Rather Than Developing Them Internally (3). Boosting CFFO by Creatively
Structuring the Sale of a Business.
Firstly, the author discusses “Inheriting Operating Inflows in a Normal Business Acquisition”. In
this, there is an accounting loophole that allows acquired companies to show strong CFFO each
quarter simply because they buy other firms. If you pay for the acquisition, you do it without
affecting the CFFOs, as if you buy the enterprise with cash, it is recorded as an outflow of
investment, and there is no cash-outflow if you buy with stocks. Once the acquired company is
controlled, all revenues and operating cash inflow from the acquired company become part of the
enterprise. Without any initial CFFO outflow, the company will generate new cash flow through
the acquired product. Companies, however, that seek to organically grow their business would
gain cash inflows to expand their business. Some of the warning signs the author has mentioned is
that the investors should be made aware of serial acquirers who make several medium business
acquisitions and brag about the strength of their underlying business to investors, referring to the
bursting CFFO. But the rise in cash flow had almost nothing to do with their business performance.
The author further turns his attention towards, the second method which is “Acquiring Contracts
or Customers Rather Than Developing Them Internally”. In this, Organizations can outsource
consumer purchases via an existing distribution network. The dealers will enable the company to
outsource a portion of its sales force that is not on the payroll of the company, but receives a lump
sum for each new customer. Many businesses can wrongly account for these "contract
acquisitions" as spending outflows when they ought to be the normal cost of soliciting customers
and therefore go into operating outflow, overstating CFFO.
Lastly, the author discusses “Boosting CFFO by Creatively Structuring the Sale of a Business.”.
In this, all revenue would normally be recorded as an investment influx from the sale of a company.
However, the company will reduce its selling price (and investing inflow) by eliminating the
receivables before the sale and soon collect the receivables from former customers and reporting
all proceeds as an operational inflow. The organization is thus able to move a portion of the capital
inflow into operating inflows. Moreover, some of the warning signs the author has identified are
See if a company sells a business, but sells all but the receivables. This is stated in a 10Q or 10 K
divulgation concerning the selling of a product. Do not be fooled that a sustainable CFFO is
created.
The author then focuses his attention towards the last cash flow shenanigan which is “Boosting
Operating Cash Flow Using Unsustainable Activities”. The author highlights and discusses four
different methods the management of the company can get it itself involved in this cash flow
shenanigan namely (1). Boosting CFFO by Paying Vendors More Slowly (2). Boosting CFFO by
Collecting from Customers More Quickly (3). Boosting CFFO by Purchasing Less Inventory (4).
Boosting CFFO with One-Time Benefits.
The author gives some famous examples to illustrate this cash flow shenanigan. For example,
UTStarcom, a supplier of telecom equipment, announced a significant increase in CFFOs in the
beginning of 2008. UTStarcom unexpectedly announce positive cash flow of US$ 97 million in
March 2008, following a miserable stretch in 2007, which saw a string of four consecutive quarters
of negative CFFOs (for a total cash burn of $218 million. Investors may easily have found that a
number of particularly aggressive working capital activities resulted from the cash flow turnover.
A quick look into the balance sheet shows a fall of 65 million dollars in liabilities and a rise in
payable accounts of 66 million dollars.
After discussing all the Cash flow shenanigans, the author directs his attention towards the “Key
Metrics shenanigans”. There are two major key Metrics shenanigans that the author highlights and
discusses in this book namely (1) Showcasing Misleading Metrics That Overstate Performance.
(2): Distorting Balance Sheet Metrics to Avoid Showing Deterioration.
Starting with the first Key metric shenanigan “Showcasing Misleading Metrics That Overstate
Performance”, the author states three methods that the management can use to manipulate
performance of the company namely (1) Highlighting a Misleading Metric as a Surrogate for
Revenue (2). Highlighting a Misleading Metric as a Surrogate for Earnings (3). Highlighting a
Misleading Metric as a Surrogate for Cash Flow.
Some of the warning signs the author has mentioned for the investors to look out for are
Underlining an erring calculation as a proxy for profit. Secondly, the management pretends that
recurring charges are nonrecurring in nature. Moreover, the management deliberately pretends that
recurring earnings recur in nature. Furthermore, the investor identifies an inaccurate metric as a
replacement for cash flow. To illustrate this Key Metric shenanigan, the author has given some
famous examples such as the case of open wave systems it silently changes the meaning of net
profit of non-GAAP twice in more than two successive years. Furthermore, the investor should
know that Ignoring adjustments to working capital when measuring cash flow would give you a
fictitious portrait of the cash generation capacity of a business – businesses must adapt to working
capital using the indirect method of cash flow presentation. Moreover, before placing any faith,
investors must understand what the metric is because of the varying definitions of bookings and
backlogs across companies. If the metric is a key performance measure for a business, investors
should use extra caution to ensure that the business does not alter its own booking concept in a
way that flatters the metric.
The second Key Metric Shenanigans that the author highlights and discusses in the book is
“Distorting Balance Sheet Metrics to Avoid Showing Deterioration”. The author discusses four
methods that the management of a company could try to fudge balance sheet metrics and not show
good performance of the company namely (1) Distorting Accounts Receivable Metrics to Hide
Revenue Problems (2). Distorting Inventory Metrics to Hide Profitability Problems (3). Distorting
Financial Asset Metrics to Hide Impairment Problems (4). Distorting Debt Metrics to Hide
Liquidity Problems
The author also highlights some of the warning signs the investors could look out for when
investing. For example, the investors should search for and classify explanations for changes in
receivables other than claims for the receivable. For example, the growth of bank notes and
commercial notes as businesses trade in their debts. The investors should always read footnotes to
see the inappropriate classification of this account. Moreover, the investors should see changes to
DSO computing by company e.g. computing based on termination of debts but changing to average
quarterly receivables. In addition to this, when a company changes how operating methods are
calculated, it attempts to prevent investors from deteriorating. Furthermore, if the investor notes a
CFFO rise from the selling of claims, it also becomes apparent that the DSO has also been
increasing by default. The sale of claims represents a financial decision and is driving DSO lower
and CFFO higher by selling the claims, not by operational effectiveness. The author has also
mentioned that Enterprises can turn accounts receivables into receivables – reclassifying them into
a non-investor-supervised account in order to minimize DSOs and deceive creditors by believing
that revenues are good and consumers have solved problems with payment on time and debt
problems.
The last chapter of the book provides a brief overview as to what was mentioned and learned in
the previous chapters. The author also gives a bigger picture of how to detect Financial shenanigans
by giving recommendations and examples of some of the companies previously mentioned in the
book. Moreover, the author then highlights all the warning signs of each financial shenanigan in
the form of tables to make it easy for the reader to understand.