cash flow manipulation, cash flow exaggeration, how companies cheat through cash flows

1. DEPARTMENT OF BUSINESS AND INDUSTRIAL
MANAGEMENT
TERM ASSIGNMENT 2014-15
MANAGERIAL ACCOUNTING
FYMBA- SEM-I
SECTION-A
TOPIC: CASH FLOW FROM OPERATIONS
BY,
16: CHAWLA DIVYA
23: GANDHI SANI
44: LAPSIWALA MANSI
47: MAKWANA KALPESH
57: MODI NANCY
SUBMITTED ON-6TH DECEMBER, 2014
SUBMITTED TO – DR. NAMRTA KHATRI

2. BASIC OF CASH FLOW:-
Meaning:-
 It shows the amount of cash generated and used by a company in a given period.
 It is calculated by adding noncash charges (exp: depreciation) to net income after
taxes.
 Cash flow can be attributed to a specific project, or to a business as a whole.
OBJECTIVES OF CASH FLOW STATEMENT
The objectives of cash flow statement are:
1) To ascertain the sources from activities (i.e., operating/investing/financing
activities) from which cash and cash equivalents were generated by an
enterprise.
2) To ascertain the uses by activities (i.e., operating/investing/financing activities)
for which cash and cash equivalents were used by an enterprise.
3) To ascertain the net change in cash or cash equivalents indicating the difference
between sources and uses from or by the three activities between the dates of
two Balance Sheets.
4) To tell how much cash come in during period, how much cash went out and what
the net cash flow was during the period.
5) To explain causes for changes in cash balance.
6) To identify financial needs and help in forecasting future cash flows.
CLASSIFICATION OFCASH FLOW:-
 There are mainly three types of activities included into cash flow statement:
1. Operating Activities
2. Investing Activities
3. Financing Activities

3. 1. Operating Activities:
 Operating activities are the principal revenue producing activities of the
enterprise and other activities that are not investing or financing activities.
 Operating activities include the production, sales and delivery of the company's
product as well as collecting payment from its customers. This could include
purchasing raw materials, building inventory, advertising, and shipping the
product.
 Generally, changes made in cash, accounts receivable, depreciation, inventory
and accounts payable are reflected in cash from operations.
 Cash flow is calculated by making certain adjustments to net income by adding
or subtracting differences in revenue, expenses and credit transactions
(appearing on the balance sheet and income statement) resulting from
transactions that occur from one period to the next. These adjustments are made
because non-cash items are calculated into net income (income statement) and
total assets and liabilities (balance sheet). So, because not all transactions
involve actual cash items, many items have to be re-evaluated when calculating
cash flow from operations.
 For example, depreciation is not really a cash expense; it is an amount that is
deducted from the total value of an asset that has previously been accounted for.
That is why it is added back into net sales for calculating cash flow. The only time
income from an asset is accounted for in CFS calculations is when the asset is
sold.
 Changes in accounts receivable on the balance sheet from one accounting period
to the next must also be reflected in cash flow. If accounts receivable decreases,
this implies that more cash has entered the company from customers paying off
their credit accounts - the amount by which AR has decreased is then added to
net sales. If accounts receivable increase from one accounting period to the next,
the amount of the increase must be deducted from net sales because, although
the amounts represented in AR are revenue, they are not cash.

4. 2. Investing Activities:
 Investing activities are the acquisition and disposal of long-term assets and other
investments not included in cash equivalents. These activities include
transactions involving purchase and sale of long term productive assets like
machinery, land, etc., which are not held for resale.
 Changes in equipment, assets or investments relate to cash from investing.
Usually cash changes from investing are a "cash out" item, because cash is used
to buy new equipment, buildings or short-term assets such as marketable
securities. However, when a company divests of an asset, the transaction is
considered "cash in" for calculating cash from investing.
OperatingActivities
Cash Inflows
cash sales
cash recieved from the debtors
cash receieved from commision
and fees
Royalty
In Case of financial companies
Cash received for Interest and
Dividends
Sale of Securities
Cash Outflows
Cash purchase
Payment to creditors
Cash operatingexpenses
Payment ofWages
Income Tax
In Case of financial companies
Cash paid for interest
Purchase of Securities

5. 3. Financing activities
 Financing activities are the activities that result in change in the size and
composition of the owner’s capital (including preference share capital in the case of
a company) and borrowing of the enterprise. Changes in debt, loans
or dividends are accounted for in cash from financing. Changes in cash from
financing are "cash in" when capital is raised, and they're "cash out" when dividends
are paid. Thus, if a company issues a bond to the public, the company receives cash
financing; however, when interest is paid to bondholders, the company is reducing
its cash.
 The separate disclosure of cash flows arising from financing activities is important
because it is useful in predicting the claims on future cash flows by the providers of
funds.
Investing
Activities
Cash Inflows
Sale of Fixed Assets
Sale of Investments
Interestreceived
Dividends received
Cash Outflows
Purchaseof Fixed
Assets
Purchaseof
Investments

6. Methods of calculating Operating Income
1. Direct Method: Reports operating cash flows as sources, uses of cash
2. Indirect Method: Reports operating cash by adjusting accrual net income to
cash flows.
Direct Method
 The cash inflows and cash outflows are directly reported on the statement of cash
flows.
 For instance, if cash received from customers as the cash effect of sales activities,
and cash paid to suppliers as the cash effect of cost of goods sold.
 Income statement items that have no cash effect are simply not reported. Such as
depreciation expenses, gains and losses on the sale of assets , etc.
 The direct method of presenting the statement of cash flows presents the specific
cash flows associated with items that affect cash flow. Items that typically do so
include:
Financing
Activities
Cash Inflows
Issue of shares in
Cash
Issue of Debentures
in cash
Proceeds from Long-
term borrowings
Cash Outflows
Paymentof Loans
Redemption of
preferenceshares
Cash Buy-back of Equity
shares
Paymentof Dividend
Paymentof Interest

7. o Cash collected from customers
o Interest and dividends received
o Cash paid to employees
o Cash paid to suppliers
o Interest paid
o Income taxes paid
Performa:-
Particulars Amount
Cash Receipts from Customers xxx
Cash Paid to suppliers and employees Xxx
Cash generated from Operations Xxx
Income Tax Paid Xxx
Cash Flow before Extra-ordinary Items Xxx
Extra-ordinary items Xxx
Net Cash from Operating Activities (Direct Method) Xxx
Indirect Method
 While preparing the Cash Flow Statement as per the Indirect Method, the Net
Profit/Loss for the period is used as the base and then adjustments are made for
items that affected the Income Statement but did not affect the Cash.
 While preparing the Cash Flow Statement as per the Indirect Method, Non Cash
and Non Operating charges in the Income Statement are added back to the Net
Profits while Non-Cash & Non-Operating Credits are deducted to calculate the
Operating Profit before Capital Changes. The Indirect Method of preparing of

8. Cash Flow Statement is a partial conversion of accrual basis profit to Cash basis
profit. Further, necessary adjustments are made for Increase/Decrease
in Current Assets and Current Liabilities to obtain Net Cash Flows from
Operating Activities as per the Indirect Method.
Format of Cash Flows from Operating Activities – Indirect Method
Particulars Amount
Net Profit before Tax and Extra-ordinary items Xxx
Adjustments for
- Depreciation Xxx
- Foreign Exchange Xxx
- Investments Xxx
- Gain or Loss on Sale of Fixed Assets Xxx
- Interest Dividend Xxx
Operating Profit before Working Capital Changes Xxx
Adjustments for
- Trade and Other Receivables Xxx
- Inventories Xxx
- Trade Payable Xxx
Cash generated from Operations Xxx
- Interest Paid (xxx)
- Direct Taxes (xxx)
Cash before Extra-Ordinary Items Xxx
Deferred Revenue Xxx
Net Cash Flow from Operating Activities (Indirect Method) Xxx

9. Manipulation FROM cash flow(operations)
Reasons for Cash Flow Manipulation
1. Cash flow is often considered to be one of the cleaner figures in the financial
statements. (WorldCom, however, has proved that this isn't true.)
2. Companies benefit from strong cash flow in the same way that an athlete
benefits from stronger muscles - a strong cash flow means being more attractive
and getting a stronger rating. After all, companies that have to use financing to
raise capital, be it debt or equity, can't keep it up without exhausting
themselves.
3. The corporate muscle that would receive the cash flow accounting injection
is operating cash flow (OCF). It is found in the cash flow statement, which comes
after the income statement and balance sheet.
Howthe Manipulation Is Done?
1) Dishonesty in Accounts Payable
 Companies can bulk up their statements simply by changing the way they deal with
the accounting recognition of their outstanding payments, or their accounts payable.
For Example
 When a company has written a check and sent it to make an outstanding payment,
the company should deduct its accounts payable. While the "check is in the mail",
however, a cash-manipulating company will not deduct the accounts payable with
complete honesty and claim the amount in the operating cash flow (OCF) as cash on
hand.
2) Non-Operating Cash
 A subtler steroid is the inclusion of cash raised from operations that are not related
to the core operations of the company.

10.  Non-operating cash is usually money from securities trading, or money borrowed
to finance securities trading, which has nothing to do with business. Short-term
investments are usually made to protect the value of excess cash before the
company is ready and able to put the cash to work in the business's operations. It
may happen that these short-term investments make money, but it's not money
generated from the power of the business's core operations.
 Therefore, because cash flow is a metric that measures a company's health, the cash
from unrelated operations should be dealt with separately. Including it would only
distort the true cash flow performance of the company's business activities. GAAP
requires these non-operating cash flows to be disclosed explicitly. And you can
analyze how well a company does simply by looking at the corporate cash flow
numbers in the cash flow statement.
3) Questionable Capitalizationof Expenses
 Also a subtle form of doping, we have the questionable capitalization of expenses.
For Example
 A company has to spend money to make products. The costs of production come out
of net income and therefore operating cash flow. Instead of taking the hit of an
expense all at once, companies capitalize the expense, creating an asset on the
balance sheet, in order to spread the expense out over time - meaning the company
can write off the costs gradually. This type of transaction is still recorded as a
negative cash flow on the cash flow statement, but it is important to note that when
it is recorded it is classified as a deduction from cash flow from investing
activities (not from operating cash flow).
 Certain types of expenditures - such as purchases of long-term manufacturing
equipment - do warrant capitalization because they are a kind of investing activity.
 The capitalization is questionable if the expenses are regular production expenses,
which are part of the operating cash flow performance of the company. If the regular

11. operating expenses are capitalized, they are recorded not as regular production
expenses but as negative cash flows from investment activities. While it is true that
the total of these figures operating cash flow and investing cash flow - remain the
same, the operating cash flow seems more muscular than that of companies that
deducted their expenses in a timely fashion.
 Basically, companies engaging in this practice of capitalizing operating expenses are
merely juggling an expense out of one column and into another for the purpose of
being perceived as a company with strong core operating cash flow. But when a
company capitalizes expenses, it can't hide the truth forever. Today's expenses will
show up in tomorrow's financial statements, at which time the stock will suffer the
consequences.
4) Stretching Out Payables
 The simplest thing that companies can do to improve reported operating cash flow
is to slow down the rate of payments to their vendors.
 Extending out vendors used to be interpreted as a sign that a company was
beginning to struggle with its cash generation. Companies now “spin” this as a
prudent cash-management strategy. Another consequence of this policy is to boost
the reported growth in cash flows from operations. In other words, reported
operating cash flows can be improved due solely to a change in policy to slow the
payment rate to vendors. If analysts or investors expect the current period
improvement to continue, they may be mistaken; vendors will eventually put
increasing pressure on the company to pay more timely. Therefore, any benefit may
be unsustainable or, at minimum, any year-over-year improvement in operating
cash flow may be unsustainable.
 The extension of payables can be identified by monitoring day’s sales in payables
(DSP).
 This metric is calculated as the end-of-period accounts-payable balance divided by
the cost of goods sold and multiplied by the number of days in the period.
 As DSP grow, operating cash flows are boosted.

12. For Example
 General Electric Corporation began stretching out its payables in 2001 and therefore
received boosts to operating cash flow. however, that while the company received a
significant benefit to cash flows from operations in 2001, that benefit began to slow
in subsequent periods, indicating that GE will probably be unable to continue to fuel
growth in operating cash flow using this method. Interestingly, GE modified some
executive compensation agreements to include cash flow from operations as a
metric on which management is evaluated.
5) Financing of Payables
 A more complicated version of stretching out payables is the financing of payables.
This occurs when a company uses a third-party financial institution to pay the
vendor in the current period, with the company then paying back the bank in a
subsequent period.
For Example
 An arrangement between Delphi Corporation and General Electric Capital
Corporation shows how seemingly innocuous ventures can affect operating cash
flows. The arrangement allowed Delphi to finance its accounts payable through GE
Capital. Specifically, GE Capital would pay Delphi’s accounts payable each quarter. In
return, Delphi would reimburse GE Capital the following quarter and pay a fee for
the service.
 This agreement provided Delphi with a means to change the timing of its operating
cash flows. In the first quarter of the venture, Delphi did not have to expend any
cash with respect to accounts payable to vendors. The impact to operating cash
flows can be seen in Delphi’s accounting for the agreement with GE Capital. After GE
Capital paid the amounts due from Delphi to its vendors, Delphi reclassified these
items from accounts payable to short-term loans due to GE Capital. Delphi did this in
a quarter in which cash flows were seasonally strong and it had access to the

13. accounts-receivable securitization facilities. The reclassification resulted in a
decrease to operating cash flow in that quarter, and an increase in financing cash
flows. In the subsequent quarter, when Delphi paid GE Capital, the cash outflow was
accounted for as a financing activity because it was a repayment of a loan. Normally,
cash expenditures for accounts payable are included in operating activities.
Therefore, because of the arrangement, Delphi was able to manage the timing of
reported operating cash flows each period because the timing and extent of the
vendor financing (and offsetting receivables securitizations) was at the discretion of
company management.
 Another example shows that the accounting profession has been slow to adapt to
these types of transactions. During 2004, three companies in the same industry—
AutoZone, Pep Boys, and Advance Auto Parts—all financed payments to vendors
through a third-party financial institution. In other words, similar to Delphi above,
the financial institution paid the vendors on behalf of the respective automotive
company. Subsequently, the company paid back the bank, thereby slowing down its
rate of payment to the vendors and boosting its operating cash flow. While each of
these auto parts companies used a similar process for financing payables, each
reflected it differently on its cash flow statement. Interestingly, two of these
companies had the same auditor. This disparity in accounting treatment made
analysts’ comparisons of free cash flow yields for each of these companies
irrelevant.
6) Selling Accounts Receivable/ Securitizations ofReceivables
 Another way a company might increase operating cash flow is by selling off
its accounts receivable. This is also called securitizing.
 The agency buying the accounts receivable pays the company a certain amount of
money, and the company passes off to this agency the entitlement to receive the
money that customers owe. The company therefore secures the cash from their
outstanding receivables sooner than the customers pay for it. The time between
sales and collection is shortened, but the company actually receives less money than

14. if it had just waited for the customers to pay. So, it really doesn't make sense for the
company to sell its receivables just to receive the cash a little sooner - unless it is
having cash troubles, and has a reason to cover up a negative performance in the
operating cash flow column.
7) Tax Benefits from StockOptions
 Most companies currently follow Accounting Principles Board (APB) Opinion 25,
which generally allows companies to avoid recording stock options as an expense
when granted. Current IRS rules do not allow a company to take a deduction on its
tax return when options are granted. At the time the stock option is exercised,
however, the company is permitted to take a deduction on its tax return for that
year reflecting the difference between the strike price and the market price of the
option. On the external financial statements reported to investors, that deduction
reduces (debits) taxes payable on the balance sheet, with the corresponding credit
going to increase the equity section (additional paid-in-capital).
 A question developed over how to classify this tax benefit (reduction of the taxes
payable) on the cash flow statement. Some companies had been including it as an
add back to net income in the operating section of the cash flow statement; others
included it as a financing activity. FASB’s Emerging Issues Task Force (EITF) Issue
00-15, released in July 2000, specifically indicated that a reduction in taxes payable
should, if significant, be shown as a separate line item on the cash flow statement in
the operating section (i.e., as a source of cash). [SFAS 123(R), Share-Based Payment,
which requires options to be expensed, also relegates the excess tax benefit to the
financing section of the cash flow statement. SFAS 123(R) takes effect for fiscal years
beginning after June 15, 2005.] If the company does not disclose the tax benefit in
the operating section or in the statement of changes in stockholders equity, then
EITF 00-15 provided that the company should disclose any material amounts in the
notes to the financial statements. The tax benefit is sometimes disclosed only in the
annual statement of stockholders equity, rather than as a separate line item in the
operating section of the cash flow statement for investors to analyze.

15.  To the extent that operating cash flow is affected by a growing impact from the tax
benefit on stock options, an investor should question whether the reported
operating cash flow growth is in fact sustainable and is indicative of improved
operations. In fact, the boost to operating cash flow is often greatest in a period
when the stock price has increased. In other words, when the stock is performing
well, more stock options are exercised, resulting in a higher tax benefit, which is
included as a source of operating cash flow, implying improving growth of operating
cash flow. Because companies in the technology sector use stock options to a higher
degree, these entities may require more-careful scrutiny. (This is an issue, however,
only when a company has taxable income and the taxes that it would have paid are
avoided by this tax benefit. If a company has a loss, there is no boost to operating
cash flow.) Analysts and investors should thoroughly review the cash flow
statement, the stockholders equity statement, and the notes to the financial
statements to glean the volume of options exercised during the period, and the
related tax benefit included as a source of operating cash flow.
8) StockBuybacks to Offset Dilution
 A second issue related to stock options that affects reported cash flows is the
buyback of company stock. A large number of companies have, in recent periods,
been buying back their own stock on the open market. In a majority of cases, this
activity is due to stock-option activity. Specifically, as stock prices generally
increased in 2003, many of those who held stock options exercised those relatively
cheap options. If companies did nothing to offset the larger number of outstanding
shares that existed as a result of the growing number of in-the-money options,
earnings per share would be negatively affected. Management of such companies
therefore face a choice: They can allow earnings per share to be diluted by the
growing share count or they can buy back company stock to offset that dilution.
 From an accounting standpoint, the impact of options on the income statement is
usually minimal, as discussed above. On the cash flow statement, the tax benefit of
option exercises is a source of operating cash flow, benefiting those companies

16. whose option exercises grow. Cash expended by a company for the buyback of
corporate stock, however, is considered a financing activity on the cash flow
statement. Consequently, as option exercises grow, so does the boost to operating
cash flows for the tax benefit, but the outflows for stock buybacks to offset dilution
of earnings are recorded in the financing section of the cash flow statement.
 Interestingly, as a company’s stock price rises, more options are generally exercised
and the company must buy back more stock at the ever-higher market prices. In
some cases, the entire amount of cash flow generated by operations in recent
periods could be expended to buy back company stock to offset the dilution from in-
the-money options. Therefore, when analyzing the true earnings power of a
company as measured by cash flows, it is important to consider the cash expended
to buy back stock to offset dilution. This cash outflow should be subtracted from the
operating cash flow in order to calculate the true free cash flow the company
generated in the period in question.
9) Other Means
 Many other means exist by which companies can influence the timing or the
magnitude of reported free cash flows. Increasing the use of capital lease
transactions as a way to acquire fixed assets obfuscates free cash flow because
capital expenditures may be understated on a year-over-year basis. The accounting
for outstanding checks and financing receivables are additional examples. In fact,
General Motors and others have restated prior years’ reported cash flow results in
order to reflect the SEC’s increased scrutiny of finance receivables. The restatement
amounted to a downward revision of almost half of the reported operating cash
flow.
 Some companies have pointed analysts toward different metrics, such as operating
cash flows, which are believed to be a more transparent indicator of a company’s
performance. The quality of a company’s cash flows must be assessed, as highly
motivated and intelligent management teams have created new ways to obfuscate
the true picture of a company’s operations. Auditors must be aware of the new focus

17. by users of financial statements on operating cash flows, and adjust their work
accordingly in order to provide the most value to the public.
How to Detect these Frauds:
Key methods (These should be part of your process for analyzing companies!):
1. Track Days’ Payables Outstanding, Days’ Sales Outstanding and Days’ in
Inventory over time and note apparent shifts in payment policies. These three items
are used to calculate the Cash Conversion Cycle, which is an important metric for
many businesses and should be calculated and tracked.
2. Track the different line items on the Statement of Cash Flows over time, and note big
swings. It may help to adjust for swings to get a clearer picture of the free cash flow
that the company generates in a sustainable manner.
3. Watch for swings in soft liabilities like “other payables” that might indicate the
company is pushing tax payments or payroll forward.
4. Watch for new disclosures about Prepayments (“due to an increase in customer
prepayments”) related to the discussion of Accounts Receivable increases (in the
notes to the Statement of Cash Flows).
5. Watch for disclosures about offering discounted terms for early payment. This will
also affect the gross margin, as these discounts would affect COGS, so you might
uncover this shenanigan by investigating changes in the gross margin.
Summary
 Whether it is the world of sports or the world of finance, people will always find
some way to cheat; only a paralyzing amount of regulation can ever remove all
opportunities for dishonest competition and business requires reasonable
amounts of operating freedom to function effectively. Not every athlete is cycling
anabolic steroids, just as many companies are honest on their financial
statements. That said, the existence of steroids and dishonest accounting
methods mean that we have to treat every gold medalist and every company's
financial statement with the proper amount of scrutiny before we accept them.

18. Bibliography
1. http://www.investopedia.com/exam-guide/cfa-level-
1/financial-statements/cash-flow-direct.asp
2. http://www.accountingtools.com/cash-flows-direct-method
3. http://accountingexplained.com/financial/statements/cash-
flow-operating-activities-direct-method