CFA Level I:FSA : Accounting shenanigans on the cash flow statement(Reading 34) indicate, increase

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1. Which of the following will most likely increase a company’s operating cash flow? An increase in: A. days sales payable (DSP). B. gains on the sale of long-term assets. C. use of operating leases versus financing leases.

Ans: A. An increase in the days sales payable would indicate the company is stretching out its payables (that is, delaying payments to its suppliers. By delaying payment, the firm effectively receives no-cost financing.), which would increase the cash from operations. B is incorrect. Gains (or loss) on the sale of assets has no effect on the net cash flow. It will be a reconciling item under operating cash flow on cash flow statements prepared using the indirect method. C is incorrect. While the overall change in cash is the same for both types of leases. For a finance lease, the cash outflow from the lease payments are allocated partly to an operating cash outflow (interest expense) under U.S.GAAP and partly to a financing cash outflow (repayment of the lease obligation principal). For an operating lease the entire cash outflow paid on the lease is recorded as an operating cash outflow.  So using of operating leases versus financing leases will decrease a company’s operating cash flow.

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. An analyst has found that a firm’s cash conversion cycle has decreased significantly over the past year and suspects accounting manipulation of cash flows. The least likely way for the company to have decreased its cash conversion cycle is by: A. financing payables. B. stretching out payables. C. securitization of receivables.

Ans: A. Cash conversion cycle = Days of inventory on hand (DOH) + Days Sales Outstanding (DSO) – days in payables. Financing payables reduces accounts payables, decreases days in payables, and lengthens the cash conversion cycle. B is incorrect. Stretching out payables increases accounts payable, increases days’ payable, and decreases the cash conversion cycle. C is incorrect. Securitization of receivables decreases receivables and days’ receivables, which decreases the cash conversion cycle.

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7. An analyst should most appropriately reclassify financing cash outflows as operating cash outflow is a firm has: A. financed its payables. B. securitized receivables. C. repurchased stock to offset dilution.

Ans: C. Firms that give employee stock options as part of compensation often buy back stock to offset the dilution from option exercise. Since the cost to the firm of option exercise is more properly a part of compensation expense, the analyst should reclassify the financing cash flow to repurchase shares as operating cash flow. Neither financing payables not securitizing receivables results in financing outflows.

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6. Which of the following trends may signal the beginning of a liquidity crisis for an entity? A. A shift from operating debt to financing liabilities. B. An increase in trade credit and decrease in retained earnings. C. A shift from operating debt to increases in owners’ contributed capital.

Ans: A. A shift from operating debt to financing liabilities may indicate a company has reduced access to trade credit and may signal the beginning of a liquidity crisis.

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5. Which of the following is the simplest way for a company to increase its reported operating cash flow? A. Record sales on a bill-and-hold basis. B. Slow down the rate of payment to suppliers. C. Use a third party financial institution to pay suppliers.

Ans: B. 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. A is incorrect. A bill-and-hold basis is one method of revenue recognition. It is a method of conducting sales by billing the customer on the same day the transaction occurs, but not delivering the goods until a later date. Using the bill-and-hold basis is sometimes regarded as a controversial proactive because allowing the seller to receive payment before transferring the product could be used to inflate revenues meant for subsequent quarters. C is incorrect. Using a third party financial institution to pay suppliers can delay the cash flow associated with payables. It can help the firm to manage the timing of the reported cash flows. But the financial institution will charge a fee to handle the arrangement. so slowing down the payment to supplier would be simpler.

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4. Which of the following transactions is least likely to increase a company’s reported cash from operations? A. Securitizing accounts receivable B. Delaying payments made to suppliers C. Using short-term debt to reduce an existing account payable

Ans: C. Using short-term debt to pay down payables will have no effect on the cash from operations. Payables will decrease which decreases cash from operations, but short-term debt will increase, which is an offsetting increase in cash from operations, resulting in no net effect on cash from operations.

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3. If a nonfinancial company securitizes its accounts receivables for less than their book value, the most likely effect on the financial statements is to increase: A. net income. B. cash from operations. C. cash from financing activities.

Ans: B. The securitization of accounts receivables for less than book value would result in a loss on the income statement, but an increase in the cash from operations, reflecting the proceeds received. A is incorrect. If a nonfinancial company securitizes its accounts receivables for more than their book value, the company can recognize a gain. But GAAP is silent on where the gains from securitizations should be reported in the income statement. Some firms take a more aggressive approach and include the gains as revenue (thus increase net income). Other firms reduce operating expenses by the amount of the gains. Some firms report the gains as a part of nonoperating income. C is incorrect. Firms can convert AR 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.

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2. A company reports that to maintain good relations with its suppliers, it has entered into a financing arrangement with a bank whereby it will periodically have the bank pay its suppliers the amounts owed and it will then repay the bank in the following period. The motivation for the company’s behavior is most likely to: A. improve its current ratio. B. improve its relations with its suppliers. C. manage the timing of operating cash flows.

Ans: C. The company can choose when to enter into the short-term borrowing with the bank and reclassify its accounts payable into short-term financing. It will likely do so when cash flows are seasonally strong, thereby reducing operating cash flows but increasing financing cash flows. On repayment, the cash outflow is treated as a financing activity (loan repayment) not an operating cash flow. The result is that the company can manipulate the timing of reported cash flows since the timing and extent of vendor financing is at management’s discretion.