New Lecture 7 Spring 09

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.

Lecture 7

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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: • • • •

Lecture 7

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 t Total Assets t

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

Revenue growth

Net Income

+ 0 Operations

+ 0 -

Introduction

Lecture 7

Growth

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Maturity

Decline

Reading and Interpreting the Statement of Cash Flows – CBRL Investing

Financing

Lecture 7

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Reading and Interpreting the Statement of Cash Flows

Company A ______________

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Net Income Depreciation & Amort. Amort. of Goodwill and Intangibles Other Amortization (Gain) Loss From Sale Of Assets (Gain) Loss On Sale Of Invest. (Income) Loss on Equity Invest. Stock-Based Compensation Provision & Write-off of Bad debts Other Operating Activities Change in Acc. Receivable Change in Acc. Payable Change in Unearned Rev. Change in Other Net Operating Assets Cash from Ops.

For fiscal year ended 12/31/2004 12/31/2005 12/31/2006 (Amounts in Millions) (642.4) (666.7) (718.9) 145.9 144.6 167.6 1.3 1.3 1.3 18.5 30.2 41.3 (4.5) 76.6 0.5 23.2 2.0 6.0 68.0 3.2 8.3 15.2 157.3 75.5 112.4 (8.4) (35.4) (37.5) 57.4 125.8 (102.2) 98.5 208.3 66.1 91.5 (65.0) (170.8) (75.2) (166.7) (462.1)

Capital Expenditure Sale of Property, Plant, and Equipment Invest. in Marketable & Equity Securt. Other Investing Activities Cash from Investing

(169.9) 133.6 (36.3)

(179.8) (25.3) (1.0) (206.1)

(275.0) 7.2 3.4 (264.4)

Long-Term Debt Issued Short Term Debt Repaid Long-Term Debt Repaid Issuance of Common Stock Repurchase of Preferred Other Financing Activities Cash from Financing

533.3 (103.0) (232.6) 236.8 (23.4) 411.1

100.0 (47.9) 319.6 (5.8) 366.0

800.0 (499.8) 6.4 (24.0) (48.8) 233.8

(6.9)

(492.8)

Net Change in Cash

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299.6

Reading and Interpreting the Statement of Cash Flows

Company B ______________

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Net Income Depreciation & Amort. Amort. of Goodwill and Intangibles (Gain) Loss From Sale Of Assets Asset Writedown & Restructuring Costs (Income) Loss on Equity Invest. Net Cash From Discontinued Ops. Other Operating Activities Change in Acc. Receivable Change In Inventories Change in Other Net Operating Assets Cash from Ops.

For fiscal year ended 12/31/2005 12/31/2006 12/31/2007 (Amounts in Millions) (1,261.0) (601.0) 676.0 890.0 900.0 785.0 121.0 146.0 (78.0) (65.0) (157.0) 640.0 426.0 336.0 (12.0) 28.0 (37.0) 250.0 (103.0) (988.0) 228.0 157.0 161.0 306.0 271.0 108.0 96.0 (175.0) (569.0) 1,208.0 956.0 315.0

Capital Expenditure Sale of Property, Plant, and Equipment Cash Acquisitions Divestitures Invest. in Marketable & Equity Securt. Cash from Investing

(472.0) 130.0 (984.0) 22.0 (1,304.0)

(379.0) 178.0 (3.0) (21.0) (225.0)

(259.0) (2.0) 2,676.0 (7.0) 2,408.0

Long-Term Debt Issued Short Term Debt Repaid Long-Term Debt Repaid Issuance of Common Stock Common Dividends Paid Other Financing Activities Cash from Financing

2,520.0 (126.0) (1,672.0) 12.0 (144.0) (57.0) 533.0

765.0 (11.0) (1,557.0) (144.0) (947.0)

177.0 (1,363.0) 6.0 (145.0) 44.0 (1,281.0)

Foreign Exchange Rate Adj. Net Change in Cash

(27.0) 410.0

20.0 (196.0)

36.0 1,478.0

Economic Consequences of Earnings Manipulation Example: Cendant Corporation

Cendant Corporation to Restate Earnings

C

April 15, 1998-endant 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). Lecture 7

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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)

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

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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: Factor DSRI (Days sales in receivables)* GMI (Gross margin index)*

Effect or Precondition?

Intuition Booking fictitious sales

Effect 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)* SGAI (SG&A index) TATA (Total accruals to total assets)* LVGI (Leverage)

Stretching useful lives Effect Precondition Effect

Distortions in accruals from manipulation Avoid violating debt covenants

Precondition

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Increased advertising to stem falling demand

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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

Calculation

DSRI (Days sales in receivables)*

%Rect/%Rect-1

GMI (Gross margin index)*

%GMt-1 / GMt

AQI (Asset quality index)*

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

SGI (Sales growth index)*

Salest / Salest-1

DEPI (Depreciation index)* SGAI (SG&A index) TATA (Total accruals to total assets)* LVGI (Leverage)

Sample Averages Manipulators Control 1.46

1.03

1.19

1.01

1.25

1.04

1.61

1.13

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

1.08

0.97

%SGAt / %SGAt-1

1.04

1.05

As defined prev.

0.031

0.018

(LTD+CL / TA) t / (LTD+CL / TA) t-1

1.11

1.04

%Rec=AR/Sales

%GM=(sales-cogs) / sales

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-scoreWorksheet (you need to input therelevant data) TheFull Beneish model for earnings manipulation detection (Based on Eight Variables) Input data in shaded green cells INPUT VARIABLES Net Sales CGS Net Receivables Current Assets (CA) PPE (Net) Depreciation Total Assets SGA Expense Net Income (before Xitems) CFO (Cash flow from operations) Current Liabilities Long-term Debt

2008 2,384,521 744,275 13,484 220,639 1,045,240 57,689 1,313,703 127,273 162,065 124,510 274,669 787,775

2007 2,351,576 706,095 11,759 200,281 1,018,982 56,908 1,265,030 136,186 116,291 96,872 330,533 764,494

DERIVED VARIABLES Other L/T Assets [TA-(CA+PPE)]

47824

45767

DSRI GMI

1.131 1.017

AQI SGI DEPI SGAI TATA LVGI

1.006 1.014 1.011 0.922 0.029 0.934

Company: Cracker Barrel

M =-4.84 +.920 DSRI +.528 GMI +.404 AQI +.892 SGI +.115 DEPI -.172 SGAI +4.679 TATA - .327 Leverage M-score(8-variablemodel)

-2.17

Note: if M <-1.78, firmdoes not havecharacteristics of a manipulator

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

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M-scoreWorksheet (you need to input therelevant data) TheFull Beneish model for earnings manipulation detection (Based on Eight Variables) Input data in shaded green cells INPUT VARIABLES Net Sales CGS Net Receivables Current Assets (CA) PPE (Net) Depreciation Total Assets SGA Expense Net Income (before Xitems) CFO (Cash flow from operations) Current Liabilities Long-term Debt

2000 100789 94517 10396 30381 15459 855 65503 3184 979 4779 28405 8550

1999 40112 34761 3030 7255 13912 870 33381 3045 1024 1228 6759 7151

DERIVED VARIABLES Other L/T Assets [TA-(CA+PPE)]

19663

12214

DSRI GMI

1.365 2.144

AQI SGI DEPI SGAI TATA LVGI

0.820 2.513 1.123 0.416 -0.058 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-variablemodel)

-0.54

Note: if M <-1.78, firmdoes not havecharacteristics of a manipulator

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Company: Enron Corp.

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. Company Name

Flagged as manipulator?

Adelphia Communications American International Group, Inc. AOL Time Warner, Inc. Cendant Corporation Citigroup Computer Associates International, Inc. Enron Broadband Services, Inc. Global Crossing, Ltd HealthSouth Corporation JDS Uniphase Corporation Lucent Technologies, Inc Motorola Qwest Communications International Rite Aid Corporation Sunbeam Corporation Tyco International Vivendi Universal Waste Management Inc WorldCom Inc. - MCI Group Xerox Corporation

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Year Year Market Cap Market Cap Flagged Discovered Lost ($B) Lost (%)

Yes

1999 N/A - Financial Yes 2001 Yes 1997 N/A - Financial

2002

4.82

96.8%

2002 1998

25.77 11.32

32.2% 38.1%

Yes 2000 2002 Yes 1998 2001 Yes 1999 2002 No 2002 Yes 1999 2001 Yes 1999 2001 N/A – Abetted Adelphia Yes Yes Yes No No Yes No No

2000 1997 1997

1998

2002 1999 1998 2002 2002 1999 2002 2000

7.23 36.4% 26.04 99.3% (Delisted due to bankruptcy) 2.31 57.3% 32.49 61.0% 11.15 24.7% 9.84 2.83 1.28 37.55 1.28 20.82 1.03 7.73

41.8% 59.1% 58.8% 58.2% 27.9% 63.6% 69.8% 43.8%