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Sunday, February 19, 2006

cash flow three card monte, CF3CM

3 card monte is scam card trick involving 3 cards where after mixing the cards around the sucker is made to believe a queen is in one place when it's either not, or else they're fooled into thinking it's not.

Question: How many legs does a dog have if you count the tail as a leg.
Answer: Four, a tail isn't a leg.

Jack Ciesielski at the Accounting Observer ("AAO") Weblog posted this entry about an Atari restatement. He calls this phenomenon "cash flow arbitrage", although that term seems to be associated with GSEs like Fannie Mae and securitized debt obligations.

Jack links to Professor Charles Mulford's Financial Reporting and Analysis Lab which issued this report in 2004 about this phenomenon which led the SEC to crack down on the problem and the FRAL issued another report about it in 2005 (see below).

In cash flow three card monte (or "CF3CM"), a company sells something and instead of accepting a trade receivable, they accept a note receivable. But instead of associating the note receivable with operations, they shift it into investments. Then, when computing the cash flow statement, they place changes in this notes receivable account in cash flows from investing rather than cash flows from operations. That last step is the real trick.

The effect of this is to make it look like they received cash from the revenues and then turned around and invested that cash in a note receivable. Now that I think about it, I wonder if they ever try to get away with putting notes receivable with a duration of less than 3 months into the cash and cash equivalents account???

Apparently, companies had been doing this because SFAS 95 didn't specifically mention notes receivable.

The AAO weblog had an earlier article about floor plan financing falling into this category. I had seen a restatement of this type back when I was looking at HCAR. I didn't realize the significance at the time.

Categories to look for: long-term receivables, notes receivable, floor-plan notes, leases receivable, franchise receivables.

Note that lease receivables must fulfill any of these 4 criteria
  1. legal ownership of the asset transfers to the lessee at the end of the lease
  2. lease contains a bargain purchase option
  3. lease term is equal to or greater than 75% of the asset's estimated economic life
  4. present value of minimum lease payments is equal to or greater than 90% of the asset's fair market value
Three more mandatory criteria
  1. lessor can predict whether or not minimum lease payments will be collected
  2. additional costs to the lessor can be reasonably predicted
  3. the lessor's cost must be significantly greater than the fair market value of the asset (actually, the real criteria is the presence of a manufacturer/dealer profit from the deal)
Selling durable equipment in wholesale financing of a dealer's inventory: the report mentions that many of these have separate subsidiaries for financing. They mention Harley Davidson (HDI) which puts both wholesale and retail financing in the investing part of cash flows. When you look at the table of companies shown in the report and the effects of CF3CM on the cash flow statement, it's definitely material. In 2003, if GM had not done a CF3CM, their cash flows from operations would drop by more than 50%!

In the franchise receivables category, the examples in the report (7-Eleven, Applebees, Elmers, Emerging Vision, IHOP, Outback Steakhouse, Roma) didn't have as much of an impact on cash flows. It was still material.

What really impressed me about the Financial Reporting and Analysis Lab is that they went back after the companies they had identified were forced to restate their financials and determined how accurate their initial prediction was. But they didn't make it all that easy to see the accuracy.

First, they noted how huge the changes turned out to be. Catepillar went from providing $2.2 billion in 2003 to burning $5.6 billion in operations!!!

The difference between the predicted changes and the actual changes were large and varied. They were right on the money with Ford. They way overestimated the impact on GE. They greatly underestimated the impact on Harley Davidson. For Paccar, it looks like they had the years wrong. Textron was way off.

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