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Asian Financial Statement Analysis: Detecting Financial Irregularities by Howard Schilit, Thomas R. Robinson, ChinHwee Tan

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CHAPTER 5

DETECTING OVERSTATED OPERATING CASH FLOWS*

This chapter examines how companies may massage reported numbers to inflate some measure of cash flow such as operating cash flow. Often, but not always, this accompanies an overstatement of earnings as presented in earlier chapters. The chapter provides a checklist of analysis techniques and warnings signs to help you detect cash flow manipulation.

While accrual accounting and the income statement essentially reflects the economic activity and profitability of the period, a company cannot pay employees, creditors, and others with accrual-based net income; for this, an understanding of cash flows is necessary. Valuation models used in financial analysis are often based on projections of future cash flows as it depicts the day-to-day operational financial viability of a business. Analysts would like to know the sources and uses of cash, particularly whether cash flow is derived from operating, investing, or financing activities. Some analysts use cash flow as a check on the quality of earnings. If a company is massaging its income statement to inflate income, this can be discovered by looking at the cash flow statement to see if it supports the strong income or contradicts it. There have been many cases where a company reports strong and rising earnings coupled with negative cash flows, which have turned out to be accounting frauds.

Nevertheless, the cash flow statement is not infallible and can be manipulated. As with net income, ...

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