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Acquisition Accounting Shenanigan No. 2: Inflating Reported Cash Flow
The Friday after Thanksgiving is generally considered the unofficial start of the holiday shopping season. Traditionally, it is one of the biggest shopping days of the year, if not the biggest. The day has long been called “Black Friday” since many people are hopeful that it will be the day when retailers move “into the black” (accounting slang for “turning a profit”) for the year. Every time Black Friday approaches, retailers are quick to remind us of all the holiday shopping we need to do. They offer huge sales and fill the airwaves and newsprint with “Shop ’til You Drop” advertisements trying to lure us into their stores.
Tyco and WorldCom seemed to adhere to the “Shop ’til You Drop” mantra quite literally; however, they were buying entire businesses, and their holiday season ran all year long for many years. In the late 1990s and early 2000s, both companies went on lavish shopping sprees, acquiring business after business to fuel impressive performance. Organic growth at Tyco and WorldCom was much weaker than investors realized, though, as the companies hid their problems by acquiring oodles of companies and futzing with the accounting to show impressive results. They shopped and shopped—until the exposure of their massive accounting frauds caused them to drop like a ton of bricks.
Throughout their shopping sprees, both companies satiated investors and quashed naysayers by consistently reporting strong cash flow from operations. However, this cash flow was not a sign of operational strength at all. Rather, it came mainly from a liberal use of AA Shananigan No. 2: Inflating Reported Cash Flow.
In this chapter, we will discuss three techniques by which Tyco, WorldCom, and other companies use acquisitions and disposals to enhance and flatter CFFO.
Acquisition Accounting Techniques to Artificially Boost Cash Flow from Operations
1. Inheriting Operating Inflows in a Normal Business Acquisition
The cash flow shifting tricks in this chapter have many similarities to the ones we discussed in Chapter 11; they represent shifts between the Operating section and other sections. However, in this chapter, we focus solely on shifts that are related to acquisitions and disposals. The first two techniques in this chapter involve shifting cash outflows from the Operating section to the Investing section, as shown in Figure 16-1.
Rabidly acquisitive companies such as Tyco and WorldCom often report impressive CFFO quarter after quarter. Faced with the opacity that is inherent whenever multiple sets of financial statements are suddenly combined, investors in these types of companies often rely more heavily on CFFO generation as a sign of business strength and earnings quality. Unfortunately, heavy reliance on CFFO for acquisitive companies is ill-advised because of a deep, dark secret that companies want to hide from investors.
Figure 16-1 Shifting Cash Outflows from Operating Activities to Investing Activities
This secret concerns an accounting quirk (read “loophole”) that enables acquisitive companies to show strong CFFO every quarter simply because they are acquiring other businesses. In other words, the mere act of acquiring a company provides a benefit to CFFO. How can this be true? Well, it’s a peculiar side effect from the accounting rules that segregate cash flows into three sections. The quirk is quite simple and easy to understand.
Imagine you are a company that is getting ready to make a business acquisition. When you pay for the acquisition, you do so without affecting CFFO. If you buy the company with cash, the payment is recorded as an investing outflow. If you offer stock instead, there is, of course, no cash outflow.
As soon as you gain control of the company, all the ins and outs of the acquired business become a part of the combined company’s operations. For example, when the newly acquired company makes a sale, you record that sale on your Income Statement as revenue. Similarly, when the newly acquired company collects cash from a customer, you record that collection on your Statement of Cash Flows (SCF) as an operating inflow. Think about the cash flow implications of this situation. For one, you could generate a new cash flow stream (the acquired business) without any initial CFFO outflow. In contrast, companies that seek to grow their business organically would generally first incur CFFO outflows to build the new business.
Additionally, now that you have inherited the receivables and inventory of the acquired business, you can generate an unsustainable CFFO benefit by rapidly liquidating these assets (that is, by collecting the receivables and selling the inventory). Normally, accounts receivable result from past cash expenditures (e.g., cash paid to purchase or manufacture the inventory sold). In other words, a cash inflow from collecting a receivable comes only after you have had a cash outflow to generate that receivable. When you acquire a company, however, and inherit its accounts receivable, the cash outflows involved in generating those receivables were recorded on the acquired company’s books prior to the acquisition. This means that when you collect these receivables, you will be receiving an operating cash inflow without ever having recorded a corresponding operating cash outflow. The same is true with inventory. The proceeds received from selling inventory inherited in an acquisition will be recorded as an operating inflow even though no operating outflow ever occurred.
Think of it this way: cash spent to purchase inventory and other costs related to the sale occurred before the acquisition, and when you close on the deal, you obviously must pay the seller for inventory, receivables, and so on, but those outflows are reflected in the Investing section. Then, after the deal closes, you collect all that delicious cash from customers and show it as inflows in the Operating section. By liquidating and not replenishing these assets (i.e.., keeping the acquired business’s inventories at a lower level), you can show an unsustainable benefit to cash flow. Brilliant! In an acquisition context, cash outflows never hit the Operating section, yet all the inflows do.
To be fair, when companies inherit working capital liabilities (such as accounts payable), then the acquirer will be on the hook for paying off the seller’s vendors and the cash paid will be an operating cash outflow. However, most acquisitions involve companies that have positive net working capital (more receivables and inventory than accounts payable).
It is important to realize that because this CFFO boost is simply an artifact of required acquisition accounting, even the most honest companies will benefit from inflated CFFO after an acquisition. Moreover, this boost may cause “quality of earnings” measures (such as comparisons of CFFO to net income) to improve, particularly if a company does not engage in any Earnings Manipulation Shenanigans at the time of the acquisition.
Serial Acquirers Receive This CFFO Boost Repeatedly
So far, we have established that by their very nature, acquisitions serve to boost CFFO. Consider the impact at companies that make numerous acquisitions every year, serial acquirers like Tyco and WorldCom. Many investors criticize serial acquirers for being able to produce revenue and earnings growth only inorganically by “rolling up” acquisitions.
These “roll-ups” often reject this criticism and point to their CFFO as proof that they are running the acquired businesses well and exploiting synergies. Many investors believe this hype because they fail to understand the lesson you just learned: stronger reported CFFO is merely an accounting side effect from acquiring numerous companies each year.
Putting the “Con” in Conglomerate
For some companies, these pure boosts to cash flow are seemingly not enough. They want to squeeze even more juice out of these acquisitions. Consider the following scenario, based on allegations in legal proceedings of Tyco’s behavior during the acquisition process.
Imagine that you work in the accounting department of a company that just announced that it was being bought by a serial acquirer. The acquisition has not officially happened yet, but it is a friendly takeover with lucrative terms, and the deal is likely to close before the end of the month. The new owners want to start coordinating operations.
In walks one of the finance executives from the acquirer. He calls a meeting with the team and discusses some logistics that he says will help the transition go more smoothly. He points to a pile of checks—payments from customers that you had planned to deposit later that day. “You see all those checks? I know you normally deposit them at the end of the day, but let’s hold off on that for now. Put them in the drawer, and we’ll deposit them in a few weeks. And let’s call up our biggest customers and tell them that they can hold off on paying us for a few weeks. I know that sounds odd, but this will score us some points and ensure that they stay loyal through the transition.
“And you see that pile of bills? I know you normally wait until the deadline approaches to pay them; however, let’s pay them down ASAP. In fact, see if you can prepay any vendors or suppliers—I’m sure those folks would be willing to take our money and perhaps even give us a discount. We certainly have enough cash in the bank; let’s put it to good use.”
The day after the acquisition closes, the executive returns. “Now that we are one company, it’s time to go back to normal business procedure. Deposit those checks immediately and start collecting from customers. And stop paying those bills early—let’s wait until we get closer to the deadline.”
Think about the cash flow implications of this scenario. The target company’s CFFO was abnormally low in the weeks leading up to the acquisition because of abandoning collection efforts and paying down bills rapidly. However, once the acquisition closed, there were an unusually large number of receivables to collect and an unusually small number of bills to pay. This causes CFFO for your division to be abnormally high in the period immediately after the acquisition.
The finance executive had a trick up his sleeve. His reasons for abandoning collection efforts and prepaying vendors had little to do with engendering goodwill. He concocted this scheme to boost the CFFO of the combined company in the first quarter after the acquisition. Granted, the effect of this benefit would be short-lived; however, the executive knew that the scheme could continue if the company kept rolling up more and more acquisitions each quarter.
Tyco: The Mother of All Roll-Ups
This scenario is similar to allegations of what happened behind the scenes when Tyco made its acquisitions. And Tyco made a lot of acquisitions. From 1999 to 2002, Tyco bought more than 700 companies (not a typo) for a total of approximately $29 billion. Some of these acquisitions were large companies; however, most of the businesses acquired were small enough that Tyco considered them “immaterial” and chose to disclose nothing at all about them. Imagine the impact that this game could have with 700 companies worth a combined $29 billion! It should come as no surprise, then, that Tyco was able to generate strong CFFO over these years, as shown in Table 16-1. But it certainly was not from a booming business!
Table 16-1 Tyco’s Cash Flow from Operations (from Continuing Operations)
Treat CFFO Differently for Acquisitive Companies Since acquisitions create an unsustainable boost to CFFO, investors should not blindly rely on CFFO as a barometer of performance. Use free cash flow after acquisitions to assess cash generation at acquisitive companies. Table 16-2 shows that Tyco recorded negative free cash flow after acquisitions each year, despite reporting positive CFFO; this was a warning that operating cash flow was not what it appeared to be.
Table 16-2 Tyco’s Free Cash Flow After Acquisitions (from Continuing Operations)
TIP
“Free cash flow after acquisitions” is a useful measure of cash flow when analyzing serial acquirers. This metric can easily be calculated from the Statement of Cash Flows: CFFO minus capital expenditures minus cash paid for acquisitions.
Review the Balance Sheets of Acquired Companies If these documents are available, then absolutely review them. Doing so should help you gauge the potential inherent working capital benefits. It may be difficult to be precise in this analysis; however, you often will be able to make an assessment that is within the “ballpark” of the benefit. Companies often disclose the Balance Sheets of larger acquisitions and sometimes an aggregate Balance Sheet for smaller ones in their footnotes. If the acquired company had publicly traded stock or bonds, you can probably obtain a Balance Sheet from public records.
2. Acquiring Contracts or Customers Rather Than Developing Them Internally
In the previous section, we discussed how acquisitions, by their very nature, provide a boost to CFFO. This benefit results not from illegitimate accounting maneuvers, but rather from quirky accounting rules. We witnessed Tyco abusing the rules by quietly snapping up hundreds of small companies and finding ways to squeeze even more CFFO out of these acquisitions.
In this section, we take a step into more nefarious terrain and explore how companies use the acquisition accounting loophole for nonacquisition situations to shift normal operating cash flows to the Investing section.
Among the hundreds of businesses Tyco owned was an electronic security monitoring provider. Home security monitoring was a fast-growing industry in the 1990s, and Tyco’s ADT division proved to be among the most popular brand names. Tyco generated new security systems contracts in two ways: through its own direct sales force and through an external network of dealerships. The dealers allowed Tyco to outsource a portion of its sales force. They were not on Tyco’s payroll, but they sold security contracts, and Tyco paid them about $800 for every new customer.
Oddly, Tyco executives did not view these $800 payments to dealers to be normal customer solicitation costs, as the economics would suggest. Instead, they deemed these payments to be a purchase price for the “acquisition” of contracts. Thus, after the dealer presented Tyco with many contracts and received payment, Tyco curiously accounted for these “contract acquisitions” in the same way that it accounted for normal business acquisitions: as investing outflows.
Given how deeply the acquisition mentality was engrained in Tyco’s culture and DNA, you can almost picture the confusion among its executives. Almost. These customer solicitation costs resemble normal operating expenditures much more closely than they resemble business acquisitions. As a result, it makes more sense for them to be recorded on the Statement of Cash Flows in the same way that Tyco’s internal sales force commissions are recorded: as operating outflows. By classifying these operating outflows in the “acquisitions” line in the Investing section, Tyco found a convenient way to overstate CFFO. And the company didn’t stop there!
From Aggressive Accounting to Fraud
By turning the Investing section into a hidden dumping ground for customer solicitation costs, Tyco aggressively and creatively twisted the accounting rules. But the company still wanted more. So it concocted a new scheme to inflate CFFO (and earnings) even further, and in so doing, it crossed the line from aggressive accounting to fraud. The SEC charged that from 1998 to 2002, Tyco used a “Dealer Connection Fee Sham Transaction” to fraudulently generate $719 million in CFFO. Here’s how it worked:
For every contract Tyco purchased from a dealer, the dealer would be required to pay an up-front $200 “dealer connection fee.” Of course, the dealers would not be happy about this new fee, so Tyco raised the price at which it would purchase new contracts by the same $200—from $800 to $1,000. The net result caused no change in the economics of the transaction—Tyco was still paying a net of $800 to purchase these contracts from dealers.
However, Tyco did not see it that way. After all, the company would not have created the ruse unless management felt the tactic would be beneficial in the end. Tyco now recorded a $1,000 investing outflow for the purchase of these contracts and an offsetting $200 as an operating inflow. Essentially, Tyco created a bogus $200 CFFO inflow by depressing its investing cash flow. (See Table 16-3.) Over the course of five years and hundreds of thousands of contracts, this was quite a contribution to CFFO!
Table 16-3 Tyco’s Creative Classification of Net Payments to Dealers
3. Boosting CFFO by Creatively Structuring the Sale of a Business
In the previous two sections, we showed how companies use acquisitions to shift cash outflows from the Operating section to the Investing section of the SCF. In this next section, we discuss the flip side of that coin: how companies use disposals to shift cash inflows from the Investing section to the Operating section, as shown in Figure 16-2.
Figure 16-2 Shifting Cash Inflows from Investing Activities to Operating Activities
Recording CFFO for Proceeds from the Sale of a Business
In 2005, Softbank structured an interesting two-way arrangement with fellow Japanese telecom company Gemini BB. Softbank sold its modem rental business to Gemini, and simultaneously, the companies entered into a “service agreement” in which Gemini would pay Softbank royalties based on the modem rental business’s future revenue. At the time of the sale, Softbank received ¥85 billion in cash from Gemini, but Softbank did not consider the entire amount to be related to the sale price of the business. Instead, Softbank decided to split the cash received into two categories: ¥45 billion was allocated to the sale of the business, and ¥40 billion was deemed to be an “advance” on the future royalty revenue stream. (You may recall the earnings boost that this transaction provided, as discussed in EM Shenanigan No. 3 in Chapter 5.)
The economic reality of this situation seems to be that Softbank sold its modem rental business for ¥85 billion. However, the way it structured the transaction seemingly allowed Softbank to exercise discretion in its presentation of cash flow. Rather than recording an ¥85 billion investing inflow from the sale of the business, Softbank recorded (1) a ¥45 billion investing inflow from the sale of the business and (2) a ¥40 billion operating inflow from the “advance” on future revenue. This ¥40 billion boost to CFFO represented 69 percent of Softbank’s ¥57.8 billion in CFFO for the full year.
Watch for New Categories on the Statement of Cash Flows Investors could easily have spotted Softbank’s CFFO boost just by looking at the Statement of Cash Flows. Look at Table 16-4, and note that a new line item surfaced in 2006—a ¥40 billion “increase in deferred revenue.” This Statement of Cash Flows disclosure (together with the magnitude of its impact on CFFO) would be reason enough for astute investors to dig deeper.
Table 16-4 Softbank’s Statement of Cash Flows, 2005–2006
Sell the Business, but Keep Some of the Good Stuff
Tenet Healthcare is a company that owns and operates hospitals and medical centers. In recent years, Tenet has sold some of its hospitals to improve its liquidity and profitability. It often played a neat little CFFO-enhancing trick when structuring the sale of these hospitals—it sold everything but the receivables.
Let’s discuss how this works. Think of each hospital as being its own little business, with revenue, expenses, cash, receivables, payables, and so on, just like any other company. Before putting a hospital up for sale, Tenet strips the receivables out of the business. In other words, if a hospital has, say, $10 million in receivables, Tenet keeps the rights to those receivables and puts the rest of the business up for sale. This, of course, lowers the eventual sale price of the hospital by about $10 million, but Tenet couldn’t care less, as it recoups that amount when it collects the receivables.
What are the implications about cash flow? Well, normally all proceeds from selling a hospital would be recorded as an investing inflow (just like the sale of any business or fixed assets). But by stripping out the receivables prior to the sale, Tenet lowers the sale price (and the investing inflow) by $10 million. However, the company will soon collect the $10 million from its former customers, and here’s the nice part: all the proceeds will be reported as an operating inflow, since it is related to the collection of receivables. This trick allowed Tenet to shift the $10 million inflow from the Investing to the Operating section.
This game would have been spotted by those diligent investors who read Tenet’s financial reports. As presented below, the company clearly disclosed in its March 2004 10-Q that it planned to keep $394 million in receivables related to the sale of 27 hospitals.
Buy the Business, but Not Any of the Bad Stuff
In the last section, we showed how Tenet inflated its future operating cash flows by cleverly structuring a sale of a business—by selling everything except the receivables. Well, a buyer of a business can also inflate its cash flows in much the same way; that is, by buying everything except the payables. And that is exactly the ploy used by Treehouse Foods in early 2016 when it bought Private Brands for $2.7 billion. Ordinarily in this type of acquisition, Treehouse would have assumed the assets and liabilities of Private Brands on the day the deal closed. However, in this case, the acquisition specifically excluded accounts payable for nine of Private Brands’ manufacturing facilities. These obligations were essentially carved out of the acquisition, resulting in a higher purchase price corresponding with higher net assets. Following the consolidation, Treehouse’s operating cash flow benefited from cash collections of the working capital assets that had been acquired, and conveniently did not incur the natural offset of these benefits, as it didn’t hold the associated accounts payable. Very clever, indeed.
Buy Controlling Interest in a Business, but Use Restricted Cash to Hide Outflows
When Whirlpool acquired a controlling interest in Chinese appliance manufacturer Hefei Sanyo, the company segregated cash into a restricted account to cover the working capital and ongoing research and development needs of that business. Over the next few years the liquidity needs of Hefei Sanyo (renamed Whirlpool China) were funded from the restricted cash account. Like most companies, Whirlpool’s Statement of Cash Flows provided a reconciliation to the beginning and ending balances of ordinary (unrestricted) cash, so the payments from the separate account had no adverse impact on reported operating or free cash flow.
Fuzzy Line Between Operating and Investing Outflows
Sometimes acquisitions create a murky situation making it difficult to distinguish between investment activities and operating activities. This is particularly true when the acquired business was previously owned by partners/employees who are to remain involved in operations on an ongoing basis. MDC Partners provides a good example. This New York City–based advertising agency grew in large part by acquiring smaller agencies, closing several deals each year. Typically, only part of the acquisition price would be paid up front, with significant portions structured as earn-outs and paid over time. Since the company mainly acquired partnerships, the ongoing earn-out payments were directed to existing workers and likely represented a big portion of their annual income. Whether such payments are strictly “capital payments” or in some part more like compensation is hard to determine and can be quite subjective. In all cases, though, the payments are reflected as a reduction of cash flow from financing activities, and they enrich employees without having any adverse effect on reported operating or free cash flow.
Looking Ahead
The next chapter covers AA Shenanigan No. 3: Manipulating Key Metrics and completes our discussion on acquisition accounting tricks.