A company’s statement of cash flows offers an invaluable view into the sources and uses of cash in the organization’s operations. At the same time, the cash flow statement can provide important clues about the operation’s financial stability and solvency (ability to meet obligations as they are due or sufficient assets to meet ongoing liabilities). For example, poor cash flow and the likelihood of insolvency can represent a critical set of numerical red flags for uncovering the motives for committing accounting or insurance fraud.

Moreover, investigative analysis of a company’s cash flow numbers can uncover incentives to commit fraud in two key categories—motive out of desperation (to stave off insolvency, for instance), and motive out of intentional calculation. 1

ESSENTIAL ACCOUNTING RULES

Publication of the statement of cash flows is required by Generally Accepted Accounting Principles (GAAP) in the United States. 2 Essentially, the cash flow statement provides for the sources and uses of cash within three categories of activities within each entity—operating, investing and financing operations. The combined net cash provided or used for each of the three groupings of activity equals the company’s overall increase or decrease in the cash balance during the year.

Cash Flow from Operating Activities

Net Income $500,000

Adjustments to Reconcile Net Income

to Net Cash from Operating Activities:

Depreciation (Non-Cash Expense) $100,000

(Increase) / Decrease Receivables ($400,000)

(Increase) / Decrease in Inventories ($200,000)

Increase / (Decrease) Payables ($200,000)

Increase / (Decrease) in Taxes Payable ($200,000)

Net Cash Provided by Operating Activities ($400,000)

As you can see, this particular entity earned $500,000 in net profit for the year while operations actually resulted in a $400,000 decline in cash due to the ways in which cash was generated and used for operations. The change in accounts receivable provides important insight into the difficulty the entity has had in converting sales to cash.

Key: If the accounts receivable balance increases during a year it means that cash receipts were less than sales for the year. This is often symptomatic of a strain on available cash for operating activities, which in turn could be caused by other problems such as the following:

• Financial difficulties at one or more customers. In today’s economic times, many companies are facing financial difficulty that often translates into slower payment of suppliers and vendors. This could be a widespread problem or one that is isolated to few customers.

Accounts receivable aging reports will help to shed light on the specific accounts that are slow in paying.

• Customer service or billing difficulties. Another possible explanation for the increase in the receivables balance is that the entity is not providing quality customer service (including sub-par product quality) and customers are refusing to pay the amount owed on account or are demanding an allowance as compensation. These problems may or may not be properly accounted for through the establishment of a reserve for doubtful accounts. And, of course, these types of problems may be indicative of a larger more systemic customer service problem.

Helpful: Speaking with selected customers about the reasons for delay in payment is often very valuable in this regard. Confirmation of receivable balances could also include an opportunity for the customer to provide feedback on the customer service received.

• Artificial overstatement of sales and accounts receivable. The cash strain described above could also be the result of fictitious entries to the ledger. This results in artificial overstatement of sales and accounts receivable. This is a common form of financial statement fraud designed to misrepresent the financial condition of the entity for a fraudulent purpose. The result is to overstate assets – primarily accounts receivable— and sales, thus artificially inflating profitability and equity balance of the operation.

Tracing these transactions to the underlying sales invoices and other supporting documentation as well as to specific confirmations of the receivable balance with the customer is essential to this analysis.

Of course, there could be other explanations for the increase in the receivables balance that may suggest that it is a normal, temporary increase. To determine if this is the case, analyze and understand the trends and cycles of the receivables to discover whether the correlation of sales to receivables balance is seriously eroding or simply fluctuates over time.

For illustration, in the example above, it is possible that the previous year experienced a dramatic decrease in the receivable balance, which translated to a dramatic increase in cash on hand.

Key: The timing and history of transactions are important to the investigation and understanding of the financial situation in the context of financial motive to commit fraud.

Bottom line: Getting to the true facts about this entity’s financial activities requires an understanding of the “why” and not simply the transactions and account balances.

As mentioned, an important factor is the timing of changes and their correlation —or lack thereof— to the approach to insolvency. The question that must be asked in order to determine if there is a motive to commit fraud is whether there is a trend towards insolvency. If there is, the pressure on management to falsify its financial reports may be great enough to push them to commit fraud. If, on the other hand, you determine that legitimate forces are behind the entities cash flow problems, you must assess the ability of the operation to survive through alternative financing or investment with a plan to turn it around. This is the nature of structured turnarounds; rethinking the financial model and business concept with the goal of returning the operation to solvency.

CASH FLOW FROM FINANCING

Another section of the Statement of Cash Flows that is of particular significance to the analysis of financial motive for fraud is that relating to cash flow from financing activities.

In this situation, the motive investigation should always include an analysis of the ability of the business entity to meet its debt obligations (and preferred stock dividends if applicable) as they come due. And, while there is important information provided in the cash flows statement relevant to this issue, more investigation is required to unravel the real story behind the numbers.

Cash Flow from Financing Activities

Payments of Loan Principal ($500,000)

Loan Proceeds 200,000

Net Cash Provided by Financing Activities ($300,000)

A quick glance of this abbreviated section of the cash flow statement tells you that payments toward the principal balance of the entity’s debt made during the year totaled $500,000 and the loan proceeds from new debt were $200,000. The result is a further $300,000 decline in the cash balance. While this is valuable information, it does not give us sufficient understanding of the cash flow and financing of the operation.

For example, while $500,000 in payments were made towards the principal on the entity’s debt, the statement does not reveal the amount of debt principal that was due and owing during the year. It could be that the principal portion of loan payments scheduled for remittance totaled more than $1 million, but the entity lacked sufficient cash or additional financing to meet that obligation. As such, the entity may have been forced to pursue restructuring of its debt — by, for example, having the principal amount due in the current year pushed to the following. This would help to ease the entity’s current cash flow problem, but it would increase the risk of being unable to meet its obligations in the subsequent period.

The notes to the financial statements often will provide some additional insight to the loan balances, due dates, amounts due during the year, refinances, liquidations and new loans. There may also be information on the collateral or security pledged for the loans and even compliance with loan covenants and other requirements. These covenants and requirements are designed to assist the lending institution in managing its financial interest in the underlying security protecting its investment.

Where this information is not disclosed on the financial statements or notes, the analyst must seek the details in order to completely understand the nature and complexity of the entity’s debt financing. This is critical to understanding the financial implications to negative cash flow and its relationship to the approach of insolvency.

And perhaps most importantly, the ability of an entity to finance its operation is critical in understanding the potential motive for fraud. In the case of the desperate entity, for example, current debt payments due may outweigh the entity’s ability to generate cash from other sources. Thus, among the main ways for such an organization to obtain the desperately needed cash are refinancing or borrowing additional funds. An investigation of the cash flow from financing activities provides insight into whether management has misrepresented its financial records to facilitate such borrowing potential.

GETTING THE NEEDED INFORMATION

Often, the most important source for this information is directly from the company’s financial institution itself.

Important: Whenever you request information about a specific entity from its bank, be sure to ask for complete copies of loan files, loan underwriting files, loan agreements including covenants, loan payment history, as well as collateral and security interests, procedures for loan approval and covenant violation as well as financial information files, etc.

Key: Banks accept requests for information very literally so if it is not requested you won’t get it.

Of course, this investigation of the loan principal payments and debt financing may also lead to the conclusion that the entity is appropriately financed with a relatively modest loan to value ratio and that its loan repayment history would provide its lending institution with the confidence in providing additional debt financing if necessary.

CASH FLOW FROM INVESTING

The other section of the Statement of Cash Flows important to the analysis of financial motive for fraud is that relating to cash flow from investing activities.

Here. the motives for investigation can include an analysis of the reasons for the acquisition or sale of such assets as property, plant and equipment and investments. Once again, while the cash flows statement related to investing activities provides important information of the actual cash impact of these investing transactions, more investigation is required to unravel the full story behind the numbers.

Cash Flow from Investing Activities

Proceeds from Sale of Equipment $100,000

Proceeds from Sale of Investment in IBM 100,000

Net Cash Provided by Investing Activities $200,000

A quick glance at this abbreviated section of the cash flow statement tells you that the entity was able to generate $200,000 in cash during the year by selling off equipment and investments. The financial investigator will want to know the rationale behind the decision to sell these assets. If the were purely to meet current debt obligations it could signal further cash deficiencies in subsequent periods in that the income that these assets produce will no longer be earned. Understanding the rationale for these investing decisions is another key to understanding the true cash flow picture and the potential pressure on management to falsify financial records.

CONCLUSION

In summary, the Statement of Cash Flows provides important information as to the financial health of a business entity in that it provides a road map of the sources and uses of cash during the year and a look at the implications that current cash flow strategy decisions have on subsequent periods. As such, any conclusion drawn from the cash flow statement must be coupled with a keen understanding of the facts and explanations behind the numbers, including those that may pertain to fraud.

1 Motive for Fraud: Desperation or Calculation. Randall Wilson, Claims Magazine, May 2004

2 Statement of Financial Accounting Standards No. 95, Statement of Cash Flow, Financial Accounting Standards Board (FASB), November 1987