Question

On capital budgeting area, discuss why do managers focus on the impact that an investment will have on reported earnings rather than on the investment’s cash flow consequences?

Please explain in detail with examples for 3-4 paragraph.

Answer 1

Answer:-

The managers will generally look business in a way of increasing Earnings per share (EPS) or Return on equity (ROE) that will help them earn their bonus, it is usually safe to assume that the income statement will overstate profits.

Operating cash flow (OCF) of a company is arguably the most important barometer that investors use for judging corporate well-being. Even though many investors incline towards net income, operating cash flow is often seen as a better metric of a company's financial health for two important reasons. The first reason is that cash flow is harder to manipulate than earnings although it can be done to a certain extent and secondly "cash is king" and a company that does not generate cash over the long term is likely to go out of business.

The managers may try to manipulate the earnings. An example of earnings manipulation is channel stuffing. In order to increase their sales, a company can provide retailers with incentives such as extended terms or a promise to take back the inventory if it is not sold. Inventories will then pushed to the distribution channel and sales will be booked. This will increase the accrued earnings, but cash may actually never be received because the inventory may be returned by the customer. This may increase sales in one quarter, but will eventually effect the sales in the coming quarters.However when operating cash flow is less than net income, there is something wrong with the cash cycle. In extreme cases, a company could have consecutive quarters of negative operating cash flow and a positive EPS thus revealing thus there is an earnings manipulation.

The other example of manipulating revenue is by bill and hold transaction. In this case the seller does not ship goods to the buyer, but still records the related revenue in his books.This increases the current  revenue thus increasing earnings.

The other example of manipulating revenues is by creating off-balance sheet items. When a company creates separate subsidiaries that can hold liabilities or incur expenses that the parent company does not want to disclose. If these subsidiaries are set up as separate legal entities that are not wholly owned by the parent, there is no need to record it in the parent's financial statements and the company can hide them from investors, and increase earnings.

This are generally done in the last quarter (fourth quarter) of the financial year to increase the overall earnings for the year, which increases the EPS, however the analyst should scrutinize that if there is abnormal growth in the fourth quarter this can be the warning sign for manipulation of earnings.