Following an Increase in Accounts Receivable through the Company Financial Statements

An increase in accounts receivable is often seen as a red flag, signaling potential liquidity issues or ineffective credit policies. However, the story doesn’t end there. While a surge in accounts receivable can indeed indicate problems, it can also be a sign of robust sales or strategic business decisions that could pay off in the long run. One of the complexities of accounts receivable is the considerable leeway companies have in defining what constitutes a receivable. Unlike some other components of the financial statements, which are more straightforward, the criteria for accounts receivable can involve a range of gray areas, from payment terms to revenue recognition practices.

The latitude in accounts receivable reporting is an opportunity for companies to exaggerate earnings, painting a rosier financial picture than reality. The impact of rising accounts receivable on a company’s financial statements is crucial for investors, analysts, and stakeholders. It not only affects the balance sheet but also has ripple effects on the income statement and the cash flow statement. In this blog post, we will dissect how an increase in accounts receivable influences each of these financial statements. This provides a view of investing implications.

We’ll start with an example of how a company can change its accounting method in a way that increases accounts receivables. After that, we’ll walk through the Income Statement, Statement of Cash Flows and Balance Sheet to show the effect and potential for earnings manipulation

Let’s dive into a specific example to illustrate how accounting changes can manipulate financial statements. Meet Company X, a consumer staples manufacturer. Under its old accounting method, products that were produced but not yet shipped were classified as “Finished Goods Inventory,” which is a line item under “Inventories” on the Balance Sheet. This inventory is stored in Company X’s warehouse and has not yet been shipped to the customer.

Company X decided to adopt a “bill and hold” strategy. In this approach, products are billed to customers as soon as they are produced, even if they are still sitting in the warehouse. Ownership is considered transferred, but the goods are “held” until the customer requests shipment. The same inventory is still stored in Company X’s warehouse and has not yet been shipped to the customer.

Why would the customer agree to a transfer of ownership? Company X has offered a 5% discount to the customer, in exchange to agreeing to the new contract.

By switching to this “bill and hold” method, Company X can show a sudden increase in revenue and accounts receivable, making the company appear more profitable and liquid than it might actually be. But remember, the underlying business is the same! The same quantity of the same products are being shipped to the same customer at the same time. Under the bill and hold Company X even receives 5% LESS from the sale.

As we’ll see, this change has ripple effects across all financial statements, affecting not just revenue but also cash flows and asset valuation.

In this section, we’ll walk through the Income Statement to understand the full impact of the “Bill and Hold” strategy on Company X. We’ll go line by line through key items such as Revenue, Cost of Goods Sold (COGS), Gross Profit, Operating Expenses, Operating Income, and Net Income. The objective is to reveal how this accounting change can create a fairy tale of higher revenues, increased gross profit, and higher net income—all without changing the underlying business. Here is a summary of the changes.

First, let’s focus on Revenue and COGS. With the “Bill and Hold” strategy, Revenue is recognized as soon as the products are billed, even if they haven’t left the warehouse. This inflates the Revenue line, giving the appearance of a more profitable operation. Meanwhile, COGS remains the same per product, as the cost of production hasn’t changed. Assuming there is a positive gross profit margin, The result is a higher Gross Profit, calculated as Revenue minus COGS.

Next, let’s discuss the treatment of discounts, like the 5% discount Company X offers to encourage the “Bill and Hold” agreement. Generally, such discounts are recorded as Sales Discounts under Operating Expenses in the Income Statement for the applicable quarter. However, the accounting treatment can vary depending on the company’s accounting policies and the specific terms of the contract. Companies might have some leeway in how they account for these discounts, but they are generally expected to adhere to Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). Will this show up as a lower Operating Income, even though the Revenue is higher? No, in most cases. For Company X, the 5% discount (subtracted from Operating Income as an increase in Operating Expense) is less than the increase in Revenues that has flowed directly down the income statement to higher Gross Profit. The 5% discount is a small increase in expenses compared to a large increase in Gross Profit. The result is a higher Operating Income.

Finally, we’ll look at the impact on Net Income. So far we have seen the Bill and Hold arrangement increase Revenue and Gross Profit, slightly increase Operating Expenses, but still increase Operating Income. The Bill and Hold will not likely impact the interest expenses or non-operating expenses. Company X will likely report an increase in provision for Income Taxes. Similar to the above, where the 5% increase in Operating Expenses was only a fraction of the increase in Gross Profit (resulting in higher Operating Income), the increase in Income Taxes will be less than the increase in Operating Income. This will result in an inflated Net Income.

In summary, the “Bill and Hold” strategy significantly alters the Income Statement. It creates an illusion of higher Revenue, Gross Profit, and even improved profit margins. Most notably, it also inflates Net Income, making the company appear more profitable than it actually is. However, it’s crucial to understand that these changes are merely accounting maneuvers; the core business operations have not changed. The strategy simply changes how transactions are accounted for.

To evaluate Company X, a prudent investor would then have to attempt to adjust the income statement, backing out the impact of the Bill and Hold arrangement. If an investor has been valuing the company based on any of the ratios from the income statement (P/E, P/S, ROE etc….) these might no longer be helpful as reported as they will all look better compared to the underlying business fundamentals. If the investor has been using operating margin or EBIT margin, those also will now be skewed.

In this section, we’ll explore how the “Bill and Hold” strategy impacts the Statement of Cash Flows. Specifically, we’ll look at the Operating Activities section, where the cash generated or used by the core business operations is recorded. As indicated, Cash Flow from Operations (CFFO) and Free Cash Flow (FCF), will not increase along with Revenues, Operating Income and Net Income. CFFO and FCF provide a reality check for earnings that have been manipulated higher with a “Bill and Hold” strategy.

Investors often turn to the Statement of Cash Flows to evaluate the underlying business. Accounting manipulation to increase CFFO is less common. It is important to note that most companies do not directly report cash flows, but rather use the indirect method to present adjustments to net income to arrive at cash flow from operations. More on that later. Why is it helpful to look at CFFO and FCF for companies with Bill and Hold arrangements? Because changes in accounts receivable are one of the adjustments in the indirect method. An increase in accounts receivable (which takes place when a Bill and Hold is initiated) is subtracted from Net Income to adjust CFFO. Comparing Net Income to FCF and CFFO is a quick way to validate. This is one of three tabs on our site, and there are several other free services that allow this comparison!

While CFFO and FCF are helpful, it is important to understand the nuances of their reporting under GAAP, as outlined by the Financial Accounting Standards Board (FASB). Since the introduction of FASB Statement No. 95 in 1987, companies have had the option to report operating cash flows using either the direct or indirect method. The FASB encourages but does not require the direct method. The direct method is very straightforward and presents information about specific cash inflows. Most companies, however, use the indirect method. The indirect method is much easier for the company to prepare, as it largely uses data that is already gathered for other sections.

We’ve described the risks an investor takes when investing in a company that is employing a Bill and Hold arrangement. We hope this will motivate the reader to compare net income to CFFO and FCF before investing! There are several services available to search for “Bill and Hold” references within 10-K and 10-Q filings. For the recently generated list of companies employing “Bill and Hold”, message @scrapefinancial on twitter. We intend to add this to our flags for companies, we are currently finishing up our data validation processes.

These are not necessarily bad investments, or companies severely manipulating earnings. This is not a recommendation to short any of these companies (please read or disclaimer). This is a reminder to dig a little deeper if you are considering investing in one of these companies.

Unfortunately, yes. There are ways that CFFO and FCF can be manipulated. Selling accounts receivable will increase CFFO and FCF. This will mask and increase in accounts receivable. Flagging this is the main value add of our site. We observe several companies selling accounts receivable and flag this on the “DSO” tab on our site (image below).