Understanding the “Kitchen Sink” Effect: When Companies Underreport Cash Flow

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During their latest episode of the VALUE: After Hours Podcast, Taylor, Carlisle, and Trainer discussed Understanding the “Kitchen Sink” Effect: When Companies Underreport Cash Flow. Here’s an excerpt from the episode:

Tobias: I got a good question for you here, David. You ever seen any companies trying to underreport their true cash flows?

David: Yeah, that happens quite a bit, especially during bad economic times. We call it the kitchen sink effect.

Tobias: Oh, yeah.

David: The idea is when, look, the market is bad, you might as well just tank your earnings, because if you beat in a market with negative sentiment, you’re not going to get any credit for it, and the market is just beating everything down. So, you understate your earnings and cash flows for as long as you can, and then when the market sentiment turns, you take all the cookies you put in the cookie jar and you throw them on the pile when the market sentiment is positive, and you get a multiplier effect on positive sentiment, on earnings, beats on top of the fact that your comps have been reduced as well. So, you beat the numbers down, and then you can come back higher, faster and you get better comps. And so, it’s part of the way they play the game.

Tobias: That’s smart.

Jake: And you want to time your option pool for that big bath quarter?

David: Great point. Yeah, we should– Can we grant a few more options here during this bad time?

Jake: We need to retain all of our management. We don’t want people to leave.

David: Yeah. Especially when things are looking bad, bonuses are going to be lower, maybe we need to increase our equity comp. Yeah, so it does happen. It does happen. I’m not here to say that every single company is intentionally manipulating their earnings. That’s part of the challenge. It’s not always intentional for all of them. But for some, it’s a big deal. For some, it’s a big deal to the negative, it’s a big deal to the positive. For some, it’s accidental. For some, they don’t really realize, because you don’t really want a management team that pays that much attention to accounting stuff. You want them to focus on the business. That was a huge red flag for Enron. Two-thirds of the organization was employed in the accounting division. And all they did was try to figure out ways to manipulate accounting. They called it the risk management division.

Tobias: It’s a good name.

Jake: The accounting was the product at the end of the day.

David: That’s the best way to put it, Jake. It was the product. Two-thirds of the organization worked there, and that’s what they, exactly, it was the product. [laughs]

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