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

In their latest episode of the VALUE: After Hours podcast, Taylor, Carlisle and Trainer discussed understanding the “kitchen sink” effect: when companies under-report their cash flow. Here is an excerpt from the episode:

Tobias: I have a good question for you here, David. Have you ever seen companies try to understate their actual cash flows?

David: Yes, that happens quite often, especially in bad economic times. We call it the kitchen sink effect.

Tobias: Oh yeah.

David: The idea is, if the market is bad, you might as well cut your profits, because if you win in a market with negative sentiment, you don't get any credit for it, and the market just crushes it all. So you underestimate your earnings and cash flows for as long as possible, and then when market sentiment changes, you take all the cookies you put in the cookie jar and throw them on the pile when market sentiment is positive, and you get a multiplier effect on the positive mood, on the income and also on the fact that your compensation has also been reduced. So if you lower the numbers, you'll come back faster, higher, and get better comps. And so it's part of the way they play the game.

Tobias: That's smart.

Jake: And you want to plan your option pool for the large swimming district?

David: Great point. Yes, we should – can we give a few more options here in these bad times?

Jake: We need to keep all of our management. We don't want people to leave.

David: Yes. Especially if things look bad, bonuses will be lower, maybe we need to increase our equity compensation. So yes, it happens. It happens. I don't want to say that every single company intentionally manipulates their profits. That's part of the challenge. It's not always intentional for everyone. But for some it's a big deal. For some it's a big deal for a negative, it's a big deal for a positive. For some it is coincidence. Some people don't really notice because you don't want a management team that's so busy with accounting. You want them to focus on business. This was a big warning sign for Enron. Two-thirds of the organization was employed in the accounting department. And all they did was find ways to manipulate the accounting. They called it the risk management department.

Tobias: It's a good name.

Jake: 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 was exactly what the product was. [laughs]

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