The financial numbers game detecting creative accounting practices phần 5 pptx

Premature revenue recognition and fictitious revenue recognition differ in the degree towhich aggressive accounting actions are taken.. Goods Ordered But Not Shipped Revenue recognized f

Exhibit 5.11 (Continued)

Earnings management could either inflate or keep stock price low depending on whetherearnings are managed up or down Inflating stock price will come back to bite the

company and investors—Lender

Hurts Firm Performance

When earnings management involves taking more risks, e.g., relaxing credit standards, itincreases the probability that the company will suffer losses—ACPA

Widespread earnings management can increase the cost of capital to all firms that accessU.S capital markets—ACPA

Provides excessive compensation and security for top level executives—ACPA

Earnings management taken to excess, where poor business decisions are taken as a result,will weaken the business in the long run—CFO

Encourages management to pursue strategies that may not maximize firm value in the longrun—FA

Takes management’s attention away from their true task, i.e., managing the firm—FAInappropriate increases in bonuses—Lender

Managing earnings takes significant effort away from managing true profit and loss—CPAManagement may be expending inappropriate resources to manage earnings or makingshort-term decisions that are detrimental to long-term performance—CPA

Other Reasons

Occasionally earnings management leads to manipulation that leads to fraud and

devastates the firm, ruining lives of all involved in the firm—ACPA

Some earnings management cannot be detected—ACPA

Evidence of earnings management over time reduces the credibility of corporate

management—ACPA

Distorts the predictability of future cash flows—CFO

Potentially unable to detect operational difficulties—CFO

Accounting should be results neutral, just reporting what has happened and not affectingthe actual results—CFO

It will lead management to use more questionable accounting practices in order to smoothearnings to meet security analysts’ expectations—FA

Intentional deception is viewed very unfavorably in the marketplace—Lender

ACPA: Academic, also typically a CPA

CPA: Certified public accountant in public practice

CFO: Chief financial officer or comparable position

Lender: Commercial bank

FA: Financial analyst, typically a CFA

MBA: Advanced MBA student

Earnings Management as Helpful The 66 statements suggesting that earnings agement could be helpful are categorized as follows:

man-Number Percentage

Signals management’s private information 9 14

to investors by managing earnings down

With all the attention given to consensus analyst earnings estimates, the identification

of meeting such expectations as a potential benefit of earnings management is not prising The rationalization of expectations could be seen as another avenue for guidingexpectations toward reality In fact, this action is comparable to management using earn-ings management to signal its superior information about the level of future earnings

sur-Exhibit 5.12 Statements that Earnings Management May Be Helpful to

Investors

Reduces Earnings Volatility

The ability to reduce earnings volatility is an indicator of financial strength—ACPA

It can reduce earnings volatility and thereby increase returns because the market perceivesthe earnings to be more predictable, i.e., less risky—ACPA

I think that intent is the key Some accruals management might be helpful to preserve underlying trends—ACPA

core-Smoothing rather than volatility is often useful—CFO

Even if management of a company is running the business well for the long term,

uncontrolled earnings volatility can lead to unfounded concerns of management ability andresult in a lower price-to-earnings ratio Smoothing earnings legitimately, e.g., pacingexpenditures, improves investor confidence—CFO

Exhibit 5.12 (Continued)

Reducing some volatility from the EPS stream can be okay if it is within a fair band

around the normal earnings trend line—FA

Minor adjustments to smooth EPS can produce investor confidence to buy and hold for thelong term and avoid the Street’s constant noise to trade—FA

Could sometimes be used to offset a loss from an extraordinary item, e.g., selling

investments at a gain to offset losses—CPA

In the absence of fraud, a smooth stream of earnings will help the investor over time—Lender

Provides a Share-Price Benefit

Mild earnings management that simply reduces price volatility over time can be helpful instabilizing investment return and investor activities—ACPA

Smoothes out certain nonrecurring items that might otherwise lead to increased stock pricevolatility—ACPA

Conservative accounting practices within GAAP are prudent business actions to provide ashock absorber to unforeseen negative events Sustained earnings growth consistent withexpectations creates value for all stakeholders—CFO

Earnings management helps eliminate extreme volatility in the stock price when a

company does not meet the analysts’ consensus estimate—CFO14

May result in higher stock prices over the short term—FA

With the hypersensitivity of the stock market, some earnings management has been

required to temper the effects of the peaks and valleys or routine variations in business.Without the ability to report consistency or stability, a stock could fluctuate radically—CPA

It helps companies who manipulate earnings for the purpose of maintaining stability intheir stock price by smoothing earnings over time, rather than sending volatile earningsreports to the market and having stock price fluctuate wildly—Lender

Signals Management’s Private Information

It could be used to signal managers’ superior information concerning future returns—ACPA

Management can use accruals to communicate superior information about future

outcomes—ACPA

Can be used as a signaling tool about otherwise unobservable information—ACPA

Legitimate earnings management can convey information about management plans andexpectations—ACPA

Helps to Meet Forecasts

Since stock prices may be affected by whether or not earnings forecasts have been met,earnings management can help those investors in the short term—ACPA

Meeting or beating analysts’ estimates is important these days As long as this is donewithin GAAP rules, earnings management tools are very helpful to investors—Lender

May act as a counterbalance to the rules of GAAP that create rough edges—ACPA

If the quality of earnings is defined as the ability to forecast future cash flows and

managing earnings can increase quality (because of GAAP deficiencies), then earningsmanagement can be helpful—ACPA

Some definitions of earnings management may include useful activities, such as risk

management through the use of derivative instruments—ACPA

For cyclical firms, earnings management helps investors to more properly view earningspower and determine firm value—FA

ACPA: Academic, also typically a CPA

CPA: Certified public accountant

CFO: Chief financial officer or comparable position

Lender: Commercial bank lender

FA: Financial analyst, typically a CFA

MBA: Advanced MBA student

SUMMARY

Earnings management has attracted much attention in recent years, but there is still atively little systematic information available about the nature of earnings managementand how and why it is practiced The survey results presented in this chapter are designed

rel-to help fill this void Key points made in the chapter, based on the survey, include the lowing:

fol-• Financial professionals are generally in agreement on when earnings managementcrosses the line between the exercise of the legitimate flexibility inherent in GAAPand abusive or fraudulent financial reporting However, a nontrivial subset of profes-sionals appears to understate the potential seriousness of certain earnings-manage-ment actions

• Financial professionals agree that earnings management is common, that it hasincreased over the past decade, and that the SEC campaign against abusive earningsmanagement is necessary

• The major objectives of earnings management are to reduce earnings volatility, port or increase stock prices, increase earnings-based compensation, and meet con-sensus earnings forecasts of analysts

sup-• The major categories of earnings-management actions, in order of frequency, are thetiming of expense recognition, big bath and cookie jar reserves, the timing of revenuerecognition, and real actions While not in conflict with GAAP, real actions still could

be used to produce misleading results

• Trend analysis (analytical review), analysis of high-likelihood conditions and cumstances, footnote review, days statistics, and the proximity of actual to estimatedresults are the most frequently mentioned earnings-management detection techniques

cir-• Earnings management is viewed as more likely to be harmful than helpful

• Harmful earnings-management effects are seen to include the distortion of financialperformance, inflation of share prices, and potential damage to firm performance

• Possible helpful effects from earnings management include a reduction in earningsvolatility and share-price volatility, the potential for management to signal its privateinformation, and helping to meet forecasts and rationalize expectations

Analytical Review The process of attempting to infer the presence of potential problemsthrough the analysis of ratios and other relationships, often over time

Bill and Hold A sales agreement where goods that have been sold are not shipped to a customerbut as an accommodation simply are segregated outside of other inventory of the selling company

or shipped to a warehouse for storage awaiting customer instructions

Channel Stuffing Shipments of product to distributors who are encouraged to overbuy underthe short-term offer of deep discounts

Consignment A shipment of goods to a party who agrees to try to sell them to third parties Asale is not considered to have taken place until the goods are sold to a third party

Consignor A party shipping goods to a consignee The consignee then makes an effort to sellthe goods for the account of the consignor

Consignee A party to whom goods are shipped under a consignment agreement from a signor Until ultimate sale, the goods remain the property of the consignor

con-Days Statistics Measures the number days’ worth of sales in accounts receivable (accounts able days) or days’ worth of sales at cost in inventory (inventory days) Sharp increases in these mea-sures might indicate that the receivables are not collectible and that the inventory is not salable

receiv-Field Representatives Company employees who negotiate sales transactions on behalf of theiremployers

LIFO Dipping Reducing LIFO inventory quantities and, as a result, including older and lowercosts in the computation of cost of sales, resulting in an increase in earnings

Real Actions (Earnings) Management Involves operational steps and not simply acceleration

or delay in the recognition of revenue or expenses The delay or acceleration of shipment would

be an example

1 Accounting academic respondent

2 Chief financial officer respondent

9 This action might be seen to be in the shareholders’ interests if the goal were to increaseincentive compensation by increasing the value of stock options However, the intent was toframe the action as tied to increasing earnings-based incentive compensation

10 Statement of Position No 81-1, Accounting for Performance of Construction-Type and tain Production-Type Contracts (New York: American Institute of Certified Public Accoun- tants, July 15, 1981), para 65–67 Earlier GAAP, SFAS No 5, Accounting for Contingencies

Cer-(Norwalk, CT: Financial Accounting Standards Board, March 1975), para 17, held that tingent gains are not normally reflected in the accounts

con-11 The CFO survey did not include this element We expected it to be difficult to get CFOs torespond to the survey Therefore, to reduce its length somewhat, we decided to exclude thiselement from the CFO version of the survey Our low, but not unexpected, response ratefrom the CFOs would probably have been even lower if the questionnaire had been longer

12 M Beasley, J Carcello, and D Hermanson, Fraudulent Financial Reporting: 1987–1997,

An Analysis of U.S Public Companies, Research Commissioned by the Committee of

Spon-soring Organizations of the Treadway Committee (NJ: American Institute of Certified lic Accountants, 1999), p 24

Pub-13 LIFO dipping refers to increases in earnings that result from a reduction in inventory thatcauses older and lower inventory costs to be included in the calculation of cost of sales A

lower cost of sales increases earnings The expressions LIFO dipping and LIFO liquidations

tend to be used interchangeably

14 This statement continues: “The penalty can cause significant losses for investors when thestock price crashes and street expectations are not met While I do not advocate earningsmanagement, it would seem that a company reversing an accrual (with some justification) orbooking an accrual or contingency at somewhat less than the company policy to meet expec-tations wouldn’t be harmful to investors This would presume this type of behavior wasn’t aregular occurrence and it wasn’t material to the financials.”

CHAPTER SIX

Recognizing Premature or Fictitious Revenue

Lucent Technologies, Inc., continuing to pay the price for years of pushing for faster growth than it could sustain, significantly restated revenue from the last quarter and said it expects a “substantial”

loss We mortgaged future sales and revenue in a way we’re paying for now 1

The people said the biggest problem was the old Sunbeam’s practice

of overstating sales by recognizing revenue in improper periods, including through its “bill and hold” practice of billing customers for products, but holding the goods for later delivery 2

The scheme began with the Supervisors arranging for a shipment of

$1.2 million in software to one of Insignia’s resellers and concealing side letters that granted extremely liberal return rights 3

Undetected by auditors, according to testimony in a criminal trial

of Cal Micro’s former chairman and former treasurer, were a dozen

or more accounting tricks They include one particularly bold one:

booking bogus sales to fake companies for products that didn’t exist 4

Reported revenue and its rate of growth are key components in the understanding of porate financial performance The account is displayed prominently on the income state-ment as the top line It provides a preliminary indication of success and directly affects theamount of earnings reported and, correspondingly, assessments of earning power Formany companies, especially start-up operations that have not yet become profitable, val-uation often is calculated as a multiple of revenue We will not soon forget the stratos-pheric valuations enjoyed, although briefly, by Internet companies as market participantsraced to value their meager but growing revenue streams with ever increasing multiples

cor-TE AM

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In this setting it is not surprising that premature or fictitious revenue recognition is often

at the top of the list of tools used in playing the financial numbers game

IS IT PREMATURE OR FICTITIOUS REVENUE?

Premature revenue recognition and fictitious revenue recognition differ in the degree towhich aggressive accounting actions are taken In the case of premature revenue, rev-enue is recognized for a legitimate sale in a period prior to that called for by generallyaccepted accounting principles In contrast, fictitious revenue recognition entails therecording of revenue for a nonexistent sale It is often difficult, however, to assign a label

to such revenue recognition practices because of the large gray area that exists betweenwhat is considered to be premature and what is considered to be fictitious revenuerecognition

Goods Ordered But Not Shipped

Revenue recognized for goods that have been ordered but that have not been shipped atthe time of recognition would be considered by most to be premature Twinlab Corp., forexample, restated results for 1997 and 1998 because “some sales orders were booked butnot ‘completely shipped’ in the same quarter.”5The company made an apparently validsale to a presumably creditworthy customer Revenue was recognized prematurely, how-ever, because the full order had not been shipped to the customer Twinlab had not yetearned the revenue

In a similar example of premature revenue recognition, Peritus Software Services,Inc., received a purchase order for its year 2000 software product in August 1997 Thecompany recorded revenue under this order in the quarter ended September 1997 eventhough the software was not shipped until November 1997.6

In some instances of premature revenue recognition, companies will ship productafter the end of a reporting period to fill orders received prior to the end of that period

In order to include the late shipments in sales for the period just ending, the books will

be left open well into the new period Pinnacle Micro, Inc., used this practice and becamerather brazen about its premature revenue recognition practices

For approximately one year following its initial public offering in July 1993, the pany consistently reported increasing sales and earnings Like any young and growingcompany, Pinnacle established ambitious sales targets At times, however, those targetsbecame difficult to meet If shipments for a quarter were not up to target, the shippingdepartment was instructed to continue shipping until the sales goal was met In order torecognize revenue from such shipments made after the end of a quarter, employees wereinstructed to predate packing lists, shipping records, and invoices to conceal the fact thatorders had not been shipped until later To facilitate such predating, the calendar on acomputer that generated an automatic shipping log was reset to an earlier date On sev-eral occasions there was insufficient product available to fill orders needed to meet salesgoals Accordingly, even manufacturing had to continue after the end of a reporting

com-period to generate product for use in shipments dated prior to that com-period’s end Thispractice continued, getting progressively worse, until a newly hired controller, whorefused to get involved, contacted the company’s audit committee and independent audi-tors and advised them of the postperiod shipments.7 In the end, financial results wererestated to remove the prematurely recognized revenue The restatement effects weresignificant Net income for 1993 was reduced from $2.6 million to $1.6 million and netincome for the fourth quarter of that year was restated to a loss of $804,000 from a profit

of $652,000

Goods Shipped But Not Ordered

A more aggressive action than recording sales for goods not yet shipped would entailproduct shipment and revenue recognition in advance of an expected order Given thelack of an actual order, such an act would, in our view, entail fictitious revenue recogni-tion If the expected order is received later, some might argue that the transactioninvolved, at worst, premature revenue recognition

For example, among several aggressive revenue recognition actions, Digital wave, Inc., recorded revenue on the shipment of product to a customer that, at the time,had not placed an order The units shipped were, in fact, demonstration units for whichthere was never a firm commitment for purchase The shipped units were later returned

Light-to the company and the revenue was reversed.8 Revenue should not have been nized in the first place Similarly, Ernst & Young LLP resigned as the independent audi-tor for Premier Laser Systems, Inc., because of a disagreement over the company’saccounting practices In particular, a customer claimed that “it didn’t order certain laserproducts that Premier Laser apparently booked as sales.”9

recog-Late in 1998, Telxon Corp., a manufacturer of bar-code scanning equipment, wasinterested in being acquired by its longtime competitor and once hostile suitor, SymbolTechnologies, Inc Curiously, Telxon was now pushing for a quick deal and stipulatedthat Symbol would not be allowed to look at the company’s books before completing thepurchase Telxon’s results looked healthy enough In the third quarter ended September

1998, net income before nonrecurring items was up 47% on a 13% increase in revenue.However, Symbol balked at such an arrangement and insisted on being allowed to com-plete a full due-diligence review of Telxon’s finances Interested in a deal, Telxonrelented

What Symbol found was not pretty In particular, a single sale for $14 million worth

of equipment was recorded toward the end of the September quarter That equipmentwas sold to a distributor with no purchase agreement from an end buyer To make mat-ters worse, the financing for the purchase was backed by Telxon This single sale wasvery important to Telxon’s results because, without it, the company’s revenue would beflat and it would have reported a loss for the quarter

Symbol’s interpretation of the $14 million transaction was that it was not a bona-fidesale but rather a secured financing arrangement In effect, inventory had been shipped

to Telxon’s distributor, awaiting sale In this view, while product had been shipped,there was effectively no valid order and, thus, no sale Telxon had recognized revenueprematurely Soon after the Symbol review, Telxon restated its results to remove the

premature recognition effects of the $14 million deal along with other questionabletransactions.10

Selected examples of premature revenue recognition are provided in Exhibit 6.1

More Egregious Acts

In going beyond simply recognizing revenue for product shipments prior to an expectedorder, some companies will record sales for shipments for which orders are not expected,

or, even worse, they will record sales for nonexistent shipments Revenue recognized insuch situations would be considered fictitious

For example, during 1997 and 1998, sales managers at Boston Scientific Corp wereparticularly eager to meet or exceed sales goals To facilitate increased, although ficti-tious sales of the company’s medical devices, commercial warehouses were leased andunsold goods were shipped there To mask the fact that these “noncustomers” never paidfor the goods, credits were later issued and the same goods were later “resold” to differ-ent customers In other cases, product was shipped to distributors who had not placedorders Sometimes these distributors were not even in the medical device business Cred-its were then issued when these distributors returned the shipments, although by thenrevenue had been recognized in an earlier period.11Such alleged acts clearly would con-stitute fictitious revenue recognition

Exhibit 6.1 Examples of Premature Revenue Recognition

Acclaim Entertainment, Inc • Recognized revenue on a foreign distribution AAER No 1309, September 26, 2000 agreement in advance of required product

deliveryBausch & Lomb, Inc • Used aggressive promotion campaign to AAER No 987, November 17, 1997 encourage orders and shipments that could

not be economically justifiedPeritus Software Services, Inc • Revenue recognized for valid order that was AAER No 1247, April 13, 2000 not shipped until a later period

Pinnacle Micro Corp • Books left open and revenue recognized for AAER No 975, October 3, 1997 shipments made in a later period

December 23, 1998, p C1

The Wall Street Journal, not completely shipped

February 25, 1999, p B9

Source: SEC’s Accounting and Auditing Enforcement Release (AAER) or article from The Wall Street Journal for the indicated date.

California Micro Devices Corp provides a particularly egregious example of tious revenue recognition As noted in the opening quotes to this chapter, the chipmaker’s acts of revenue recognition included “booking bogus sales to fake companiesfor products that didn’t exist.” In fact, evidence obtained in a criminal trial of the com-pany’s former chairman and former treasurer indicated that one-third of its $45 million

ficti-of revenue in fiscal 1994 was spurious Facing ever more aggressive revenue goals,managers at the company began relaxing their definition of what constitutes a sale Rev-enue was soon being recognized for product shipped to customers before it was ordered,and those sales were not reversed when the product was returned In other cases, dis-tributors were paid special handling fees to accept product that had unlimited rights ofreturn Revenue was recognized when product was shipped to those distributors As thefiction developed, the company began recording sales for fake shipments In fact, as thealleged fraud grew and more of the company’s staff became involved in it, a runningjoke developed in which staff would say to each other, “like in a Bugs Bunny cartoon,

‘What’s wevenue?’ ”12

One final example of fictitious revenue recognition is that of Mercury Finance Co Inearly 1997 the fast-growing auto loan company announced that it had uncovered phonybookkeeping entries, including fictitious revenue, that led it to overstate earnings in

1995 and 1996 In fact, in 1996 earnings were overstated by more than 100%.13In thiscase, much of the fictitious revenue was recognized by the stroke of a pen—throughjournal entries recorded without even the semblance of a sale The erroneous entriesaccompanied other operational problems at the company from which it never recovered,ultimately leading to a bankruptcy filing

Cover-up Activities

Commonly found among cases of fictitious revenue recognition are steps taken by agement to cover up its acts Such cover-up activities might take the form of backdatinginvoices, changing shipping dates, or creating totally false records The actions takenoften are limited only by the imagination of those concocting the scheme and may bemore offensive than the original acts of fictitious revenue recognition themselves.For its fiscal year ended September 1993, Automated Telephone Management Sys-tems, Inc (ATM) reported revenue of $4.9 million Included in that revenue total was a

man-$1.3 million sale of telecommunications equipment to a single customer, National HealthServices, Inc (National Health) National Health, however, did not actually purchase thegoods in question In fact, the company did not take delivery or pay for them Instead,National Health’s president signed documents that simply made it appear as if the $1.3million sale had taken place In particular, he signed a sales contract, a document indi-cating completion of installation of the equipment in question, and an audit confirmationletter, all of which were provided to ATM’s independent auditors as support for the sale.For signing these bogus documents, he was provided $17,000 in gifts and payments.Eventually the scheme was uncovered and National Health’s president found himself inthe middle of an SEC enforcement action along with management of ATM.14

In 1991 a distributor for Cambridge Biotech Corp took delivery of $975,000 worth

of product at the direction of Cambridge’s CEO The distributor had no obligation to pay

for the goods delivered Later that year, Cambridge’s CFO devised a scheme to retrievethe product and simultaneously make it appear as if the distributor had paid the $975,000price To effect the plan, Cambridge ordered other product from a third company for anamount approximately equal to the value of the original shipment The order was a shamorder, however, and was in actuality an order to take delivery of the same product thathad been shipped to the distributor in the first place The goods were shipped back toCambridge from the distributor Then, by paying for the goods, Cambridge provided thedistributor with the money needed to “pay” for the original shipment It was a convolutedplan and one that netted to zero; however, Cambridge was able to report revenue, profit,and cash flow.

In another transaction, Cambridge shipped product valued at $817,000 to a tor whom the company had negotiated to acquire Here again the distributor had noobligation to pay for the product that had been shipped Cambridge recognized revenuefor the transaction amount and showed a receivable Later, in completing the purchase

distribu-of the distributor, the $817,000 was netted from the acquisition price

A third transaction was even more involved, entailing even greater cover-up actions.Here Cambridge management convinced a trading company to order $600,000 worth ofproduct Cambridge recognized revenue for $600,000 even though the trading companyhad no real obligation to pay for the order Then Cambridge agreed to purchase goodsworth $48,640 from another company, one that was related to the trading company Theagreed purchase price was set at $737,349 Cambridge then paid the related company the

$737,349 and took delivery of the $48,640 in goods purchased The related companypaid $600,000 to the trading company, which used the money to pay for the originalorder The related company kept $88,709 to pay for the goods ordered, shipping costs,duties, and taxes, and as a “commission” on the transaction.15

These three transactions are only representative of the great lengths taken by agement of Cambridge Biotech to cover up its recognition of fictitious revenue Therewere others Fortunately, the transactions were uncovered and the company’s cover-upactivities were foiled

man-Selected examples of cover-up activities seen in the area of revenue recognition aresummarized in Exhibit 6.2

A Precise Demarcation Is Not Practical

We have looked at many examples of both premature and fictitious revenue recognition

In some instances identifying when revenue has been recognized prematurely is verystraightforward Most would agree that revenue is recognized prematurely when it isrecorded for a shipment made immediately after a period’s cutoff date to fill a valid orderfrom a creditworthy customer The revenue is not fictitious because the sale exists It wasrecorded early Most also would agree that revenue recorded for nonexistent sales tononexistent customers is fictitious Here a sale simply does not exist Between these twoextremes, however, within that gray area noted earlier, it is difficult to get consensus onwhat constitutes premature and what constitutes fictitious revenue recognition Fortu-nately, such a precise demarcation is not necessary

For purposes of analysis, a precise labeling of premature or fictitious revenue is lessimportant than acknowledging that revenue has been recognized improperly In bothcases, revenue has been reported on the income statement that does not belong Expec-tations about earning power will have been unduly influenced in a positive way Cer-tainly the more egregious the acts of improper revenue recognition become, the greaterwill be the penalty that ultimately is exacted But all forms of improper revenue recog-nition typically will have some form of penalty, including a negative market reaction.Accordingly, the point of view taken here is that all forms of improper revenue recogni-tion, whether premature or fictitious, should be avoided whenever possible.

WHEN SHOULD REVENUE BE RECOGNIZED?

Managers, accountants, and regulators have struggled for decades with the question ofwhen revenue should be recognized As our economy evolves and new forms of prod-

Exhibit 6.2 Revenue Recognition Cover-up Activities

Advanced Medical Products, Inc • Did not mail invoices and monthly statements AAER No 812, September 5, 1996 to “customers” that had not placed ordersAutomated Telephone • Prepared fictitious sales contract, completion Management Systems, Inc of installation document, and audit

AAER No 852, October 31, 1996 confirmation letter

Cambridge Biotech Corp • Provided money to customer to pay for an AAER No 843, October 17, 1996 order, netted receivable out as part of an

acquisition of a customer, paid commission to

a third party to provide funds to customer topay amount due

AAER No 1313, September 27, 2000

AAER No 1215, January 11, 2000 periods

Laser Photonics, Inc • Did not record credit memos for returns

AAER No 971, September 30, 1997

AAER No 1211, December 3, 1999 • Shipments made to third-party warehousePremier Laser Systems, Inc • Prepared fictitious customer order form

AAER No 1314, September 27, 2000 • Shipments made to third-party warehouse

Source: SEC’s Accounting and Auditing Enforcement Release (AAER) for the indicated date.

ucts, services, and transactions arise, the appropriate timing of revenue recognitionbecomes more difficult to define In its most elemental form, revenue should be recog-nized when it is earned and realized or realizable Revenue is earned when a companyhas substantially accomplished what it must do to be entitled to the benefit represented

by the revenue being recognized Revenue is realized when goods and services areexchanged for cash or claims to cash Revenue is realizable when assets received inexchange for goods and services are readily convertible into known amounts of cash orclaims to cash

While this definition of revenue might appear to be appropriate for most transactions,often it is deficient In particular, problems often arise in determining when revenue isearned Consider the software industry, which has struggled with problems of revenuerecognition for years The industry has evolved from what was effectively the sale of aproduct—the software—to something that is more of an ongoing subscription Ser-vices provided by the software firm, which extend well beyond the date of sale, includenot only installation and training but also such customer services as ongoing telephonesupport and unspecified product upgrades and enhancements With such services beingprovided over extended periods, determining when the revenue is earned becomes aproblem

Initially, there was no specific guidance as to when revenue should be recognized inthe software industry Accordingly, the industry struggled to determine when its revenuewas earned, and companies formulated revenue recognition practices that were quitedivergent For example, it was not long ago that software companies were employingsuch revenue recognition policies as the following:

From the annual report of BMC Software, Inc.:

Revenue from the licensing of software is recognized upon the receipt and acceptance of asigned contract or order.16

From the annual report of American Software, Inc.:

Upon entering into a licensing agreement for the standard proprietary software, the pany recognized eighty percent (80%) of the licensing fee upon delivery of the softwaredocumentation (system and user manuals), ten percent (10%) upon delivery of the software(computer tapes with source code), and ten percent (10%) upon installation.17

com-From the annual report of Autodesk, Inc.:

Revenue from sales to distributors and dealers is recognized when the products areshipped.18

From the annual report of Computer Associates International, Inc.:

Product license fee revenue is recognized after both acceptance by the client and delivery

of the product.19

Note how each company defined quite differently when the revenue from an initialsoftware licensing agreement was to be recognized BMC Software was most aggressiveand considered the revenue earned when an order was received American Softwarewaited until shipment but, curiously, recognized most of the revenue associated with atransaction when the system and user manuals were shipped At that time, the softwareitself had not been shipped Autodesk waited until the software was shipped, while Com-puter Associates was most conservative, recognizing revenue when the product wasdelivered and accepted by the client With such diverse revenue recognition practices, itwas difficult to compare financial performance across companies in the same industry.

As they became aware of the problem in the industry, accounting regulators began tochip away at the inherent flexibility in software revenue recognition Accounting policiesfor revenue recognition gradually were tightened until an important document, State-

ment of Position 97-2, Software Revenue Recognition (SOP 97-2), was issued by the

Accounting Standards Executive Committee of the American Institute of CPAs.20erally, for software that does not entail significant production, modification, or cus-tomization, SOP 97-2 indicates that the following four criteria must be met beforesoftware revenue can be recognized:

Gen-1 Persuasive evidence of an arrangement exists.

2 Delivery has occurred.

3 The vendor’s fee is fixed or determinable.

4 Collectibility is probable.

More specifically, SOP 97-2 requires that before software revenue can be recognized,there must be a valid order from a third-party customer, the software has been shipped,the price is not dependent on a future varying number of users or units distributed, andthe total sale price is collectible Note how the past practices of BMC Software andAmerican Software would not be in accordance with this statement In fact, as a directresult of changes in accounting policies for revenue recognition in the software industry,both companies changed their revenue recognition practices, linking recognition to soft-ware shipment

SOP 97-2 also provides direction for software arrangements involving multiple ments, such as upgrades and enhancements, ongoing telephone support, and other ser-vices, such as installation, training, and consulting Such services go well beyond theactual shipment of a software product and require special attention When such addi-tional elements are part of a software sale, the total software license fee must be dividedamong the various elements, including the software itself, based on their relative fairmarket values Revenue then is recognized over time as performance takes place for eachelement of the total package As a result, revenue recognition is delayed beyond the soft-ware delivery date for what can amount to a significant part of the total sale

ele-Consider the revenue recognition policy for Microsoft Corp., as provided in the pany’s annual report:

com-Revenue from products licensed to original equipment manufacturers is recorded whenOEMs ship licensed products while revenue from certain license programs is recorded

when the software has been delivered and the customer is invoiced Revenue from aged product sales to and through distributors and resellers is recorded when related prod-ucts are shipped Maintenance and subscription revenue is recognized ratably over thecontract period Revenue attributable to undelivered elements, including technical supportand Internet browser technologies, is based on the average sales price of those elements and

pack-is recognized ratably on a straight-line baspack-is over the product’s life cycle When the revenuerecognition criteria required for distributor and reseller arrangements are not met, revenue

is recognized as payments are received Costs related to insignificant obligations, whichinclude telephone support for certain products, are accrued Provisions are recorded forreturns, concessions and bad debts.21

The policy is very descriptive and appears to abide well with the requirements of SOP97-2 Note that revenue is not recognized until product is shipped, either by the companyitself or by its OEMs (original equipment manufacturers) Revenue associated withmaintenance and subscription activities and other elements, such as technical supportand browser technologies, is deferred and recognized over time, as earned The companydescribes this policy further as follows:

A portion of Microsoft’s revenue is earned ratably over the product life cycle or, in thecase of subscriptions, over the period of the license agreement End users receive certainelements of the Company’s products over a period of time These elements include itemssuch as browser technologies and technical support Consequently, Microsoft’s earnedrevenue reflects the recognition of the fair value of these elements over the product’s lifecycle.22

Microsoft’s policy has led to the deferral of a significant amount of revenue Usingamounts provided in the company’s annual report, deferred revenue at June 30, 2000,was $4.87 billion, up from $4.2 billion in 1999

In some instances, a software sale requires significant production, modification, orcustomization to suit a particular customer’s needs In such cases, SOP 97-2 calls for use

of contract accounting In particular, the percentage-of-completion method should beused when the software vendor can make reasonably dependable estimates of the extent

of progress toward completion, of contract revenue and contract costs Here softwarerevenue is recognized as progress is made toward completion of the total software instal-lation When conditions for use of the percentage-of-completion method are not met, thecompleted-contract method is appropriate Here software revenue is not recognized untilthe software installation is complete

Advent Software, Inc., notes use of the following policy for software sales requiring

an extended production period:

Revenues for interface and other development and custom programming are recognizedusing the percentage of completion method of accounting based on the costs incurred todate compared with the estimated cost of completion.23

More is said about contract accounting in a subsequent section of this chapter

The SEC Clarifies Criteria for Revenue Recognition

The Securities and Exchange Commission has long been aware that companies often useaggressive revenue recognition practices to play the financial numbers game Recallfrom Chapter 4 that revenue recognition was one of the five creative accounting prac-tices specifically identified by the SEC as requiring action To address the problems itsees with revenue recognition, the commission issued Staff Accounting Bulletin No

101, Revenue Recognition in Financial Statements (SAB 101) SAB 101 noted that in

many industries, such as the software industry, and for many non–industry-specific enue recognition situations, such as with leases or when a sale entails a right of return,specific revenue recognition guidance exists The SEC did not want its SAB 101 toinfringe on those preexisting standards However, the commission noted that in manyother ongoing situations no specific guidance was provided to help accountants andmanagers determine when revenue is earned and realized or realizable This StaffAccounting Bulletin was written to provide such guidance

SAB 101 borrows its revenue recognition criteria from SOP 97-2, the software enue statement In fact, the criteria for revenue recognition in SAB 101—persuasive evi-dence of an arrangement, delivery has occurred or services have been rendered, theseller’s price to the buyer is fixed or determinable, and collectibility is reasonablyassured—are identical to those contained in SOP 97-2 In the paragraphs that follow,each of these criteria is given careful consideration Examples are provided to show howthey are applied and how companies that seek to record premature or fictitious revenuemight abuse them

rev-Persuasive Evidence of an Arrangement

Practice varies across companies and industries as to what constitutes a valid arrangement

or purchase order In some instances a verbal order may be the norm, followed by a ten confirmation In others, a sale may require a written and signed sales agreement SAB

writ-101 specifically notes that if customary business practice is to use a signed sales ment, then revenue should not be recognized without it For example, a written salesagreement may be prepared and signed by an authorized representative of the selling com-pany While verbally agreeing to the terms of the contract, the purchasing company’s rep-resentative may not have signed the agreement until approved by the company’s legaldepartment Even though the purchasing company’s representative provides verbal assur-ances of the company’s interest in the product or service, according to SAB 101 persua-sive evidence of an arrangement does not exist Revenue should not be recognized.Examples of revenue recognition in the absence of an arrangement often entail thetotal lack of an order For example, Structural Dynamics Research Corp sold its soft-ware products in the Far East through company representatives who acted as companysales agents These sales agents would place orders with Structural Dynamics for prod-uct in the absence of orders from end users The orders were therefore not final but wereinstead contingent on sales to legitimate end users The orders themselves even con-tained conditional language; in fact, some were labeled as conditional purchase orders.Nonetheless, Structural Dynamics recognized revenue related to the orders The product

agree-Recognizing Premature or Fictitious Revenue

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that was sold under them often was shipped to a freight forwarder and held there until anend user purchased the product and sought delivery Payment was piecemeal, tied to pur-chases by end users Often end users never materialized, and the related receivables werewritten off.24

Cylink Corp also provides an example of revenue recognized for a shipment made inthe absence of a firm order The company recognized revenue for a shipment to a third-party warehouse on an order placed by a small international distributor The sale wascontingent on the distributor’s ability to obtain a letter of credit When that letter of creditwas not granted, company management decided to store the shipped product in the ware-house awaiting a future sale Given the sale’s contingent nature, revenue should not havebeen recognized.25

In one of the opening quotes to this chapter, Lucent Technologies, Inc., indicated,

“We mortgaged future sales and revenue in a way we’re paying for now.”26In effect, thecompany was admitting to premature revenue recognition—revenue was recognizedcurrently that should have been recognized at a later date The company restated resultsfor its fiscal fourth quarter, reducing revenue by $679 million The bulk of that adjust-ment, in fact, $452 million worth, was for equipment that it took back from distributorswhen they did not sell it Apparently the company made verbal commitments to the dis-tributors that it would take the equipment back if it was not sold After the large and dif-ficult adjustment, the company changed its revenue recognition practices to postponerevenue recognition until after end user customers had purchased the product However,the company continues to suffer from its earlier accounting misdeeds; the EnforcementDivision of the Securities and Exchange Commission decided to conduct a “formalinvestigation into possible fraudulent accounting practices” at the firm.27

Informix Corp provides a clear example of revenue recognition in the absence of aformal arrangement To meet end-of-quarter revenue and earnings goals, company salespersonnel often rushed to conclude as many transactions as possible The company’swritten policy was that revenue on any license agreement is not recognized for a report-ing period unless the agreement is signed and dated prior to that period’s end However,

in numerous instances, sales personnel were unable to obtain signed license agreementsfrom customers prior to a period’s end Nonetheless, there was an accepted practice atthe company of signing license agreements after a period’s end and then backdatingthem to appear as if they had been executed prior to that time.28

Sensormatic Electronics, Inc mastered the art of premature revenue recognition withseveral creative accounting practices In each case, the company had a valid order; that

is, there was persuasive evidence of an arrangement However, the scheduled deliverydate was for a later reporting period For example, goods were shipped and revenue wasrecognized for orders received near the end of a reporting period but for which deliverywas requested for a few days into a new period To avoid an early delivery, the carrierwas asked to delay delivery until the requested delivery date For shipments with evenlonger delivery horizons, goods were shipped to company warehouses and stored untilthe requested delivery date Revenue was recognized at the time of shipment to the com-pany warehouse On other occasions, customers issued purchase orders with FOB (free-on-board) destination terms In such instances, title passes and revenue should berecognized when the goods reach their destination However, the company accounted for

such transactions as FOB shipping point transactions, recognizing revenue at the time thegoods were shipped While this act and others performed by the company might accel-erate revenue recognition by as little as a few days, those few days typically would beenough to boost end-of-period revenue by a sufficient amount to meet revenue and earn-ings growth targets.

Kurzweil Applied Intelligence, Inc., also used warehouses to store shipped goods thathad not been ordered Across a two-year period straddling the company’s initial publicoffering in August 1993, the company recorded millions of dollars in phony sales Whilethe goods were supposedly sold to customers, they were instead shipped and stored at alocal warehouse controlled by the company To hide the scheme, company managersallegedly forged customer signatures, altered other crucial documents, and occasionally,when needed, shifted unsold good between warehouses.29

Channel Stuffing

Channel stuffing is closely related to revenue recognition for shipments made in theabsence of outstanding orders However, in the case of channel stuffing, orders are infact received Channel stuffing refers to shipments of product to distributors who areencouraged to overbuy under the short-term offer of deep discounts While at the time

of shipment, an order is in hand, revenue is recognized somewhat prematurely by theseller because its customers are purchasing goods that will not be needed or resold until

a later period The seller is effectively borrowing sales from a later period In such cases,sales are not sustainable

Some would refer to the practice of channel stuffing as trade loading, a term tionally used in the tobacco industry This quote describes the practice well: “Tradeloading is a crazy, uneconomic, insidious practice through which manufacturers—trying

tradi-to show sales, profits, and market share they don’t actually have—induce their wholesalecustomers, known as the trade, to buy more product than they can promptly resell.”30

For example, in a particularly aggressive marketing and promotion campaign, Bausch

& Lomb, Inc., offered deep discounts on contact lenses to distributors for product chased during the third quarter of 1993 The promotion enabled the company to exceedits third-quarter sales forecast In the process, however, the company sold distributorsenough inventory to meet or exceed their fourth-quarter needs Then in December of thatsame year, the company used other promotional tactics and extended payment terms toconvince distributors to buy even more product In some instances distributors boughtenough product in two weeks to service their needs for up to two years.31While Bausch

pur-& Lomb technically had orders for the product shipped, one could clearly questionwhether revenue recognition was economically justified

neutralizes the purchase transaction between the company and its customer Note thatthere is nothing inherently wrong with a side letter that is generally known by companymanagement and is used to clarify or modify terms of a sales agreement without some-how undermining the agreement as a whole The problem with side agreements ariseswhen they are maintained outside of normal reporting channels and are used to negatesome or all terms of the disclosed agreement.

Stipulations of an improper side letter might include: liberal rights of return; rights tocancel orders at any time; contingencies, such as the need to raise funds on the part of thecustomer, that if not met make the sale null and void; being excused from payment ifgoods purchased are not resold; or, even worse, a total absolution of payment As aresult, there is no arrangement per se between the two companies A sale has not takenplace and revenue should not be recognized

Insignia Solutions, PLC, a software company, sold product to resellers and offeredlimited rights of return The company provided for estimated future returns that werededucted from gross revenue in deriving net revenue The estimate of returns was cal-culated by measuring inventory on hand at resellers that exceeded a 45-day supply In asignificant sale to a single reseller, the sales manager, at the direction of the sales vicepresident, signed a side letter offering a more liberal right of return than normally pro-vided Then, after the shipment, a subordinate was instructed to report only 10% of theinventory held by the reseller By underreporting inventory, amounts on hand at thereseller were made to appear to be much less than the 45-day supply that would require

an additional provision for returns As a result, the company was able to report higher netrevenue than would have been reported in the absence of the side letter and the mis-statement of inventory.32

Sales personnel and management at Informix Corp used a variety of both written andoral side agreements to encourage orders by resellers that effectively rendered their salesagreements unenforceable Terms varied and included such provisions as:

• Committing the company to use its own sales force to find customers for resellers

• Offering to assign future end user orders to resellers

• Extending payment terms beyond 12 months

• Committing the company to purchase computer hardware or services from resellersunder terms that effectively refunded all, or a substantial portion, of the license feespaid by them

• Diverting the company’s own future service revenue to resellers as a means of ing their license fees

refund-• Paying fictitious consulting or other fees to resellers to be repaid to the company aslicense fees33

Given the liberal use of limits on their sales agreements, it is evident that in the presence

of these side letters, a true sales arrangement was not in effect Revenue should not havebeen recognized

In a review of SEC enforcement actions against companies with alleged premature orfictitious revenue recognition practices, many companies were noted with side letters to