A POTPOURRI OF LIBERAL REVENUE RECOGNITION TECHNIQUES

By intensifying its enforcement of established revenue recognition rules in SAB 101, the SEC put a stop to techniques that the staff considered overly aggressive.

Percentage-Of-Completion Method

Under certain circumstances, a company engaged in long-term contract work can book revenue before billing its customer. This result arises from GAAP’s solution to a mismatch commonly observed at construction firms. A variety of service companies, defense contractors, and capital goods man­ufacturers come up against the same accounting issue.

Typically, the company agrees to bill its customers in several install­ments over the life of the contract. The billing may lag behind the com­pany’s incurring of expenses to fulfill its obligations. Without some means of correcting this mismatch, reported profit will be inappropriately high in the contract’s early stages and inappropriately low in the late stages.

GAAP addresses the problem through the percentage-of-completion method, which permits the company to recognize revenue in proportion to the amount of work completed, rather than in line with its billing.

Crossing the Line

In the foregoing cases, the regulators merely complained that the com­panies’ existing revenue recognition policies painted too rosy a picture, but in other instances the management has been accused of misrepresentation. For example, in 1996, the SEC claimed that computer manufacturer Se­quoia Systems and four former executives engaged in a “fraudulent scheme” aimed at inflating the company’s revenue and income. According to the complaint filed in U.S. District Court in Washington, the ex-chair­man and three other officials booked letters of intent as revenue, backdated some purchase orders, and granted customers special terms that Sequoia never disclosed. Furthermore, charged the SEC, the executives profited from the scheme by selling stock before a true picture of the company’s financial condition emerged. The company and its former officials settled the SEC’s civil charges without admitting or denying guilt.²⁶

Loading the Distribution Channels

A classic technique that manufacturing companies use to exaggerate revenues over the short run is to “load” their distribution channels. Loading consists of inducing distributors or retailers to accept larger shipments of goods than their near-term sales expectations warrant.

As a further distortion of economic reality, the distributors will proba­bly agree to accept higher-than-necessary inventories only if the manufac­turer offsets the resulting increase in their inventory-financing costs by granting price concessions. In so doing, the manufacturer reduces its bona fide profits to make earnings seem higher in the near term. Loading there­fore creates the appearance of higher company value (based on the implied trajectory of profits) but the reality of lower value.

Worse still, the manufacturer may try to bolster revenues indefinitely by loading the distribution channels year after year. Inevitably, the underlying trend of final sales to consumers slows down, at least temporarily. At that point, the manufacturer’s growth in reported revenue will maintain its trend only if its distributors take on even bigger inventories, relative to their sales. If the distributors balk, the loading scheme will unravel, forcing a sizable write-off of previously recorded profits.

Through a Lens Darkly

At a special December 13, 1993, meeting, according to a Business Week re­port,²⁷ Bausch & Lomb (B&L) informed its 32 independent contact lens distributors of a new policy. Going forward, the company would make fewer direct shipments to eye doctors and do a larger portion of its business through the distributors.

B&L’s sales representatives promptly presented distributors with lists of the products they were expected to buy. The distributors were dismayed to learn that they would have to pay carrying costs on inventories equivalent to as much as two years’ sales. Furthermore, they discovered that B&L’s prices were 50% or more above the levels of just three months earlier. To top it off, Johnson told the distributors that they would have to purchases the lenses by December 24, when the company closed its books for the year. Any firm that refused to accept its quota, he added, would lose its distribu­torship. By January 1994, B&L had terminated the two distributors that re­jected the new arrangement.

Bausch & Lomb’s aggressive stance in December 1993 may not have generated much Christmas cheer among its contact lens distributors, but the near-term impact on reported earnings was like a gift from Santa. The company loaded $25 million into the distribution channels in the last few days of the year, raising 1993 lens sales by 20%, to $145 million. Half of the division’s $15 million of earnings for the year were attributable to the enforced buildup of distributors’ inventories.

To outside analysts, it was not clear that the fourth-quarter sales rise re­sulted from channel-loading, rather than increased consumer demand for B&L lenses. Presumably, the distributors’ inventory-to-sales ratios rose as they reluctantly stocked up on lenses, a classic clue that something was out of kilter. Those private companies’ financial statements were not generally available to analysts, however.

The ostensible rationale for Bausch & Lomb’s stepped-up inventory requirement, a shift toward greater reliance on distributors, was some­what undercut by the company’s continued direct sales to high-volume eye doctors and optical retailing chains. An executive of one small chain re­ported that early in 1994, he was able to buy a particular type of lens di­rectly from B&L at 75% of the price that the distributors were charged. Many distributors saw their sales rise in response to the company’s new strategy, but by only modest amounts.

As for B&L’s insistence that the distributors place new orders by De­cember 24, 1993, even though they said their inventories were already high as a result of an earlier promotion in September, one distributor’s contact lens marketing manager commented, “It was just a blatant attempt to make their numbers.” For lens chief Johnson, it appears, achieving sales targets was an outcome much to be desired. According to the company’s proxy statement, he received a 64% bonus on top of his 1993 salary of $275, 000 for performance “substantially in excess” of corporate goals. (B&L later declined to discuss Johnson’s compensation, but claimed that the year-end sales surge accounted for just “a small fraction” of the bonuses received by contact lens executives.)

Business Week contended that in addition to presenting an overly rosy impression of consumer demand for its contact lenses, Bausch & Lomb im­properly recognized the revenue generated by its channel-loading.

In interviews with more than a dozen of B&L’s distributors, most tell a remarkably similar tale: Company executives promised that the distrib­utors wouldn’t have to pay for the lenses until they were sold and said that a final payment would be renegotiated if the program flopped.²⁸

B&L executives admitted telling distributors that during the first six months of the new arrangement, they would have to pay only for the mer­chandise they sold. The company officials insisted, however, that final pay­ment was unequivocally due in June 1994. Nevertheless, in October 1994 the company agreed to take back approximately three-quarters of the December 1993 shipments and discount the remainder. By then, Harold O. Johnson had stepped down as head of the lens division and shareholders had filed a class action accusing B&L of falsely overstating its sales and profits.

The Bausch & Lomb affair teaches the valuable lesson that analysts who uncover solid evidence of inaccurate financial reporting should stick to their guns, even in the face of indignant and vehement denials by corporate management. Franklin T. Jepson, B&L’s vice president of communications and investor relations immediately decried Business Week’s December 1994 report as an “unwarranted assault on the reputation and ethics of Bausch & Lomb” and “the product of poor editorial and journalistic judgment.”²⁹ His comment appeared in a B&L press release that claimed Business Week’s article “falsely allege[d] the company may have improperly accounted for sales related to” its December 1993 marketing program. The press release further stated:

■    Company officials had not represented that lenses sold in the special program were returnable if unsold.

■    The distributors understood that the sales were final and irrevocable.

■    B&L’s financial and accounting staff, as well as its independent ac­countants, continued to believe that questions about revenue recogni­tion were unmerited.

A month after issuing its strongly worded press release, Bausch & Lomb conceded that a reexamination by Price Waterhouse and a second in­dependent accounting firm “identified certain items which were inappropri­ately recorded as sales.”³⁰ According to the newest comment, the company continued to believe that the improperly recognized revenue was immaterial to 1993 full-year results and that the accounting for the contact lens divi­sion’s special marketing initiative was appropriate. At the same time, B&L noted, the Securities and Exchange Commission staff had begun an inquiry “apparently prompted” by the program.

In October 1995, the company’s board named four independent direc­tors to a committee to review the 1994 internal review that produced an es­sentially clean bill of health. Three months later, B&L restated 1993 results for its contact lens and sunglass businesses. The downward revisions, which B&L had said a year earlier it believed would be immaterial, totaled $42.1 million in sales and $17.6 million in earnings. Those numbers were hardly inconsequential, compared with originally reported fourth-quarter 1993 revenues of $479.1 million and a loss of $62.9 million. The company added that its 1994 results would rise by corresponding amounts.³¹

By the time B&L disclosed the restatement, Chairman and Chief Exec­utive Officer Daniel Gill had announced that he would step down from his posts at the age of 59, an action attributed by some observers to the com­pany’s lackluster earnings.³² Outside analysts could not know all of the in­ternal machinations that led to the 1993 special marketing program, but the subsequent resignations of both the contact lens division’s head and the CEO made it plausible to suppose that senior management was indeed under pressure to make the numbers.

After six months of internal investigation, though, B&L’s committee of outside directors concluded that the company’s top executives were not to blame for the accounting improprieties. Without issuing a written report, the committee characterized the January 1996 restatement of contact lens and sunglass earnings as “appropriate” and said that control procedures had been strengthened. Committee chairman William Balderston III added that no future meetings were planned.³³

The committee had added credibility to its findings by hiring Gary Lynch, former director of enforcement for the SEC, to assist in the investi­gation. Some seasoned observers of such inquiries, however, said that it was impossible to assess the quality of an internal investigation without infor­mation on the methods employed and the basis for its conclusions. “An in­vestor can’t find comfort in just the reputation of the investigator,” shareholder advocate Ralph Whitworth asserted. Commented attorney Edwin H. Stier, “A lot of what is called an independent investigation is re­ally advocacy.”³⁴

In any case, Bausch & Lomb’s step-by-step retreat in the months fol­lowing the December 1994 Business Week article is instructive. The com­pany began by saying that the magazine “flagrantly disregarded facts presented to the magazine’s reporter.”³⁵ A month later, the company fell back to the position that immaterial amounts of revenue had been recorded improperly. Eventually, management conceded that the incorrect accounting was material enough to warrant a $42.1 million restatement. In light of this sequence, which has countless parallels in the annals of financial reporting controversies, users of financial statements should not be intimidated by corporate press releases that denounce allegedly irresponsible securities an­alysts and journalists.

Making the Numbers... Up, if Necessary

An executive on the receiving end of Bausch & Lomb’s 1993 channel-loading escapade cited a desire to “make the numbers” as a motive for the lens divi­sion’s pumping up of its reported revenues. In the achievement-oriented world of business, gung-ho salespeople sometimes go so far as to make the numbers up. A desire for bragging rights, rather than revenue figures, ap­pear to have caused General Motors’ Cadillac division to exaggerate its 1998 performance.

In December of that year, GM’s luxury car unit was trailing its arch­rival, Ford’s Lincoln division, in the annual competition to make the most final sales of vehicles to motorists. Cadillac’s six-decade reign as the top American luxury car brand was in jeopardy. This danger was regarded as nothing short of apocalyptic, reflecting a strong view among auto industry executives that capturing the number-one position in a product category conferred a valuable marketing advantage.³⁶

When Cadillac announced December results in January 1999, however, it appeared that the hard-charging sales force had achieved a come-from- behind victory straight out of Chariots of Fire, the cinematic epic of the Olympiad. According to the division’s report, sales surged from 13,698 in November to a remarkable 23,861 in December. Even more astonishingly, and implausibly, in the view of many observers, sales of Cadillac’s Escalade sport-utility vehicle skyrocketed from 960 to 3,642 in the space of a month.

After Escalade volume mysteriously receded to just 225 in January 1999, Lincoln’s executives quietly began circulating data from the consumer market­ing company R. L. Polk. The figures showed a sizable discrepancy between the number of cars that Cadillac claimed to have sold and the number registered by consumers during December. Cadillac officials responded by vehemently denying that its reported sales reflected any improper manipulation.

In May 1999, however, General Motors abruptly changed its story. Management confessed that Cadillac had inflated its December sales by 4,773 vehicles. The revelation followed an internal audit that resulted in vaguely described “appropriate disciplinary action.” A spokesman blamed the false sales report on “a combination of an internal control breakdown and overzealousness on the part of some folks.”

Interestingly, the automaker added that the revision of December vehi­cle sales would not necessitate a restatement of its 1998 financials. GM’s accounting practice was to recognize a sale when a vehicle left the factory and became the dealer’s property. The vehicles involved in the overcount had left the factory, but had not yet been sold to consumers.

Evidently, Cadillac officials manipulated the numbers solely to beat out Lincoln, rather than to puff up revenues or earnings. Strictly speaking, the affair lay outside the realm of financial statement analysis. Still, the over­statement of Cadillac’s competitive position may have caused investors to place slightly too high a value on General Motors stock. After all, a stock’s value is a function of expected future earnings (see Chapter 14), which partly depend on the popularity of the company’s products vis-a-vis those of its competitors.

For analysts of financial statements, Cadillac’s fib reinforces the mes­sage that when an issuer’s numbers look too good to be true, they probably are. Generally, the initial response of corporate executives caught in a lie is to dig themselves a deeper hole, but gratifyingly often, the truth ultimately emerges. An equally valuable object lesson is Lincoln’s detection of the mis­chief through checking Cadillac’s figures against an independent source, R. L. Polk. Analysts who strive to go beyond routine number-crunching can profit by seeking independent verification of corporate disclosure, even when the auditors have already placed their stamp of approval on it.

Managing Earnings with “Rainy Day” Reserves

Overstating near-term reported earnings by recognizing sales prematurely is the revenue-related abuse that creates the greatest notoriety. Analysts must also watch out for the opposite sort of finagle, however. Sometimes, management delays revenue recognition to understate short-run profits. The motive for this paradoxical behavior is a desire to report the sort of smooth year-to -year earnings growth that equity investors reward with high price-earnings multiples (see Chapter 14).

Steady earnings growth rarely occurs naturally. A company can pro­duce it artificially, however, by creating a “rainy day” reserve. When net profit happens to be running above exp ectations, management stows part of it in a “rainy day” reserve. Later on, when the income is needed to boost re­sults to targeted levels, management pulls the earnings out of storage. Smoothing the bottom line is not uncommon, but companies are touchy about the subject.

Chemical producer W. R. Grace reacted with indignation when it was accused of managing its earnings through improper reserves. On December 22, 1998, the Securities and Exchange Commission charged the company and six of its former executives with falsely reporting earnings over the pre­ceding five years by improperly shifting revenue. Grace followed the stan­dard script, declaring that it would “vigorously contest”³⁷ the charges, stating its belief that its financial reporting was proper, and pointing out that its outside auditors had raised no objections to the accounting. An at­torney for former Grace chief executive officer J. P. Bolduc, who was among the accused executives, said that his client would fight the charges and ex­pected to be vindicated. The SEC, complained the lawyer, was trying to punish Bolduc for carrying out his duties exactly as he should have.

The SEC specifically alleged that Grace had declined to report $10 mil­lion to $20 million of revenue that its kidney dialysis services subsidiary, National Medical Care (NMC), received in the early 1990s as the result of a change in Medicare reimbursement rules. According to the commission’s enforcement division, the Grace executives reckoned that with earnings al­ready meeting Wall Street analysts’ forecasts, the windfall would not help the company’s stock price. Such an inference would have been consistent with investors’ customary downplaying of profits and losses that they per­ceive to be generated by one-time events (see Chapter 3). In fact, it was possible that the unexpected revenue would actually hurt the stock price down the road by causing NMC's profits to increase by 30 %, an above­target and unsustainable level.

To solve the perceived problem of excessively high profits at NMC, Grace’s management allegedly placed the extra revenue in another account, which it later drew on to increase the health care group’s reported revenues between 1993 and 1995. As an example, claimed the SEC, senior managers of Grace asked NMC’s managers to report an extra $1.5 million of income in the fourth quarter of 1994, when corporate earnings needed a boost.

Brian J. Smith, who was Grace’s chief financial officer until July 1995, testified in a deposition that because the kidney dialysis unit could not maintain its pace of earnings increases, “We believed that it was prudent to reduce the growth rates.”³⁸ His attorney denied, however, that the goal was to please Wall Street analysts by keeping reported earnings smooth, as for­mer Grace and NMC employees asserted. Smith had bona fide liabilities in mind, claimed the attorney.

A senior partner at Grace’s auditing firm, Price Waterhouse, did not agree that the additions to reserves were appropriate. Eugene Gaughan tes­tified that in 1991, he pointed out the accounting rules clearly stated that profits could be set aside only for foreseeable and quantifiable liabilities. GAAP did not give companies discretion to create rainy day funds.

In its year-end audit, Price Waterhouse proposed reversing the reserves, but management refused. According to the auditing firm’s records, the Grace executives said that they wanted a “cushion for unforeseen future events.³⁹ (Italics added.) Eventually, Price Waterhouse allowed the additions to reserves to stand. The auditors’ decision reflected a finding that the amount placed in the reserve was not material from Grace’s corporatewide standpoint, al­though it would be if NMC were a stand-alone company. (At the time, audi­tors generally judged an item material if it affected earnings by 5% or 10%. The Securities and Exchange Commission later established the criterion that an event was material if it would affect an investor’s decision.)

According to Gaughan, Price Waterhouse objected again around the end of 1992, after seeing a memo that described Grace’s use of reserves to influence reported growth in profits, while gearing NMC executives’ incen­tive compensation to “actual results.” Another Price Waterhouse partner, Thomas Scanlon, said that he told Grace CEO Bolduc that stockpiling re­serves was wrong and would have to stop. By that time, the contents of the “rainy day” reserve had grown to about $55 million.

It appears, in short, that Grace’s 1998 statement that its auditors had raised no objections to its accounting for the Medicare reimbursement windfall was true only in the technical sense that Price Waterhouse issued

clean financials, based on materiality considerations. As a spokeswoman for the auditing firm pointed out, such an opinion does not imply agree­ment with everything in the statements. As late as April 1999, however, Grace was still insisting that Price Waterhouse had approved its accounting “without reservation.”⁴⁰

On June 30, 1999, Grace settled the case without admitting or denying the SEC’s charges. The company agreed to cease and desist from further se­curities law violations and also to set up a $1 million education fund to pro­mote awareness of and education about financial statements and generally accepted accounting principles. Adhering again to the standard script, the corporation explained that it settled the case “because we think it is in the best interests of our employees and shareholders to put this matter behind us and move forward.”⁴¹

The Grace affair serves as a reminder that almost invariably, an allega­tion of irregularities in corporate financial reporting is followed by a vehe­ment, formulaic denial. No matter how offended the company purports to be about having its integrity questioned, analysts should take the protests of innocence with a grain of salt. The record does not suggest that the com­panies that bray loudest in defending their accounting practices are sure to be vindicated in the end.

Fudging the Numbers: A Systematic Problem

As the preceding examples demonstrate, manipulation of reported revenue is distressingly common. Readers may nevertheless wonder whether this dis­cussion presents too bleak a picture of human nature. Are not most people basically honest, after all? To a novice analyst who has never been blind­sided by revisions of previously reported sales figures that proved mislead­ing or fraudulent, it may seem paranoid to view every company’s income statement with suspicion.

Harvard Business School Professor Emeritus Michael C. Jensen observes, however, that misrepresenting revenues is the inevitable consequence of using budget targets in employee compensation formulas.⁴² “Tell a manager that he will get a bonus when targets are realized and two things will happen,” writes Jensen. “First, managers will attempt to set easy targets, and, second, once these are set, they will do their best to see that they are met even if it damages the company.” He cites real-life examples of managers who “did their best” through such stratagems as:

■ Shipping fruit baskets that weighed exactly the same amount as their product and booking them as sales.

■    Announcing a price increase, effective January 2, to induce customers to order before year-end and thereby help managers achieve their sales targets. The price hike put the company out of line with the competi­tion.

■    Shipping unfinished heavy equipment from a plant in England (result­ing in revenue recognition in the desired quarter) to the Netherlands. At considerable cost and inconvenience, the manufacturer then completed the assembly in a warehouse located near its customer.

Compounding the problem of managers who play games with their rev­enues is the willingness of some corporate customers to play along. “All too often, companies wouldn’t be able to accomplish the frauds without the as­sistance of their customers,” observes Helane L. Morrison, a district admin­istrator for the Securities and Exchange Commission.⁴³ For example, one-third of wireless communications provider Hybrid Networks’s revenue in the fourth quarter of 1997 consisted of a sale made on the final day of the reporting period to a distributor, Ikon Office Solutions. Ikon agreed to pur­chase $1.5 million worth of modems from Hybrid, despite knowing that it had no customers for the equipment. Hybrid closed the sale by providing a side letter essentially permitting Ikon to return the modems without paying for them. Ikon exercised that option in 1998, yet Ronald Davies, the Ikon executive who handled the purchase, sent an e-mail to Hybrid denying any knowledge of the side letter. Unfortunately, Hybrid later gave a copy of the side letter to its auditors. The SEC then sued Hybrid, which was forced to restate its revenues to eliminate the nonfinal sale of modems to Ikon. Fur­thermore, Davies received a cease-and-desist order to refrain from further violations of the securities laws. In certain other recent enforcement actions alleging improper recognition of sales, as well, the SEC has charged execu­tives of corporate customers with collusion.

How widespread are revenue recognition gambits that enrich managers but impair bona fide profits? According to Ikon executive Davies, “It’s very common for a manufacturer to call you up and say, ‘I need to hit my quar­terly number, would you mind giving me a purchase order for $100,000?’ ”⁴⁴ In the litigation surrounding W. R. Grace’s alleged delay of revenue recogni­tion to smooth earnings, the chief financial officer’s attorney defended his client’s action by arguing, “Any CFO anywhere has managed earnings in a way the SEC is now jumping up and down and calling fraud.”⁴⁵ Michael Jensen chimes in, “Almost every company uses a budget system that re­wards employees for lying and punishes them for telling the truth.” He pro­poses reforming the system by severing the link between budget targets and compensation. Realistically, however, radical reforms are not likely to occur any time soon.

Analysts therefore need to scrutinize carefully the revenues of every company they examine. Even in the case of the bluest of the blue chips, watching for rising levels of accounts receivable or inventory, relative to sales, should be standard operating procedure. Regardless of management’s programmed reassurances, conspicuous surges in unbilled receivables and deferred income are telltale danger signals. It is imperative that analysts raise a red flag when a membership-based company’s registrations deviate from their customary relationship with reported sales. “Budget-gaming is rife,” says Jensen, and “in most corporate cultures, much of this is ex­pected, even praised.” Let the analyst beware.

Restatements of revenues and earnings arise in a wide range of circum­stances. Many well-publicized cases involve young companies in compara­tively new industries. Until the potential abuses have been demonstrated, managements may be able to take greater liberties than the auditors will countenance at a later point. On the other hand, major, long-established corporations are sometimes overzealous in booking sales. Mature com­panies may pump up revenues out of a desire to meet high expectations cre­ated by earlier, rapid growth.

After the fact, companies variously attribute excesses in reporting to misjudgment, bookkeeping errors, deliberate misrepresentation by “rogue managers,” or some combination of the three. Seasoned analysts, having been burned on many occasions by revenue revisions, tend to doubt that overstatements are ever innocent mistakes. To gain some of the veterans’ perspective, if not necessarily their jaundiced view of human nature, it is worthwhile to review a few case histories of adjustments to previously recorded revenues.

In November 1991, Citicorp restated $23 million in revenues associ­ated with its credit card processing division. The bank holding company dismissed the unit’s head and several other officials, saying they had been misreporting data for nearly two years. Financial executives were among those involved in the scam, which helped to explain why it had gone unde­tected for so long. Deadpanned the Wall Street Journal, “[Citicorp] officials didn’t specify why the employees had been inflating revenue, although their bonuses were tied directly to the unit’s performance.”⁴⁶

Cincinnati Milacron credited an anonymous tip for its uncovering of a $2.3 million overstatement of sales in the first half of 1993. The “isolated” incident, said the company, involved a failure by the Sano plastic machinery unit to observe the “sales cutoff” rule. Contrary to Cincinnati Milacron’s policy, Sano had counted in sales units that had not been shipped. The obligatory firing centered on a senior manager, while others escaped with reprimands.⁴⁷

First Financial Management blamed accounting errors, rather than pol­icy violations, for its restatement of revenues for the first nine months of 1991. (Some of the employees at fault were fired, all the same.) The problem arose in the Basis Information Technologies subsidiary, a unit that First Fi­nancial had formed by consolidating 19 separate companies. Basis Informa­tion Technologies reportedly lost track of certain accruals of revenue, which should have been reduced as contracts expired. While uncovering the mess, First Financial also found that certain acquisition-related expenses had been amortized improperly.⁴⁸

In July 1993, T2 Medical placed in Fortune’s list of the 25 fastest grow­ing companies. The following month, the manager of home infusion ther­apy centers acknowledged that accounting irregularities had contributed to its remarkable sales growth. T2 (pronounced “T squared”) had evidently recognized revenues on billings that neither patients nor insurers would cover. On the same day that T2^,s financial reporting came under a cloud, the Department of Health and Human Services announced it was investi­gating possible Medicare fraud at the company. T2^,s president resigned in the wake of the disclosures, and the company’s stock price promptly fell 35% to $8.875. Only three months earlier, rumors of a management-led buyout of T2 had been rife, with one securities analyst speculating that the stock might run to $20 in such a scenario.⁴⁹