Improper timing of revenue recognition is the most common type of accounting fraud the Securities and Exchange Commission (SEC) has taken action against under its whistleblower program, say lawyers who work with employees who've come forward.
About 60% of the SEC's actions taken against fraud uncovered by whistleblowers involve companies that accelerate revenue recognition to meet earnings targets or delay it if they've already met their targets, say Jason Zuckerman, Matthew Stock and Katherine Krems of Zuckerman Law.
Since its launch in 2012, the program has generated more than 33,000 tips and paid more than $500 million in awards.
More enforcement action is expected in the near-term because of the economic slowdown, the attorneys say in an analysis they published this week in Accounting Today.
"Companies are under increased pressure to show stability, or even growth, and paint a rosy picture for investors," they said. "That pressure will undoubtedly cause some companies to engage in accounting fraud to distort their financial results."
In addition to improper timing of revenue recognition, common schemes include recognition of fictitious revenue, channel stuffing, third-party transactions, and fraudulent management estimates. They list 10 types of fraud in all.
Improper timing of revenue recognition
Most incidences of improper timing involve accelerating revenue recognition — a way for companies to give the appearance they're meeting targets they've announced publicly.
In a case last year involving Marvell Technology Group, the company was charged with pulling in sales from future quarters to close the gap between actual and forecasted revenue. The pull-ins amounted to as much as 16% of the company's total quarterly revenues, according to the SEC. The company settled for $5.5 million. Under Armour is under investigation for something similar.
Less common but also harder to detect are cases in which revenue recognition is delayed. Companies tend to do this if they've already met their revenue targets and want to level out, or smooth, their net income. In general, investors like to see a steady income from one period to the next. Income smoothing in and of itself isn't illegal, but it has to be done in accordance with GAAP standards.
A company inflating its earnings by recognizing revenue related to fake contracts or other nonexistent sales is another common type of fraud. The attorneys pointed to an internal investigation at Chinese chain Luckin Coffee, which revealed it had recognized $300 million in fictitious revenue in 2019. When word of the investigation got out, the company's stock plummeted.
The attorney's pointed to a number of SEC cases involving fictitious revenue, including one in which wire and cable products company Anicom was charged with reporting nonexistent sales to inflate net income by more than $20 million, much of that to one fictitious customer, SCL Integration.
Another common fraud involves companies sending excessive amounts of products to its distributors ahead of demand. This happens most often near the end of reporting periods, when companies try to increase revenues to meet financial projections. "A company will oversell inventory to distributors in amounts that far exceed the public's demand for the products and prematurely recognize revenue on future sales," the attorneys said.
Two high-profile cases from the past. Biopharmaceutical company Bristol-Myers Squibb in 2004 agreed to pay a $150 million fine for recognizing $1.5 billion in revenue for selling excessive amounts of pharmaceutical products to its two largest wholesalers. And in 2010, Symbol Technologies paid a $131 million judgment for stuffing its distribution channel to help meet revenue and earnings targets imposed by its CEO.
Most common fraudulent third-party transactions are bill and hold sales, consignment sales, side letter agreements and other contingency sales. In a 2017 case, diagnostic testing company Alere was charged with recognizing revenue from contingent arrangements, bill and hold transactions, and sales in which product was stored at a third-party's warehouse. These arrangements led the company to improperly recognize approximately $24 million earlier than permissible under GAAP, the attorneys said.
Other common types of fraud:
- Fraudulent management estimates. This is when a company uses inappropriate methodologies to determine write-offs or in other ways makes inappropriate adjustments to favorably impact financial statements. Computer Sciences Corporation, for example, agreed in 2015 to pay $190 million to settle charges it materially overstated its earnings and concealed significant problems with its largest contract. According to the SEC, the company's former finance director prepared a fraudulent accounting model in which he included false assumptions to avoid reporting a negative hit to the company's earnings.
- Improper capitalization of expenses. This is when a company capitalizes current costs that don't benefit future periods. In doing this, a company can understate its expenses in the period and overstate its net income. The most well-known example of this scheme involved WorldCom. The company in 2002 overstated its net income by more than $9 billion, in part by improperly capitalizing operating expenses.
- Other improper expense recognition schemes. There are many. Among them: 1) falsely inflating net income in a period by improperly eliminating or deferring current period expenses, or by allocating more costs to inventory than cost of goods sold, 2) creating excess reserves by initially over-accruing a liability in one period (also known as "cookie-jar" reserves) and then reducing the excess reserves in later periods, 3) understating reserves for bad debt and loan losses, 4) failing to record asset impairments.
- Misleading forecasts or projections. In this scheme, a company might issue misleading forecasts to avoid disclosing a known, increased risk of missing key financial goals or metrics. In a case involving Walgreens Boots Alliance, the SEC charged the company with misleading investors during the company's merger with Alliance Boots. After the first step of the merger, the company internally forecast an increased risk of missing its yearly earnings projection but publicly reaffirmed its original projection.
- Misleading non-GAAP reporting. It's a well-accepted practice for companies to use non-GAAP reporting metrics if GAAP figures don't fully portray their financial condition. Problems occur when the non-GAAP metrics are manipulated to reflect stronger growth or higher earnings. In a case involving Brixmor Property Group, the SEC alleged that, to meet public growth targets, the real estate investment company improperly adjusted its same property net operating income.
- Inadequate internal controls over financial reporting. Federal law requires companies reporting to the SEC to maintain a system of internal controls over financial reporting. In a case against Monsanto, the SEC charged the company with failing to properly account for millions of dollars in rebates offered to retailers and distributors of Roundup, its pesticide product. The company booked substantial amounts of revenue from sales incentivized by the rebate program but failed to recognize all of the related program costs.
The many types of fraud the attorneys highlight have one characteristic in common — they're hard to maintain over time.
"As with most accounting scandals, companies are usually unable to sustain the deception, and the house of cards eventually collapses," the attorneys said.