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 cor- 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 the amount of earnings reported and, correspondingly, assessments of earning power. For many 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 participants raced to value their meager but growing revenue streams with ever increasing multiples.
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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 to which 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 generally accepted accounting principles. In contrast, fictitious revenue recognition entails the recording 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 between what is considered to be premature and what is considered to be fictitious revenue recognition.
Goods Ordered But Not Shipped
Revenue recognized for goods that have been ordered but that have not been shipped at the time of recognition would be considered by most to be premature. Twinlab Corp., for example, restated results for 1997 and 1998 because “some sales orders were booked but not ‘completely shipped’ in the same quarter.”5The company made an apparently valid sale 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 yet earned 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. The company recorded revenue under this order in the quarter ended September 1997 even though the software was not shipped until November 1997.6
In some instances of premature revenue recognition, companies will ship product after 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 became rather brazen about its premature revenue recognition practices.
For approximately one year following its initial public offering in July 1993, the com- pany consistently reported increasing sales and earnings. Like any young and growing company, Pinnacle established ambitious sales targets. At times, however, those targets became difficult to meet. If shipments for a quarter were not up to target, the shipping department was instructed to continue shipping until the sales goal was met. In order to recognize revenue from such shipments made after the end of a quarter, employees were instructed to predate packing lists, shipping records, and invoices to conceal the fact that orders had not been shipped until later. To facilitate such predating, the calendar on a computer 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 sales goals. Accordingly, even manufacturing had to continue after the end of a reporting
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period to generate product for use in shipments dated prior to that period’s end. This practice continued, getting progressively worse, until a newly hired controller, who refused 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 were restated to remove the prematurely recognized revenue. The restatement effects were significant. Net income for 1993 was reduced from $2.6 million to $1.6 million and net income 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 entail product shipment and revenue recognition in advance of an expected order. Given the lack 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 transaction involved, at worst, premature revenue recognition.
For example, among several aggressive revenue recognition actions, Digital Light- 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 which there was never a firm commitment for purchase. The shipped units were later returned to the company and the revenue was reversed.8 Revenue should not have been recog- 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’s accounting practices. In particular, a customer claimed that “it didn’t order certain laser products that Premier Laser apparently booked as sales.”9
Late in 1998, Telxon Corp., a manufacturer of bar-code scanning equipment, was interested in being acquired by its longtime competitor and once hostile suitor, Symbol Technologies, Inc. Curiously, Telxon was now pushing for a quick deal and stipulated that Symbol would not be allowed to look at the company’s books before completing the purchase. 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, Telxon relented.
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 equipment was 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 was very important to Telxon’s results because, without it, the company’s revenue would be flat 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-fide sale 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 revenue prematurely. Soon after the Symbol review, Telxon restated its results to remove the
Recognizing Premature or Fictitious Revenue
premature recognition effects of the $14 million deal along with other questionable transactions.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 expected order, 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 in such situations would be considered fictitious.
For example, during 1997 and 1998, sales managers at Boston Scientific Corp. were particularly eager to meet or exceed sales goals. To facilitate increased, although ficti- tious sales of the company’s medical devices, commercial warehouses were leased and unsold goods were shipped there. To mask the fact that these “noncustomers” never paid for 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 placed orders. Sometimes these distributors were not even in the medical device business. Cred- its were then issued when these distributors returned the shipments, although by then revenue 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
Company Premature Revenue
Acclaim Entertainment, Inc. • Recognized revenue on a foreign distribution AAER No. 1309, September 26, 2000 agreement in advance of required product
delivery
Bausch & Lomb, Inc. • Used aggressive promotion campaign to AAER No. 987, November 17, 1997 encourage orders and shipments that could
not be economically justified
Peritus 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
Telxon Corp. • Shipment to reseller that was not financially The Wall Street Journal, viable
December 23, 1998, p. C1
Twinlab Corp. • Revenue recognized for valid orders that were 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.
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California Micro Devices Corp. provides a particularly egregious example of ficti- tious revenue recognition. As noted in the opening quotes to this chapter, the chip maker’s acts of revenue recognition included “booking bogus sales to fake companies for 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 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 of return. Revenue was recognized when product was shipped to those distributors. As the fiction developed, the company began recording sales for fake shipments. In fact, as the alleged fraud grew and more of the company’s staff became involved in it, a running joke 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. In early 1997 the fast-growing auto loan company announced that it had uncovered phony bookkeeping 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 this case, much of the fictitious revenue was recognized by the stroke of a pen—through journal entries recorded without even the semblance of a sale. The erroneous entries accompanied 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 man- agement to cover up its acts. Such cover-up activities might take the form of backdating invoices, changing shipping dates, or creating totally false records. The actions taken often are limited only by the imagination of those concocting the scheme and may be more 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
$1.3 million sale of telecommunications equipment to a single customer, National Health Services, Inc. (National Health). National Health, however, did not actually purchase the goods 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 $1.3 million 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 confirmation letter, 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 in the 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
Recognizing Premature or Fictitious Revenue
for the goods delivered. Later that year, Cambridge’s CFO devised a scheme to retrieve the product and simultaneously make it appear as if the distributor had paid the $975,000 price. To effect the plan, Cambridge ordered other product from a third company for an amount approximately equal to the value of the original shipment. The order was a sham order, however, and was in actuality an order to take delivery of the same product that had been shipped to the distributor in the first place. The goods were shipped back to Cambridge from the distributor. Then, by paying for the goods, Cambridge provided the distributor with the money needed to “pay” for the original shipment. It was a convoluted plan 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 distribu- tor whom the company had negotiated to acquire. Here again the distributor had no obligation to pay for the product that had been shipped. Cambridge recognized revenue for the transaction amount and showed a receivable. Later, in completing the purchase 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 of product. Cambridge recognized revenue for $600,000 even though the trading company had no real obligation to pay for the order. Then Cambridge agreed to purchase goods worth $48,640 from another company, one that was related to the trading company. The agreed 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 company paid $600,000 to the trading company, which used the money to pay for the original order. 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 man- agement of Cambridge Biotech to cover up its recognition of fictitious revenue. There were others. Fortunately, the transactions were uncovered and the company’s cover-up activities were foiled.
Selected examples of cover-up activities seen in the area of revenue recognition are summarized 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 very straightforward. Most would agree that revenue is recognized prematurely when it is recorded for a shipment made immediately after a period’s cutoff date to fill a valid order from a creditworthy customer. The revenue is not fictitious because the sale exists. It was recorded early. Most also would agree that revenue recorded for nonexistent sales to nonexistent customers is fictitious. Here a sale simply does not exist. Between these two extremes, however, within that gray area noted earlier, it is difficult to get consensus on what constitutes premature and what constitutes fictitious revenue recognition. Fortu- nately, such a precise demarcation is not necessary.
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For purposes of analysis, a precise labeling of premature or fictitious revenue is less important than acknowledging that revenue has been recognized improperly. In both cases, 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 greater will 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 of when revenue should be recognized. As our economy evolves and new forms of prod-
Recognizing Premature or Fictitious Revenue
Exhibit 6.2 Revenue Recognition Cover-up Activities
Company Cover-up
Advanced Medical Products, Inc. • Did not mail invoices and monthly statements AAER No. 812, September 5, 1996 to “customers” that had not placed orders Automated 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 to pay amount due
Cendant Corp. • Charges to cancellation reserve kept off the AAER No. 1272, June 14, 2000 books
Cylink, Inc. • Shipments made to third-party warehouse
AAER No. 1313, September 27, 2000
Informix Corp. • Backdated license agreements to earlier AAER No. 1215, January 11, 2000 periods
Laser Photonics, Inc. • Did not record credit memos for returns AAER No. 971, September 30, 1997
Photran Corp. • Backdated order and shipping documents AAER No. 1211, December 3, 1999 • Shipments made to third-party warehouse Premier 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 recognition becomes 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 company has 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 are exchanged for cash or claims to cash. Revenue is realizable when assets received in exchange for goods and services are readily convertible into known amounts of cash or claims 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 is earned. Consider the software industry, which has struggled with problems of revenue recognition for years. The industry has evolved from what was effectively the sale of a product—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, include not only installation and training but also such customer services as ongoing telephone support and unspecified product upgrades and enhancements. With such services being provided over extended periods, determining when the revenue is earned becomes a problem.
Initially, there was no specific guidance as to when revenue should be recognized in the software industry. Accordingly, the industry struggled to determine when its revenue was earned, and companies formulated revenue recognition practices that were quite divergent. For example, it was not long ago that software companies were employing such 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 a signed contract or order.16
From the annual report of American Software, Inc.:
Upon entering into a licensing agreement for the standard proprietary software, the com- pany recognized eighty percent (80%) of the licensing fee upon delivery of the software documentation (system and user manuals), ten percent (10%) upon delivery of the software (computer tapes with source code), and ten percent (10%) upon installation.17
From the annual report of Autodesk, Inc.:
Revenue from sales to distributors and dealers is recognized when the products are shipped.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