153 Financial Professionals Speak Out Exhibit 5.11 (Continued) Earnings management could either inflate or keep stock price low depending on whether earnings 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, it increases the probability that the company will suffer losses—ACPA Widespread earnings management can increase the cost of capital to all firms that access U.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 long run—FA Takes management’s attention away from their true task, i.e., managing the firm—FA Inappropriate increases in bonuses—Lender Managing earnings takes significant effort away from managing true profit and loss—CPA Management may be expending inappropriate resources to manage earnings or making short-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 affecting the actual results—CFO It will lead management to use more questionable accounting practices in order to smooth earnings 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 154 Earnings Management as Helpful The 66 statements suggesting that earnings man- agement could be helpful are categorized as follows: Number Percentage Reduces earnings volatility 16 24 Provides a share-price benefit 15 23 Signals management’s private information 9 14 Helps to meet forecasts 6 9 Rationalizes expectations 4 6 Other reasons 16 24 —– —– Total 66 100 A sampling of the statements from each of these categories is provided in Exhibit 5.12. The reduction in earnings volatility is the most frequently mentioned benefit of earn- ings management. The recurrent theme is that a smoother earnings stream is likely to benefit share value and also may reflect favorably on management of the firm. Earnings management as a means of signaling management’s private information is cited only by the academics. Positive information possessed by management can be signaled to investors by managing earnings up. Alternatively, negative information can be signaled 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 sur- prising. The rationalization of expectations could be seen as another avenue for guiding expectations 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. T HE F INANCIAL N UMBERS G AME 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 perceives the 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 core- underlying trends—ACPA 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 and result in a lower price-to-earnings ratio. Smoothing earnings legitimately, e.g., pacing expenditures, improves investor confidence—CFO 155 Financial Professionals Speak Out 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 the long 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 in stabilizing investment return and investor activities—ACPA Smoothes out certain nonrecurring items that might otherwise lead to increased stock price volatility—ACPA Conservative accounting practices within GAAP are prudent business actions to provide a shock absorber to unforeseen negative events. Sustained earnings growth consistent with expectations 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—CFO 14 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 in their stock price by smoothing earnings over time, rather than sending volatile earnings reports 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 and expectations—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 done within GAAP rules, earnings management tools are very helpful to investors—Lender (continues) 156 T HE F INANCIAL N UMBERS G AME Exhibit 5.12 (Continued) Rationalizes Expectations Within reason, earnings management can help to rationalize expectations in periods where there may be unusual charges or credits in current earnings—CFO Perhaps okay if an extraordinarily good quarter occurs and some genuine sales or earnings are deferred to a later date to avoid extra-optimistic assumptions on the part of investors—FA Other Reasons 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 earnings management 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 earnings power 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 rel- atively little systematic information available about the nature of earnings management and how and why it is practiced. The survey results presented in this chapter are designed to help fill this void. Key points made in the chapter, based on the survey, include the fol- lowing: • Financial professionals are generally in agreement on when earnings management crosses the line between the exercise of the legitimate flexibility inherent in GAAP and 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 has increased over the past decade, and that the SEC campaign against abusive earnings management is necessary. • The major objectives of earnings management are to reduce earnings volatility, sup- port or increase stock prices, increase earnings-based compensation, and meet con- sensus earnings forecasts of analysts. 157 • The major categories of earnings-management actions, in order of frequency, are the timing of expense recognition, big bath and cookie jar reserves, the timing of revenue recognition, 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 cir- cumstances, footnote review, days statistics, and the proximity of actual to estimated results are the most frequently mentioned earnings-management detection techniques. • Earnings management is viewed as more likely to be harmful than helpful. • Harmful earnings-management effects are seen to include the distortion of financial performance, inflation of share prices, and potential damage to firm performance. • Possible helpful effects from earnings management include a reduction in earnings volatility and share-price volatility, the potential for management to signal its private information, and helping to meet forecasts and rationalize expectations. GLOSSARY Absolute Right of Return Goods may be returned to the seller by the purchaser without restric- tions. Abusive Earnings Management A characterization used by the Securities and Exchange Commission to designate earnings management that results in an intentional and material mis- representation of results. Analytical Review The process of attempting to infer the presence of potential problems through 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 customer but 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 under the short-term offer of deep discounts. Consignment A shipment of goods to a party who agrees to try to sell them to third parties. A sale 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 sell the goods for the account of the consignor. Consignee A party to whom goods are shipped under a consignment agreement from a con- signor. Until ultimate sale, the goods remain the property of the consignor. Days Statistics Measures the number days’ worth of sales in accounts receivable (accounts receiv- 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. Field Representatives Company employees who negotiate sales transactions on behalf of their employers. LIFO Dipping Reducing LIFO inventory quantities and, as a result, including older and lower costs 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. Financial Professionals Speak Out 158 NOTES 1. Accounting academic respondent. 2. Chief financial officer respondent. 3. Analyst respondent. 4. Chief financial officer respondent. 5. Lender respondent. 6. Lender respondent. 7. In view of the limited sample sizes and nonrandom character of most of the samples, no effort is made to test for statistical differences between the means of the various groups. 8. One chief financial officer provided the following comment on this case: “Not a realistic example. If history showed a pattern of returns, where policy was no right of return, they would have to provide a reserve or auditors would be all over them.” 9. This action might be seen to be in the shareholders’ interests if the goal were to increase incentive compensation by increasing the value of stock options. However, the intent was to frame the action as tied to increasing earnings-based incentive compensation. 10. Statement of Position No. 81-1, Accounting for Performance of Construction-Type and Cer- 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 (Norwalk, CT: Financial Accounting Standards Board, March 1975), para. 17, held that con- tingent gains are not normally reflected in the accounts. 11. The CFO survey did not include this element. We expected it to be difficult to get CFOs to respond to the survey. Therefore, to reduce its length somewhat, we decided to exclude this element from the CFO version of the survey. Our low, but not unexpected, response rate from 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 Pub- lic Accountants, 1999), p. 24. 13. LIFO dipping refers to increases in earnings that result from a reduction in inventory that causes 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 the stock price crashes and street expectations are not met. While I do not advocate earnings management, it would seem that a company reversing an accrual (with some justification) or booking 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 a regular occurrence and it wasn’t material to the financials.” T HE F INANCIAL N UMBERS G AME 159 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 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. TEAMFLY Team-Fly ® TEAMFLY Team-Fly ® 160 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.” 5 The 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 T HE F INANCIAL N UMBERS G AME 161 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 162 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. 11 Such alleged acts clearly would con- stitute fictitious revenue recognition. T HE F INANCIAL N UMBERS G AME 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. [...]... no obligation to pay 163 THE FINANCIAL NUMBERS GAME 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 $9 75, 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,... Source: SEC’s Accounting and Auditing Enforcement Release (AAER) for the indicated date 173 THE FINANCIAL NUMBERS GAME Interestingly, as seen in the exhibit, most of the companies with side agreements were in the software industry It is unclear why the practice was so prevalent with software firms Possibly the relative youth of the industry, the specialized nature of many software sales, and the very low... On the last day of the quarter in June 1997, the company recognized revenue of $1 .5 million for 40 units of a 60-unit order The sale comprised 28% of the company’s revenue for the quarter Bill-and-hold accounting treatment was used as the goods were not shipped at the time of recognition The bill-and-hold treatment accorded the sale was based on the terms and conditions contained in a letter from the. .. term In the view of the SEC, the company earned its revenue on these contracts over time The effect on the company’s financial position was significant, shaving approximately $50 million from revenue for 1999 The company’s share price dropped 62% with the announcement of the accounting change and, as of this writing, had not recovered Interestingly, the share-price decline occurred in spite of the fact... some of the criteria specified by the SEC Consider the case of Sunbeam Corp The consumer products company employed extensive use of bill-and-hold practices as a sales promotion campaign During 1997 the company sold barbecue grills to retailers at 177 THE FINANCIAL NUMBERS GAME Exhibit 6.4 Criteria for Recognizing Revenue in Advance of Shipment 1 The risks of ownership have passed to the buyer 2 The customer... expected to receive on the loans above the amounts funded on the loans over (2) the present value of the interest they had agreed to pay the buyers of the loan-backed securities When properly executed, there is nothing inherently wrong with this process However, Green Tree, like other subprime lenders, was somewhat aggressive in the assumptions used in calculating the present value of the amount of interest... outlined below These steps also may prove helpful in detecting revenue that has been recognized properly but whose sustainability nonetheless can be questioned 1 85 THE FINANCIAL NUMBERS GAME Understand the Policy for Revenue Recognition It is very easy to avoid a careful read of the footnotes that accompany an annual report The small print and accompanying accounting terminology make the reading dense... purchase the goods, preferably in written documentation 3 The buyer, not the seller, must request that the transaction be on a bill-and-hold basis The buyer must have a substantial business purpose for ordering the goods on a bill and hold basis 4 There must be a fixed schedule for delivery of the goods The date for delivery must be reasonable and must be consistent with the buyer’s business purpose 5 The. .. $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,... bill-and-hold treatment For example, the letter did not specify that the risk of ownership had passed to the customer In addition, it was the company and not the customer that had decided to structure the transaction as bill and hold Further, the goods were not complete at the time of sale and could not have been shipped even if the customer wanted them In fact, there was no scheduled delivery date . 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. Public Accoun- tants, July 15, 1981), para. 65 67. Earlier GAAP, SFAS No. 5, Accounting for Contingencies (Norwalk, CT: Financial Accounting Standards Board, March 19 75) , para. 17, held that con- tingent. 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