Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition (14 page)

Syntax-Brillian’s elaborate related-party transactions (and many other red flags, such as surging receivables) were in plain sight for any investor who read the SEC filings. Take, for example, the following reference to SCHOT found in Syntax-Brillian’s March 2006 10-Q that would have led even the most novice investor to raise questions.

At March 31, 2006, the accounts receivable balance from one of our Asian customers, that is also a joint venture partner, totaled $9.6 million, or 70.8 percent of the outstanding balance of accounts that had not been assigned to CIT.

Watch for Unusual Sources of Revenue at the Time of an Acquisition.
Revenue between two parties that are about to merge clearly lacks an arm’s-length process. Consider Krispy Kreme’s nifty scheme to inflate revenue when it was about to reacquire one of its franchises in 2003.

Before the acquisition closed, Krispy Kreme sold doughnut-making equipment to the franchise for $700,000. As part of the deal, Krispy Kreme increased the amount that it would pay to acquire the franchise by the same $700,000 in order to cover the price of the equipment. This arrangement clearly had no real net economic impact, so no revenue should have been recorded. Krispy Kreme, however, did not see it that way, and so it recorded the sale of equipment as revenue rather than as an offset to the increased franchise purchase price. Not surprisingly, this ruse helped Krispy Kreme maintain its streak of consistently exceeding Wall Street expectations.

Be Alert to Two-Way Transactions with a Nontraditional Buyer.
Symbol Technologies simultaneously purchased software for $8.5 million and sold one of its products to that vendor-customer company for $4.25 million (of which $2 million was returned). Curiously, Symbol retained possession of the inventory it had “sold” and provided the funds for the software company to “purchase” its product. In a side agreement, the software company had an unlimited right of return for an indefinite period. Incidentally, Symbol never used the software it had purportedly purchased; it still remained packed up in the original box years after the transaction.

3. Recording Revenue on Receipts from Non-Revenue-Producing Transactions

So far, we have addressed bogus revenue generated from transactions that are completely lacking in economic substance and ones that may have some economic substance but lack a necessary arm’s-length process. We now investigate situations in which bogus revenue arises from misclassification of cash received from non-revenue-producing activities.

Investors understand that not all cash received represents revenue or even directly pertains to a company’s core operations. Some inflows are related to financing activities (borrowing and stock issuance), and others to the sale of businesses or sundry assets. Companies that recognize revenue or income from non-revenue-producing sources should be deemed guilty of reporting phony revenue to inflate earnings.

Question Revenue Recorded When Cash Is Received in Lending Transactions.
Never confuse money received from your friendly banker with money received from a customer. A bank loan must be repaid and is considered a liability. In contrast, money received from a customer in return for a service rendered is yours to keep and should be considered revenue.

Apparently, auto parts manufacturer Delphi Corporation failed to understand the distinction between a liability and revenue. In late December 2000, Delphi took out a $200 million short-term loan, posting inventory as collateral. Rather than recording the cash received as what it was (a liability that needed to be paid back), Delphi improperly recorded it as the sale of goods. As you will see with Delphi in Chapter 10, this twisted interpretation not only allowed Delphi to record bogus revenue, it also provided bogus cash flow from operations.

Challenge Advances Received from a Partnership That Are Classified as Revenue
. An equally suspect source of revenue involves cash from a joint venture partner. Consider the research and development partnership on waste technology formed between Molten Metal and Lockheed Martin. Lockheed provided the funding, and Molten performed the research. Molten took $14 million from the partnership and recorded that amount as revenue. Molten was still essentially a development-stage company; it derived virtually none of its revenue from actual sales to unaffiliated customers. The $14 million taken from the partnership should have been considered a distribution or a loan from the partnership to fund the research, not revenue.

Be Wary of Revenue Recorded on Receipts from Vendors.
Generally, cash flows with vendors involve cash outflows to purchase products or services. Occasionally, a company will agree to overpay a vendor for inventory upon purchase, provided the vendor rebates that excess charge with a cash payment in a later period.

Recording that cash rebate as revenue is clearly inappropriate, as it should be considered an adjustment to the cost of the inventory purchased. However, our good friends at Sunbeam did not see it that way. Sunbeam played a neat trick to boost revenue in which it advanced cash to vendors and then recorded revenue when that cash was repaid. Additionally, Sunbeam would commit to future purchases from a particular vendor in exchange for an immediate “rebate” from that vendor, which Sunbeam, of course, recorded as revenue.

Consider How Retailers Account for Returned Goods.
While the Sunbeam example illustrates a fraudulent transaction, certain retailers may receive cash refunds or credits from suppliers or other vendors in the normal course of business. The proper accounting to use for these credits would be to reduce the value of the inventory purchased. Sometimes, however, retailers aggressively overstate their sales by recording these credits as revenue. For example, the SEC charged that retailer L.A. Gear improperly classified as income one-time vendor credits (for supplier misshipments and other sourcing troubles) that it had not actually collected.

4. Recording Revenue from Appropriate Transactions, but at Inflated Amounts

The first three sections of this chapter focused on sources of revenue that were wholly inappropriate, as they lacked any economic substance, failed the necessary arm’s-length test, or derived from non-revenue-producing activities. Companies profiled in this section, on the other hand, generally meet the broad guidelines for recognizing revenue. The transgression, however (and not an insignificant one), concerns recording revenue in an amount that seems excessive or misleading to investors.

Excessive or misleading revenue might result from

(1) 
using an inappropriate methodology to recognize revenue or

(2) 
grossing up revenue to make a company appear much larger than it really is

Using an Inappropriate Methodology to Recognize Revenue

Surging revenue growth always wows investors, especially when it occurs in an industry that does not normally grow at breakneck speed. While meteoric sales growth is often found in the technology industry, rarely do investors find it at small management and consulting companies. However, back in 1993, one such darling consulting company, Education Alternatives Inc., enchanted Wall Street with revenue leaping tenfold in a single year. And boy did Wall Street notice, as the firm’s share price doubled in three short months. Let’s take a close look and review a key warning sign that those investors missed.

Education Alternatives provided consulting services to school boards on topics such as security, maintenance, and improving student performance. The company was tiny (with a few dozen employees and a few million dollars in revenue), and its business model was simple. Such small and uncomplicated consulting companies rarely present complicated accounting issues for auditors or investors.

Things changed dramatically for the company in 1992, however, when it won a contract to manage the entire budget for nine Baltimore public schools. This was more than a plain-vanilla consulting arrangement. Education Alternatives was charged with improving student performance, and it was given control of the school board’s checkbook in managing the $133 million budget over the next five years.

Education Alternatives’ Unique Consulting Gig.
How would Education Alternatives be compensated for this unique consulting gig? The terms seemed to be a bit unusual, but they were certainly unambiguous. Let’s start with the $133 million total for the five years. That works out to $26.6 million available to spend each year for the schools. The deal worked as follows: Baltimore would pay no more than the amount allocated in the budget, $26.6 million annually. If, for example, Education Alternatives spent $25 million on the schools, the remaining $1.6 million would be considered its fee. If, instead, it spent the entire $26.6 million (about $5,900 per student), the company would get nothing; and if it went over the budget, the company would have to dig into its pocket to make up the shortfall. It could actually lose money on the deal.

Although Education Alternatives’ fee provided by the contract was nebulous and uncertain, it would appear logical for the firm to book revenue in the same way as a typical management consulting company, that is, by calculating an imputed hourly or daily rate. While the method used is certainly subject to management discretion, this would seem to be the most accurate approach for estimating revenue. Surely, during the contract bidding, the company priced out its costs in order to make a rational decision on whether to accept this engagement.

Education Alternatives’ Creative Approach to Revenue Recognition.
Education Alternatives shunned the traditional consulting revenue model and came up with something that might be considered a bit crazy. The company decided to recognize as its own revenue the entire $26.6 million received each year (or $133 million over five years). As a result, the company’s revenue jumped from approximately $3 million to $30 million in the first year of the contract. How were investors to interpret this dramatic growth? Well, they must have come to one of three conclusions: either (1) there was a typo in the company’s revenue line, with a zero mistakenly added, (2) the company was an unbelievably attractive investment opportunity, or (3) the company was a complete fraud.

The following year, Education Alternatives hit an even bigger jackpot when the city of Hartford decided to turn the management of its entire school system over to the company. Revenue raced to $214 million in 1995, as Education Alternatives treated the entire budget for Hartford’s schools as though it were its own sales. As a result, revenue that in 1992 had barely reached $3 million climbed to over $200 million in three short years. (Enron executives must have been studying this meteoric revenue rise and taken it upon themselves to outdo Education Alternatives!)

Testing Education Alternatives’ Revenue Recognition Methodology.
Let’s extend Education Alternatives’ business model beyond the Hartford and Baltimore contracts to test the legitimacy of the company’s revenue recognition policy. Imagine if the company won a contract to manage New York City’s budget. Using this unconventional revenue model and reasonably assuming approximately 1 million public school students and $6,000 per student, the company’s sales would have jumped by $6 billion, a figure higher than the total revenue of Arthur Andersen, the largest of the “Big Eight” accounting firms at that time. Would any sane investor believe that Education Alternatives and its few dozen employees generated revenue equivalent to that of the global behemoth accounting and consulting firm?

So, which of the three conclusions do you believe investors should have come to [(1) there was a typo in the company’s revenue line, with a zero mistakenly added, (2) the company was an unbelievably attractive investment opportunity, or (3) the company was a complete fraud]? If you picked (2), you need to read this book a bit more carefully and put away that beer you are drinking! We hope that you did not blow this one, but fortunately you will have another chance to show your mastery of detecting financial shenanigans with a final exam question at the end of Chapter 15.

Tip:
If you spot signs of a questionable accounting approach, test it by comparing the results and practices to those of a similar company that is much larger. With Education Alternatives, let’s compare it to the biggest firms in its industry—consulting firms. During the early 1990s, the Big Eight accounting and management firms dominated the industry.

In addition to inflating revenue by using an unorthodox accounting methodology, companies might be able to properly report higher revenue based on their business model or on assumptions made by management. That is the focus of the final section of this chapter.

Grossing Up Revenue to Appear to Be a Larger Company

Unlike companies that produce or purchase inventory and then sell it to customers (called “principals” of the sale), some companies are simply matchmakers (called “agents” of the sale)—they facilitate the sale between a buyer and a seller. Real estate agencies, auction houses, and travel agencies are examples of agents—they normally do not sell inventory that they own; rather, they connect a buyer and a seller.