How Financial Report Readers Can Detect Problems with Revenue
There is a gamut of revenue recognition games, from slight misrepresentations to gross exaggerations. Unfortunately, many of these problems are difficult for financial report readers who are company outsiders to find.
Goods ordered but not shipped
In some cases, a company considers goods that have been ordered but not yet shipped to be part of its revenue earned. Orders can get severely backlogged, and ultimately, the company may have a lot of problems satisfying its customers.
Additionally, this practice can have a big impact on a company's bottom line. Accrual accounting is specifically designed to match revenue with expenses each accounting period. As more goods build up that are ordered but not shipped, financial reports overstate the firm's revenue and understate expenses until the deception is exposed. Eventually, the firm has to restate its net income.
Goods shipped but not ordered
Some companies count goods that they've shipped but that customers haven't ordered yet. Companies that use this technique commonly ship items for inspection or demonstration purposes in the hope that customers will buy the product. This tactic can help a company meet its revenue for the upcoming reporting period because it counts these unordered goods as sales.
As the problem snowballs, the company has to ship more orders without actually having the sales to meet its revenue expectations. Eventually, the company must correct its financial statements, lowering the amount it reported as revenue and reducing its net income.
Extended reporting period
Some companies try to meet Wall Street's expectations by keeping their books open for days or weeks into the next reporting period to generate last-minutes sales. This tactic eventually creates major problems because it takes the sales from what should have been reported as income during the next reporting period. Eventually, the company has to reveal its deceptive practices because it has to leave its books open longer and longer.
The most outrageous acts are the ones that involve reporting purely fictional sales. How do companies do this? Well, they recognize revenue for sales that were never ordered and never shipped. Company insiders fill financial records with false order, billing, and shipping information. Eventually, the business will likely go bankrupt.
Channel stuffing is a way for companies to get more products out of their manufacturing warehouses and onto shelves. The most common method is to offer distributors large discounts so that they stock up on products. Then distributors sell the product to their customers; however, several months may pass before they sell all the products. If the products don't sell, in some cases, companies can return the product.
Although this strategy is a legitimate type of revenue, it can come back to haunt the company in later accounting periods, when distributors have more product than they can sell.
Sometimes companies make agreements with their regular customers outside the actual documentation used for the corporate reporting of revenue. This agreement is called a side letter, which involves the company and customer changing terms behind the scenes.
In all cases, the side letter terms eventually result in turning revenue that was recognized on a previous income statement into a nonsale, either by the return of goods or by the extension of credit beyond a 12-month payment period. This practice makes revenue from these sales look better initially, but the revenue is later subtracted when the goods are returned.
Rights of return
Giving customers liberal return rights is another way of getting them to order goods. By offering distributors or retailers terms that allow them to order goods for resale that they can return as much as 12 months later if they don't sell, the sales shouldn't be recognized as revenue on a company's financial report.
Rights of return are offered to most customers, but when payment for goods depends on the need for the distributor or retailer to first resell the goods, the recognition of that revenue is questionable.
Related-party revenue comes from a company selling goods to another entity in which the seller controls the management of operating policies. For example, if the parent company of a tissue manufacturer sells the raw materials needed for manufacturing that tissue to its subsidiary, the parent company can't count that sale of raw materials as revenue.
These related-party sales don't meet the SEC's requirement for an arm's-length transaction, which is a transaction that involves a buyer and a seller who can act independently of each other and have no relationship to each other.
Sometimes a buyer places an order but asks the company to hold on to the goods until it has room in its store or warehouse. So the company has sold the goods but hasn't shipped them yet. This sale is called a bill-and-hold transaction.
The SEC has a set of criteria that a company must meet for it to recognize revenue for items it hasn't shipped yet. These criteria include the following:
The seller passes the risks of ownership to the buyer.
The customer makes a fiscal commitment to purchase the goods.
The buyer, not the seller, requests the bill-and-hold transaction.
The buyer and seller set up a fixed schedule for the delivery of the goods.
The seller separates the ordered goods from its inventory so that it won't use the goods to fill other orders.
The seller has the goods complete and ready for shipment.
Up-front service fees
Companies that collect up-front service fees for services that they provide over a long period of time must be careful about how they recognize this revenue. If the company collects fees to service equipment up front, it can't count these fees as revenue when the money is collected.
The SEC requires that such companies recognize their revenue over time as the fees are earned. Companies that recognize this type of revenue all at once are prematurely recognizing revenue.