Investment Banking: When Companies Aggressively Report Revenue - dummies

Investment Banking: When Companies Aggressively Report Revenue

By Matt Krantz, Robert R. Johnson

It would seem pretty straightforward to identify when a sale has been made. In the investment banking world, however, things aren’t as simple as having a yard sale. What if someone comes to your yard sale and promises to pay you tomorrow for your items? What if you send your items to someone who says he’ll try to sell them for you? Have the items truly been sold?

To understand how companies cook the books, you need to understand why they do it in the first place. And there are few better examples of why cheating is so tempting than with the career of Al Dunlap, a CEO who garnered a reputation as a successful, yet ruthless turnaround specialist.

Dunlap earned the colorful nickname “Chainsaw Al” while at Scott Paper by firing thousands of employees, closing plants, and cutting costs to the bone. After downsizing Scott Paper and making it more attractive to suitors, he engineered the 1995 sale of the firm to Kimberly-Clark and personally parachuted off with a lucrative cash payout of over $100 million.

Sunbeam — maker of grills, blenders, bread makers, coffee makers, microwave ovens, and many other consumer products — hired Dunlap shortly after he left Scott Paper, and it appeared that his methods were very successful in turning Sunbeam around.

Shortly after Dunlap assumed control, Sunbeam went on a buying spree, acquiring several well-known brands; the stock price soared. In 1996, when he took the company over, it had reported negative net income and in 1997 it reported large positive net income — an impressive turn of events. Dunlap’s reputation was burnished, and he was lauded as a hero. Or was he?

A careful examination of the numbers reveals that while revenue increased by a robust 19 percent in 1997, inventories and accounts receivable both increased at a much higher rate — 59 percent for inventories and 38 percent for accounts receivable. This situation is certainly not ideal, and it would raise red flags for any forensic accountant worth her salt.

Mounting inventories meant warehouses were filling up with unsold goods. Rising accounts receivables meant the company was accumulating IOUs from customers. Ideally, both receivables and inventory would grow no more than the increase in revenues. Not seeing those things move in lockstep raised suspicions of mismanagement, accounting games, or outright fraud. In Sunbeam’s case, it was allegedly a little bit of all three.

What was going on at Sunbeam reveals the key to why companies cheat with their numbers in the first place: The company was recognizing sales on products at the time of simply shipping an invoice — but not the product — to customers (the retailers) in a practice known as bill and hold.

As an example, Sunbeam was invoicing hardware stores for outdoor gas grills in the fourth quarter of the year, and holding that inventory in Sunbeam’s warehouses, knowing full well that the grills weren’t even going to be shipped to the retailers and put out for sale until the spring.

Yet, Sunbeam was counting those grills as sold when they were sitting in their own warehouses! In fact, Sunbeam was offering incentives for retailers to agree to this practice — a practice that is pejoratively referred to as channel stuffing.

Typically, businesses produce inventories, sell them to firms on credit, and finally collect on that account receivable by getting the cash. If a firm is growing, all those accounting line items should be growing by approximately the same rate. If inventories and accounts receivable are growing faster than revenue, then either customers are paying awfully slowly or inventory is piling up — both developments that signal problems.

Sunbeam overstated revenue by aggressively booking sales. Reported net income did increase in 1997, but cash flow was decidedly negative — the grills were sitting in Sunbeam’s warehouse and not generating cash. An examination of Sunbeam’s statement of cash flow revealed that Sunbeam had positive net income in 1997, yet actually had negative cash flow.

This was exactly the opposite situation as occurred in 1996, when the firm had negative net income but positive cash flow. This turn of events was alarming. As any businessman knows, you can’t pay bills with inventory — you can only pay bills with cash.

Dunlap was fired in 1998, and the Securities and Exchange Commission (SEC) investigated and determined that, for 1997, at least $60 million of Sunbeam’s reported $189 million in earnings from continuing operations before income taxes came from accounting fraud.

The SEC issued a consent judgment against Dunlap, and he was permanently barred from serving as an officer or director of a public company. Sunbeam declared bankruptcy in 2001 and emerged from bankruptcy in 2002 as American Household, Inc., a privately held company. In 2009, Condé Nast Portfolio named Dunlap the sixth worst CEO of all time. Just imagine: There are five CEOs worse than he was!

If the company is doing an adequate job of collecting from customers, receivables should grow no faster than revenues. In fact, ideally the growth rate in receivables would be less than revenue growth as companies improve their collection cycle.