Best Guesses, Revenue Recognition, and Compliance: A Fine Line to Walk

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A nifty application that runs on the Mac called Photobooth creates hilarious visual distortions. Business accounting has something similar, but way more purposeful. It’s called revenue recognition. As Karen Berman and Joe Knight wrote in their excellent book, Financial Intelligence, “Revenue recognition is a common arena for financial fraud . . . the most common source of accounting fraud has been and probably always will be in that top line: Sales.”

“Those bendy numerals at the top of the screen? That’s not Captcha, that’s our annual sales!” The accounting definition of Sales or Revenue is “the dollar value of all the products or services a company provided to its customers during a given period of time.” And the guideline that accountants use to recognize a sale is that the revenue must have been earned. But according to the authors of Financial Intelligence, “the sales figure on a company’s [income statement] always reflects the accountants’ judgments about when they should recognize revenue. And where there is judgment, there is room for dispute—not to say manipulation . . .”

Guideline – not rule – is the operative word. Suppose you’re the new VP of Sales for a technology services provider that expects to be acquired. Last week, your company landed a huge contract with a new customer. The engagement will begin right away with a pilot, and the project will be fully implemented in about 12 months. In the past, your company has always recognized 50% of the revenue at the time of contract signing, and the remainder applied after meeting key project milestones. But there’s pressure to change: you have a significant bonus riding on over-achieving your quarterly quota. And after all, you worked hard to land this deal. So why not recognize 80% percent right now? Fortunately, you have a helpful lever—the company’s desire for a high valuation. A strong revenue gain over last year will appear lovely to any investor.

The change isn’t illegal. But because this revenue accrual ratio isn’t consistent with your company’s past accounting practices, you remind your CFO that she can footnote this as a material change on the company’s financial statements. As it turns out, she’s under no obligation to do so. Material, in the accounting sense, depends on her personal judgment. As Berman and Knight concisely stated, “Revenue on the income statement is an estimate, a best guess.” Sales numbers don’t lie, but they don’t necessarily tell the truth, either.

There are other ways to game revenue reporting. One technique, Bill-and-hold, allows customers to purchase products well in advance of when they are needed. The supplier assumes all logistics overhead, including warehousing, inventorying, and staging for shipment. The supplier has committed the inventory for sale to that customer. So when should revenue be recognized? There isn’t always a clear answer. Once again, though, compensation considerations help narrow the options. Nortel Networks of Canada allegedly used bill-and-hold in 2000 to inflate the company’s revenues, allowing company executives to earn millions in bonuses.

Channel stuffing, a practice sometimes used for sales of IT hardware, presents a shadier way to warp revenue reporting. In 1998, a class-action lawsuit against Telxon Corporation included channel stuffing among the indictments. “The Company’s increased revenues in the second quarter was not attributable to increased acceptance of its products, but was instead the result of the Company’s channel-stuffing, i.e., shipments of excessive product to its distributors that it knew would not be resold in the second quarter, and its premature recognition of revenue on such shipments.” The company was a takeover target at the time.

Sunbeam, Cendant, Xerox, Rite Aid, HealthSouth, MicroStrategy, and Qwest. All of these companies fiddled with revenue recognition, until their chicanery tripped the alarms of government regulators. And the penalties assessed were no mere rap on the knuckles. Xerox, Rite Aid, HealthSouth, and Qwest paid the government over $1 billion – each.

Rampant accounting non-compliance and other corporate malfeasance led to the passage of the Sarbanes-Oxley act in 2002. In the US alone, there are over 10,000 federal, state, and local regulations, covering healthcare, education, financial services, public corporations, and privately-held companies. Throw in FINRA, HIPAA, and the Foreign Corrupt Practices Act, and you have dangerously high risk for coloring outside regulatory lines, so to speak.

How do companies deal with the complexity? Odell Guyton, head of global compliance for Jabil, Inc. recently shared that most of his work focuses on “preventative law,” or “helping [managers] to understand the business of the company, and helping them navigate around these land mines they may not be aware of in terms of compliance risk.” “There’s a recognition that to be effective, compliance has to be knitted into the fabric of an organization,” said Paul McGreal, dean of the University of Dayton law school. “It’s more of a role in the leadership team within an organization.”

Above all, the outcome from compliance enforcement must be to provide customers, suppliers, employees, and investors protection from harm. And for revenue recognition compliance, companies must maintain governance over how their products are developed, priced, and sold—and how employees are compensated for these activities.

Mark Twain understood human foibles quite well. As he wrote in The Adventures of Huckleberry Finn, “Right is right, and wrong is wrong, and a body ain’t got no business doing wrong when he ain’t ignorant and knows better.” For now, we’re stuck with regulatory oversight.

Republished with author's permission from original post.

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