I'm starting a new series of articles to record and share what I learned about detecting problem accounting in companies. Most of the information is based on the excellent book, Financial Shenanigans by Howard Schilit. What I cover here is probably not enough to keep us all safe from accounting frauds. However, it will do us well to know at least some clues about accounting fraud. I invite those of you who are more experienced to correct me if I am wrong and share your experiences with us so we can all learn.

This is a first of about seven or more parts of the series. Each part contains a few key points that help identify accounting frauds. I will present each point followed by a case study of a stock and the warning signs as I write each article. I find examples to be the easiest way for me to understand stuff. Unfortunately, I may not be able to find a stock in the current market for each key point. In such cases, I may just use historical cases. Okay, enough blabbering. Let's get to the nitty-gritty dirty laundry.

Premature Revenue Recognition
Premature revenue recognition means recording revenue before the earnings process has completed. This is also known as "front-end load" in the accounting world. Not to be confused with the front-end load fees charged by mutual funds, front-end load in accounting refers to revenue recorded before an exchange has occurred.

Key Point 1: Recording Future Revenue As Current
Many companies sign long-term contracts with their clients, some spanning multiple years. When a company signs a five-year contract with a client for $10 million, it is most likely that the company has not earned the $10 million until the end of the contract term. Depending on the terms in the contract, the company may earn $6 million in the first year and the remaining $4 million is spread over the contract term. In this scenario, the company should only record as revenue in the first year the $6 million earned, not the full $10 million.

Case Study: Tyco International
We have all heard about Tyco (NYSE: TYC) CEO, Dennis Kozlowski's $6,000 shower curtain and $2,000 trash can. However, that's a pittance compared to the $280 million he stole from investors. How could we as investors have known about this? Is it even possible to foresee such catastrophe?

The "good" news is I could see the post-warning signs after reading the news, not that this would help. :) The "bad" news is I didn't know much about stocks back then. So, had I started picking stocks back then I would have been in the same boat.

Warning Sign: Jump in Receivables
After examining Tyco's financial statements from the years before the fiasco, I discovered one warning sign — a huge jump in receivables in the year preceding the indictment in 2002.

Of course, looking at the table above, it only indicates that Tyco may have used aggressive accounting to record its revenue. We as investors would have had no way of knowing Dennis' spending our money on Renoir art pieces or expensive parties for families and friends considering he intentionally hid that from not just the shareholders but also the board of directors. However, knowing that the jump in receivables could be a sign of trouble, we may have been able to save ourselves by getting out at the time. Tyco's stock fell to $6.98/share in July 2002. It was trading at $59.79 in December 2001.

Assuming we didn't know about the outrageous expenditures by Tyco management, what would have prompted us to sell at the first sign of a huge jump in receivables? The problem with recognizing revenue too soon is it creates two more problems down the road:

1) Revenue earned in the future can no longer be recognized because it has been used. If a company signed a five year contract worth $10 million and recorded all $10 million this quarter, it cannot record the same revenue in the quarters spanning the remaining term of the contract.

2) It's harder to beat current revenue due to the artificial inflation by recognizing revenue prematurely. By boosting revenue for current year with future revenue, management has raised the bar significantly making it extremely difficult for the company to beat the current revenue let alone match it.

I think these two inevitable problems are reason enough to sell at the first sign of disproportionate increase in receivables.

Key Point 2: Recording Revenue Before Shipment or Customer's Unconditional Acceptance
It is important to record revenue at the right time when it comes to accounting. Revenue should be recognized:
a) when products have been shipped to the customer and the customer is obligated to pay.
b) if products sold to customers are not refundable or the return period has lapsed.
c) during the accounting period the contracts are signed and dated.

Case Study: Sunbeam
Sunbeam, now a subsidiary of Jarden (NYSE: JAH), used what is known as "bill and hold accounting" back in 1996. Sunbeam convinced retailers to buy grills six months in advance. The retailers were not obligated to pay until the grills were delivered six month later. In the meantime, Sunbeam had to hold the inventory somewhere. So Sunbeam leased some warehouses and shipped the inventory there. Even so, Sunbeam recorded the revenue.

Warning Sign: Unbilled Receivables Grow Much Faster Than Billed Receivables
This one is really hard to spot. As far as I know, most financial statements do not separate billed receivables from unbilled receivables. So to separate the two, one may have to scour the footnotes of financial statements.

Some of the tricks employed can be very hard to almost impossible to detect. The following are some tricks we should be aware of:

a) Shipping before the sale occurs
According to Howard Schilit, automobile manufacturers usually does this by overstocking the dealerships.
b) Backdating contracts
Informix fraudulently boosted their quarterly and annual revenues by backdating contracts signed in future quarters.
c) Changes in quarter end date
Some companies extended a quarter end date to record additional revenue so as to meet analyst estimates.
d) Ignoring the return of goods
Goods that are returnable should not be considered sold until the return period has lapsed or a reserve is setup for returnable goods. Most consumer goods are returnable.

I do not know how to detect these other than looking for inconsistent receivables. If you know of any other simpler ways, I'd be very interested to learn.

Key Point 3: Recording Revenue Even Though Customer Could Not Pay
Manufacturers that sell big-ticket products are faced with the problem of financed purchases. Of course, it is common business practice to provide financing to customers who can't pay cash. But it is important to understand who provides the financing. It wouldn't make much business sense if the seller is providing the financing. That would be equivalent to buying one's own products with one's own money.

Case Study: Informix
In an attempt to "save their own asses", former sales managers of Informix pressured finance staff to disregard customer creditworthiness. By doing so, quarterly numbers were boosted with artificial sales.

Under GAAP, revenue cannot be recognized until presuasive evidence with the customer exists and an assessment of the customer's creditworthiness has been made.

In short, if there's no convincing proof that the customer can pay, it's not a sale. The company probably shouldn't have sold to the customer in the first place because there is a high risk the sale would result in a loss.

Warning Sign: Receivables Grow Substantially Faster Than Revenues
This one is probably not too hard to detect. But then, when receivables grow faster than revenues, it does not necessarily mean that a company is selling to customers who cannot pay. However, it does mean that the company may be in trouble or at least heading for trouble.

Conclusion
It's not easy to detect accounting gimmicks simply by looking at a company's financial statements. However, from the three key points I stole from Howard Schilit's excellent book, we know that receivables is a pretty important figure in the financial statements. We may not know the true reason behind a jump in receivables, but we know it's a bad omen. At least now I know to scan the year-to-year receivables when I attempt to value a company. Hopefully, this will keep me away from bad company (pun intended).

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