How Can Accounting Used to Inflate RevenueHow can accounting be used to inflate revenue? In brief, when investors use a method based on revenue to value a firm, the valuation will be excessive if the revenue is exaggerated. If investors derive cash flow estimates from reported revenue, exaggerated revenue will result in an overestimate of cash flows and thus an overestimate of value. Alternatively, if investors use a price/revenue ratio, the reported revenue will influence value. If the industry norm is a price/revenue ratio of 2 and the firm reports revenue of $15 per share, the estimated value of the firm will be $30 per share when the price/revenue ratio is applied. However, the firm would have reported revenue of $13 per share if it had used a more traditional method of measuring revenue, its estimated value would have been $26 per share when the price/revenue ratio was applied. Even if investors use a price/earnings ratio, inflated revenue will still affect the stock valuation because it will result in inflated earnings. Thus, the industry price/earnings ratio will be applied to an overestimated earnings level.

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That is in brief. Through this post, I will discuss some methods that used by unethical management to inflate their revenues to pull investor’s interest. Some of the practiced methods are under the Securities and Exchange Commission (SEC) investigation. The purpose of this post is not to persuade or suggest you to implement the methods, but to show you inappropriate revenue estimation methods that you should avoid. Investors should find it useful, on other hand.

 

Fraud Classification by the Association of Certified Fraud Examiners (ACFE)

The Association of Certified Fraud Examiners (ACFE), headquartered in Austin, Texas, periodically surveys a random sample of Certified Fraud Examiners (CFEs) discussing recent fraud cases they have investigated. These survey responses form the basis for the publication titled Report to the Nation on Occupational Fraud and Abuse, first published in 1996 and with subsequent surveys done in 2002, 2004, 2006 and 2008.

In its surveys, the ACFE classifies fraud in three broad categories:

[1]. Asset misappropriation, or the theft of an organization’s assets, such as embezzling cash or stealing inventory.

[2]. Fraudulent financial reporting, or the intentional falsification of financial statement information, such as overstating revenues.

[3]. Corruption, or using one’s position in an organization wrongfully to obtain a personal benefit, such as accepting kickbacks (cash from a vendor in exchange for having the organization make purchases from that vendor) The ACFE results suggest that although it is not common, fraudulent financial  reporting is occurring more frequently.

Not only has the occurrence of financial statement fraud increased, as might be expected, the median dollar misstatement caused by fraudulent financial reporting is significantly greater than the median dollar loss in either of the other two fraud categories.

 
Next, let’s see how accounting can be used to inflate revenue. Read on…

 

Reporting Future Revenue

Some service firms that receive multiyear contracts from clients record all the revenue in the first year of the contract, even when they have received payment only for the first year. Some Internet firms that generate revenue from online membership subscriptions count potential renewals when they record their sales for the year. Some firms report all of their sales as revenue even when the cash has not been received. When a large portion of the sales are credit sales, the cash flow attributed to those sales will either occur in a future period or not occur at all.

In April 2002, Gemstar (owner of TV Guide) used a method for reporting revenue that includes orders not yet paid by customers. This accounting method is not illegal, but investors recognized that the reported revenue might have overestimated cash inflows because some of the cash had not yet been collected. Once analysts recognized that this accounting method was used, the company’s stock price quickly declined by more than 30 percent.

 

 

Reporting Canceled Orders As Revenue

Sunbeam used a selling strategy that made it easy for customers to cancel orders. Yet it counted all the orders it received as revenue, even though it was likely that many of them would be canceled. In 1998, Sunbeam restated earnings for the six previous quarters. One of the reasons was that it had overstated its revenue, which resulted in overstated earnings.

In 2001, when the SEC filed a complaint against Xerox concerning the company’s financial reporting, one of the main issues was that Xerox had included expected future revenue from suppliers within its reported revenue. In April 2002, Xerox paid a $10 million fine to the SEC as a result of the manner in which it had estimated its revenue from leasing its copiers and printers. Xerox also agreed to restate earnings over a 4-year period.

 

Given the wide flexibility that firms have when reporting revenue and earnings, they have to stretch the rules a long way before they are forced to restate earnings. However, while a restatement is appropriate as a means of correcting the error, it does not correct the losses suffered by investors who purchased the stock based on their analysis of the firm’s financial statements. It also does not correct the gains that executives may have realized from selling their holdings of the firm’s shares over the period during which the earnings were inflated.

 

Reporting Products Allocated To Distributors As Revenue

Some manufacturing firms book revenue when they allocate their products to their distributors. However, the distributors are not the ultimate purchasers of the product, as they must attempt to sell the products for the firms. If the distributors do not sell the products, they will return them to the manufacturers. Therefore, the revenue will be overstated. Even if the products allocated to the distributor are sold in the next year, this accounting method inflates the reported sales and therefore the reported earnings for the present year.

Consider how a firm that serves as an intermediary might report revenue. Assume that you have a business that serves as an intermediary between a steel firm and various car manufacturers. Assume that over the last year, the supplier has paid you $100,000 for helping it to sell steel valued at $3 million. What is your revenue for the year? The logical response is $100,000, since that is the amount of funds that you received in return for providing your service. However, using creative accounting, you might claim revenue of $3 million for the year by arguing that the steel was yours momentarily before it was purchased by the car manufacturers.

Priceline.com has used this accounting method, which explains how it could achieve a revenue of more than $1 billion per year. That is, Priceline’s accounting suggests that Priceline owns the products that it sells for others.

 

 

Reporting Security Trades As Revenue

Some firms trade various types of derivative securities whose values are tied to commodities or other securities. These firms hope to buy the contracts for less than they sell them for. A traditional method of accounting for such a contract is to report the “net,” or the difference between the amount received from selling the contract and the amount paid for the contract. This net is reported in a section of the income statement called “trading gains and losses”.

Example: if a firm purchases a contract for $260,000 and sells that contract for $300,000, it would report a $40,000 net from the contract. An alternative method of accounting is to report the “gross,” with the $300,000 received from selling the contract being classified as revenue. Critics contend that such a method is misleading because it allows a firm to generate revenue simply by purchasing contracts and selling them. Firms can create the appearance of revenue growth simply by trading more contracts every year. Even if they sell the contracts for the same price at which they purchased them, they can report the sale of the contracts as revenue.

Enron used this type of accounting when it traded various types of energy contracts. This accounting method magnified the size of Enron’s operations and was a major reason for Enron’s reported revenue growth during the late 1990s.

 

Many other energy firms also used this type of accounting method, so Enron might have argued that it was the convention within the industry. Two firms could have the exact same operations, but the firm that reports gross will appear to have more revenue than the firm that reports net. If analysts and other investors have the ability to recognize the difference between net and gross reporting, perhaps the accounting method used does not matter. However, the fact that many firms in the energy industry use the accounting method that inflates revenue seems to suggest that they are better off with that method. That is, by following the “industry standard”, each firm can keep up with its competitors by providing equally misleading reports of revenue. It should not be surprising that firms use whatever means they can within the guidelines to present their financial position in the most optimistic perspective.

In April 2002, it was made public that Dynergy had used optimistic valuations of its contracts to buy or sell natural gas. Such valuations are not illegal, as accounting guidelines allow much flexibility. However, this form of accounting can be misleading to investors.

 

Investors can review the footnotes of financial statements to catch a creative accounting method that exaggerates a firm’s revenue. However, many investors will not have the resources to detect the accounting methods used by some firms. The analysis of financial statements could be done much more efficiently if investors did not have to waste their time trying to correct for inflated revenue numbers reported by some firms.

 

The Auditors’ Responsibility for Detecting Fraud

Fooling the auditors is certainly the trick to master when one is engaging in fraudulent Financial reporting. On the surface, this may seem difficult, but numerous fraud surveys indicate that auditors seldom detect fraud.

What exactly is the auditor’s responsibility for detecting fraud?

 

External auditors—the auditors from a public accounting firm who are hired by a company to audit its financial statements and render an opinion on them—are required under professional auditing standards to plan and conduct the audit to provide reasonable assurance about detecting material misstatements regardless of whether the material misstatement is due to errors or to fraud.

However, recall that the dollar amount of some frauds may not have a material effect in the financial statements for the company as a whole. Note the following points:

  • The auditor has no responsibility to detect immaterial fraud (where materiality is defined in relation to the financial statements as a whole); recall that an item is considered material if its misstatement  or omission would cause a reasonable person to make a decision different from the decision that would be made if the item had been stated correctly.
  • The auditors’ responsibility to detect material frauds is no different from their responsibility to detect material errors (unintentional misstatements).
  • The auditors do not provide absolute assurance or any kind of guarantee that all material fraud will be detected.

 

Internal auditors are employees of the company and as such are not considered independent in the required sense for rendering an opinion on financial statements. Therefore, they cannot audit a company’s financial statements. However, they provide useful services to management, such as assisting in the design and implementation of internal controls and monitoring the effectiveness of those controls over time.

The professional standards for internal auditors require that those auditors have sufficient knowledge to identify fraud indicators; however, they are not expected to have the same level of fraud expertise as an individual whose primary responsibility is fraud investigation. Internal auditors can assist in fraud deterrence by evaluating the effectiveness of the internal control system, identifying areas of the organization that may be vulnerable to fraud, and implementing controls to help minimize that risk.

In light of the different functions of external and internal auditors, it is not surprising that few fraud cases are detected by external auditors or that more instances are caught by internal auditors, who work year-round at the same company on a closer and more detailed level. The moral of the story is that auditors, both internal and external, cannot be relied on to detect fraud. However, audited financial statements are still preferable to unaudited financial statements (some assurance is better than no assurance).

The Sarbanes-Oxley Act of 2002 (SOX) was passed in response to the numerous widely publicized corporate accounting scandals that had occurred from the 1990s until that time (e.g., Enron, WorldCom, Xerox, Tyco, Waste Management, Global Crossing). Section 404 of the Act requires auditors to provide an opinion on the effectiveness of public companies’ internal control over financial reporting. The logic behind this requirement is essentially that if a public company has effective internal controls over financial reporting, there is a reduced risk of fraudulently misstated ?  nancial statements being published and relied on by the investing public.