Accounting Tricks: Recording revenue before completing obligations

Thursday December 24th 2020

Joris Kersten MSc RAB

Kersten Corporate Finance (M&A and Business Valuation)

Uden – The Netherlands

Source used – book: Financial Shenanigans – How to detect accounting gimmicks and fraud in
financial reports – 4th edition (2018). Howard M. Schilit, Jeremy Perler and Yoni Engelhart.
McGraw-Hill New York.

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Introduction

As a M&A consultant and Business Valuator I need to understand accounting since it is the
“grammar” of the language of business.

The source of this article is the book mentioned; Financial Shenanigans, and it is just lovely!

Learned so much on how the books can be “cooked” and how to detect that.

When you are not an accountant and work in corporate finance like me, I highly recommend you
to read the book! 😊

In this sequence of blogs on “Accounting Tricks” I share the most important tricks that I have
learned from the book.

Internet driven bull market in the ‘90s

One of the stars in the internet market in the late nineties was the Virginia based software seller
MicroStrategy (MSTR).

In less than two years after going IPO it reached a market value of 25 billion USD.
Only later turned out that a key driver of its growth was a practice of recording sales to parties
that MicroStrategy had recently invested in.

The company went public in 1998 with a market value of about 200 million USD.

But at the end of 1999 the share price rose from 20 USD to 100 USD, and shortly after to about
330 USD.

And the net worth of the founder; Michael Saylor, reached almost 14 billion USD.

(H.M. Schilit, J. Perler & Y. Engelhart 2018)

Material accounting irregularities

In March 2000 MicroStrategy (MSTR) disclosed to investors that its financial reports contained
“material accounting irregularities”.

Financial reports of 1997-1999 had to be restated and this resulted in massive losses instead of
the reported profits.

Investors were shocked and started dumping their shares, share price decreased from about 220
USD per share to about 85 USD per share in 1 day.

But this was not the end because 12 months later the stock was worth less than 2 USD per share.

(H.M. Schilit, J. Perler & Y. Engelhart 2018)

What happened at the company MicroStrategy ?

Forbes magazine came up with a story, in early March 2000, that raised questions about MSTR’s
“revenue recognition” practices.

And this was just after the accountant; PricewaterhouseCoopers (PWC), had blessed MSTR’s
1999 financial reports. And this contained a prospectus for a proposed stock offering.

After the article of Forbes PWC conducted an internal investigation and concluded that MSTR’s
financial reports were indeed false and misleading.

And this change of mind of the auditors of the company caused the stock price of MSTR to fall
down.

(H.M. Schilit, J. Perler & Y. Engelhart 2018)

Warning sign: “Boomerang Transactions”

With the case of MSTR there were some warning signs.

In October 1999 MSTR announced a press release that it had signed a deal with “NCR
Corporation”.

MSTR described an over 50 million USD licencing agreement and partnership with this NCR
Corporation.

MSTR invested in the NCR partnership, and NCR returned the favor and purchase MSTR
products.

But when money flows in both directions, from seller (MSTR) to customer (NCR), and then
from customer to seller, they are called “Boomerang Transactions”.

(H.M. Schilit, J. Perler & Y. Engelhart 2018)

Key lessons for investors

From the MicroStrategy story we can learn two lessons.

Lesson 1:

Funds flowing back and forth between a customer and seller should raise suspicions about the
legitimacy of both transactions.

Lesson 2:

Suspicious timing of press releases that announce new sales just after a period ended, should
raise questions about whether revenue has been recognized to early.

(H.M. Schilit, J. Perler & Y. Engelhart 2018)

Playing with dates

The company “Computer Associates” (CA) used a “revenue inflation trick” by regularly
stretching out its months to 35 days.

This in order to capture sales booked after the conventional month end.
The scheme worked well for a while, until the company was caught, and the CEO Sanjay Kumar
went to jail.

The company “Sunbeam” did sort of the same in the mid-90s and changed the company’s quarter
end from March 29th to March 31st to deal with a revenue shortfall.

This enabled Sunbeam to recognize another 5 million USD from its core operations.

And another 15 million USD from it’s recently acquired company “Coleman Corporation”.

(H.M. Schilit, J. Perler & Y. Engelhart 2018)

Changing “accounting policies” to keep up growth

The coffee seller “Keurig Green Mountain” KGM tried to hide its slowing revenue growth from
investors.

The company basically changed its decision rules on when “revenue recognition” begins, and
where “large-quantity-rebates” get categorized in the P&L (profit & loss statement).

After very fast growth from 2005-2008 it could not keep the pace.

After that they could have let the stakeholders of the company know that growth slowed down.

Or they could “keep up” the growth for the public.

They did the latter with 2 accounting policy changes in 2008 that inflated revenues.

First:

KGM began to recognize some revenue earlier in the sales process, at the point of shipment,
instead of at the delivery.

Second:

KGM started to treat incentives (large-quantity-rebates) to customers as an “operating expense”

rather that a "reduction of revenue”.

(H.M. Schilit, J. Perler & Y. Engelhart 2018)

In the next article in this sequence I will talk about:

·       Revenue recording far in excess of work completed!

Source used – book: Financial Shenanigans – How to detect accounting gimmicks and
fraud in financial reports – 4th edition (2018). Howard M. Schilit, Jeremy Perler and Yoni
Engelhart. McGraw-Hill New York.