Understand How Companies Cook Their Books

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The quarterly and annual financial results are among the most awaited events in a company’s calendar. Everyone, including shareholders, investors, analysts, fund managers, and the management, looks forward to it. Most management teams act ethically and follow the prescribed accounting rules. However, some companies engage in financial shenanigans.

Financial shenanigans refer to misrepresentation of a company’s actual financial performance or financial position. It can range from relatively minor infractions involving merely a loose interpretation of accounting rules to outright fraud perpetrated over many years.

This blog will examine how companies use creative accounting techniques to manipulate their revenue numbers. To write this blog, we have borrowed a lot from the book Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports.

The idea is to help you understand the accounting tricks used by some unethical companies. Understanding these tricks will help you closely examine companies’ financial statements and get better at investing.

1. Bringing Time To A Halt To Show Additional Revenue

Achieving sales targets is challenging for any company. Listed companies have their own set of challenges as they have to show the numbers publicly every quarter. And some of these companies feel no guilt in taking the dishonest route to meet their targets.

An often-used tactic is to stretch a month. From 30-31 days, companies extend the month to 33, 35, or 38 days to reach the target. Companies do this by simply stopping the booking system’s clock on the last day of the previous month. As a result, the sales that happen on the 36th day, for example, get lodged within the last month.

Mathematically, a company gives itself an additional 20% time by stretching a month for six days. It is quite a considerable time to meet its revenue numbers.

As investors, when we come across a scenario like this, there are two things for us to consider.
If the company management is resorting to such questionable practices, what else is it hiding?
And secondly, if the company has to resort to extending its month-end, its revenue generation engine is probably not as strong as portrayed on their financial statements.

2. Showing Revenue In Excess Of Completed Work

Many industries sell multi-year contracts. For example, it is common for software companies to sell licenses for 5-10 years. Under a multi-year contract, the customer pays some money upfront for the license. And then it pays an annual charge in the subsequent years. It effectively means that a decent amount of the license’s total value is not payable to the company for many years to come.

However, a company’s management sometimes takes a few desperate steps to inflate revenue. The company simply rewrites the accounting guidelines to suit itself. It recognizes the license’s total value as revenue in the ongoing financial year without actually providing the service.

Similarly, there are companies that earn their revenue with a subscription-based business. Examples of such companies are Tata Sky, Amazon Prime, ZOHO, etc. Their service runs into many months, quarters, and years.

Let’s understand how such subscription-based businesses can cook their books with an example. Say, for example, the subscription fee for the software is Rs. 10,000 per year. So that’s Rs. 10,000 rupees for 12 months. An aggressive company looking to boost its revenue will immediately record the entire Rs. 10,000 as revenue. However, a more prudent approach would have been to charge Rs. 2,500 every quarter or in whichever frequency the billing is done.

We often see that companies start with a moderate or a conservative revenue recognition policy. But as the pressure mounts, they change tracks and end up adopting a more aggressive approach. As investors, it is our responsibility to discover these changes, which are often buried deep within the footnotes of the company’s annual report or quarterly statements.

3. Changing Revenue Recognition Policy

Accounting of leases is an area that relies heavily on management estimates. And a couple of bad quarters is all it takes for them to be unreasonably optimistic with their projections. The book, Financial Shenanigans, takes the example of Xerox Corporation. And explains how it inflated revenue and earnings using creative accounting techniques.

A large portion of Xerox’s revenue comes from equipment lease agreements. An equipment lease agreement is a contractual agreement where the owner of the equipment allows its clients to use the equipment for a specified period in exchange for periodic payments.

According to regulations, Xerox could recognize the present value of future lease payments as revenue at the inception stage itself. The present value estimates are a function of the discount rate, the residual value, the length of the contract, and the periodic lease payments.

Present Value (PV) = {FV/(1+Discount Rate)} + {FV/(1+Discount Rate)2}+{FV/(1+Discount Rate)3} +………+{FV/(1+Discount Rate)n}

Where,
FV = Future Value and
n = number of years

For now, let’s focus on just this discount rate. As you can see in the present value’s formula, the discount rate is in the denominator. So, if the management chooses a low discount rate then the present value will come to a lot higher. And accordingly, a higher number can be apportioned as revenue.

This is exactly what the Xerox management did. As a result, it led to a $6 billion USD reinstatement of revenue and a $1.4 billion USD reinstatement of earnings.

Accounting Trickery In Multiple Product Launches

Yet another variation of revenue recognition trickery is played when multiple deliveries are involved in long-term arrangements. Let’s say a company starts bundling a hi-definition Smart TV with a super-fast broadband connection. Say it is launched with the monthly offer where a customer need to just pay for the broadband services and the TV is free of cost.

These two parts of the offering (the TV and the broadband connection) can give way to a lot of revenue recognition trickery.

As per the accounting rules, this company would need to allocate a portion of the total contract value to the TV set which has to be recognized as revenue upfront. And it needs to recognize the broadband service revenue over the life of that contract.

However, as these two products are bundled, the distribution of how much to allocate to the TV and broadband depends on the company’s management. In such a situation, if the management turns out an unprincipled one, they can have a massive incentive in allocating a higher number to the TV’s price in order to book more revenue upfront.

From an investor’s perspective, the detection of these creative anomalies will require you to look into the revenue recognition policies of these companies. You have to be alert to any changes in this policy. And you have to closely monitor the receivables to spot any gaps.

4. Recognizing Revenue Before The Buyer’s Final Acceptance

There are three tricks that creative accountants can play to record revenue before the buyer accepts the product or service.

One, the company can recognize revenue before the shipment.

Two, they can recognize revenue after the goods are shipped to the distributor but without having any evidence if these goods have been bought by the end customer.

And thirdly, some companies can recognize revenue while ignoring return scenarios like shipping a defective or wrong product, etc.

On the face of it, none of these revenue recognition methods are invalid. But as investors, it is our job to understand the context in which the company is using either of these methods. So we need to understand if the accounting approach is the most ideal for a business or the company is simply using an accounting approach to inflate revenues.

5. Recording Bogus Transactions

There is no concept of a 99% sale. Thus, a sale is not completed till the customer signs on the dotted line. But some companies find a way to magically convert the incomplete sale to a complete one and inflate their revenue.

In Financial Shenanigans, the authors of the book give examples where companies recorded millions of dollars in revenue from “non-binding” sales of software licenses to their resellers.
The company did non-binding sales worth millions although the resellers were under no obligation to pay the company.

The authors cited another variation of a bogus transaction that involved a different company .. which also happened to be in the software business. This particular company used a creative three-party circular scam to create fake revenue out of thin air.

On the face of it, the company’s system looked like any regular distribution system.

• The company would sell its product to a middleman
• The middleman would then sell it to the final customer
• The customer would pay the distributor
• And the distributor pays the company after deducting its commission

But what the auditors found was something completely bizarre. The company was actually paying a bribe to the customer to place sale orders. In fact, the company was also transferring the cost of buying the products to its customers. Therefore, purchasing its own product at a much higher price.

But why would a company be doing all this?

For one simple reason: To show revenue growth

6. When A Loan Is Not A Liability, But A Sale

A company earns revenue when it receives money from a customer in return for a product or service. On the other hand, if the company receives money in its bank account as a loan, it is a liability. It needs to be repaid. It is as simple as that. But when accounting becomes creative, a few more scenarios unexpectedly turn up.

For example, in some cases, companies record the loan money as cash received for the sale of goods. Another variation of this unprincipled practice is for a company to overpay a vendor with an understanding that the vendor will pay back the excess amount as a rebate. And then, the company records the repaid cash as revenue in their books.

Let’s understand this with an example.

Say, a business makes Rs. 150 in revenue. And the expense is Rs. 100.

Now, say, this company intentionally overpays Rs. 20 to the vendor. The understanding between the company and the vendors is that the vendor will pay back the excess amount in the next quarter.

In the revised scenario, revenue is the same at Rs. 150. But the costs now have risen by Rs. 20 (the amount given to the vendor). In the next quarter, when the vendor pays back the Rs. 20, the company adds it to their revenue.

So if sales in the next quarter were also Rs. 150, that quarter will now show Rs. 170. It is on account of that additional Rs. 20 that the company received from the vendors. This way, without an overall change in profit numbers, the company has managed to show an increase in revenue.

7. Masquerading As A Large Company

Several businesses act as facilitators. They facilitate a transaction between the buyer and seller. Examples of such businesses can be real estate agents, e-commerce companies, marketing agencies, etc. These businesses rarely hold any inventory, and the revenue they earn comes as fees or payable commission.

In that context, the manufacturer or the seller is expected to recognize a lot more revenue for a transaction as compared to the agent. But a creative and misleading accounting practice arises when this agent (who bears no inventory risk) starts accounting for sales and revenue like a principal.

Let’s take ET Money as an example. Actually, ET Money is not the right example. We don’t take any commission on our mutual fund sales as we have only direct plans on our platform. But to explain the above theory, let’s assume that ET Money gets a 0.1% commission on the total assets it brings.

At over Rs. 100 crore of investment value, the commission comes to Rs. 10 lakh. Now, the question is what number should we record as ET Money’s sales? Is it Rs. 10 lakh or is it Rs. 100 crores?

The prudent approach is to take the Rs. 10 lakh number. But if you want to project your company as a big company, then you will use the higher number.

Therefore, as an investor, it is important to understand a company’s business model and the metrics that are being passed off as the company’s revenue.

Bottom Line

Companies use multiple creative accounting practices to show a higher revenue number.

If you directly invest in some stocks, here are some quarterly trends that you need to examine carefully: Sales numbers, operating cash flows, receivables, and any changes in the revenue recognition policy. Besides, you should also look at comments and declarations made by auditors.

Detecting these accounting trickeries might take some time, but if you directly invest in stocks, it is crucial to examine the financial statements carefully.