Creative accounting vs complex accounting judgements: choice of accounting policies or shenanigans when accounting for revenue
In this article, I will continue to elaborate a little on the choices which the CFO and its accounting team make when treating certain business activities. The existing financial reporting standards sometimes provide a wide range of choices when treating certain operations: how to recognize, measure or disclose those in the financial statements.
In the previous insights, I focused more on how companies manipulate financial results. Today I will try to summarize the most obvious ways of manipulating revenue and oppose those to the normal accounting judgements when the management does not plan to mislead the user of the financial statements. It is very important for all the stakeholders, including investors and bankers, to understand those potential areas and be able to prevent being misled.
I will continue with the analysis of revenue as one of the most usual areas of significant judgements leading to fair and unfair financial information presentation. The example of normal accounting judgements, which can be made by the management, will be based on a real-life case from our ADE team’s experience.
Potential areas of significant accounting judgement when recognizing revenue: example of a machinery-producing company with long-term construction contracts
My team had an interesting 2-month project on consulting on revenue recognition issues for a company producing turbines and other equipment for a hydro-generation power plant. Each piece of equipment could consist of several pieces, each being constructed for a long?period, mostly more than 1?year. In addition, the company transported the equipment to the construction site and provided installation services. The company had a number of clients in different countries.
The company presented its financial statements in accordance with IFRS, so we had to thoroughly dig into the company’s business, its financial and management reporting and apply the relevant IFRS 15 requirements. In certain cases when we lacked the relevant guidance in IFRS 15, we applied the respective US GAAP standard ASC 606.
Below are just a number of significant accounting judgements, which we had to discuss and agree upon with the client for his revenue recognition accounting policies. The analysis was conducted based on deep research of the customer’s products, market analysis and interviews with its research, production, sales and finally finance teams.
The client was very eager to deeply analyze the issues below since they resulted in tens of millions of US dollars effect on its revenues and resulting net earnings to be recognized in its financial statements presented to the management and investors.
Listed below are a few examples of normal accounting judgements:
One of the criteria that contracts should meet before an entity applies the revenue standard, is that collectability is probable.? The client had a number of very difficult customers in countries with unstable political regimes. We had to look at whether the revenue is collectable at all.
IFRS defines probable as ‘more likely than not’, which is greater than 50%. In other standards, for example in US GAAP, revenue should be recognized when ‘likely to occur’, which is generally considered a 75%–80% threshold.
As a result, we had to establish a grading scale for each client and establish a framework for the definition of collectability based on a number of externally observable and updated factors.
We had to identify sales of which parts of equipment should be recognized separately and which should be aggregated. In making the judgement on which level the equipment produced by the customers can be aggregated we analyzed the potential other suppliers of similar equipment since IFRS 15:22 points out the need to identify distinct goods, which can be supplied elsewhere.
The same analysis was conducted for the sale of services, which included sales of installation and transportation services.
Sales of installation services were not distinct from sales of equipment and could not be recognized separately. The reasoning was that installation services are deeply integrated with the supply of primary equipment and could not be outsourced elsewhere.
As for transportation services, we established detailed guidance depending on the INCOTERMS regulations and transfer of control.
In this case, the main point for decision-making was an analysis of principal-agent issues for each delivery option offered to the clients.
The contracts with the clients contained a number of various guarantees, which had to be accounted as a separate performance obligation, or as a liability in accordance with IAS 37.
In making the judgement on the separation of guarantee as a separate performance obligation we analyzed if the guarantee is mandatory under the contract or legislation and what the length of the term of the guarantee is.
If the guarantee is promised by the law, then it can not be recognized as a separate performance obligation. The longer the guarantee term the more likely it is to be a separate performance obligation.
In this case, the key point of analysis was what happens if the client decides to terminate the contract.? We had to extensively consult with the client’s legal team and research the available legal cases.
The analysis proved that in case of unilateral termination, the client will compensate our client fees in proportionate to the percentage of completion of the total contractual value, i.e. cost plus a profit margin.
As a result, we confirmed that the client could apply over a time recognition basis for its contracts.
IFRS 15: 60 requires analysis for separate recognition of financing components in revenue contracts when there is a significant difference between the amount of promised consideration and the cash-selling price of the promised goods or services.
In this particular case, the financing component was identified and required separate recognition. We developed a financial model for the calculation of the financing component for long-term contracts with multiple advances and post-payments applicable for this particular client’s contracts.
In addition, we analyzed and provided detailed guidance to the client for the following fewer material issues: revenue recognition when contracting part of the order to the sub-contractor, capitalization of pre-project expenses, recognition of fines as cost via variable consideration, loss-making orders, allocation of revenue to separate orders from clients and some others.
The dark side of revenue accounting: the 17 shenanigans based on the recent cases with the listed companies
Let’s now look at the dark side and review the most common ways to mislead the user of financial statements when presenting revenues.
I have collected the 17 tricks or shenanigans based on the recent SEC and other regulators' investigations in respect of the listed companies. Of course, I think that the list is not complete and there can be many more other issues to be added.
Listed below are a few tricks:
The companies can be very eager to recognize early some of the revenue by giving the customers additional discounts or other ways of motivation to buy additional orders early or simply recognize the revenues prematurely even without the customer’s approval or request.
I have provided an example of such transactions in my previous article (the case of Surgalin).
This is one of the technically most difficult cases to identify since it is applied mainly in long-term construction contracts and requires a very deep understanding of both advanced accounting and business operations.
I have provided an example of such transactions in my prior article (the case of Austal).
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Recognition of upfront or total license/rental fees in the first reporting period, rather than spreading it over the total contract time.
A notable recent example was that of Saba Software company, charged by the SEC in 2008. The company inflated its reported revenues by recognizing revenue upfront from multi-year licensing agreements, even though the revenue should have been recognized over the term of the agreement.
In this case, the seller bills the customer, and holds the goods, but recognizes the revenue, though no control over the goods has passed to the customer
One example of a bill-and-hold arrangement involves the case of Bristol-Myers Squibb (BMS), a pharmaceutical company, in the early 2000s.
In 2002, BMS was investigated by the U.S. Securities and Exchange Commission (SEC) for engaging in improper bill-and-hold arrangements. The company used these arrangements to accelerate revenue recognition by shipping products to wholesalers, but not actually transferring ownership or allowing the products to be sold to end customers.
Recognize revenue from sales of goods to dealers or other intermediaries prior to actual delivery or sales to the final customers.
This case also deals with no transfer of control over the goods like the bill-and-hold arrangements above.
Part of the revenue related to the financing of the customer should be recognized as interest income rather than revenue from sales. The more the payment deferred is, the more significant the financing component can be.
Revenue should be recognized net of provision for estimated return percentage.
The companies often lend goods, especially in mining industries where the counterparty has to return the same amount of material, which is often misinterpreted as sales transactions.
The companies inflate revenues and recognize the gross amount of sales rather than its agency fee.
An example of recognizing revenue on a gross basis involves the case of Waste Management Inc., one of the largest waste management companies in the United States. In the late 1990s, Waste Management engaged in accounting fraud by recognizing revenue on a gross basis instead of a net basis, thereby inflating its reported revenues and misleading investors and stakeholders.
These are usually typical for the B2B market: for example, the production company has several large contracts with wholesalers, which include success bonuses for “minimum annual volume purchased”.? The contract condition states a discount at the year-end if a certain volume of sales is reached. The production company forgets to reduce revenue for this discount.? Usually, it makes it possible through non-transparent formulation in contracts or non-disclosure of additional agreements on bonuses to the auditors/other interested persons. The practice is widely spread in businesses where the commercial department has aggressive sales success bonuses.
The latest accounting scandal involving early recognition of payments from suppliers was with the large British retail chain Tesco in 2014, which not only accelerated recognition of payments from suppliers but also accounted for as income rather than a deduction in the cost of goods sold. The case resulted in a settlement in 2017 when Tesco agreed to pay a substantial financial penalty of $162 million to settle the criminal investigation into the accounting fraud.
The most common way to manipulate sales revenues is through bogus sales to fake related parties, shareholders, joint ventures or other related parties.
I have provided an example of such transactions in my prior article (the case of Luckin Coffee Inc.).
When making barter transactions the revenue is recognized based on the fair value of the consideration. Fair value especially when dealing with intangibles or services can be very tricky to determine and as a result subject to manipulation.
I have provided an example of such transactions in my prior article (the case of comScore).
Barter accounting can be very tricky. Let me bring a very simple example of when barter sales should not be recognized at all.
Entity A is a supplier of crude oil. Adverse weather events can lead to a sudden increase in demand and entity A does not always have a sufficient supply of crude oil to meet this demand on short notice. Entity A enters into a contract with a supplier of crude oil in another region, such that each party will provide crude oil to the other during local adverse weather events, as they are rarely affected at the same time. No other consideration is provided by the parties.
In this case, there are no additional economic benefits brought to the company at all and the available international accounting guidance prohibits recognition of revenue in this case at all.
Round-trip transactions involve swapping assets or services with another company to create the appearance of revenue. These circular transactions had no economic substance but are usually designed solely to inflate reported revenue.
These transactions were actively used by Enron and HealthSouth Corp., which were two high-scale accounting cases in the early 2000s.
The available financial reporting guidance specifically tells that revenue should only include recurring profits while one-off gains should be presented separately. The companies often try to inflate their profits by moving the one-off gains into the revenues.
An example of such sham transactions could be WorldCom, which entered into agreements with other companies to exchange or sell assets at inflated prices, creating the appearance of revenue generation without actual economic substance.
Another potential way of inflating revenue could be the consolidation of part of the JV’s revenues. The conditions for such proportionate consolidation are quite rare and specific, so the cases when the company out-of-the-blue starts consolidation of JV’s revenues should be carefully analyzed.
In addition, some public businesses in order to ensure a high revenue growth rate consolidate newly acquired businesses, but the facts of control over these entities are quite questionable. A good example is the Wirecard scandal, where the Group consolidated revenues of new entities, but the new businesses did not satisfy the criteria of control in accordance with IFRS 10.
Trading companies often make long-term sales contracts at fixed prices.? If the market conditions deteriorate such practice can result in losses (for instance, when they purchase at market-linked prices), which should be recognized immediately in the current reporting period.
Construction companies often face the same problem. The available accounting guidance requires them to recognize losses on onerous contracts immediately.? One of the famous recent cases was with Carillion, a British multinational construction and facilities management company, which collapsed in 2018 following an accounting scandal. The company had entered into onerous contracts with inflated revenue projections and underestimated costs. Carillion recognized revenue prematurely on these contracts and failed to adequately account for losses, leading to significant financial misstatements and the eventual collapse of the company.
As was later disclosed, one of the most problematic cases, which led to the collapse, was in Qatar. The construction project doubled in size, the architect was changed three times, and as a result, it stretched from the original three years to six years. It had 2,500 design variations to it, and essentially Carillion was not paid for 18 months prior to the business failing.
I hope this comparison of the fair and unfair ways to recognize and measure revenue will be helpful for the accountants and users of the financial statements.