This is the first in a series of eight articles examining different forms of accounting manipulation. Forthcoming articles will include pieces on channel stuffing and off-balance sheet transactions.
The principle of revenue recognition is a fundamental accounting guideline that dictates how and when revenue should be recognized in financial statements.
The revenue recognition principle operates under the accrual accounting framework, which states that revenues should be recognized when they are realized and earned, not necessarily when cash is received. This means that if goods or services have been delivered to customers, revenue can be recorded even if payment has not yet been made.
Premature revenue recognition is by far the most common form of account manipulation as companies seek to inflate earnings by reporting revenue before it is earned, thereby inflating profits. In more extreme cases, companies record fictitious revenue.
In this piece, we provide three famous examples: Xerox, Dell Corporation, and Autonomy Corporation. In each case, premature revenue recognition led to regulatory action and severe losses to investors.
Premature revenue recognition reduces future earnings and allows management wriggle room to hide problems that should be addressed. This invariably causes even greater difficulties at some future point. Those seeking a greater understanding of improper asset valuation will find these companies a great place to start.
Where relevant, we complement the examples with readings from the Transparently Risk Engine, an AI-powered system that detects accounting manipulation. The TRE scores the quality of a company’s accounting on a 0-100% scale, in the process assigning them a rating of A+ to F. In the cases of the companies below, it certainly picked up risky signals well before the problems bubbled to the surface.
XEROX
Xerox Corporation, primarily known for its photocopying equipment, was facing intense competition and declining profits in the late 1990s. To mask these difficulties, the company engaged in a complex scheme of accelerating revenue recognition from long-term leases of their equipment.
Specifically, Xerox started bundling equipment sales with service contracts and financing options. Instead of recognizing revenue over the entire lease term (which could be several years), the company booked a significant portion of the revenue upfront, as soon as the lease was signed. It is alleged that Xerox incentivized customers to accept these bundled deals by offering side agreements with generous terms, further distorting the true value of the contracts.
This practice led Xerox to overstate revenue by billions of dollars between 1997 and 2000. The Securities and Exchange Commission (SEC) launched an investigation, ultimately finding that Xerox had fraudulently inflated its revenue by $6.4 billion. Xerox faced hefty fines, had to restate its earnings, and its stock price plummeted. While companies have some flexibility in how they recognize revenue, pushing the boundaries too far can cross the line into fraudulent reporting.
The Transparently Risk Engine gave Xerox’s 2000 accounts an accounting risk score of 82.3% and a rating of F, putting it in the worst 3% of the market for accounting quality. The system highlighted accruals management, which captures revenue recognition, as one of its top concerns.
DELL INC.
A prominent example of a company that used aggressive accounting with respect to revenue recognition is Dell Inc., a computer technology company, in the early 2000s.
Dell had a long-standing exclusivity agreement with Intel, the chip manufacturer. As part of this agreement, Intel provided Dell with substantial rebates and incentives to exclusively use their processors.
Instead of treating these payments from Intel as reductions in their operating expenses (cost of goods sold), Dell improperly recorded them as revenue. This practice artificially inflated Dell's reported revenue and profit margins, misleading investors about the company's true financial performance.
The SEC investigated Dell's accounting practices and found that the company had engaged in a multi-year accounting fraud. Dell agreed to pay a $100 million penalty to settle the charges. Dell was forced to restate its earnings for several years, reducing its previously reported profits by hundreds of millions of dollars. The accounting scandal damaged Dell's reputation and led to numerous shareholder lawsuits. Rebates and incentives are common in many industries. Mischaracterizing these payments to inflate revenue is a serious accounting violation.
The Transparently Risk Engine scored Dell at 74% for accounting risk in 1999, putting it in the worst 8% of the market for accounting quality. Although that score declined in subsequent years, the system highlighted accruals management as one of its top concerns from that year through to 2005.
AUTONOMY CORPORATION
A famous recent example of improper revenue recognition involved Autonomy Corporation, a British software company. The company faced scrutiny and controversy following its acquisition by Hewlett-Packard (HP) in 2011. HP alleged that Autonomy had engaged in aggressive accounting practices, particularly related to revenue recognition, prior to the acquisition.
HP claimed that Autonomy had prematurely recognized revenue from software sales, booking revenue before the software was fully delivered or implemented. HP also alleged that Autonomy had engaged in "round-trip" transactions, where they would sell software to a reseller at the end of a quarter and then buy it back at the beginning of the next quarter, artificially inflating revenue.
In addition, it accused Autonomy of mischaracterizing hardware sales as software sales, which typically have higher profit margins and are viewed more favorably by investors.
HP took an $8.8 billion write-down on the value of Autonomy, alleging that the company's accounting practices had inflated its value. Following this write-down, HP filed lawsuits against former Autonomy executives, and the case sparked investigations by regulators in both the United States and the United Kingdom.
The legal dispute primarily revolved around allegations of fraud against Mike Lynch, the former CEO of Autonomy. After a lengthy legal battle, Lynch was found not guilty of wire fraud charges in a U.S. court. In the UK, HP won a court case against Lynch regarding damages related to the alleged accounting irregularities at Autonomy. Despite his acquittal in the U.S., Lynch faced ongoing legal challenges until his death in a boating accident shortly after celebrating his victory.
The Autonomy-HP saga damaged the reputations of both companies. The case highlights the complexities of revenue recognition in the software industry, where revenue models can be complex and the timing of revenue recognition can be subjective.
For the first half of the 2000s, Autonomy averaged close to 70% for accounting risk, according to theransparently Risk Engine. Its score peaked at 71 in 2002, putting it in the worst 5% of companies globally for accounting quality. Business manipulation featured as a top concern for the TRE that year.
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