Revenue Recognition: Financial Fraud and Financial Statements – Part 3

As noted in our previous columns on this subject (Part 1 and Part 2), the goal of financial statement fraud (FSF) is usually to hide certain aspects of a business’s financial reality. One of the most common ways is to “play” with the recording of transactions. What do we need to know to be comfortable with the financial information provided to us?

Examples of accounting techniques used in FSF

Users of financial statements must be aware of the various grey areas in financial statements. When analyzing financial statements, some items may require additional attention. The following are some examples of elements that require careful review.

One method that can be used to bias the representation of results is to record revenues in the wrong period. This leads to a timing difference that shifts revenues ahead or back from one period to another. In doing so, the person doing it seeks to show false profits during a desired period. At first glance, this scheme may not appear all that harmful, as it is only a timing difference. However, the consequences can be enormous for users of financial statements who base their decisions, directly or indirectly, on revenues or profits of a specific time period.

Another example of incorrect revenue recognition is what is known as “channel stuffing.” This technique consists of selling more goods to retailers or distributors than they are normally able to sell or absorb, using, among other things, more advantageous conditions, such as significant rebates or longer payment periods. In this way, the company can artificially inflate its sales for a certain period. This scheme is typically used at the end of a fiscal period or year so the company or even a seller can reach their targets. Channel stuffing thus results in a misleading accounting of revenues. Channel stuffing is often considered to be fraud when it presents a misleading picture of a company’s sales or financial health.

A well-known example of fraudulent revenue recognition and channel stuffing is Valeant Pharmaceuticals (now known as Bausch Health). That company used various types of accounting malfeasances, including channel stuffing of $58 million in sales of pharmaceutical products to a mail order pharmacy company. This led the U.S. Securities and Exchange Commission (SEC) to assess the company a penalty of over US$45 million. Three former executives – the CEO, the chief financial officer and the comptroller – also had to pay fines to resolve the charges against them.

Who commits this type of scheme and why?

As explained above, there are several factors that encourage the use of this type of scheme, particularly at the end of a fiscal period or year, if certain results have not been achieved, including to:

• meet bank loan covenants (i.e. mandatory ratios);
• attract new investors; and
• obtain a higher selling price. 

This type of scheme can also be used by sellers to meet their sales objectives and / or obtain a higher commission.

Some industries are at a greater risk for channel stuffing, such as automobile or pharmaceutical companies. Overall, companies with large inventories are more at risk for this type of FSF.

How to detect FSF

This scheme can be based on the hope that the next period will be better. However, early accounting of revenues makes it harder to meet future objectives and increases the chances of the cycle repeating itself with additional accounting fraud to cover up the channel stuffing.

This misleading practice is hard to detect without a whistleblower and a forensic accounting review. This therefore suggests that channel stuffing may be more widespread than it is believed. Everyone can play a role by remaining vigilant, particularly concerning transactions recorded at the end of a period, large, unusual or overly complex transactions.

Users of financial statements need to be skeptical and question the growth in sales and certain ratios. This includes asking questions and asking for explanations about the terms of sale and the timing of delivery.

Some indicators of early or inappropriate revenue recognition accounting may include:

• Changes in accounting principles: For example, a change in credit conditions at the end of a period in order to achieve a sales objective may indicate the presence of channel stuffing.
• Rapid growth in revenues or unusual performance compared with past years: Early accounting recognition of revenues and channel stuffing often lead to aging accounts receivable and/or a higher volume of product returns.
• Significant decrease in the cost of sales compared with sales: If the cost of sales is lower than sales, an analysis of gross margin growth relative to the industry may be useful. Above-market performance may be one indicator of channel stuffing.
• Unusual growth in the collection ratio for accounts receivable: If a company’s accounts receivables are growing faster than sales, the “quality of sales” should be questioned. An analysis of the growth of this ratio can help detect more favourable terms of payment for certain types of clients, for example.

FSF vs. accounting choice

Revenue recognition is difficult to apply due to the many recognition criteria and the application of criteria from accounting standards. Nevertheless, the principles of revenue recognition have been standardized over the years. It is important to remember that we are not necessarily dealing with fraud when the accounting of certain transactions seems problematic; there must be an intention to mislead the user of the financial statements. Remember here the motivation is often linked to the pressure on executives to show profits and on sellers to meet sales targets. Businesses should aim for a balance between short-term and long-term gains, review their sales incentive plan, their return policies, etc.

When there are doubts or suspicions concerning the financial statements submitted to you, it is important to have a qualified and experienced team that includes a forensic accountant.

For more information, contact

Corey Anne Bloom, FCPA, FCA, CA•IFA (CA•EJC), CFF, CFE, ACFE Regent Emeritus
Partner, Eastern Canada Leader, Forensics, Investigation and Disputes
[email protected]
514-861-9446

Gabrielle Schmidt, CPA, CGA, CFE
Analyst, Forensics, Investigations and Disputes
[email protected]
514-861-9446