White-collar litigation frequently involves allegations relating to how management accounted for or disclosed transactions in its financial statements. Because accounting for certain types of transactions can be complex and subject to professional judgment, it can be difficult for litigators to determine whether or not management followed accounting practices in accordance with United States Generally Accepted Accounting Principles (U.S. GAAP). That is particularly evident in the area of revenue recognition, where allegations have been made of earnings management to create an overly positive picture of a company's financial position.
Accounting Standards for Revenue Recognition
Prior to 2009, U.S. GAAP was set forth in a confusing array of standards issued by various "standard setters." The standard setters included the Accounting Principles Board (APB), American Institute of Certified Public Accountants (AICPA), Financial Accounting Standards Board (FASB), FASB Emerging Issues Task Force (EITF), and Securities and Exchange Commission (SEC). The "GAAP Hierarchy," as drafted by the FASB, set out the order of authority of such standards as follows:
1. Level A: FASB Statements of Financial Accounting Standards and Interpretations, FASB Staff Positions, APB Opinions, and AICPA Accounting Research Bulletins;
2. Level B: FASB Technical Bulletins, AICPA Industry Audit and Accounting Guides, and AICPA Statements of Position;
3. Level C: AICPA Accounting Standards Executive Committee Practice Bulletins, EITF Consensus Positions, and EITF Appendix D Topics; and
4. Level D: AICPA Accounting Interpretations, FASB Implementation Guides, and industry practices that are widely recognized and prevalent.
FASB Statement No. 162, The Hierarchy of Generally Accepted Accounting Principles (2008). The FASB simplified this complex array of authoritative guidance in 2009 with the Accounting Standards Codification (ASC), which consolidated all authoritative U.S. GAAP into one place. FASB Statement No. 168, The FASB Accounting Standards Codification™ and the Hierarchy of Generally Accepted Accounting Principles (2009). The ASC dissolved the complicated GAAP Hierarchy and gave the same weight to all guidance included in the ASC.
U.S. GAAP, as codified in ASC 605, states that revenue should not be recognized until (1) realized or realizable and (2) earned. ASC 605-10-25-1. The SEC clarifies this statement in Topic 13 of its "Codification of Staff Accounting Bulletins," which is incorporated into ASC 605-10-S99 and states that revenue is generally realized or realizable and earned when all of the following four criteria are met:
1. Persuasive evidence of an arrangement exists (arrangement in this context is meant to identify the final understanding between the parties as to the specific nature and terms of the agreed-upon transaction);
2. Delivery has occurred or services have been rendered;
3. The seller's price is fixed or determinable; and
4. Collectability is reasonably assured.
Common Revenue Recognition Issues in White Collar Litigation
Notwithstanding the FASB's efforts to simplify U.S. GAAP guidance, management of some companies has ignored the guidance set forth in ASC 605 and continued to enhance profitability (i.e., the bottom line) through improper revenue recognition accounting. This is evident in SEC enforcement actions over the years alleging improper revenue recognition schemes. Common revenue recognition schemes include: "bill and hold" transactions, "channel stuffing," and "round-trip" transactions.
Bill and hold. Delivery is one of the four general criteria that must be met in order to recognize revenue under U.S. GAAP. "Bill and hold" transactions occur when an entity bills a customer for goods and recognizes the associated revenue before delivering the goods. This treatment of revenue prior to delivery is only acceptable under U.S. GAAP (at ASC 605-10-S99) if certain stringent criteria are met, including:
1. the risks of ownership have passed to the buyer;
2. the customer has made a fixed commitment to purchase the goods;
3. the buyer, not the seller, requested the transaction to be on a "bill and hold" basis;
4. there is a fixed delivery schedule for the goods;
5. the seller does not have any remaining performance obligations;
6. the ordered goods are segregated from the seller's inventory; and
7. the ordered goods are complete and ready for shipment.
When entities have recognized revenue on bill and hold transactions without satisfying the criteria required for bill and hold sales, then a violation of U.S. GAAP has occurred.
For example, in SEC v. Diebold, Inc., No. 1:10-cv-00908 (D.D.C. filed June 2, 2010), the SEC alleged, among other things, that Diebold inappropriately recognized revenue on bill and hold transactions with the goal of inflating earnings to meet forecasts. Specifically, the SEC alleged that Diebold recognized revenue after shipping goods from its factory to a Diebold warehouse but not to the end customer. According to the SEC, these transactions failed to satisfy the bill and hold criteria for revenue recognition because: (1) Diebold's customers had not requested that the transactions be on a bill and hold basis; (2) the transactions generally did not have fixed delivery schedules; and (3) in certain instances, the goods were not complete and ready for shipment to the customer. Diebold, without admitting or denying the SEC's charges, was ordered to pay a $25 million civil penalty in this matter.
Channel stuffing. "Channel stuffing" occurs when a seller convinces a buyer to purchase more goods than it actually needs, to enhance sales figures for a specific period. A seller will typically offer significant incentives to the buyer in the form of discounts, expanded return rights, favorable shipping terms, or other concessions, to encourage the buyer to make the purchase. After the seller records the revenue, the goods that were "stuffed" into the channel are frequently returned to the seller for a full refund in a later period.
ASC 605-15-25-1 includes six criteria that must be met in order to recognize revenue when a customer has a right of return and are in addition to the four general revenue recognition criteria that must be met under ASC 605-10-S99. One of the six additional criteria is that returns must be able to be "reasonably estimated." In channel stuffing transactions, sellers often grant buyers exceptional return rights that go well beyond the seller's standard return policies. In these instances, the seller recognizes revenue in violation of U.S. GAAP because a reliable estimate of future returns cannot be made for the channel stuffing transaction. The extraordinary return rights render past returns experience an insufficient guide to estimate future returns.
Other concessions granted to the buyer to induce it to purchase excess goods frequently cause the transaction to fail the "collectibility provision" under ASC 605-10-S99. Extended payment terms and other concessions may limit the seller's ability to estimate the amount that will be ultimately collected on the sale, thus precluding revenue recognition.
Channel stuffing was addressed in SEC v. Vitesse Semiconductor Corp., 771 F. Supp. 2d 310 (S.D.N.Y. 2009), where the SEC charged Vitesse with fraudulent revenue recognition practices, among other things, from channel stuffing transactions that included granting unconditional rights of return on the sales at issue. Because Vitesse granted unconditional rights of return to its customer, future returns could not be reasonably estimated and revenue should not have been recognized under U.S. GAAP. Vitesse, without admitting or denying the SEC's allegations, was ordered to pay a $3 million civil penalty in this matter.
Round-trip transactions. "Round-trip" transactions occur when sales between entities contain no economic substance, and the sole purpose is to inflate revenue. For example, a company records a sale of $100,000 of merchandise to a buyer where there is an agreement that the buyer will later sell identical merchandise back to the seller for $100,000. The parties receive no actual economic benefit from the transaction, but revenue for each company is $100,000 more than if the transactions were not recorded. Round-trip transactions also occur when an entity loans or invests money in another company based on the agreement that the recipient of the loan/investment will use the cash to make purchases from the lending entity, thereby allowing the lending entity to record revenue. Companies are tempted to engage in round-trip transactions when investors are overly reliant on revenue growth as a way to value the company. Round-trip transactions lack economic substance and are made purely to enhance a company's financial picture, in violation of U.S. GAAP.
Round-trip transactions violate the principles set forth in the FASB Concepts Statements issued to provide overarching guidance related to all transactions that are recognized and measured in financial statements. FASB Concepts Statement No. 8 (CON 8) states that the fundamental qualitative characteristics of useful financial information are relevance and faithful representation. Regarding faithful representation, CON 8 states:
Faithful representation means that financial information represents the substance of an economic phenomenon rather than merely representing its legal form. Representing a legal form that differs from the economic substance of the underlying economic phenomenon could not result in a faithful representation.
In the case of round-trip transactions, the fundamental substance of the transactions is to inflate revenue. Under U.S. GAAP, they should not be recorded.
Round-trip transactions were addressed in SEC v. Time Warner, Inc., No. 1:05-cv-00578 (D.D.C. filed Mar. 21, 2005), where the SEC charged, among other things, that Time Warner "funded its own online advertising revenue by giving the counterparties the means to pay for advertising that they would not otherwise have purchased." In this case, the SEC invoked the "substance over form" concept, stating that U.S. GAAP "requires accounting to reflect the substance of a transaction over its legal form." Time Warner, without admitting or denying the SEC's claims, was ordered to pay $300 million in civil penalties in this matter.
Revenue recognition accounting under U.S. GAAP is complex and continues to evolve. Although there have been major steps to streamlining the content and clarifying the authoritative literature, many revenue recognition issues continue to be prevalent in white collar litigation. Even as companies prepare to adopt a new and improved revenue recognition standard issued by the FASB and effective beginning in 2018 (ASC 606, Revenue from Contracts with Customers), it is a safe bet that the issues discussed above will continue to persist.
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