ETHICAL ISSUES RELATED TO REVENUE PROCESSES (STUDY OBJECTIVE 9)
A sad fact of the business and accounting environment is that many deceptions and fraudulent acts relate to revenue measurement and recognition. Many managers or owners succumb to the temptation to inflate (overstate) revenues so that they can make the company's financial performance appear better than it is. Intentional revenue inflation is unethical, and many types of revenue inflation are illegal.
THE REAL WORLD
In the early days of personal computers, one of the manufacturers of hard drives was MiniScribe Corporation. The chief executive officer of MiniScribe, Q.T. Wiles, was convicted of fraud in 1994 and subsequently served 30 months in prison for falsifying revenue. To inflate revenues, Q.T. Wiles came up with a novel idea. He made the employees ship bricks, rather than hard drives, in boxes that were sent to distributors. The company also shipped scrapped parts in boxes that were labeled as hard drives. The company inflated revenue by recording completely fictitious, fraudulent sales of these bricks and scrap materials. In addition to the CEO being sentenced to jail time, the chief financial officer, a CPA, was disciplined by the SEC. The company ultimately failed.4
There are many examples of companies inflating revenue. The MiniScribe example points out an unfortunate truth: If top management is intent on falsifying financial statements by inflating revenue, it does not matter how good the underlying processes and accounting systems are; it can still often find ways to misstate revenue despite the effectiveness of the accounting system. Accurate financial reports can only be an output of an accounting system if management desires accurate financial reports. Unethical managers can easily cause fictitious or inflated sales revenues to be recorded, although doing so requires the assistance of those who work for the top managers. Since top managers have so much control over those whom they employ, it is possible for them to convince employees to assist in the deception. If MiniScribe's employees had been more ethical, it would have been more difficult for its leaders to conduct the fraud.
In addition to the novel approach of MiniScribe, there are more mundane ways to inflate revenue. Two popular approaches are “channel stuffing” and “leaving sales open” beyond the end of the fiscal period. Channel stuffing is intentionally persuading a customer to buy more than needed, thereby “stuffing” more product into the sales channel. “Leaving sales open” is a term that refers to moving a period cut-off date forward to include sales that rightly would occur in a future period. This means that the company records sales revenue that should actually be recorded in the following fiscal year. From an accounting system perspective, it is important that the system properly account for revenue in the proper period. This can become complex when the order, shipment, and payment dates occur near or after the fiscal year end. The system that records revenue transactions must be so designed that it includes in current period revenues only those items that were actually shipped before year-end. Any shipments occurring after year-end must be counted in the subsequent fiscal year. The system should be tested to make sure that it handles this sales revenue cutoff correctly.
In 2008, the Coca-Cola Company agreed to pay a $137.5 million settlement related to accusations of channel stuffing. After an eight-year SEC investigation, Coke agreed to the settlement but admitted no wrongdoing. The company had been accused of pressuring bottlers to buy more soft drink concentrate than necessary. This overselling technique added sales, and therefore higher profits, to Coke's financial reports, and it kept the stock price artificially inflated. Those who purchased Coke stock in a short period in late 1999 to early 2000 were entitled to a portion of the settlement.
In a similar case, the SEC investigated McAfee, Inc. in 2006. McAfee, a software seller, was accused of selling its software products to its distributors in quantities greater than end-consumer demand. The company admitted no wrongdoing but ultimately agreed to a $50 million settlement.
Management has a responsibility to maintain an accounting system that properly recognizes revenue. If management chooses to do so, inflating revenues by shifting revenue cutoffs is easy. This emphasizes the fact that the ethics of management and the control environment are the most important factors in accurate and complete financial statements. Without ethical management at the top of a company, financial reports must be suspect.
In many cases where revenue is intentionally overstated, accountants or CFOs have participated in the deception. In the cases of MiniScribe and Sunbeam, the chief financial officers were involved in the fraud. Accountants throughout an organization should try to ensure that the department, area, or division they work in does not overstate revenues. Overstated revenues mislead the general public as they make investment decisions regarding stocks to buy. If any unit within the company overstates revenue, it can mislead investors. Therefore, accountants must make sure that the accounting systems used to record revenue are accurate. Second, accountants must not allow managers to coerce them into assisting in the overstatement of revenue through the use of accounting tricks or deceptions. Unfortunately, an accountant or CFO can be swayed by arguments advanced by top managers. For example, a CEO might say that the revenue overstatement is only temporary until earnings targets are met. The CEO might even say that the company will have to cut back its workforce if revenues deception is not carried out. These arguments can be very persuasive, and many accountants have agreed to participate in such deceptions involving revenue. Obviously, it is best to be vigilant about resisting involvement in revenue overstatement. Once it begins, it usually seems to snowball into more and more overstatements as pressure mounts to report continued revenue growth. Accountants must continually guard against persuasion to participate in such frauds.
THE REAL WORLD
A recent example of accountants being involved in revenue misstatement in an accounting fraud scheme occurred at HealthSouth Corp. Richard Scrushy, the CEO, and five different financial officers were accused of inflating profits by $1.4 billion. The accountants involved claimed that Scrushy held so-called “family meetings” to help devise and cover up earnings falsifications.
In June 2005, to the surprise of federal prosecutors, Scrushy was found not guilty of all counts against him even though the five other HealthSouth officials had plead guilty and testified that Scrushy ordered the actions. Although a jury found him not guilty, Scrushy's job prospects as a CEO are severely damaged. At a minimum, he tolerated and failed to prevent unethical behavior, even though it was not proven beyond a reasonable doubt that he participated in the events.