Hello I'm professor Brian Bushee, welcome back. In this video we're gonna take a look at revenue manipulations. A revenue manipulation is where a manager takes advantage of the discretion in the revenue recognition criteria to find a way to recognize more revenue during the period which in turn should increase the company’s earnings. We’ll look at a number of tools and ratios that you could use to try to detect these kinds of revenue manipulations. Let’s get started. Let’s start with a brief overview of the issues involved in revenue recognition. So if you remember, revenue is recognized when it's both earned, which means the company provides goods or services, and realizable, which means the price is fixed and collection of cash is probable. But note that this does not require that the company has actually collected the cash. And that means that revenue can be recognized before cash is collected and we're gonna call this noncash revenue. So at the delivery of goods or services, what the company would do is increase revenue and increase accounts receivable which is the money owed to the company by the customers. Then eventually when the cash is collected, the company would increase cash and then reduce these accounts receivable. What we're gonna look out for is acceleration of revenue into the current period. Maybe what happens is the company recognizes the revenue before it's fully delivered the goods and services. Or maybe what the company does, it provides the customer right of return if it's not resold by the customer. Which would mean that it's not technically realizable, because collection of cash is not probable. Anyway, 50% of SEC enforcement actions are related to revenue recognition. So half the companies that get busted by the SEC do so for these revenue recognition criteria, and that's because it's not quite this simple. Here's what the true standard looks like, this is SAB 101. And this is a simplified flow chart explaining how companies should decide whether they can recognize revenue or not. >> Ay caramba! I need my other pair of glasses to read this. This is going to take me a long time to memorize. >> Don't worry, you don't have to memorize this. Again I just put this up there to highlight the amount of discretion and judgement there is in the revenue recognition process. Besides, you're never gonna see this flowchart anyway outside the company, so you wouldn't be able to evaluate it. Instead we have to work backwards, we have to start with the financial statement results. Then look at some red flags to try to figure if we're suspicious in how the company implemented all of these decisions, in this complicated revenue recognition flow chart. So, we're gonna use some red flags to try to identify potential changes in revenue recognition policies for companies. We're gonna look for unusual, seasonally adjusted quarterly trends in revenue growth, accounts receivable growth. We're gonna look for unusual trends in ratios, such as days receivable, accounts receivable to revenue, and revenue per capacity unit. And then we'll try to figure out what happened if we find unusual trends. So do earnings management incentives exist for a company in this quarter? And is there anything unusual in their revenue recognition policy that we can find? So the first thing we're gonna look at are revenue growth trends. So growing firms tend to have revenue growth in all four quarters. Whereas earnings management is much more likely to happen in a specific quarter when you're trying to meet a specific target. One thing we have to be aware of is that firms have some seasonality in their revenue. So, what seasonality means is maybe you have a higher percentage of your sales during a holiday season than a non-holiday season. So to get a good comparison we need to look at the holiday season this year to the same holiday season last year. So we are going to compute something call year over year revenue growth or YoY revenue growth. That’s revenue this quarter minus revenue for the same quarter last year divided by revenue for the same quarter last year. And we’ll compare this to a couple benchmarks. Time series, we’re going to look at whether the growth is unusual for one specific quarter for the firm. And then cross-sectionally we'll see if the growth is unusual for the industry in a given quarter. >> Time-Series? Cross-sectional? Y'all are speakin' like a pointy-head professor again! >> Sorry, I do talk like an academic sometimes and I probably will use these terms a lot. Times series just means you're looking at the same firm across time. Whereas cross-sectional means you're comparing the firm to other companies or to the industry. We're also going to look at growth in accounts receivable. If you remember noncash revenue would be captured in changes in accounts receivable. So by looking at changes in accounts receivable we get a sense for how much of this revenue is not cash. So we're gonna look at YoY growth in accounts receivable, again YoY is year over year. As the accounts receivable at the end of this quarter minus the the accounts receivable by the end of the same quarter last year divided by that accounts receivable, so it's seasonally adjusted. We're gonna compare it to benchmarks. We're gonna look at time trends for the company. We're gonna compare the company's trends to the industry trends. We're also gonna compare the growth in accounts receivable to revenue growth to see how much of the revenue growth is noncash. Not only will we compare it to growth and revenue but we're gonna compare it to the growth in the amount of cash that's collected. And cash collected can be calculated by taking revenue plus accounts receivable at the beginning of the period. So that's the total amount of cash that could have been collected. Minus ending accounts receivable, which is cash that wasn't collected. What's left over is the amount of cash collected during the period. We're gonna take a look at some ratios. So we're gonna go back to our old friend, days receivable. Because a large increase in days receivable could indicate a spike in noncash revenue at the end of the quarter. We've seen this before using annual data, the average of accounts receivable over the year, divided by annual revenue, times 365. We're gonna look at a quarterly version where we take the average accounts receivable over the past five quarters. And divided by it TT revenue, then times 365. TT stands for trailing 12 months. So we're gonna add up the four quarters that end at the quarter we're looking to approximate a year's worth of revenue that ends at the point of the quarter that we're looking at. >> Although I am a genius at math, I would rather not do more math than absolutely necessary. So why not just use this quarter instead of adding up all of the prior quarters? >> Great question, the reason that we don't just use one quarter is seasonality. Because of seasonality, these quarterly ratios could jump up and down quite a bit from quarter to quarter just due to the seasonality in sales. By using the year ended with that quarter, we smooth out the seasonality which makes it easier to spot abnormal trends in the ratios. We're also gonna look at the ratio of accounts receivable to revenue, which again could indicate a spike in noncash revenue if we see a large increase. This is gonna be defined as accounts receivable divided by our trailing 12 month revenue. And finally we're gonna look at revenue per capacity unit. The idea here is a large increase in revenue per capacity unit could indicate fraudulent revenue that's beyond the normal capacity of the company to produce. So we'll look at revenue per employee, which is our trailing 12 month revenue divided by number of employees. Revenue per property, plant and equipment, which is our TT Revenue divided by gross PP&E. Again, if these go up, it could indicate we're producing more revenue per employee, more revenue per piece of equipment than we have before. Which may be beyond our capacity to produce and could indicate fraudulent revenue. >> Yada, yada, yada. Please give us some numbers already. >> Sure no problem, why don't we go ahead and do a case? Case we're gonna look at is Pawsome Electronics. They make consumer products for dogs, things like microchip enabled food bowls, electric toothbrushes, soothing sound machines to help the dog sleep. Electric blankets, and of course their popular aromatherapy vaporizers. They sell products to retail stores and to online retailers. They don't make any direct sales to customers. Pawsome was struggling during 2012-2013, so they hired a new CEO who was a turnaround expert. The new CEO made a lot of changes during 2013-2014, increased their marketing budget, implemented a new, just in time, automatic, retail delivery arrangement. So when a customer was running low on vaporizers, Pawsome would automatically send them more product. They reduced their product line to focus just on the winners, so they got rid of a lot of their loser products. Which allowed them to close 18 of their 26 factories and cut their work force from 12,000 to 7,500 employees. Pawsome now has had an awesome turnaround in performance in 2014. Revenues are up 19%, net income is $123 million, versus a loss of $196 million in the prior year. Stock price has risen 59% over the year and eight security analysts now have buy or strong buy recommendations on the stock. There's a lot of rumors about the company that you can find on TV, that the company's looking to acquire other companies and that the CEO actually got a job offer to come to another company. So before we look at the numbers, let's take a second to think are there any earnings management incentives that Pawsome's management might have. Without a turnaround the CEO would lose his reputation as a turnaround expert. >> And it sounds like the CEO is looking to jump ship to another company. >> With a high stock price it will be easier for Pawsome to acquire another company. >> And I bet those security analysts would be madder than a wet armadillo If Pawsome did not have such high earnings. >> Excellent job identifying earnings management incentives. Seems like the CEO has some pretty strong incentives this period to manipulate earnings. That's the process that I want you to go through before you look at the numbers in the rest of these cases. Now in the interest of time, I'm not gonna have the virtual students do it in the future. Instead, I want you to try this on your own, so before you look at the numbers, pause the video and think about the earnings management incentives. So now let's go to the Pawsome spreadsheet and take a look at some numbers. So let's look at the data for Pawsome, I pulled in three years of quarterly results. I got the revenue, net income, accounts receivable. Cash collected is computed from revenue and accounts receivable, you can see the formula there if you want. Gross property, plant, equipment, number of employees. So first let's look at the year on year change in revenue. So 2013, it was negative, as they were still struggling. 2014, the first two quarters of the year, we see 10%, 13% growth. And then we see 25 and 26% growth in the last two quarters of 2014. So it looks like the turnaround strategy is really kicking in those last two quarters. If we look at change in receivables, it's negative when the change in revenue's negative. It's roughly comparable to the change in revenue in the first two quarters, but in the last two quarters it gets to be a much bigger change in accounts receivable than in revenue, hm. If we look at change in cash collected, negative when revenue growth was negative. Then it's sort of up and down a lot during 2014, but it's certainly much less than the growth in revenue. If we look at the ratio of accounts receivable to revenue, it was in the low 20s. It went up a lot in the quarter one of 2014, back down, and then back up again in the last two quarters. Same pattern for days receivable, around 81 to 82 days in 2013, jumps up to 88, down to 84, 85, jumps back up to 87 in the fourth quarter of 2014. Now let's look at revenue per property plant and equipment. It was in the low twos, and then it jumped up dramatically in the last two quarters of 2014. Same thing with revenue per employee, a big jump in these last two quarters. Now, it's never gonna be the case that all of these ratios jump out and scream, earnings management, earnings management, earnings management. This is fairly typical where some of the ratios are suspicious, other ratios are not that suspicious. And so, I think there's a little reason to be suspicious based on the change in receivables versus the change in revenue. And the revenue capacity per capacity unit, but not every ratio is screaming earnings management, which is fairly typical unfortunately. >> Is it not within the realm of possibility that the growth in sales was due to a splendiferous holiday sales season? >> Yes it is within the realm of possibility and that's why we need to benchmark these trends with some competitors. So if we see the same trends in the competitors then it's probably not earnings management but just something going on in the industry. So I'll bring up a couple competitors and we'll do this analysis now. But just as a heads up I'm not gonna do this every video. In the interest of time you can assume in the future, that the things that we're looking at for the firm are abnormal. But I figure we may as well take the time to go through a competitor analysis at least once. So I brought in data for two of Possum's competitors, Fidotronics and Chienco. Instead of fighting through all the numbers, I've put them into graphs so that we can easily compare. So Pawsome is in orange, this is the year on year change in revenue. You see the big increase in 2014 that was not shared by their competitors. If we look at the year on year change in accounts receivable we see the big spike for Pawsome. Again, not reflected in their competitors, so we know that the accounts receivable increase was not due to industry or economy effects, but it was unique to Pawsome. Change in cash collected, not much of a trend. Accounts receivable to revenue, days receivable, yeah, it's hard to see much of a trend going on. Sales to PP&E we can see for Pawsome, it's hard to see with the scale, but Pawsome, we see it going up whereas the two competitors it's flat or down. And sales to employees, it's going up for all of these companies, but there's a continued big increase for Pawsome at the point where their competitors seem to level out a little bit. So again, not conclusive, but it does suggest that Pawsome was unique in terms of its growth in revenue versus its growth in AR and in these revenue per capacity unit measures. >> You have piqued my curiosity. Please tells us what happened. >> Okay here's what happened. So it turned out Pawsome CEO engaged in a channel stuffing scheme in the last two quarters of 2014. Remember that change in policy to going to the just in time inventory delivery system? Well, the CEO manipulated that system to deliver extra goods to retailers just before the quarter end, increase revenue, but of course it's all noncash. The retailers then returned all the excess inventory to Pawsome, but the returns happened in the next quarter. So that allowed Pawsome to get the benefit of the sales and make their earnings target this quarter and then they took the hit next quarter. But what it did was it kept their stock price high because they were meeting their earnings target which allowed them to acquire two other companies which doubled the size of the company. However, some analysts started to raise some concerns about the high growth in accounts receivable. The auditor saw that and the auditor saw all the returns that were coming back and started to question the revenue recognition practices. And eventually Pawsome, because of these criticisms, had to restate their prior results to remove all their questionable revenue and all this stuff became public. Pawsome's reputation took a big hit with customers and investors, they ended up filing for bankruptcy within three years of this scheme and eventually were acquired by DogWorld Industries. So this was a situation where Pawsome had clear earnings management incentives, they were trying to do acquisitions, the CEO was looking to get out of the company before things went bad. We saw the change in the revenue recognition policy, and then a lot of these ratios indicated that there was a lot of noncash revenue, and maybe the revenue was too big for their capacity, and so there were a lot of suspicions here. Again, putting those together doesn't conclusively mean that it's always gonna be a fraud, but when you see those things line up, the incentives, the change in policy, the ratios. Then it becomes much more likely that you're looking at something where there's been earnings management. That was an awesome example of this kind of analysis. So the tools that we looked at are gonna be really good at trying to spot aggressive revenue recognition that happens before cash is received. But sometimes the aggressive revenue recognition happens after the cash is received. And that's what we're gonna take a look at in the next video. I'll see you then. >> See you next video.
