It's all about the revenue

ACFE Cookbook: Explaining the many recipes for financial statement fraud

"The ACFE Cookbook" is a column devoted to examining recent cases and news involving alleged financial reporting fraud. Our focus is global, so no matter where you are, if you see news of financial reporting fraud, we'd like to hear about it for possible coverage. Send your links, news or information on public reports of alleged fraud to GZack@bdo.com. — ed.

This issue's cookbook is devoted to two recent and interesting cases involving revenue manipulation — the most popular method of cooking the books. But I serve up several menu options in these cases. Which would you prefer today: round-tripping, channel stuffing or perhaps an order of side deals? Let's get cooking.

Hong Kong watchdog wins important case

Hong Kong's Securities and Futures Commission (SFC) brought this case — a major development in cross-border enforcement — against China Metal Recycling Holdings, Ltd (CMR). CMR is incorporated in the Cayman Islands and operates in Hong Kong and Macau, but its most valuable assets are located in mainland China.

Mainland China is home to approximately 60 percent of companies publicly traded in Hong Kong. Therefore, SFC's victory in February 2015 is a significant step in the watchdog agency's quest to pursue firms that are listed and traded in Hong Kong, but which are based in other countries.

The nature of the fraud appears to have involved a revenue recognition scheme referred to as round-tripping. Often when fraudsters attempt to create phony revenue they find no cash flow associated with the fictitious income. Fictitious revenue usually displays two telltale signs: 1) Cash flows from operating activities lag behind operating profits reported on the income statement, and 2) deteriorating aging in a company's accounts receivable. The bottom line is that nobody pays the company for made-up revenue.

So, fraudsters will then use round-tripping: paying someone to return the money back to them. They will classify the outbound payment as some type of asset — a loan, prepaid expense, equipment, etc. The fraudsters will then classify the incoming funds from this cooperative third party as a payment applied to the account receivable that was set up when the phony revenue was initially recorded.

This series of transactions creates the appearance that customers have paid the company for the revenue that's been recorded. The accounts receivable aging is kept in check, and the statement of cash flows appears to reflect cash flows from operating activities. This technique has fooled many investors, regulators, auditors and analysts through the years.

According to a November 2014 judgment, CMR began trading on Hong Kong's stock exchange in June 2009, and at one point employed more than 6,000 people. CMR purchased scrap metal from suppliers and either produced recycled scrap metal products or sold the scrap outright with no further processing.

The SFC began looking into CMR in December 2009 based on suspicions that the company issued false or misleading information the month prior. SFC's allegations concerned a subsidiary of CMR — identified as Central Steel Macao in the judgment — and the subsidiary's dealings with three suppliers.

According to the judgment, between 2007 and 2009, Central Steel Macao transferred funds from its bank account into those of the three suppliers. SFC alleged these transactions were disguised as steel transactions. These suppliers, in turn, transferred those funds back into Central Steel Macao's account. Round-tripped funds exceeded $277 million. As a result, CMR inflated its gross profits by 38 percent for 2007, 64 percent for 2008 and 90 percent for 2009.

In July 2013, the SFC invoked a special provision of Hong Kong's securities law to force CMR into a provisional liquidation based on evidence of accounting fraud. This then led to the February ruling, which CMR didn't contest (although former management has denied the allegations).

The ruling represents a big victory for the SFC. However, its biggest challenge might yet lie ahead — securing those CMR assets on mainland China for liquidation. But that's another story for another time.

Canadian Solar Inc.

Our second case takes us from China and Hong Kong to the Ontario, Canada, headquarters of Canadian Solar Inc. (CSI) The company designs, develops, manufactures and markets solar power products. CSI's stock is listed in the U.S. and the U.S. Securities Exchange Commission (SEC) initiated proceedings against CSI in 2014.

In connection with its improper recognition of revenue, the SEC charged CSI with violating the reporting, books and records, and internal controls provisions of the Securities Exchange Act of 1934. While the SEC doesn't specifically use the word "fraud" in the charge, it's clear that the agency feels the company's financial statements were inaccurate and that the company was overly aggressive in its recognition of revenue. (See the March/April column for a related discussion on proving intent.)

The CSI case is useful and instructive because of the SEC's application of Generally Accepted Accounting Principles (GAAP) to two specific revenue arrangements. U.S. GAAP calls for four characteristics to be present to recognize revenue:

1. Persuasive evidence of an arrangement exists.
2. Delivery has occurred or services have been rendered.
3. The seller's price to the buyer is fixed and determinable.
4. Collectability is reasonably assured.

(These criteria are "old GAAP." The more recently issued joint standard from the Financial Accounting Standards Board and the International Accounting Standards Board wouldn't yet apply to this case because the events took place in 2009.)

The SEC focuses on two customer arrangements to show that three of the four criteria weren't met.

Customer A

CSI shipped two batches of solar panels to one customer (identified by the SEC only as "Customer A") in June 2009 and recognized $1.2 million in revenue for each batch, which totaled $2.4 million. These two shipments were part of a deal with a contractor for two large municipal projects in the U.S. CSI anticipated a total of $7.7 million in revenue.

The SEC claimed that the evidence of an arrangement criterion wasn't met. It pointed out that negotiations about funding for the transaction between CSI and Customer A continued into the third quarter of 2009. (Recall that the shipments and revenue recognition already took place in June.) Customer A expected large U.S. government subsidies and significant income upon completion of the projects but had no source of financing to cover the upfront costs, including the cost of acquiring the solar panels from CSI. CSI's argument was that it had access to financing from Chinese banks and would be able to arrange for the financing that Customer A needed.

The SEC's position is that the evidence of an arrangement criterion must be met at the time the revenue is recognized. CSI was still in negotiations over the terms of this deal at the time it shipped and recognized revenue for the $2.4 million of solar panels. Therefore, the criterion wasn't met at the time of delivery. In other words, CSI should have waited until all terms and financing were in place before recognizing the revenue.

Not only were negotiations ongoing at the time of delivery, those negotiations eventually fell apart in mid-September 2009, and all of the solar panels were returned.

The SEC also found compelling evidence that the collectability criterion wasn't met either. The SEC identified internal communications in which CSI employees expressed serious concerns about Customer A's ability to pay, citing a poor Dun & Bradstreet credit report and at one point noting, "They are very short money. They are not confident they can pay us on November 1st and not confident enough to find money to finish the project." This provided further support to reverse the June 2009 recognition of revenue.

Customer B

A $3.4 million arrangement with a second customer (Customer B) also shouldn't have resulted in recognition of revenue, according to the SEC. This arrangement failed to meet the fixed and determinable price criterion as a result of a side deal with Customer B. Beginning in the second quarter of 2009, CSI began adjusting prices of solar modules that had already been shipped to Customer B (and revenue already recognized). The SEC notes that this practice "was a way for CSI to effectively guarantee Customer B against losses by adjusting Customer B's price below that which Customer B could expect on resale." The SEC refers to one internal communication in which a CSI executive directed CSI employees to "drop the price of [Customer B's] inventory. … Need them to move the goods to pay us."

In essence, a sale had occurred, but the price was neither fixed nor determinable at the time of the sale.

The existence of side deals often results in a failure to meet one or more of the criteria for revenue recognition. Investigators and auditors should always be on the lookout for indications of side deals.

Finally, the SEC raised several issues involving the collectability criterion with Customer B. Customer B fell behind in its payments to CSI and entered into a payment plan. Customer B's level of inventory also exceeded its insurance coverage limit. CSI nonetheless continued to ship more orders to Customer B in one of several variations of channel stuffing — selling more than what a customer reasonably needs (and more than what they might be able to pay for) in order to make a company's sales targets. Continuing to sell and recognize revenue under such conditions raises questions about whether collectability is reasonably assured at the time these sales were recorded.

As further evidence of channel stuffing, at one point Customer B requested — and CSI agreed to — a reimbursement of the costs of holding such large volumes of product in its inventory.

Positive professional skepticism

Rulings like the China Metal Recycling and Canadian Solar cases are helpful for auditors and fraud examiners. They're examples of how our professional skepticism of arrangements can sometimes lead to conclusions that conflict with management's fraudulent push to recognize revenue.

Gerry Zack, CFE, CPA, CIA, is a managing director in the Global Forensics practice of BDO Consulting, at which he provides fraud risk advisory and investigation services. He is also the 2015 chair of the ACFE Board of Regents and is an ACFE faculty member. His email address is: gzack@bdo.com.

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