It's all about customer service

This column's cases deal with improper accounting for special arrangements made with customers. Companies go to great lengths to meet sales goals, including offering special incentives for customers to buy their products. But the accounting rules provide a framework for how and when such incentives should be reflected in a company's financial statements.

Monsanto

A February 2016 enforcement release from the U.S. Securities and Exchange Commission (SEC) describes a misstatement in the financial statements of Monsanto Company. Monsanto is a leading multinational agricultural seed and chemical producer. You might be familiar with Monsanto's "Roundup" — a yard and garden herbicide.

From 2009 to 2011, Monsanto improperly accounted for rebates offered to Roundup distributors and retailers. The pressure for the improper accounting can be traced back to 2000, when the patent for Roundup expired. Competition from generic producers then began chipping away at Roundup's market share. Price competition reached a peak in 2009. One of the side effects of the increased competition was that Monsanto's customers (retailers and distributors) were keeping less Roundup on hand because they anticipated price reductions from Monsanto in reaction to the price pressures.

Monsanto's solution was to launch a rebate program encouraging customers to maximize their Roundup purchases in the fourth quarter of 2009 (at the then-current, higher prices) by allowing them to participate in a new customer loyalty program that would begin in 2010.

Under the program, if retailers achieved a 2010 sales target, they'd earn a rebate for each gallon of Roundup they held in inventory as of Dec. 31, 2009, which effectively compensated the retailers for the anticipated price decrease that Monsanto would roll out in 2010. In the second quarter of 2010, Monsanto even prepaid rebates to retailers who were making substantial progress towards their 2010 goals.

Monsanto improperly accounted for the rebates by reflecting them as reductions in 2010 revenue, when they should've reduced 2009 revenue. The specific U.S. accounting standard is found at ASC 605-50-25-3, which requires a company to recognize sales incentives on the later of: (1) the date in which the related revenue is recognized; or (2) the date on which the sales incentive is offered (both events of which occurred in 2009).

Monsanto also made a second type of accounting error initially in connection with its Canadian operations, where it determined the rebate program insufficiently compensated customers for the 2010 price decrease. So Monsanto decided a second round of rebates was in order. However, out of concerns over its reported revenue and gross margin figures, Monsanto decided to account for the second rebate as a selling, general and administrative (SG&A) expense.

Once again, generally accepted accounting principles (GAAP) provide very specific guidance on the classification of costs of programs like this. The assumption under ASC 605-50-45-2 is that cash provided to customers should be accounted for as a reduction in revenue unless two criteria are met:

1. The provider of the cash (Monsanto) receives an identifiable benefit (from the customer) that's sufficiently separable from the sales transaction (i.e. from Monsanto's sale of Roundup to the customers).
2. The fair value of the benefit provided by the customer can be reasonably estimated.

In most cases, the benefit a customer provides to a manufacturer involves some form of additional marketing or administrative service above and beyond what the customer is already doing (i.e. the customer is already likely trying to sell the product if it's a retailer or wholesaler, so this service would usually be something on top of that).

Monsanto created documents that described marketing services that customers were to provide, and it even arranged for an independent assessment of the fair value of these services. (Although the independent value was about a third of Monsanto's internal estimate.) Most customers even certified that they performed the services described in the agreement. However, the SEC couldn't find any other evidence that the customers provided any marketing services for Monsanto. In most other cases, a company would normally maintain documentation showing customers' specific marketing efforts. Evidently, in this case, however, there was none of that — only the certifications (which one customer refused to sign), resulting in Monsanto's failure to demonstrate an "identifiable benefit."

In the end, the Monsanto case falls into two categories: (1) a timing difference misstatement from pushing recognition of rebates into periods after the period in which they should be recognized and (2) a misclassification scheme that inflated top line revenues and gross margin at the expense of inflating SG&A costs.

Monsanto reached an $80 million settlement with the SEC. Under the settlement, the company neither admitted nor denied the charges, which included fraud. Monsanto also agreed to a series of remedial measures, including the hiring of an independent compliance monitor to oversee the other remedial efforts.

BioElectronics Corp.

Another February enforcement release from the SEC pertains to BioElectronics Corp. (BIEL), a small maker of drug-free, anti-inflammatory medical devices and patches that utilize electromagnetic energy. BIEL is a small company; so the two transactions it improperly accounted for, while amounting to only $366,000, represented 47 percent of its 2009 revenue.

BIEL's case is a classic bill-and-hold situation in which a company makes a sale to a customer with the added condition that the seller holds onto the purchased products rather than shipping them immediately to the customer. The company might do this to satisfy a customer who wants to perhaps take advantage of an attractive price, but doesn't currently have sufficient storage capacity. The company can also do it to entice a customer to purchase a greater quantity than what it might currently need. Both of those are legitimate reasons for bill-and-hold transactions. However, accounting rules specifically address bill-and-hold arrangements because of their unique nature and potential for abuse.

Consistent with GAAP, BIEL's stated revenue recognition policy indicated that revenue on bill-and-hold transactions would only be recognized if seven distinct criteria are all met at the time the revenue is recognized:

1. Risk of ownership has passed to the buyer.
2. The buyer has made a fixed commitment to purchase the goods.
3. The buyer, not the seller, requested the bill-and-hold terms.
4. There's a fixed schedule for delivery of the products, and the schedule is reasonable and consistent with the buyer's business purpose.
5. The buyer hasn't retained any specific performance obligations such that the earnings process isn't complete.
6. The goods ordered by the buyer are physically segregated from the seller's inventory and not used to fill other orders.
7. The product must be complete and ready for shipment.

In one of the transactions, BIEL allowed the customer to cancel the agreement for six months, which resulted in the company's failure to meet the second criterion above. Additionally, the customer hadn't agreed to take delivery of any specific quantity of product at any specific date, so BIEL also failed the fourth criterion. In another transaction, BIEL failed to have a fixed delivery schedule in place (criterion 4) and hadn't yet completed the final steps of making the product (criterion 7).

Unfortunately for BIEL, meeting a majority of the seven criteria wasn't enough. The company should've abided by all of them to justify recording revenue for bill-and-hold arrangements.

AirTouch Communications

The third ruling, which goes back a bit further to April 2015, illustrates another technique companies use to entice customers to buy more product — with serious accounting implications. This case involves AirTouch Communications, a developer and seller of telecommunications equipment designed to integrate mobile telephones into landline telephone systems in a consumer's home.

Virtually all of AirTouch's revenue recognized in the third quarter of 2012 stemmed from a shipment of inventory to one customer. This customer planned to sell the AirTouch products to one of its own customers. AirTouch and its customer — in anticipation of this arrangement — executed a fulfillment and logistics agreement just a few months earlier, in July. But AirTouch, which wanted to keep this new customer happy, included a provision that it would later regret. The provision stated that if the customer of AirTouch's customer didn't fulfill the anticipated purchase orders or canceled any orders, AirTouch's customer had the right to return the products to AirTouch for full credit.

Whether AirTouch realized it or not at the time, this provision essentially made the transactions between AirTouch and this customer consignment sales, which meant risks of ownership wouldn't pass to the customer until the customer, in turn, sold the products to its own customer. Accordingly, this attempt at pleasing an important new customer backfired on AirTouch from a revenue recognition standpoint.

On a side note, AirTouch's controller provided the outside auditor with the purchase order supporting this transaction but not the agreement describing the consignment term. However, AirTouch's CFO never provided the controller with a copy of the agreement. Accordingly, the now-former CFO was penalized $60,000 and barred for 10 years from either acting as an officer or director of a public company or practicing before the SEC as an accountant.

Takeaways

Companies can get very creative in their attempts to (1) meet the needs and requests of their customers or (2) meet their own needs to achieve revenue targets. In doing so, they might lose sight of the accounting principles on revenue recognition or, even worse, intentionally manipulate transactions to appear to comply with those rules. Sales with special conditions and/or undisclosed side deals are the two most common characteristics of these situations.

These three rulings also illustrate an underlying historical difference between accounting standards in the U.S. and those found globally or described in the International Financial Reporting Standards (IFRS). U.S. accounting standards have included many detailed rules aimed at addressing numerous distinct circumstances, whereas IFRS and many other country-specific accounting rules have tended to be more principles-based — a broad set of principles subject to interpretation and application to individual transactions. Many of the rules described in this column don't appear in nearly the same level of detail outside the U.S. But with a new revenue recognition standard approved by the Financial Accounting Standards Board and the International Accounting Standards Board and becoming effective in 2018, U.S. GAAP and International Financial Reporting Standards have issued a consistent approach to revenue recognition.

I'm always looking for recent cases and news involving alleged financial reporting fraud around the globe. Email me your links, news or information on public reports of alleged fraud.

Regent Emeritus 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's an ACFE faculty member and was also the 2015 chair of the ACFE Board of Regents. His email address is: gzack@bdo.com.