Pressure to meet short-term sales targets or enhance stock prices can lead companies to engage in a deceptive practice known as channel stuffing. A recent lawsuit against Crocs Inc., alleging that the shoemaker misled investors with the practice, provides lessons about the financial and reputational consequences of channel stuffing, and the author offers strategies that can keep companies in their investors’ good graces.
In 2004, a costume designer with a limited budget discovered a startup company designing shoes that perfectly fit the comical, dystopian movie she was working on. Those shoes were absurd, bright plastic clogs called Crocs that seemed unlikely to ever become popular, so the costume designer featured them in the movie, “Idiocracy.” Now, two decades later, Crocs, Inc., the maker of those comical clogs, is facing a dilemma beyond its shoes’ improbable popularity, as investors accuse the company of coercing sales in a channel stuffing scheme.
Channel stuffing, as the name suggests, occurs when too much product is forced through the sales channel, overburdening the receiving end with more product than conceivably can be sold. Although it makes sales to third parties appear stronger, it results in prematurely recognized revenue and is considered a form of financial statement manipulation.
Over the course of a year, Crocs’ stock degraded when it announced information about the growth, or lack thereof, of its subsidiary, HEYDUDE. A class-action lawsuit purports that investors suffered damages when Crocs’ stock price declined from the alleged channel-stuffing fallout.
When revenue is recognized too soon, it violates Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). It misrepresents the financial situation of a company to investors and analysts, which can initially result in falsely inflated stock prices, followed by market volatility when the inevitable corrections occur. Channel stuffing can also artificially improve financial ratios that are used to evaluate company performance and financial stability. For example, an organization’s accounts receivable turnover ratio might indicate greater creditworthiness, and thus be used to secure better financing, than would be possible without revenues from channel stuffing.
In this column, the author evaluates the timeline of Crocs’ revelations concerning its brand HEYDUDE’s growth against its decline in stock value. Then the author examines how channel stuffing influences organizations through historical cases of the practice. Finally, the author discusses what companies can do to detect and prevent it.
Crocs’ timeline and stock prices
In 2022, Crocs acquired the comfort-shoe company HEYDUDE for $2.5 billion. At first, HEYDUDE appeared to be a fruitful purchase, and profits increased. It wasn’t until April 27, 2023, that Crocs revealed that HEYDUDE’s 2022 revenue growth was due to efforts to stock wholesale partners with products — and not necessarily because HEYDUDE was selling well to end consumers. After Crocs made this information available, its stock price plummeted. In June 2023, Crocs further revealed that more than half of HEYDUDE’s third-quarter wholesale revenue came from stocking HEYDUDE products with Crocs’ major retailers. With this news, Crocs’ stock price fell once again.
More than a month later, Crocs admitted that the deliberate overstocking accounted for approximately $220 million of HEYDUDE’s $896 million in revenue for the period directly following its acquisition of HEYDUDE in 2022. When Crocs announced that it was reducing HEYDUDE’s revenue growth guidance for the remainder of 2023, Crocs’ stock price dropped even further.
In August 2023, when brokerage firm Williams Trading LLC significantly decreased its price target on Crocs, citing elevated HEYDUDE inventory levels, Crocs’ stock prices yet again decreased. Then, in November 2023, Crocs released its third-quarter 2023 financial results, revealing that HEYDUDE’s wholesale revenue had declined significantly “following prior year pipeline fill.” Crocs further reduced its 2023 HEYDUDE revenue growth guidance from 14% to 18% to only 4% to 6%. On these HEYDUDE revelations, Crocs’ stock price fell even more.
Finally, on Oct. 29, 2024, Crocs held an earnings call, during which Chief Executive Officer (CEO) Andrew Rees revealed that HEYDUDE’s revenue had fallen below expectations again and admitted it was struggling due to “excess inventories in the market.” Reese then conceded that “in retrospect, we absolutely shipped too much product.” Again, Crocs’ stock price fell.
From April 2023 to October 2024, Crocs’ stock prices fell from approximately $147.78 to $111.58, a total decline of 24.5% after the company’s admissions. Companies often experience market fluctuations, but investors took issue with the significant decline from Crocs’ alleged actions and revelations.
How channel stuffing happens
Companies might be tempted to engage in channel stuffing because it can help their sales appear stronger temporarily. They might offer deep discounts and rebates to customers to encourage bulk buying or extend overfriendly payment terms to ease the purchaser’s financial burden.
For example, in 1997, home appliance maker Sunbeam, offered discounts and incentives to customers to purchase merchandise immediately that otherwise would’ve been sold in later periods. The U.S. Securities and Exchange Commission (SEC) found that Sunbeam officers engaged in this acceleration of sales and revenue from later periods. Officers then deleted records to conceal the inevitable pending returns of merchandise, which misrepresented Sunbeam’s performance and prospects in its filing on Form 10-Q for the first quarter of 1998. The misrepresentations extended to Sunbeam’s offering materials for a bond offering, its press releases and its communications with analysts.
As a result of negative press, Sunbeam’s board of directors conducted an internal investigation and issued an extensive multiyear restatement of financials. Ultimately, the company filed Chapter 11 bankruptcy for reorganization. The SEC estimated that $60 million of the $189 million in earnings was due to accounting fraud. Albert Dunlap, former Sunbeam chairman and CEO, paid $15 million to settle a lawsuit with shareholders as a result of the scandal.
In addition to customer inducements, companies engaging in channel stuffing might pursue aggressive sales tactics, selecting short-term revenue over sustainable demand. Orders might be received, but their terms might raise questions about the collectability of the resulting accounts receivable. Additionally, any existing side agreements that grant a right of return might, effectively, turn sales into consignment sales, which require different accounting measures. A greater risk of returns for certain products exists if they can’t be sold before their shelf life ends.
Accordingly, industries with high gross margins, such as branded consumer goods, luxury items and pharmaceuticals, may be more tempted to engage in such activities because they can easily and quickly improve short-term earnings. However, over time, sales targets become increasingly harder to hit because the earnings gained in the current period are essentially borrowed by the push of sales that would be properly recognized in the following period. In turn, the increased pressure can lead to further channel stuffing, eventually requiring a financial restatement when the cycle can no longer sustain the scheme.
From 2000 to 2001 global biopharmaceutical company Bristol-Myers Squibb intentionally misled the market and investors with a channel stuffing scheme to make it appear as though it met or exceeded expectations by inflating sales to two of its largest wholesalers. The company also used “cookie jar” reserves to meet its internal sales and earnings targets, as well as analysts’ earnings estimates. Cookie jar reserves are funds set aside from revenue of previously successful periods to be used during future difficult times. While companies can create proper cookie jar reserves, such as liabilities for bad debts, warranties and other contingencies, they must be managed with proper methods and disclosures. However, accruing excess expenses or deferring revenue that should be recognized is considered improper cookie jar reserves. Similarly, mis-accruing, such as over-accruing during high earnings and under-accruing during low earnings, can also indicate improper cookie jar reserves.
As part of their channel stuffing scheme, Bristol-Myers Squibb covered the wholesalers’ carrying costs and guaranteed them a return on investment until they sold the products. The company also recognized the $1.5 billion in revenue upon shipment, contrary to GAAP. Additionally, the company’s accruals for rebates were materially understated in conjunction with its pushed sales. Unfortunately for Bristol-Myers Squibb, those pushed sales were insufficient to meet market expectations. The company then opened its cookie jar divesture reserves and reversed the safety reserves into income to further inflate its earnings.
In another case, from 1998 to 2003, 11 former executives of Symbol Technologies, a manufacturer and supplier of mobile data capture and delivery equipment, schemed to inflate all measures of financial performance to exceed Wall Street estimates. At the time, Symbol was run by Tomo Razmilovic, who abruptly retired during the SEC inquest. To align with market expectations, the perpetrators reported manufactured financial results, including through the use of a “Tango sheet.” The Tango sheet informed all the colluding parties of the company’s schedule for any proposed fabrication and manipulation and was used to conform the unadjusted quarterly results to management’s projections. Symbol also fabricated and misused restructuring and other nonrecurring charges to artificially reduce operating expenses.
Like Bristol-Myers Squibb, Symbol Technologies created improper cookie jar reserves. Symbol executives overstated inventory write-offs and inflated the accrued expenses when the real operating costs were lower than forecasted. The company reversed these excess reserves as needed to increase earnings in future periods. Additionally, when actual sales fell short of company targets, Symbol overfilled the distribution channel by granting resellers return rights and contingent payment terms in side agreements that top executives negotiated or authorized. Sometimes, internally known as “candy” deals, additional phony revenue came from three-way “round trip” transactions by way of resellers and distributors. Resellers would “purchase” large volumes of Symbol’s product from a distributor at the end of a quarter. This action induced the distributor to place a corresponding order with Symbol to meet fake demand. Symbol then paid the reseller for the product, which included the markup from the distributor, and additionally paid the reseller an extra 1% of the purchase price, the “candy.”
Symbol also knowingly shipped the wrong products to customers when the ordered product was unavailable. Further, the company then recognized revenue on shipments that shouldn’t occur until the following quarter. To conceal this premature recognition of revenue, Symbol secured backdated phony “bill and hold” letters from the customers.
Detecting and preventing channel stuffing
The temptation to increase short-term earnings, demonstrate growth or meet market expectations can entice companies and executives to engage in channel stuffing and other forms of improper revenue recognition. Like any fraud scheme, channel stuffing has red flags, which can be detected in the following ways:
Determine whether accounts receivable is growing faster than sales. Unusual growth in channel sales without a logical explanation (such as supply increases to meet increased demand) should prompt examination.
Look at the days sales outstanding (DSO), which can help determine how quickly a company is getting paid. A low DSO means the company is promptly receiving payments; a high DSO indicates a delay in receiving payments from customers and might merit further scrutiny about the legitimacy of those sales.
Pay attention to the timing of sales and shipments. When a company suddenly has an increase in sales before a significant period ending, such as a quarter or fiscal year, this might be normal for the industry, but it might not be.
Be aware of the typical patterns of supply and demand, which can help when considering the need for, or results, of a cut-off test. Auditors often use cut-off tests to determine whether a transaction is properly recorded in the correct accounting period by examining when the expense is recorded and when the revenue is recognized, as they should happen within the same period and not be separated.
Note highly complex and unusual journal entries, such as those noted on Symbol’s Tango sheet, which might represent concealment and attempts to eschew the “substance over form” accounting principle, which states a business’s financial statements and accompanying disclosures should reflect the underlying realities of accounting transactions. The true nature of a transaction must be recorded, not manipulated to purport a different situation.
Authentic transactions should be backed up by supporting documentation and be understood and traceable; however, the presence of these characteristics shouldn’t be automatically assumed to confirm a transaction’s legitimacy, as some perpetrators do attempt to obfuscate their trail.
Channel stuffing is a deceptive practice fueled by the perception that an organization needs to show investors that sales are stronger than they actually are.
Companies can also improve detection of channel stuffing by developing and implementing strong internal controls in the sales and supply chain functions to better identify potential problems before they escalate. Proactively monitoring for unusual patterns in distributors’ data, such as inventory orders (historical and pending), sales and promotional expenses, can help identify anomalies that should be further investigated. Companies should also establish direct and transparent communication with distributors about their obligations and responsibilities, including the acceptable levels of inventory and sales targets, and should conduct ongoing training to reinforce these expectations.
Like any scheme, one of the best ways organizations can limit or prevent opportunities for channel stuffing is to create an ethical and open culture. Many of the companies discussed in this column yielded to the pressure of meeting targets, and their shareholders and stakeholders alike became the victims. Channel stuffing is a deceptive practice fueled by the perception that an organization needs to show investors that sales are stronger than they actually are. But investment in transparent operations coupled with an accountable workforce is how companies show their investors that they’re standing on solid ground. Strong internal controls function best when a company has a foundation built on an ethical culture, even for purveyors of absurdly colorful clogs.
Laura Harris, CFE, is the senior research specialist for the ACFE. Contact her at LHarris@ACFE.com.