Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition by Howard Schilit, Jeremy Perler Page B
Authors: Howard Schilit, Jeremy Perler
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substance extends far beyond insurance companies. Plenty of technology companies seemed to get the memo on how easy it is to employ this shenanigan. Take, for instance, San Diego–based Peregrine Systems, which got busted for a massive fraud scheme that involved recognition of bogus revenue.
The SEC charged that Peregrine improperly recorded millions of dollars of revenue from nonbinding sales of software licenses to resellers. The company apparently entered into secret side agreements that waived the resellers’ obligation to pay Peregrine, which means that revenue should not have been recorded. Employees at Peregrine had a great name for the scheme: “parking” the transaction. Sales that were near the finish line were often parked in order to help Peregrine achieve its revenue forecasts. Peregrine engaged in other deceptive practices as well to create bogus revenue, including entering into reciprocal transactions in which the company essentially paid for its customers’ purchases of its software. In 2003, Peregrine restated its financial results for those quarters, reducing previously reported revenue of $1.34 billion by $509 million, of which at least $259 million was reversed because the underlying transactions lacked substance.
And with Bogus Revenue Come Those Troublesome Receivables . Peregrine obviously did not receive cash from customers on these nonbinding bogus revenue contracts, resulting in bogus receivables festering on the Balance Sheet. As we have learned, a rapid increase in accounts receivable is often an indication of deteriorating financial health. Peregrine knew that analysts would naturally begin questioning the “quality of earnings” if the bulging receivables balance remained stubbornly high. To prevent these questions, Peregrine played several tricks that made it seem that the receivables had actually been collected. These shenanigans inappropriately lowered the receivables balances, and in doing so, improperly inflated cash flow from operations (CFFO). We will break down the mechanics of this chicanery and discuss Peregrine’s Cash Flow Shenanigans further in Chapter 10.
Symbol, Of Course, Wants In on the Action
Symbol Technologies found a creative way to recognize revenue that lacked economic substance. From late 1999 through early 2001, Symbol conspired with a South American distributor to fake more than $16 million in revenue. It instructed the distributor to submit purchase orders for random products at the end of each quarter, even though the distributor had absolutely no use for those products. Symbol never shipped the products to either the distributor or any of its customers. Instead, to fool the auditors into believing that a sale had actually occurred, Symbol sent the products to its own warehouse in New York; however, it still retained all “risks of loss and benefits of ownership.” The distributor, naturally, did not have to pay for the warehoused product and could “return” or “exchange” the goods at no cost when it placed legitimate new orders for any product that it actually needed. Without a doubt, the only purpose of this charade was to give the appearance of a legitimate sale so that Symbol could record revenue.
Symbol’s Three-Ring Circus. Symbol would do virtually anything, including losing money, just to recognize a sale. In a bizarre story, Symbol concocted a three-party circular scam to create fake revenue out of thin air. Typically, Symbol sold its product to a middleman (a distributor), who then sold the product to the actual customer (the reseller). Symbol found a way to use this structure to create bogus revenue: it improperly enticed (really, bribed) the reseller to purchase more of Symbol’s product from the distributor. The distributor would, in turn, purchase more products from Symbol. What a way to create artificial demand!
How did Symbol entice its resellers to go along with this scheme? Well, Symbol allegedly gave
The SEC charged that Peregrine improperly recorded millions of dollars of revenue from nonbinding sales of software licenses to resellers. The company apparently entered into secret side agreements that waived the resellers’ obligation to pay Peregrine, which means that revenue should not have been recorded. Employees at Peregrine had a great name for the scheme: “parking” the transaction. Sales that were near the finish line were often parked in order to help Peregrine achieve its revenue forecasts. Peregrine engaged in other deceptive practices as well to create bogus revenue, including entering into reciprocal transactions in which the company essentially paid for its customers’ purchases of its software. In 2003, Peregrine restated its financial results for those quarters, reducing previously reported revenue of $1.34 billion by $509 million, of which at least $259 million was reversed because the underlying transactions lacked substance.
And with Bogus Revenue Come Those Troublesome Receivables . Peregrine obviously did not receive cash from customers on these nonbinding bogus revenue contracts, resulting in bogus receivables festering on the Balance Sheet. As we have learned, a rapid increase in accounts receivable is often an indication of deteriorating financial health. Peregrine knew that analysts would naturally begin questioning the “quality of earnings” if the bulging receivables balance remained stubbornly high. To prevent these questions, Peregrine played several tricks that made it seem that the receivables had actually been collected. These shenanigans inappropriately lowered the receivables balances, and in doing so, improperly inflated cash flow from operations (CFFO). We will break down the mechanics of this chicanery and discuss Peregrine’s Cash Flow Shenanigans further in Chapter 10.
Symbol, Of Course, Wants In on the Action
Symbol Technologies found a creative way to recognize revenue that lacked economic substance. From late 1999 through early 2001, Symbol conspired with a South American distributor to fake more than $16 million in revenue. It instructed the distributor to submit purchase orders for random products at the end of each quarter, even though the distributor had absolutely no use for those products. Symbol never shipped the products to either the distributor or any of its customers. Instead, to fool the auditors into believing that a sale had actually occurred, Symbol sent the products to its own warehouse in New York; however, it still retained all “risks of loss and benefits of ownership.” The distributor, naturally, did not have to pay for the warehoused product and could “return” or “exchange” the goods at no cost when it placed legitimate new orders for any product that it actually needed. Without a doubt, the only purpose of this charade was to give the appearance of a legitimate sale so that Symbol could record revenue.
Symbol’s Three-Ring Circus. Symbol would do virtually anything, including losing money, just to recognize a sale. In a bizarre story, Symbol concocted a three-party circular scam to create fake revenue out of thin air. Typically, Symbol sold its product to a middleman (a distributor), who then sold the product to the actual customer (the reseller). Symbol found a way to use this structure to create bogus revenue: it improperly enticed (really, bribed) the reseller to purchase more of Symbol’s product from the distributor. The distributor would, in turn, purchase more products from Symbol. What a way to create artificial demand!
How did Symbol entice its resellers to go along with this scheme? Well, Symbol allegedly gave
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