Detect accounting fraud, invest safely.

Some companies will do anything to meet analyst and shareholder earning expectations. Backdating contracts is one of the easiest ways to achieve this goal. By backdating contracts so that the revenues can be recorded for the current quarter, management is essentially recording future revenues in the current quarter.

Towards the end of a quarter, sales staff are under high pressure to meet their sales quota. Similarly, management is on the hook to hit the quarter end numbers.  With a huge bonus dangling as an incentive, it’s not hard to give in to the temptation to simply record a deal a few days earlier. At first glance, such shenanigan seems hardly egregious, especially if the deal was closed one day after the quarter ends, as long as the deal is a legitimate deal. After all, late revenue is still revenue.

The Impact from Backdating Contracts

But what many investors fail to realize is that backdating contracts has the effect of artificially supporting an already lofty share price or even boosting the share price. When a company hits analyst expectations, its stock price often rises accordingly. Had the company not backdated contracts, earnings may have been significantly lower as in the case of Computer Associates. Between 1998 and 2000, Computer Associates was found to have prematurely recorded $3.3 billion in revenues. [1] Internally, it is said that Computer Associates has a 35-day month policy.

Futhermore, shifting future revenues to the current quarter is an accounting fraud scheme guaranteed to fail. Once revenue has been recorded in the current quarter, the company can no longer record the same revenue in the next quarter. And since the company met this quarter’s expectations, analysts and investors will most likely set a higher target for the next quarter. By recording future revenues in the current quarter, management has foregone legitimate revenues in the next quarter. Management will have a very hard time closing enough deals to meet the target.

A variant of the contract backdating gimmick that companies use to deceive investors is changing the quarter end date. By extending the quarter end date by a few days instead of backdating contracts, management can now include deals that could significantly boost earnings. Sunbeam recorded an additional $20 million in revenue by changing its fiscal year to a calendar year, thereby extending the quarter by two days. [2]

Sniffing Out Backdated Contracts

Admittedly, detecting accounting smells from backdated contracts is almost impossible without access to the books. An investor can only rely upon the accounting firm to do its fiduciary duty to report inappropriate recording of revenues to proper authorities. Unfortunately, this is not always the case. Despite the knowledge of the illegal contract backdating practiced by the management, the accountant, who audited Solucorp Industries financials between 1995 and 1999, did not report the matter to the SEC. What’s interesting with the Solucorp case is the SEC did not let the auditor off the hook. [3] Hopefully, this case sends a stern warning to auditors who second guess their responsibility to report known illegal acts.

The one thing that could lend a hint as to whether contracts were backdated is the auditor’s report. If the auditor expresses an opinion other than unqualified opinion, you should pay close attention. Read the auditor’s opinion and decide if the risk is worth the investment. Most often it’s better to just move on. An adverse opinion is an immediate red flag. Although auditors are required to consider the going concern of a business, most auditors don’t express their opinions because it’s a self-fulfilling prophecy. Too, this will only result in losing a client.

A change of quarter-end or year-end date is easy to spot because it’s a required accounting disclosure. You should be able to find this in 8-Ks. Most fiscal end date changes are legitimate and for good reasons. Management would usually mention the reason for the change in the 8-K. But if you smell something fishy about the reasoning behind the change, it’s time to dump the sucker and find a bigger fish.

References

1. SEC v. Computer Associates International, U.S. Securities and Exchange Commission, September 22, 2004.
2. SEC v. Sunbeam Corp, U.S. Securities and Exchange Commission, August 25, 2003.
3. Michael J. Halloran, Greater Use of SEC Enforcement Tool Against Accounting Firms Has Important Consequences for Companies, Pillsbury Winthrop Shaw Pittman LLP, September 13, 2002.

Side note: My recent post Stock Delistings - How to Cope was featured on the Festival of Stocks #117, the Rich Life Carnival #22, the Investing Carnival #24, the Cavalcade of Risk #66: Investment Grade, and the Financial Advice from Personal Finance Blogs - December 6 2008. As usual, the articles in each carnival offer a wealth of information for us newbie investors to learn from. Be sure to check them out.