On January 13, 2011 Securities and Exchange Commission filed a complaint against NutraCea, an Arizona based health foods manufacturer and seller, alleging the company of falsification of its financial statements.
The complaint states that the company overstated its revenues in 2007 by booking invalid sales and engaging in improper revenue recognition practices. Two key cases highlighted in the complaint are – false booking of sales of $2.6 million by NutraCea to Bi- Coastal Pharmaceutical Corp and improperly recording revenue on bill and hold transactions – $1.9 million sale of product to ITV Global, Inc. (“ITV”) in the fourth quarter of 2007.
As a result of these two transactions alone, NutraCea overstated its product sales revenue by 36.8% and misstated its operating loss by nearly 7% for fiscal year end 2007.
In May 2001, SEC files a complaint against 5 of Sunbeam Corporation’s former officers, alleging that senior management of Sunbeam engaged in fraudulent scheme to create an illusion of successful restructuring of the company and thus facilitating a sale of the company at an inflated price. Sunbeam created a cookie jar reserve of the amount of $35 Million at end of 1996, and used this to inflate the income in 2007. The company also used channel stuffing and improper recognition of revenue on contingent sales and indulging in improper buy and hold sales and incorrect accounting for supplier rebates. In 1997, at least $62 million of Sunbeam’s reported $189 million income came from accounting fraud.Starting with 1996, the company created improper reserves of $35 million at year end 1996. Sunbeam took a total restructuring charge of $337.6 million at year-end 1996. However, management padded this charge with at least $35 million in improper restructuring and other reserves and accruals, excessive write-downs, and prematurely recognized expenses that materially distorted the Company’s reported results of operations for fiscal year 1996, and would materially distort its reported results of operations in all quarters of fiscal year 1997, as these improper reserves were drawn into income.
The most substantial contribution to Sunbeam’s improper reserves came from $18.7 million in 1996 restructuring costs that management knew or was reckless in not knowing were not in conformity with Generally Accepted Accounting Principles (“GAAP”).
Sunbeam also created a $12 million litigation reserve against its potential liability for an environmental remediation. However, this reserve amount was not established in conformity with GAAP and improperly overstated Sunbeam’s probable liability in that matter by at least $6 million. Under Financial Accounting Standard No. 5 (“FAS 5”), a company must create a litigation loss reserve if (1) a loss is probable and (2) the amount of the expected loss is material and reasonably estimable. If a company determines that a loss is probable, it next must consider whether the amount of the loss will be material and if it can be estimated. If the loss is not material or cannot be reasonably estimated, no reserve is required. Even if it is impossible to estimate the exact amount of probable loss, however, a company should attempt to estimate the range of possible losses. If no amount within the range appears to be the best estimate, the company should reserve the low end of the range and then disclose the remaining amount, up to the high end of the range, as a “reasonably possible” loss. In 1997 the company settled for $3 million the claim to which the reserve related. At the conclusion of the fourth quarter of 1996, Sunbeam management knew or recklessly disregarded facts indicating that the $12 million reserve was at least $6 million in excess of Sunbeam’s probable liability on this claim. Thus Sunbeam’s fourth quarter 1997 results were knowingly or recklessly inflated by at least $6 million when that excess was released into income.
In connection with its restructuring, Sunbeam planned to eliminate half of its household product lines. Its inventory of eliminated products was to be sold to liquidators at a substantial discount. In adjusting the capitalized variances ( method used to assign cost basis to inventory) associated with its inventory of household products at year-end 1996, however, Company management knowingly or recklessly failed to distinguish excess and obsolete inventory from “good” inventory from continuing product lines. As a result, Sunbeam understated the balance sheet value of its good household inventory at year-end 1996 by $2.1 million. This caused Sunbeam’s 1996 loss to be overstated by $2.1 million, and improved Sunbeam’s profitability by the same amount when household products were sold at inflated margins during the first quarter of 1997.
Sunbeam had contracted to pay its advertising agency a total of approximately $2.7 million in fees and (potential) bonus to cover services rendered from late 1996 through the end of 1997. However, Sunbeam management knowingly or recklessly recognized this entire amount as a 1996 expense, including $2.3 million that related to services to be performed in 1997. This enabled Sunbeam to improperly improve its net income in all quarters of 1997($330K should have been recognized as expense in Q1 1997, $1.2 Million in Q2, $663K in Q3, as described below.) Under US GAAP, A company may pay for goods or services before they have been received. Any amounts that have been paid for goods and services not received by the end of an accounting period are shown in the balance sheet as prepayments. These amounts will not be shown as costs in the P & L. When the goods or services are received, then the amounts will be passed through the P & L and deducted from the prepayments section of the balance sheet.
Finally, in addition to buying national advertising to create demand for its products, Sunbeam funded a portion of its retailers’ costs of running local promotions. At year-end 1996, Sunbeam set its “cooperative advertising” reserve at $21.8 million without performing any test of the reasonableness of that amount. Therefore, this amount was neither probable nor arrived at by reasonable estimation, in contravention of FAS 5. This reserve was used in Q2 2007 to boost the net income by $5.8 million.
At the end of March 1997, just before the quarter closed, Sunbeam booked $1.5 million in revenue and $400,000 in income from a purported sale of barbecue grills to a wholesaler. The wholesaler held Sunbeam merchandise over a quarter end, without accepting any of the risks of ownership; the agreement provided that the wholesaler could return all of the merchandise if it did not sell it, and that Sunbeam would pay all costs of shipment (in both directions) and storage. Incurring no expenses in this transaction, the wholesaler in fact returned all of the grills to Sunbeam during the third quarter of 1997. GAAP does not permit the recognition of revenue on transactions lacking economic substance. These were contingent sales (see accounting rule for contingent sales under Xerox) and should not have been recognized in Q1.
In the second quarter of 1997, Sunbeam began using “bill and hold sales” to improve earnings. Specifically, the Company began offering its customers financial incentives to write purchase orders before they needed the goods. Thus, Sunbeam sold goods in the second quarter that it would normally have sold in later periods. Since many customers who wished to take advantage of these inducements could not burden their warehouses with out-of-season merchandise, Sunbeam offered to hold product for its customers until delivery was requested. Sunbeam typically also paid the costs of storage, shipment and insurance on the product. Moreover, the customers often retained the right, through explicit agreement or established practice, to return unsold product to Sunbeam.
Bill and hold sales are unusual transactions subject to stringent accounting criteria. The Commission has previously articulated these criteria in In the Matter of Stewart Parness, Exchange Act Rel. No. 23507, Accounting and Auditing Enforcement Rel. (“AAER”) No. 108 (August 5, 1986).The Parness criteria relevant to the instant case include: the buyer, not the seller, must request that the transaction be on a bill and hold basis; the buyer must have a substantial business purpose for ordering the goods on a bill and hold basis; and the risks of ownership must have passed to the buyer.
Sunbeam’s bill and hold transactions did not meet the above criteria. Sunbeam procured these sales by offering price, credit and other concessions to induce customers to write purchase orders before they would otherwise have done so. Thus, it would be inaccurate to claim that the buyer had requested “the transaction be on a bill and hold basis.” It is also not the case that the buyer has “a substantial business purpose for ordering the goods on a bill and hold basis,” when its only motive is to obtain the various inducements offered by the seller. Such an interpretation would substitute the seller’s business purpose (e.g., to accelerate recognition of sales revenue) for the buyer’s. Sunbeam paid the costs of insuring, storing and shipping the product, and in many instances was willing to accept the return of the product. Therefore, the customers did not accept the risks of ownership. In summation, these transactions were little more than projected orders disguised as sales.
Beginning during the second quarter of 1997, Sunbeam began recording as income rebates obtained from suppliers that properly related to later period purchases. As a result of aggressive negotiation by Sunbeam, four suppliers paid rebates in the second quarter in the total amount of $2.75 million. Under GAAP, a rebate should normally be recorded as a reduction in cost of sales in the period in which its associated sale is made. That the supplier rebates obtained by Sunbeam beginning in the second quarter of 1997 were made in contemplation of future purchases, and therefore should have been recognized on a pro rata basis as the related sales were made.
All the above (along with some more accounting inconsistencies) led the company to the path of bankruptcy. The CEO and some other senior executives were fined and removed from their place in the company. The CEO Dunlap had to accept a life time ban from ever serving again as an officer or director of a public company.