Free Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition by Howard Schilit, Jeremy Perler Page A

impatient, and in 1997 through 1999 it pulled forward approximately $300 million of equipment revenue that should not have been recognized until much later.
     
    Recording Revenue on Long-Term Arrangements with Multiple Deliverables
     
    A third type of long-term arrangement that is subject to accelerated revenue recognition as a result of aggressive management estimates is one that has “multiple deliverables.” In this type of arrangement, the seller provides several distinct, but intermingled deliverables over an extended period of time. For example, wireless telecom companies often package mobile phone service and a cell phone handset together in the same contract. Sometimes the handset is sold to the customer at a greatly discounted price (or even given away for free), as long as the customer also agrees to a two-year service contract. Accounting rules require the seller to allocate a portion of the total contract value to the handset (to be recognized as revenue up front) and a portion to the service contract (to be recognized over the life of the contract). The seller uses assumptions in estimating how to split the revenue between the two deliverables.
     
    By changing these assumptions or contract details, companies can influence the distribution of revenue in a way that may allocate more revenue to the “front end” of the contract (handset) and less to the “back end” (phone service). Investors should therefore keep an eye on the inputs (often discussed in company footnotes), including any structural changes to standard contracts. For example, Japanese telecom service provider Softbank changed the payment structure on its mobile phone contracts in 2006 in a way that increased the price of the handset and decreased the price of the monthly service, which may have allowed more revenue to be recognized up front. Monitoring receivable balances can help spot changes, as well. Softbank’s days’ sales outstanding increased from 51 days in the quarter it changed the payment structure to 61 days and 74 days in the two subsequent quarters.
     
    Recording Revenue on Utility Contracts Using Mark-to-Market Accounting
     
    Enron got creative with its accounting by conveniently forgetting that it was primarily a utility company, and instead pretending to be a financial institution. As a utility, Enron entered into long-term commodity delivery contracts with customers (e.g., selling future delivery of natural gas). Economic sense should have told investors that Enron, a utility company, must record revenue on these long-term service contracts only when the service, such as delivery of gas, had been provided. However, Enron curiously failed to treat these arrangements as service contracts. Instead, it defined them as the sale of financial trading securities or, more specifically, the sale of commodity futures contracts. Totally inappropriate, but quite clever!
     
    Using this wacky interpretation as justification, Enron adopted an accounting methodology that was specifically intended for use by financial institutions that trade securities such as futures contracts: mark-to-market accounting. Under this method, the service contract would be viewed the same way as any other tradable security, which meant that all expected profits under this contract should be recorded immediately. As estimates of contract profitability changed over time (resulting from actual activity under the contract), the value of the “security” would be adjusted, as well.
     
    Moreover, there were no actual markets for many of the contracts Enron was selling, which allowed Enron to use its own aggressive assumptions in determining the fair value of the contracts and any future markups or markdowns. This gave Enron’s management a tremendous amount of discretion in determining its quarterly earnings, effectively allowing the company to mark not to the market, but rather to its own desired results as dictated by its internal financial model (jokingly