Sometimes the pressure of achieving earnings projections can prove to be stronger than management’s integrity. One common method managements use to make a company’s financial statements look better than the company’s actual operating reality is by recognizing revenue earlier than it should. i2 Technologies (ITWO) is an example of a company that fell victim to this shenanigan, and had to settle with the SEC and pay out $10 million in a civil suit as a result of its actions.
In order to best reflect a company’s operating reality in a company’s financial statements, revenue is recognized not when cash changes hands, but rather when the revenue has been earned. In most cases, this means the good has been transferred to the buyer (and the buyer now assumes its risk) or the service has been performed. In some cases, it’s not so easy to determine when this has occurred.
As a software company, i2 Technologies was showing revenue from customers that the SEC deemed were not actually earned. An excerpt from the SEC press release reveals why the SEC drew this conclusion:
Historically, i2 favored up-front recognition of software license revenue, purportedly in accordance with generally accepted accounting principals (GAAP). However, as i2 knew or was reckless in not knowing, immediate recognition of revenue was inappropriate for some of i2’s software licenses because they required lengthy and intense implementation and customization efforts to meet customer needs. In some cases, i2 shipped certain products and product lines that lacked functionality essential to commercial use by a broad range of users. In other cases, the company licensed certain software that required additional functionality to be usable by particular customers.
In essence, i2 had not yet completed the work, but was recognizing the revenue. i2 was not dishonest in any disclosure, however. Its policy of revenue recognition was clearly identified in the notes to its financial statements. As we’ve discussed before, by reading the notes to the financial statements, you will have a much better picture of a company’s position than by relying on the financial statements alone.