Financial reporting warning signs: take action or else

The U.S. Securities and Exchange Commission’s recent settlement with Belden Inc. raises numerous lessons for legal counsel who represent public registrants, including the importance of adequately addressing internal control issues raised by acquisition due diligence procedures, assessing the pros and cons inherent in bill and hold transactions, and ensuring “know your customer” programs are in place.

The Belden settlement is reported in the SEC’s Accounting and Auditing Enforcement Release No. 4196. Below is an abbreviated background of the facts reported in the release, along with considerations and recommendations for legal counsel advising companies that may deal with similar issues.

Background

Belden, a manufacturer of networking, connectivity and cable products, headquartered in St. Louis, Missouri, improperly accelerated revenue for the first three quarters for 2017. The reporting errors occurred at its subsidiary, Grass Valley, a manufacturer of technologies for the broadcast industry, headquartered in Montreal, Canada. Belden purchased Grass Valley in 2014, and its financial results were reported as part of Belden’s Broadcast segment in Belden’s consolidated financial statements.

Per the SEC, Belden first learned there were internal control problems at Grass Valley as part of the due diligence process for the acquisition in 2014. According to the release, Belden’s diligence report stated that Grass Valley’s:

• “[m]anagement does not appear to be able to effectively control or monitor any channel stuffing or sales acceleration by the sales organization,” and
• “controls are likely not adequate for Belden’s SOX reporting requirements.”

Despite those warnings, the control weaknesses were not adequately addressed after the acquisition of Grass Valley.

According to the SEC, Belden discovered that, in 2015, Grass Valley improperly accelerated the recognition of revenue, albeit not a material amount to the overall Belden financial statements, for the shipment of goods to warehouses controlled by Grass Valley. The revenue involved a sale practice referred to as “bill and hold” transactions, which as explained below can be a form of accelerating sales and revenue recognition — the same concern and problem raised in the Grass Valley acquisition due diligence report.

Those revenue recognition control issues continued to be problem at Grass Valley. A member of Belden’s external audit firm sent a copy of the bill and hold revenue recognition requirements to the company in early 2017. The email from the auditor stated that he had “never seen [the bill and hold requirements] met,” presumably a reference to issues arising as part of the 2016 audit.

Belden’s chief accounting officer then distributed this accounting guidance to individuals with responsibility for Grass Valley’s financial reporting. The guidance stated, among other things, the very basic rules to follow including:

• the buyer, not the seller, must request that the transaction be on a bill-and-hold basis, and
• there must be a fixed schedule for delivery of the goods.

Yet, based on the release, Grass Valley continued to disregard the guidance and improperly recorded revenue from bill and hold transactions throughout the first three quarters of 2017.

As a general statement, aggressive use of bill and hold practices, invoicing and recognizing revenue without shipping the product arise out of pressures to create sales. In fact, the use of bill and hold transactions coupled with revenue pressures is always a high-risk situation.

Further evidence of Grass Valley’s revenue pressures is reported in the release when detailing the creation of a sham customer to purchase goods. The new customer scheme illustrates the extreme measures taken by Grass Valley to fabricate revenues

According to the release, during 2017, Grass Valley conspired with a former employee to establish a new customer that would act as a distributor to lease or resell the goods. However, the former employee had no experience as a distributor, no warehouse, no customers, and no ability to pay for the goods purchased, unless and until they were sold.

In fact, per the release, the new customer never re-sold or leased any goods, and the products were eventually returned to Belden. Notably, the arrangement with this alleged customer included around $3 million of software, a transaction that should have received additional scrutiny as the resale of software through a distributor raises additional revenue recognition concerns. In short, the new customer was a complete sham.

In total, more than 140 transactions, totaling more than $62 million in sales, were prematurely recorded in Belden’s books and records through the end of 2017. As a result, Belden’s reported revenue was overstated by more than $29 million for the first three quarters of 2017. Most of the revenue recorded in connection with those transactions was ultimately reversed in the fourth quarter of 2017.

Lessons and actions to avoid similar problems

The following recommendations highlight possible actions that could have been taken by Belden management and or the company’s audit committee, both with the assistance of legal counsel, to avoid the problems described above.

Heed due diligence report warnings

Companies frequently engage specialized teams, generally made up of experienced CPAs and others, to inspect the books and records of potential target companies. Quite often the diligence team prepares estimates for projected potential cash flows upon which valuation models are prepared.

The diligence team also generally provides commentary on qualitative aspects of the target’s accounting policies, systems and controls. Of significance, the first warnings for Belden regarding Grass Valley’s weak internal controls, and management’s inability to enforce the limited controls in place, appeared in 2014, in the acquisition’s due diligence report.

The release mentions that Belden took some corrective actions based on the diligence report findings, but needless to say, the actions did not sufficiently mitigate the issues that continued in 2015 and into 2017.

Steps that should have been considered and taken when dealing with the types of internal control weakness described in the diligence report include:

• involving the audit committee to ensure the control problem is addressed at the board level;
• immediately implementing Belden’s internal control policies at Grass Valley;
• evaluating the Grass Valley financial reporting personnel to ensure adequate and competent people were in place, and if required bringing in new leadership;
• scheduling and designing special internal audit testing for the new subsidiary;
• evaluating the risk raised during due diligence related to the lack of monitoring any “channel stuffing or sales acceleration by the sales organization,” and immediately replacing sales leadership personal if required;
• designing training for finance, accounting and sales personnel on Belden policies;
• creating and distributing a hotline for employee communications regarding ethics concerns; and
• requesting additional external auditor testing, even as a special agreed-upon procedures engagement.

Had Belden taken those types of actions to address the serious concerns identified in 2014, it likely would have avoided the subsequent problems and having to disclose in the company’s 2017 Form 10K that it “did not maintain internal controls that were sufficiently designed and operating effectively to ensure that all revenue recognition criteria were satisfied prior to the recognition of revenue” in its Grass Valley unit.

Assess the pros and cons of bill and hold transactions

To invoice a customer and record revenue, but not deliver the goods, is unusual. Delivery is one of the key revenue recognition criteria. Bill and hold transactions are an exception to the general delivery rule, are inherently risky, and require strict adherence to bright-line tests to support the existence and timing for recording a sale.

So before agreeing to allow bill and hold transactions at a new subsidiary, Belden would have been well advised to assess the business reasons, benefits and special risks associated with allowing such a policy to continue.

At a minimum, until a company is comfortable with its controls, it should strongly consider suspending such transactions. The “cost” to suspend bill and hold transactions is minimal in comparison to the problems arising from errors and misconduct.

In fact, the “cost” of suspending or even eliminating bill and hold transactions is limited to deferring revenue recognition into a subsequent period, not a permanent loss of the sale.

Plus, financial statement disclosures are a very meaningful way to inform and manage investor reactions as to the impact of changing from such a policy to normal delivery terms for revenue recognition.

Know your customers

As a general statement, businesses seek to generate new customers. Customers buy products and services and deliver cash and profits to businesses. From an accounting and revenue recognition standpoint, though, new customers need to be thoroughly vetted as to whether they can pay their invoices and to ensure they are credible businesses.

As described in the release, Belden’s internal control system failed to properly evaluate and vet its new customer.

Add to these sensitivities the risks inherent in any bill and hold transaction, and knowing who the customer is becomes an even more critical element of strong revenue recognition internal controls.

However, as described in the release, Belden’s internal control system failed to properly evaluate and vet its new customer. Had Belden performed background checks, requested financial statements for allowing credit, and just performed basic diligence on the new customer before recording revenue and extending credit to the business, it would have quickly uncovered the entity was a sham created for the purpose of recording sales.

In closing, the due diligence report and team had it right: Grass Valley management was not “able to effectively control or monitor any channel stuffing or sales acceleration by the sales organization,” and the Grass Valley controls were “likely not adequate for Belden’s SOX reporting requirements.”

Had the warning signs been taken more seriously and immediate remedies been implemented, we may not have had the lessons learned from this release to share.

Joseph J. Floyd, a CPA and attorney, is a partner and co-founder of Floyd Advisory, a consulting firm in Boston and New York City that provides financial and accounting expertise.