A revenue recognition classic – Bill-and-Hold arrangements

Despite recent changes impacting the US Securities and Exchange Commission (“SEC”) public statements have confirmed that they will continue to prioritize the enforcement of accounting related cases. Looking at historical actions, revenue recognition schemes, including the mis-use of bill-and-hold arrangements, are likely to feature again in future cases.

What is a bill-and-hold arrangement?

A bill-and-hold arrangement is a sales transaction in which revenue is recorded before the delivery or shipment of goods to a company’s customer. While permissible by Generally Accepted Accounting Principles (“GAAP”) provided certain conditions are met, such bill-and-hold arrangements are considered a controversial revenue recognition method due to the ease of manipulating earnings. Bill-and-hold arrangements are considered an aggressive method of revenue recognition, and its use is generally frowned upon by regulators, including the US Securities & Exchange Commission (“SEC”).

As with any revenue recognition scheme, prematurely recognizing revenue will increase a reporting periods sales – often a key performance indicator used by investors/markets to assess financial performance of a listed company – and the company’s assets, through an increase to accounts receivable. This could serve as a motive for unscrupulous individuals at a seller to collude with buyers by informing the buyer to place an order, not take delivery of the product, and subsequently either cancel the order, or take delivery at a later period under different terms (e.g., discounted rate, right to return, or a consignment basis). A form of “channel stuffing,” this has the impact of artificially inflating earnings in the current period at the detriment of later periods.

Past enforcement of bill-and-hold arrangements

One of the most significant cases that perhaps exposed best the potential issues associated with bill-and-hold arrangements was the case against Sunbeam Corporation in the late 1990s. Customers were requested to place large orders for barbeques in the middle of winter with the promise of significant discounts and Sunbeam holding the inventory until a much later date before delivery to the client. When exposed by the external auditors the company was required to restate financial statements, were prosecuted by the SEC and ultimately filed for bankruptcy in 2001.  

Since the Sunbeam case the SEC has brought in excess of 20+ cases against companies engaging in revenue recognition fraud involving bill-and-hold arrangements. The most significant case brought in the 2020s involved Revolution Lighting Technologies Inc. The Company, and four senior executives were charged with pressuring the sales team to “improperly record anticipated future sales as current “bill and hold” sales to make up the revenue shortfalls.” To conceal the fraud backdated documents related to such “bill and hold” sales were created and provided to the auditors allowing the misconduct to continue for a four year period.  

Under what conditions are bill-and-hold arrangements permissible

Under US Accounting Standard Codification 606, Revenue from Contracts with Customers, for a company to recognize revenue under a bill-and-hold arrangement, all of the following criteria must be met:

1. The reason for the bill-and-hold arrangement must be substantive (for example, the customer has requested the arrangement).
2. The product must be identified separately as belonging to the customer.
3. The product currently must be ready for physical transfer to the customer.
4. The entity cannot have the ability to use the product or to direct it to another customer.

These are consistent with key criteria outlined by the SEC and principles outlined under International Financial Reporting Standard 15, Revenue from Contracts with Customers.

How are fraud cases perpetuated?

Fraud occurs when company personnel recognize revenue knowing that the conditions set forth above for bill-and-hold arrangements have not been satisfied. In the majority of enforcement actions against companies who have engaged in misconduct, the seller has initiated the request to the buyer for a bill-and-hold arrangement, either by requesting a seller to place an order with preferred undisclosed terms, or by processing an order prior to the buyer’s requested delivery date but holding the material. Key factors to consider when looking for evidence of inappropriate bill-and-hold arrangements include:

• The buyer is granted terms that are modified from the typical and/or contractual agreements (e.g., extended payment terms, discounted pricing, right to return product that is not sold)
• The buyer has not previously requested that goods be supplied on a buy-and-sell basis
• Explanations for why the buyer has requested goods be held by the seller is provided by seller personnel, is inadequately documented or supported, and/or does not appear to have a legitimate business purpose.  
• The commercial terms for the seller to hold the goods does not make commercial sense (e.g., is additional warehousing expense incurred that deplete overall margins?)
• There are “side-agreements” or other terms agreed with the buyer outside formal contracting documentation
• There is an increase in levels of returns, credit notes, other retrospective discounts, or invoice write offs are higher in the months that follow the reporting period end than historical levels

How do you identify and/or investigate suspicions of bill-and-hold arrangements?

As a company executive, Board member, or auditor assessing the risk of revenue fraud and being aware of schemes that might be deployed to facilitate such schemes is essential. In many charging documents, some common themes emerge that gatekeepers should be aware of and make inquiries about:

• Is there excessive pressure to achieve sales targets that, based on a review of data, may give rise to the premature recognition of sales at or near the end of the reporting period?
• What controls and procedures exist to ensure that accounting function personnel are fully apprised of the salient transaction terms to permit a robust assessment under the relevant accounting standards?
• Does the buyer ultimately take delivery of the product in a timely manner, and settles the accounts receivable balances in full?
• How transparent is the use of bill-and-hold arrangements with customers – both internally and through external disclosures – including the business rationale for both parties, the anticipated timing when inventory will be shipped, and any impact that such arrangements are having on the present, and perhaps future, reporting period?

With the present turbulence in the global economy, including disruptions to supply chains and international trade practices, this may provide both the incentive and opportunity for companies to engage in “creative” accounting practices, including bill-and-hold arrangements. While permissible provided certain conditions are met, such arrangements expose companies to increased scrutiny and specific controls, procedures and transparency is required to avoid allegations of misconduct.