Revenue Recognition Frauds for Lawyers: Channel Stuffing

Revenue recognition is a central accounting principle that dictates when a company can recognise income from sales. Revenue is often used by internal and external stakeholders as a metric to determine a company’s worth, however, if revenue recognition is deliberately manipulated, the fraud can carry financial, reputational and legal consequences. This article is part of a series explaining some of the most common forms of revenue recognition frauds. For an overview of revenue recognition and the potential consequences of its abuse, please see here.

Channel stuffing is a scheme that every lawyer dealing with corporate fraud should know about. It is a deceptive revenue recognition practice where a company inflates its sales figures by pushing more products onto its distributors or retailers than they need or can reasonably sell. The aim of channel stuffing is to artificially boost revenues and profits, which may meet market expectations or internal performance benchmarks, often used to determine bonuses.

The context and specifics of a company’s activities must be considered to determine whether they amount to channel stuffing, and whether those activities are illegal in the jurisdiction(s) the company operates in. Nevertheless, channel stuffing is generally considered a fraudulent practice as it can paint a misleading picture of a company’s performance and health.

This article breaks down the essentials, highlights recent cases, provides practical red flags to watch for and details investigative steps for counsel and forensic teams.

Recent cases and their implications

Revenue recognition is a central accounting principle that dictates whether and when a company can recognise income from sales on its profit and loss statement. Revenue is generally recognised when the control of goods or services is transferred to customers in exchange for payment (actual or promised).

However, one area revenue recognition can become complex is when third-party distributors and channel partners are involved. In essence, channel stuffing is borrowing tomorrow’s sales to inflate today’s results. This can be a ticking time bomb for financial and reputational damage, as seen in these recent cases:

• Elanco Animal Health Inc (2024) agreed to pay $15 million to settle SEC fraud charges that the company failed to disclose sales practices used to boost revenue that might negatively impact future performance.
• Revolution Beauty Limited (2023) saw its shares collapse and eventually the suspension of its AIM listing in the UK for failing to file accounts on time due to its auditors refusing to sign off, partly in relation to sales included in the published revenue figures that had to be reversed as they were only undertaken for the purposes of meeting targets. Most of the products ‘sold’ were not required by the distributors at the time.
• Diageo plc (2020) agreed to pay $5 million to settle SEC charges for failing to disclose “known trends relating to the shipments of unneeded products” to distributors.

Three steps of channel stuffing building the illusion of success

1. ‍Incentives or side agreements:

A company might offer steep discounts or extended payment terms to entice distributors to accept more inventory, as per the abovementioned SEC order in the case of Elanco.

Often, we find relationships between individuals in companies and their distributors are built up over many years, with trust and goodwill underpinning the association. These strong relationships are lent on when there is heightened internal or external pressure to meet sales targets.

We have seen instances of individuals at companies making “side agreements” with distributors, which can be written or oral, whereby the company (potentially unbeknownst to a wider audience within the company) provides a right to return unsold product.

At the extreme end, pressure on distributors or retailers to accept excess inventory could extend to bribes or threats, such as threatening to cancel the distributor agreement.

2. ‍Excess inventory loading:

The incentives or side agreements result in the company shipping more goods to distributors or retailers than necessary, recording these shipments as sales. Tactics used by companies to shift excess inventory to their channel partners may also involve:

• Making deliveries to distributors before they have ordered;
• Shipping product to intermediate holding locations, rather than the distributors’ location, therefore the true control of the inventory may not have passed over; or
• Delivering products that the company has in stock, potentially including obsolete or slow-moving product lines, rather than what the distributor needs to satisfy its customer demand.

3. ‍Revenue crash and returns:

Whilst the seller will experience quieter months following period end as stock sells through, if a distributor or retailer is willing to take on the full risk of extra inventory in return for a discount the sales will likely be legitimate. However, aggressive channel stuffing is unsustainable as customers will stop buying new stock until they have sold or returned existing stocks resulting in a crash in sales revenue.

Distributors could also be forced to return unsold goods, which the company may attempt to defer or hide and further mask the issue.

Red flags of channel stuffing

The result of the above tactics is a distorted financial picture that misleads investors, creditors and other stakeholders. The bubble eventually bursts when distributors stop accepting inventory, auditors or whistleblowers force a response, or the excess stock cannot be sold. The following red flags might warrant an independent forensic investigation to get to the root of the issue.

Accounting and financial red flags

• Revenue growth significantly outpacing industry peers or historical trends, particularly sharp upticks near quarter- or year-end and not supported by cashflow.
• Distributors reporting excessive inventory levels or slower turnover rates.
• An increase in advantageous and non-standard payment terms given to distributors, which will result in a worsening accounts receivable aging profile.
• Changes to a company’s accounting treatments, including aggressive or questionable policies that prioritise shipping dates over the substance of transactions.

Operational red flags

• Customer account managers failing to record stock levels held by distributors, so no visibility of growing inventory levels.
• Distributors pushing back on excessive shipments or returning high volumes of unsold inventory.
• Executives creating pressure-cooker environments with unrealistic sales targets or an obsession with short-term financial results.

The nuances of channel stuffing investigations

The grey areas surrounding channel stuffing is such that any investigation should take a considered approach to building the facts and establishing what is defensible in the specific context of the business and jurisdiction in question. Changes to sales practices should be reviewed to ensure activities undertaken around period ends have not transgressed into channel stuffing.

Some of the evidence will lie in detailed data analysis - an increasingly complex challenge in today’s digital environment of proliferating data - including:

• Review of sales trends and inventory levels, particularly any instances of large transactions towards period end and in comparison to previous periods.=
• Data analysis of subsequent returns of product, issuance of credit notes to distributors that can be offset against future purchases, and/or write-offs of receivable balances.
• Review of changes in credit terms and discounts on distributor accounts, including for specific invoices, as well as rights of return, product substitution rights and promotional support.
• Investigation into the financials and circumstances of distributors, including their recognition of inventory receipts.

Communication evidence and interviews will also be key given the involvement of outside third parties in distributor and channel issues, and any pressures of internal sales culture. Investigation steps would include:

• Examining internal and external communications for evidence of channel stuffing intentions and side agreements.
• Interviews of whistleblowers (if relevant), sales executives, finance teams and (if possible) distributors to understand sales practices, pressure points and inventory concerns.

Channel stuffing is a deceptive practice that distorts financial reality, exposing companies to legal, financial and reputational risks. Accounting issues like this and other revenue recognition frauds (read more here) can be hard to detect as it involves digging deeper than the numbers. Understanding the mechanisms and warning signs is crucial for legal and forensic professionals to perform thorough investigations and protect corporate integrity and investor trust.