Question

Allen Software was a relatively new tech company led by aggressive founder Benjamin Allen. His strategy relied not so much on producing new products as using new equity capital to buy up other software companies. To keep attracting investors, Allen had to show year-to-year revenue growth. When his normal revenue streams stalled, he resorted to the tried-and-true “channel stuffing” technique. First, he improperly recorded shipments to his distributors as sales revenue; these shipments far exceeded the market demand for his products. Then he offered the distributors large payments to hold the excess inventory instead of returning it for a refund. Those payments were disguised as sales promotion expenses. He was able to show a considerable growth in revenues for two years running until one savvy investor group started asking questions. That led to a complaint filed with the SEC. The company is now in bankruptcy, and several criminal cases are pending.

Requirements

1. What factor may have tipped off the investor group that something was wrong?
2. In what way would those investors have been harmed?
3. If Allen had attracted enough equity capital, do you think he would have been able to conceal the scheme?

Answer 1

Que: What factor may have tipped off the investor group that something was wrong?

Ans: As mentioned in details provided, Allen used Channel Stuffing technique to inflate sales in the books of accounts. Allen used to pay huge amounts to distributors as carrying cost of inventory which was disguised by Allen as sales promotion expense in the books of accounts. Some investors asked some questions from Allen. Investors might have asked about increasing sales promotion expenses. Allen would not have been able to show evidence of these expenses nor he must have valid explanations as these expenses were not really sales promotion expenses. This inability of Allen might have tipped off the investors.

Que: In what way would those investors have been harmed?

Ans: As goods sent to distributors were disguised as sales in the books of accounts and on the other hand carrying cost of inventory paid to distributors were disguised as sales promotion expenses. This made the books of accounts totally artificial as compared to reality. More goods were shipped to distributors as compared to market demand so there is no chance of selling of all the products available with distributors as inventory. One or the another day they will return it back to Allen, the unsold inventory which will have effect on Profit & Loss A/c of Allen Software. Allen was paying huge carrying cost to distributors, this cost will earn not much return as distributors will not be able to sell all the products in the market in view of market demand. Investors were harmed on account of artificial accounts and spending of too much on carrying cost payment to distributors. After filing of complaint Company ran in to bankruptcy which erodes investor's money invested in the company.

Que: If Allen had attracted enough equity capital, do you think he would have been able to conceal the scheme?

Ans: Allen could have concealed the scheme for some more time if he would have attracted more equity capital because this increases Company's cash receipts. Inflow of cash would have helped Allen to produce more, ship to distributors disguising it as sales and payment to distributors to hold extra inventory. In any business if cash flow is positive, it can survive and will not create doubts in the minds of investors. Until and unless investors ask for intricacies or inquire in to books of accounts, Allen would have been able to conceal his Channel Stuffing technique till he has positive cash flows