One of the most common and egregious tricks that companies pull is channel stuffing. This is done primarily by manufacturers but other companies can be guilty as well. What they do is offer retailers or distributors very generous terms in order to get them to take on inventory. Once that inventory is at the store or distributor’s warehouse, the company books it as accounts receivable, i.e., a sale.
There are two flavors of channel stuffing, legal and illegal. The legal kind is when the company offers a discount on a big order. The illegal kind is when a company gets the distributor to take on the inventory, but gives them the right to return it with no penalty if they can’t sell it. You can see that this is not truly a receivable, as the distributor takes on no risk and doesn’t actually have to sell anything. Therefore the company should not (but often does) book this as a receivable. When Chainsaw Al Dunlop got in big trouble over at Sunbeam a few years ago, it was because he was engaging in channel stuffing.
Now how do we detect this going on? Well it’s impossible to say with absolute certainty, but we’re going to get help from all three accounting statements. If a company is doing legitimate sales in a timely fashion, they may have a rise in accounts receivable, but they will also have a rise in actual cash as those items are paid for. So we want to compare the income statement with the cash flow statement. We want to see an increase in cash flow as well as an increase in the sales booked. If we don’t, that could be a sign of channel stuffing. The balance sheet gives us another clue. Again, cash should be coming in. So ideally we may see an increase in receivables, but not a big decrease in cash. If we see that receivables and inventory balloons and cash is disappearing, that’s another sign.
Unfortunately this doesn’t give us a guarantee, it’s only a strong hint. A company may legitimately have just introduced a new product and they don’t have the cash in yet. But if you see this happen for two quarters in a row, it really is a point of concern. This leads to doing the real forensic work. Find a couple of small local retail stores that carry the product and find out when the owner may be there (usually for small retail stores the owner is also the buyer) so you can talk with him/her. If there is a big sale on products for that company (another sign) chat them up about how he/she got such great deals. If you can get an indication that the retailer can return the product without penalty, congratulations, you’ve stolen a march on Wall Street and the SEC. You know that channel stuffing is going on.