More of this Feature • Part 1: How Revenue is Inflated • Part 2: What's Being Done

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Wall Street has been up in arms recently over the disturbing amount of revenue inflating gimmicks companies have used to distort their financial statements.  The practice has invaded every industry, but energy and power companies seem to be the worst perpetrators, with CMS Energy standing out as the poster child for accounting abuse.

How Revenue is Inflated

Imagine you are the manager of a dairy farm.  Every year, you report the profit from selling milk and trading cows to the owner, who lives several hundred miles away.  Your performance as manager is based on the revenue [money taken in] and profit [the money that is left for the owner after all the expenses have been paid].  Increasing either will make the owner happy, and probably get you a large bonus at Christmas.

One day, while milking the prize cow Bessie, you get a brilliant idea.  You call the farmer down the road and tell him to come over with his best milk cow.  An hour later, the farmer is sitting in your barn.  "how much is your cow worth?" you ask.  "Around $1,000," the farmer replies.  "Well, Bessie here is worth the same amount. How about you and I trade cows?"

"Why would you want to do that?"  Your neighbor asks.  "If they are both worth $1,000, what good does it do us to trade?  Neither of us make any money and we both have the same thing when we go home."

You smile, proud of your brilliant scheme.  "Because," you reply, "the owner of this farm judges me based on revenue and profit.  Although neither of us made any money, something of value changed hands.  This means I can record an extra $1,000 in revenue when I report to the owner.

How CMS Energy Fabricated $4.4 Billion Dollars Out of Thin Air

Using the same tactics as our creative farmer, CMS management traded the same amount of energy with two of its competitors, Dynegy Inc., and Reliant Resources, on the same dates for the same price.  These transactions (called "round-tripping") were executed solely to boost the revenue figure the companies reported to their shareholders.  In 1999 and 2000 alone, CMS recorded more than $4.4 billion dollars in revenue from meaningless transactions.

Why is this a problem?  Revenue is one of the most important numbers investors and analysts look at when valuing a company.  It gives a general measure of the amount of growth a company is experiencing.  Although revenue doesn't always equal profit, it is considered important because it is generally assumed that the more revenue a business earns, the more potential it has for profitability (through cost cutting initiatives, etc.)

Next page > What is being done to stop further accounting abuses? > Page 1, 2