F. The Labels and Studios Improperly Overstate Net Operating Revenues and Gross Profits Because No Marketing is Required.
115. A second problem is that Labels and Studios knowingly and intentionally misreport these payments for “promotional funds” in a way that artificially and fraudulently inflates their own revenues and gross profits.
116. Labels and Studios know full well that Trans World routinely spends only about 25 percent of their “promotional funds” on marketing. The remaining 75% was pocketed by Trans World at the direction of Labels and Studios.
117. In fact, Labels and Studios knowingly refused to require proof that Trans World used the “promotional funds” as required. When questioned by me, a senior executive at Trans World told me that Labels and Studios had insisted on this scheme of keeping the money as its fraudulent “profit” – and that the fact was well known to Labels and Studios. As a result, Labels and Studios received nothing of legally recognizable value in return for 75 percent of its marketing-allowance payments.
118. A senior executive at Trans World told me that Labels’ and Studios’ excuse for refusing to require proper use of the promotional funds on advertising was that they “could not live without the instant fix of inflated sales when a new products are released.” The cash paid to Trans World ensured that the Trans World retail stores would report the inflated sales they needed.
119. Thus, as Labels and Studios well knew, about 75% of Labels’ and Studios’ annual promotional funds were in truth and in fact “rebates.” The payments went into the Trans World’s cash accounts.
120. Labels and Studios, despite a legal duty to do so, knew they would not seek proof of the customers’ performance when they paid the promotional funds. And Labels and Studios knew that Trans World was not using the money to promote their products. Trans World simply kept the money to offset the cost of buying Labels and Studios CDs and DVDs.
121. The payments, from an accounting perspective, subsidized Trans World’s gross unit costs for Labels’ and Studios’ CDs and DVDs. That meant -- as Labels and Studios well knew -- that the payments were “rebates” under GAAP.
122. GAAP has always required that rebates be booked in contra-revenue account. In lay terms, a contra-revenue account offsets, or reduces, a company’s gross operating revenues. That reduction yields a company’s net operating revenues. Net operating revenues are then reduced by the company’s cost of goods sold to determine gross profits. Consequently, if a company’s net operating revenues shrink, then its gross profits shrink. Shrinking revenues suggest lost market share and slower growth. Shrinking gross profits suggest lost efficiencies.
123. On the other hand, until January 1, 2002 when the accounting rules changed pursuant to EITF 01-9 to prevent the very type of fraudulent manipulations by Labels and Studios, a marketing allowance that actually reimbursed a customer’s advertising expense was supposed to be included in general administrative expenses under GAAP. Those kinds of expenses are deducted from a company’s gross profits to calculate its operating income. Advertising expenses, unlike rebates, reflect nothing about market share and cost efficiencies.
124. The distinction between a “rebate” and a “promotional allowance expense” is vital to investors. A rebate reduces revenues.
125. Lower revenues suggest a weakness in a company’s product line -- hence, the need to cut prices with a rebate. And by improperly accounting for a rebate as an expense, thereby inflating gross profits, the guilty company falsely appears more cost efficient than is in fact the case. Important valuation ratios used by investors are distorted. In a word, inflated gross profits mislead investors about market penetration and productivity.
126. Labels and Studios, by willfully mischaracterizing the rebate payments as “promotional funds,” intentionally misstated and fraudulently inflated their net operating revenues and gross profits.
127. While Labels’ and Studios’ operating income may have remained unchanged if the vendor had honestly applied GAAP, two of the key factors in that calculation -- net operating revenues and operating expenses -- would have been materially different.
128. Labels and Studios knowingly and intentionally violated GAAP and S.E.C. Staff Accounting Bulleting No. 101 by materially misstating its net operating revenues, gross profits, and operating expenses until January 1, 2002, in regard to its customers’ unused promotional funds.
129. Labels’ and Studios’ violation of GAAP and SAB No. 101 was material and significant. Labels’ and Studios’ investors should have been seeing a company whose revenues and general expenses were substantially lower than reported. Investors should have been seeing a company with a lower market share and lower gross profit margins.
130. Investors should have been seeing a lower sales/fixed assets ratio, lower sales/total assets ratio, and lower price/sales ratio. What Labels’ and Studios’ investors should have been seeing are companies in deeper financial trouble than has been admitted.
131. As a result, Labels and Studios misrepresented their revenue numbers in their annual reports mailed to shareholders and their 10-K filed with the S.E.C.
