Skip to main content

Where the SEC Is Likely to Look Next

Let's just say it isn't too keen on aggressive revenue recognition.

Now that the market is off to the races


, excuse me for reminding you that fundamentals



Late yesterday, I was on a panel discussing securities laws. Participants were asked what they thought the


was most likely to go after in the coming year. I was exhausted and running what turns out to be a very high fever and mumbled something brilliant like "public disclosure" (duh!) -- but the real critical comments came from Michael McAlevey, deputy director of the SEC's corporation-finance division, who said he thought this year the SEC would go aggressively after revenue recognition issues.

And George Kelly,

Morgan Stanley Dean Witter's

network-equipment analyst, said his dream would be that the agency goes after channel stuffing. Channel stuffing? Uttered by an analyst?

Let's go over them one at a time:

Channel stuffing refers to companies shipping way more merchandise into the distribution channel than they can ever hope to sell in any given quarter. (The more they ship, the better their earnings look if they book the sales as the goods go out the door.) Analysts


TheStreet Recommends

talk about it publicly, but Kelly has been around for years, he has seen it all -- and has nothing to lose by speaking his mind.

The trouble with channel stuffing, he said, is that you never really know how much merchandise really is being bought out there because distributors (the usual customers) are under no obligation to report what they're holding. And other than reports on PCs, third-party data-collection companies don't offer reports on how many switches and hubs have been shipped from the company to the distributors.

The way around this, of course, is for companies


to book sales until they've been sold through to end customers by the distributor. Which company does it that way? "


(CSCO) - Get Cisco Systems, Inc. Report

," Kelly said, "because it's the class act." (To determine how a company books revenue, simply go to its 10-K and look for the section on "revenue recognition." Sometimes it's called something else, but it's always there and it'll tell you whether a company books revenue the moment a product leaves the shipping dock or when it is sold by a distributor. If it ships when the product leaves the dock -- and its customers tend to be distributors -- be on guard.)

That leads to revenue recognition. McAlevey didn't elaborate what he meant, but aggressive recognition of revenue -- actually booking sales as revenue -- can lead to a false picture of how a company is really doing. It works until it doesn't. Any slowdown in biz, and investors can expect to get blindsided with an earnings miss. Given issues already with the likes of


(MSTR) - Get MicroStrategy Incorporated Class A Report


Pacific Gateway Exchange


, which was mentioned

here Monday, you can bet that just as last year was the year of the auditor, this year will be the year of revenue recognition.

(Just remember where you read it first.)

Herb Greenberg writes daily for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, though he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback at Greenberg also writes a monthly column for Fortune.

Mark Martinez assisted with the reporting of this column.