Channel Stuffing

From my ms.

There are innumerable grounds on which securities-fraud lawsuits can be and are brought.   I will offer no survey of that field here.   But it does help our cause -- it helps us set the stage for the overly dramatic events of 2007-08, if we consider one such lawsuit, one that arose out of allegations of accounting chicanery.

In 2000, investors who had bought Coca-Cola stock subsequent to October 21, 1999, filed a lawsuit claiming that beginning on or about that date Coke was overstating its revenues through an accounting practice known as channel-stuffing.   Wherever there is a channel between the manufacturer of a product and the ultimate buyer, there may arise a temptation on the part of the manufacture to push more product into that channel than there is any good reason to believe the ultimate consumers will accept.   The whole of the amount shipped to wholesalers, and then perhaps on to retailers, may then be booked, by the manufacturer, as accounts receivable, and thus as revenue.

Why would a seller do that?   Because by boosting receivables in this way it pretties up its books, at least for a specific quarter, making itself appear more attractive to prospective investors than a more truthful accounting would, helping it sell more securities if it is inclined to do so, or boosting the value of those already in the marketplace.

One important point for understanding the 2007-08 crisis is that channel stuffing, like most examples of accounting chicanery, is a self-defeating practice.   Since (in our stipulation) the retailers can’t sell all the product sent to them, they’ll end up shipping it back up the channel again.   The manufacturer will eventually have to re-adjust its books, bursting whatever stock-price bubble the practice might have created.

Even if they don’t send it back, because they have the necessary freezer space, all that leftover Coke from the previous quarter will quench the thirst of customers in the next quarter, depressing that next quarter’s revenues for the manufacturer.

This is why the practice of channel-stuffing is often cited as an example of the short-sightedness of corporate managements, which (in this critique) often look only to their this-quarter numbers, rather than to the longer run sustainability of the company.   Short sightedness represents the temporal dimension of the agency problem.

Coca-Cola settled with these plaintiffs in July 2008.   It didn’t admit that it had done anything wrong, but it did pay the plaintiff investors, led by the Carpenters Health & Welfare Fund of Philadelphia, $137.5 million.

We should think of channel stuffing as a token of a type here, a simple case of the sort of accounting chicanery that can easily become a good deal more complicated.   Simple or complex, though, it often has this feature: a corporation meets its target numbers for one quarter or year by borrowing against the next one.

How can anyone who does not expect to die or retire within three months not see the flaw in that? Perhaps some of the executives involved in some such schemes assume that they will soon hit a good-enough year or quarter to even everything out and keeping all possible hounds at bay.