The SEC wants to know if Diageo used the oldest - and worst - trick in the book to fudge its numbers

The SEC is investigating whether Diageo, the spirits maker best-known for Smirnoff and Johnny Walker, wrongly stated revenues based on products it had shipped to distributors rather than bottles of booze actually sold to drinkers, according to the Wall Street Journal.

Diageo stock declined 5% on the news last night.

It doesn't look good, the WSJ says. Diageo has recently seen the disappearance of a president and a CMO:

The inquiry coincides with a period of tumult in Diageo's executive ranks. The company announced in June that North American President Larry Schwartz would be retiring by the end of the year. Since then, the company has also announced the departures of its chief marketing officer for North America and a president of national accounts in the U.S.

It recently named Deirdre Mahlan, currently chief financial officer, as president of Diageo North America.

No executive at Diageo has been accused of any wrongdoing.

In industry parlance, what the SEC is looking for is "channel-stuffing." Channel-stuffing is one of the most tempting - and most disastrous - ways that companies cook their books.

The problem with channel-stuffing is that although it makes a company's books look great in the short-term, in the long-term it's a sort of internal Ponzi scheme: Eventually it comes crashing down. In the US, it is a criminal offence: Two medical device executives went to prison last year for 10- and 20-year stretches after they were found guilty of channel-stuffing.

We are not saying this is what happened at Diageo. Let's let the SEC probe take its course.

In the meantime, it's worth knowing what channel-stuffing actually is. It's an interesting - and common - business phenomenon, but most people don't know that it exists. Channel-stuffing can occur in almost any type of retail operation where products have to be shipped to retail sellers before they're actually bought by the public.

Here is how it goes down:

Let's say you're at a company where sales are in decline, but your bosses are insistent that you've got to show sales growth. You'd be tempted to fudge the numbers somehow. (In an amazing coincidence, that's the situation at Diageo. Volume sold in the US last year decreased 1%; the company only saw a sales increase of 3% to $5.34 billion due to price increases.)

One way of showing more "sales" is to ship more cases of product to your distributors and retailers. You've got a pretty good expectation that they're going to be sold eventually, so you book them as sales. Hooray! Sales are going up!

The problem is that next month, when you call up those distributors to ask how much new product they need, the reply is, "Well, because you shipped us slightly more than we needed last month, we've still got a bunch of stock sitting around. So this month we'd like you to ship fewer cases."

Uh oh. That one-month sales bump you showed is now going to turn into a sharp decline in the following month. So maybe you're tempted to ship extra product again, in the hopes that somehow sales will suddenly pick up dramatically and fix all your problems.

Now you're into real trouble, because you're shipping products that no one wants, and booking them as revenue (even though the revenues never arrive). And those unsold cases are piling up at distributor warehouses.

What to do?

Some bright spark suggests, "Hey, maybe if we take the cases back, no one will notice!"

This sounds like a great idea! And the distributor agrees. The unsold cases come back, and they can be written off against the original revenue as "sales returns," or something. They're going to look like defective units or stuff that customers bought, didn't like, returned and replaced with new product. And most people never look at the "sales returns" line in company accounts anyway.

Now you're cooking (the books) with gas: You're shipping more product, booking more revenue, and it's all accounted for! Sure, sales returns are increasing but that's someone else's problem: Did I mention that sales are going up!!!

Like a Ponzi scheme, this all comes crashing down. You end up shipping more product that can be sold, and accepting as returns more product than you sell, and eventually someone asks why it is that the company has become so unprofitable even though sales are growing.

And that's when the Feds show up.