1. Financial Statements: Introduction
  2. Financial Statements: Who's In Charge?
  3. Financial Statements: The System
  4. Financial Statements: Cash Flow
  5. Financial Statements: Earnings
  6. Financial Statements: Revenue
  7. Financial Statements: Working Capital
  8. Financial Statements: Long-Lived Assets
  9. Financial Statements: Long-Term Liabilities
  10. Financial Statements: Pension Plans
  11. Financial Statements: Conclusion

By David Harper
(Contact David)

Revenue recognition refers to a set of accounting rules that governs how a company accounts for its sales. Many corporate accounting scandals have started with companies admitting they have reported "irregular" revenues. This kind of dishonesty is a critical accounting issue. In several high-profile cases, management misled investors - and its own auditors - by deliberately reporting inflated revenues in order to buoy its company's stock price. As of June 2004, the Financial Accounting Standards Board (FASB) has begun working to consolidate and streamline the various accounting rules into a single authoritative pronouncement.

But this series is not concerned with detecting fraud: there are several books that catalog fraudulent accounting practices and the high-profile corporate meltdowns that have resulted from them. The problem is that most of these scams went undetected, even by professional investors, until it was too late. In practice, individual investors can rarely detect bogus revenue schemes; to a large extent, we must trust the financial statements as they are reported. However, when it comes to revenue recognition, there are a few things we can do.

1. Identify Risky Revenues
If only cash counted, revenue reporting would not pose any risk of misleading investors. But the accrual concept allows companies to book revenue before receiving cash. Basically, two conditions must be met: (1) the critical earnings event must be completed (for example, service must be provided or product delivered) and (2) the payment must be measurable in its amount, agreed upon with the buyer, and its ultimate receipt must be reasonably assured (SFAC 5, SEC Bulletin 101).

For some companies, recording revenue is simple; but for others, the application of the above standards allows for, and even requires, the discretion of management. The first thing an investor can do is identify whether the company poses a high degree of accounting risk due to this discretion. Certain companies are less likely to suffer revenue restatements simply because they operate with more basic, transparent business models. (We could call these "simple revenue" companies.) Below, we list four aspects of a company and outline the degree of accounting risk associated with each aspect:

Aspects of Companies Type Associated with Simple Revenue Type Associated with Difficult Revenue Examples of "Difficult" Revenue
1. Revenue Type Product Service Extended service warranty contract is sold with consumer electronics
Ownership Type Company is the owner/seller Company is an agent, distributor or franchisor (or products are sold on consignment) Auction site sells airline tickets (should it report "gross" revenue or "net" fee received?) Or a restaurant boosts revenue by collecting franchise fees
Type of Sales Cycle Sales are made at delivery or "point of sale" Sales are made via long-term service, subscription or membership contracts Fitness facility operator sells long-term gym memberships
Degree of Product Complexity Stand-alone products Bundled products and services (that is, multiple deliverable arrangements (MDAs)) Software publisher bundles installation and technical support with product

Many of the companies that have restated their revenues sold products or services in some combination of the modes listed above under "difficult revenues." In other words, the sales of these companies tended to involve long-term service contracts, making it difficult to determine how much revenue should be counted in the current period when the service is not yet fully performed. These companies also engaged in complex franchise arrangements, pre-sold memberships or subscriptions and/or the bundling of multiple products and/or services.

We're not suggesting that you should avoid these companies - to do so would be almost impossible! Rather, the idea is to identify the business model; if you determine that any risky factors are present, then you should scrutinize the revenue recognition policies carefully.

For example, Robert Mondavi (ticker: MOND) sells most of its wines in the U.S. to distributors under terms called FOB Shipping Point. This means that, once the wines are shipped, the buyers assume most of the risk, which means they generally cannot return the product. Mondavi collects simple revenue: it owns its product, gets paid fairly quickly after delivery and the product is not subject to overly complex bundling arrangements. Therefore, when it comes to trusting the reported revenues "as reported," a company such as Robert Mondavi poses low risk. If you were analyzing Mondavi, you could spend your time focusing on other aspects of its financial statements.

On the other hand, enterprise software companies such as Oracle or PeopleSoft naturally pose above-average accounting risk. Their products are often bundled with intangible services that are tied to long-term contracts and sold through third-party resellers. Even the most honest companies in this business cannot avoid making revenue-reporting judgments and must therefore be scrutinized.

2. Check Against Cash Collected
The second thing you can do is to check reported revenues against the actual cash received from customers. In the section on cash flow, we see that companies can show cash from operations (CFO) in either the direct or indirect format; unfortunately, almost all companies use the indirect method. A rare exception is Collins Industries:

The virtue of the direct method is that it displays a separate line for "cash received from customers." Such a line is not shown under the indirect method, but we only need three items to calculate the cash received from customers:

(1) Net sales
(2) Plus the decrease in accounts receivable (or minus the increase)
(3) Plus the increase in cash advances from customers
(or minus the decrease)
= Cash received from customers

We add the decrease in accounts receivable because it signifies cash received to pay down receivables. 'Cash advances from customers' represents cash received for services not yet rendered; this is also known as unearned or deferred revenue and is classified as a current liability on the balance sheet. Below, we do this calculation for Collins Industries. You can see that our calculated number (shown under "How to Calculate 'Cash Received from Customers'") equals the reported cash collected from customers (circled in green above):

We calculate 'cash received from customers' to compare the growth in cash received to the growth in reported revenues. If the growth in reported revenues jumps far ahead of cash received, we need to ask why. For example, a company may induce revenue growth by offering favorable financing terms - like the ads you often see for consumer electronics that offer "0% financing for 18 months." A new promotion such as this will create booked revenue in the current period, but cash won't be collected until future periods. And of course, some of the customers will default and their cash won't be collected. So the initial revenue growth may or may not be good growth, in which case, we should pay careful attention to the allowance for doubtful accounts.

Allowance for Doubtful Accounts
Of course, many sales are offered with credit terms: the product is sold and an accounts receivable is created. Because the product has been delivered (or service has been rendered) and payment is agreed upon, known and reasonably assured, the seller can book revenue.

However, the company must estimate how much of the receivables will not be collected. For example, it may book $100 in gross receivables but, because the sales were on credit, the company might estimate that $7 will ultimately not be collected. Therefore, a $7 allowance is created and only $93 is booked as revenue. As you can see, a company can report higher revenues by lowering this allowance.

Therefore, it is important to check that sufficient allowances are made. If the company is growing rapidly and funding this growth with greater accounts receivables, then the allowance for doubtful accounts should be growing too.

3. Parse Organic Growth from Other Revenue Sources
The third thing investors can do is scrutinize the sources of revenues. This involves identifying and then parsing different sources of growth. The goal is to identify the sources of temporary growth and separate them from organic, sustainable growth.

Let's consider the two dimensions of revenue sources. The first dimension is cash versus accrual: we call this "cash" versus "maybe cash" (represented on the left side of the box below). "Maybe cash" refers to any booked revenue that is not collected as cash in the current period. The second dimension is sustainable versus temporary revenue (represented on the top row of the box below):

To illustrate the parsing of revenues, we will use the latest annual report from Office Depot (ticker: ODP), a global retail supplier of office products and services. For fiscal 2003, reported sales of $12.358 billion represented an 8.8% increase over the prior year.

First, we will parse the accrual (the "maybe cash") from the cash. We can do this by looking at the receivables. You will see that, from 2002 to 2003, receivables jumped from $777.632 million to $1.112 billion, and the allowance for doubtful accounts increased from $29.149 million in 2002 to $34.173 million in 2003.

Office Depot's receivables jumped more than its allowance. If we divide the allowance into the receivables (see bottom of exhibit above), you see that the allowance (as a percentage of receivables) decreased from 3.8% to 3.1%. Perhaps this is reasonable, but the decrease helped to increase the booked revenues. Furthermore, we can perform the calculation reviewed above (in #2) to determine the cash received from customers:

Cash received did not increase as much as reported sales. This is not a bad thing by itself. It just means that we should take a closer look to determine whether we have a quality issue (upper left-hand quadrant of the box above) or a timing issue (upper right-hand quadrant of the box). A quality issue is a "red flag" and refers to the upper left-hand quadrant: temporary accruals. We want to look for any one-time revenue gains that are not cash.

When we read Office Depot's footnotes, we will not find any glaring red flags, although we will see that same store sales (sales at stores open for at least a year) actually decreased in the United States. The difference between cash and accrual appears to be largely due to timing. Office Depot did appear to factor some of its receivables, that is, sell receivables to a third party in exchange for cash, but factoring by itself is not a red flag. In Office Depot's case, the company converted receivables to cash and transferred some (or most) of the credit risk to a third party. Factoring affects cash flows (and we need to be careful with it to the extent that it boosts cash from operations) but, in terms of revenue, factoring should raise a red flag only when (i) the company retains the entire risk of collections, and/or (ii) the company factors with an affiliated party that is not at arm's length.

Cash-Based but Temporary Revenue
When it comes to analyzing the sources of sustainable revenues, it helps to parse the "technical" factors (lower left-hand quadrant). These are often strangely neglected by investors.

The first technical factor is acquisitions. Take a look at this excerpt from a footnote in Office Depot's annual report:

…impacting sales in our International Division during 2003 was our acquisition of Guilbert in June which contributed additional sales of $808.8 million. (Item 7)

Therefore, almost all of Office Depot's $1 billion in sales growth can be attributed to an acquisition. Acquisitions are not bad in and of themselves, but they are not organic growth. Here are some key follow-up questions you should ask about an acquisition: How much is the acquired company growing? How will it contribute to the parent company's growth going forward? What was the purchase price? In Office Depot's case, this acquisition should alert us to the fact that the core business (before acquisition) is flat or worse.

The second technical factor is revenue gains due to currency translation. Here is another footnote from Office Depot:

As noted above, sales in local currencies have substantially increased in recent years. For U.S. reporting, these sales are translated into U.S. dollars at average exchange rates experienced during the year. International Division sales were positively impacted by foreign exchange rates in 2003 by $253.2 million and $67.0 million in 2002 (International Division).

Here we see one of the benefits of a weaker U.S. dollar: it boosts the international sales numbers of U.S. companies! In Office Depot's case, international sales were boosted by $253 million because the dollar weakened over the year. Why? A weaker dollar means more dollars are required to buy a foreign currency, but conversely, a foreign currency is translated into more dollars. So, even though a product may maintain its price in foreign currency terms, it will translate into a greater number of dollars as the dollar weakens.

We call this a technical factor because it is a double-edged sword: if the U.S. dollar strengthens, it will hurt international sales. Unless you are a currency expert and mean to bet on the direction of the dollar, you probably want to treat this as a random variable. The follow-up question to the currency factor is this: Does the company hedge its foreign currency? (Office Depot generally does not, so it is exposed to currency risk.)

Revenue recognition is a hot topic and the subject of much post-mortem analysis in the wake of multiple high-profile restatements. We don't think you can directly guard against fraud; that is a job for a company's auditor and the audit committee of the board of directors. But you can do the following:

• Determine the degree of accounting risk posed by the company's business model.
• Compare growth in reported revenues to cash received from customers.
• Parse organic growth from the other sources and be skeptical of any one-time revenue gains not tied directly to cash (quality of revenues). Scrutinize any material gains due to acquisitions. And finally, omit currency gains.

Financial Statements: Working Capital
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