Detecting Aggressive Revenue Recognition Policies

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Aggressive and Conservative Accounting Series

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A Closer Look at Aggressive Revenue Recognition

Aggressive Revenue Recognition | Flickr: epSos.de

For a private company, one of its goals is to pay less tax. This equates to lowering revenue by taking deductions and expensing items in order to qualify for a lower tax bracket.

A public company on the other hand, is more inclined to use aggressive accounting policies in order to over report earnings in order to meet analysts’ expectations, meet debt covenants or meet stock option performance bonuses based on stock price.

This has led to numerous accounting scandals and blowups in corporate America as well as the rest of the world. In order to better understand what aggressive revenue recognition is, let’s take a look at what revenue is made up of.

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Investopedia defines “revenue” as

“The amount of money that a company actually receives during a specific period, including dianscounts and deductions for returned merchandise. It is the “top line” or “gross income” figure from which costs are subtracted to determine net income.”

and according to the Financial Accounting Standards Board (FASB), four conditions must be met in order to recognize revenue.

Persuasive evidence that an agreement exists

Delivery has occurred or services have been rendered
The seller’s price is fixed and determinable
Collectibility is reasonably assured

Aggressive Revenue Recognition Sample Scenario

Consider this example from the CPA Journal,

Capitol Motors is in its first year of operations and as of December 30 has total revenues of $5 million, projected net income of $200,000, and total assets of $40 million (Capitol’s year-end is December 31).

On December 31, a customer and Capitol Motors agree to terms on the purchase of a new automobile for $25,000. The customer signs and completes all paperwork for the sale but asks Capitol Motors to hold the full-payment check until he can complete financing with a local bank.

However, the bank has already closed for the day, and it will be January 2 before the customer can release the check to Capitol. The customer already has a $30,000 line of credit approved by his bank.

Capitol Motors’ credit manager reviews the customer’s file and offers to finance the transaction through the dealership’s financing company. The customer, however, wishes to use a local bank and declines the financing offer. The customer and Capitol agree to leave the automobile on the dealership lot overnight so it can be properly serviced (e.g., washed, fluid levels checked).

Given these facts, should Capitol Motors record a sale as of December 31?

According to the majority of accountants, a sale will be recorded on December 31, despite the full conditions not being met. You could say that the revenue is legitimately booked on Dec 31 because the point of sale has been realized, but unless the customer takes full right of the vehicle, the risk still remains with the seller. In other words, how can a revenue be booked when you, the seller, still assumes risk? Doesn’t that sound too aggressive?

The above situation is just one type of scenario where management will decide to take the conservative or aggressive approach.

Auditors and Aggressive Revenue

Before getting into the main section, a quick word on accounting and auditors.

I always thought of accounting as being black and white, but I learnt how wrong I was through my own investment failures related to fraud in CCME as well as aggressive accounting policies.

I also concluded that my recent article on CCME auditor Deloitte was incorrect. Over the past month, I’ve looked more into auditors and what they do, and it is just like what Thorton O’Glove said in Quality of Earnings, don’t trust them.

You are a much better auditor if you simply look over the reports with a keen and critical eye.

There are simply too many ways a company can manipulate the financial statements while staying within the rules of accounting and having the auditor sign off.

But here are some ways in which you can test the company’s revenue recognition policy.

The Days Sales Outstanding Ratio

A different way to look at revenue is by using the accrual accounting definition, where

Revenue = Cash Sales Collected + Changes in AR

If you consider that all sales contain some form of credit, you will notice that the equation for revenue will begin to skew to one side if aggressive revenue recognition is used.

One of the best ways to detect such policies is to use the Days’ Sales Outstanding (DSO) ratio. There are a couple different ways to calculate DSO, but the version I like to use is from the book Financial Shenanigans and is the method I applied to the stock valuation spreadsheets.

DSO = Ending Receivables/Revenue x numbers of days in period

(for quarterly period, 91.25 days is normal approximation)

DSO tells you how many days it takes a company to collect revenue after a sale. Look out for increasing DSO as it means the company is unable to collect payments and/or providing lenient terms to buyers. To put it simply, the company is disguising weak sales.

Net Income and Cash from Operations Out of Line

A profitable company should increase both net income and cash from operations. However, if you see net income increasing while cash from operations is declining, prepare to look deeper as this is a sign that there could be a misuse of revenue recognition.

You can quickly check by calculating Cash from Operations/Net Income. If the result is less than 1, then you have a sign of poor earnings quality or an accounting irregularity.

Compare Revenue Recognition with Close Competitors

Another quick way to discern the revenue recognition aggressiveness is to compare with close competitors in the industry. A quick breeze and comparison through the annual reports of competitors should provide a clear indication of whether the accounting practice is standard to the industry.

Now that everything is electronic, an easy way is to open the SEC filing, press CTRL+F on your keyboard to find text, and then type in “revenue recognition.”

Booking Non-Recurring Income as Revenue

Booking non recurring revenue isn’t considered aggressive revenue recognition, but more in line with pure manipulative intent. This topic deserves its own separate discussion, but is worth a mention.

You will find it surprising how many companies will book non recurring items higher up on the income statement to produce the idea of revenue growth.

Another way in which non recurring revenue can be masked to look like earnings is by reducing SG&A. This is what IBM did back in 1999. It sold a business unit to AT&T and instead of separating the gain, IBM recorded it as a reduction in SG&A, thus significantly boosting its earnings and booking an increase in revenue.

Aggressive Revenue Recognition

There are more ways in which a company can aggressively book revenues and it is a fine line between keeping within the rules and manipulation.

I wish I could say that this is all you need to know about revenue recognition methods, but with many companies coming up with creative ways to create new (or old) revenue, the points I’ve outlined should only be viewed as a broader topic of accounting red flags.