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How Financial Report Readers Can Detect Creative Revenue Accounting

With so many tricks up so many corporate sleeves, as a financial report reader, you may feel that you're at the mercy of the tricksters. You can get to the bottom of many of the common creative accounting tactics by carefully reading and analyzing the financial reports, but you have to play detective and crunch some numbers.

Review revenue-recognition policies

The financial report section called the notes to the financial statements is a good source for finding out at what point a company actually recognizes a sale as revenue. Some companies recognize revenue before they deliver the product or before they perform the service. If you come across this scenario, try to find details in the notes to the financial statements that indicate how the company really earned its revenue.

If you can't find this info, call the company's investor relations department to clarify its revenue-recognition policies, and be sure that you understand why it may be justified in recognizing revenue before delivery or performance has been completed.

When a firm indicates in the notes to the financial statements that it recognizes revenue at the time of delivery or performance, that timing may seem perfect, but you must look further to find other policies that may negate a sale. Dig deeper to find out what the company's rights-of-return policy is. Companies may allow a price adjustment or have a liberal return policy that may cancel out the sale.

Take note if you find that the company recently changed its revenue-recognition policies. Just the fact that the company is changing those policies can be a red flag. This change could come about because the firm is not meeting Wall Street expectations. It may decide to recognize revenue earlier in the sales process, which may mean that this revenue reported on the income statement may have to be subtracted later.

Scour the revenue-recognition section of the financial report until you understand how the change impacts the company's revenue recognition. You may want to review the annual reports from the past few years to compare the old revenue policies with the new ones.

Evaluate revenue results

Reported revenue results for the current period don't tell the whole financial story. You need to review the revenue results for the past five quarters or past three years to look for any inexplicable swings in seasonal activity. For example, high numbers for retail outlets in the last quarter of the year aren't unusual. Many retailers make about 40 percent of their profits during that quarter due to holiday sales.

Be sure you understand the fluctuations in revenue for the company you're investigating and how its results compare with the results of similar companies and the industry as a whole. If you see major shifts in revenue results that normal seasonal differences can't explain, an alarm needs to go off in your head.

Monitor accounts receivable

Accounts receivable tracks customers who buy on credit. You want to be sure that customers are promptly paying for their purchases, so closely watch the trend in accounts receivable. Compare the turnover ratio, which measures how quickly customers pay their bills, for at least the past five quarters to see whether a major change has occurred.

If you notice that customers are taking longer to pay their bills, it can be a sign that the company is having trouble collecting money, but it can also indicate revenue management. Either way, this raises a red flag for you as a financial report reader.

While you're investigating, check the percentage rate of change for accounts receivable versus the percentage rate of change for net revenue over the same period. For example, if the balance in accounts receivable increases by 10 percent and net revenues increase by 25 percent, that would be a sign of game playing.

Normally, these two accounts increase and decrease by similar percentages year to year unless the company offers its customers a significant change in credit policies. If you see significant differences between these two accounts, it may be another sign of revenue management.

Check to see if the changes you're seeing match trends for the industry as a whole. If not, ask investor relations people to explain what's behind the differences. If you don't like the answers, don't buy the stock, or consider selling the stock you already have.

Assess physical capacity

Evaluating physical capacity, the number of facilities the company has and the amount of product the company can manufacture, is another way to judge whether the company is accurately reporting revenue. You need to find out whether the firm truly has the physical capacity to generate the revenue it's reporting. You do so by comparing the following ratios:

  • Revenue per employee (Revenue ÷ Number of employees): If the annual report doesn't mention the number of employees, you can call investor relations or find it in a company profile on one of the financial websites, such as Yahoo! Finance.

  • Revenue per dollar value of property, plant, and equipment (Revenue ÷ Dollar value of property, plant, and equipment): You can find the dollar value of property, plant, and equipment on the financial report's balance sheet.

  • Revenue per dollar value of total assets (Revenue ÷ Dollar value of total assets): You can find the number for total assets on the financial report's balance sheet.

  • Revenue per square foot of retail or rental space, if appropriate (Revenue ÷ Square foot of retail space): You can find details about retail or rental space in the managers’ discussion and analysis or the notes to the financial statements, or in the company's profile on a financial website.

Compare these ratios for the past five quarters, and also compare the ratios to ones of similar companies and ones for the industry as a whole. If you see major differences from accounting period to accounting period or between similar companies, it may be a sign of a problem.

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