Thursday, April 22, 2010

Understanding Aggressive Revenue Recognition

While we normally look at items higher up on the I/S as being of higher quality (less prone to manipulation), there are still some issues which may cause analysts to take a closer look at some of the top line items. For instance, revenue is not immune to manipulation.

For example, a company that is looking to boost it's top line revenue might be more inclined to aggressively (through a variety of mechanisms) recognize revenue. However, with accrual accounting, there are many potential ways to detect some red flags with regards to changes in current practices by looking at the numbers.

First, let's decompose what revenue is actually composed of. Revenue is composed of two types of sales, cash sales and credit sales. Or expressed as:

Revenue = Cash Sales Collected + Δ A/R

Even if all sales contain some component of credit, the conversion implications as it relates to collecting debts will have a noticable effect on various ratios.

The most obvious among these is the Days Sales Outstanding (DSO) ratio:

DSO = (A/R) / Averages Sales per day = 365 * (A/R) / Sales

This is a familiar activity / operating ratio, because it is used to forcast A/R levels in the OWC schedule in a financial model and is the most obvious place to look to see if the active practices of the company have changed. It also plays a huge role in the Cash Conversion and Operating cycles.

Another interesting note is that with a constant of 365, this ratio tells the EXACT same story as the ratio (A/R) / Sales which offeres some insight into your company's policy with regards to percentage of credit extended per sale.

An alternative method is the portion of aggregated accrual attributed to revenue recognition method which is calculated as (A/R) / Δ in Net Operating Assets (or NOA).

However, note that the major components of NOA are Inventory and A/R (related to OWC which is similar but also includes A/P, prepaid expenses and other current / operating liabilities). Notice that when financial modeling, these items are modeled against ratios which incorporate I/S items such as Revenue, COGS, Operating expenses etc. Note that in turn, these items (COGS, Operating Expenses etc.) are usually modeled as a constant percentage of Revenue.

The end result? It doesn't matter which of the two ratios you use, they should both tell you the same story. If a company starts taking more aggressive revenue recognition through extending credit (and possibly risking having customers default on purchases), both of these ratios will increase as A/R as a % of sales increases faster than sales.

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