Behind The Numbers - Aggressive Revenue Recognition

Revenue is the top line of the income statement for a reason: it is the lifeblood of any company.

Management persist in massaging revenue in numerous ways to mask underlying weakness because they can. Because the rest of the financials depend on revenue, it deserves the most scrutiny. Any doubt about the quality or sustainability of revenue throws the rest of the financial model into question.

Accurate revenue is crucial to confidence in cash flow, because the bottom line of the income statement is the top line of the cash flow statement.

Revenue is recognized when it is earned, but the timing is open to interpretation. Revenue can be "realized", "realizable", and "earned" - allows for wiggle room.

The top metric to determine the quality of a company's revenue is days sales outstanding (DSO). DSO = 91.25 x (AR/Quarterly Revenue). We want to compare the quarter's DSO both year-over-year (to account for seasonality) as well as sequentially (quarter-over-quarter). The practice we want to catch is a change in payment terms that borrows revenue from the future to make this quarter look better than it is. Higher DSO has nothing to do with collections but everything to do with revenue recognition.

If management alludes to a "heavily back end loaded quarter" it may mean the company signed deals at generous terms near the end of the quarter in order to feed the Street. Raise your eyebrows if you hear "hockey stick growth" or "non-linear growth" for anything but a hypergrowth company.

Anytime discretion enters into the equation, there is the opportunity to manipulate the numbers. Management my underestimate costs incurred or overestimate the proportion completed in a given period, providing a boost to current results at the expense of future reporting periods (watch out in Percentage of Completion accounting).

When a company derives an increasing portion of its revenue from affiliated entities (related parties of some sort), investors should be concerned.

Keep an eye on the deferred revenue number (liability on the balance sheet offset against a cash asset received but revenue not yet realized).

Watch out for nonmonetary transactions as a boost to reported revenue (barter).

Watch out for bill-and-hold revenue - vendor invoices the customer and recognizes the transaction as revenue, but the products aren't shipped until later.

Watch out for one time gains reported as revenue or interest income falsely counted as regular income. One time revenue events can obscure real underlying growth or organic growth. Strip them out.

Look for growth in sales-type leases (where a company can lease a product but treat it as a sale).

Be wary when a company purchases a distributor - it can slip by some double counting.

Any change in revenue recognition policy should raise eyebrows and warrant increased scrutiny. Even a change to a more conservative policy can boost results by double counting revenue.

Wall St has a nasty habit of seeing write-offs as one time events and forgetting about them, when in fact they are prima facie evidence of weakness in accounting systems.