Detecting Creative Revenue Accounting in Financial Reports

Analyzing financial reports is difficult enough, but the tricks used for reporting revenue add another layer of complexity. You can see through many common creative accounting tactics by carefully analyzing the financial reports, but you'll have to play detective and crunch some numbers.
Reviewing revenue recognition policies

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, call the company's investor relations department to clarify the company's 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 company indicates in the notes to the financial statements that it recognizes revenue at the time of delivery or performance that timing may seem perfect to you, but you must look further to see if there are other policies that might negate a sale. Dig deeper into the revenue-recognition section of the notes to find out what the company's rights-of-return policy is and how it determines pricing. Some 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. Many times this change comes about because the company is having difficulty meeting its Wall Street expectations. The company may decide to recognize revenue earlier in the sales process, which could mean that more of this revenue reported on the income statement may have to be subtracted in later reporting periods. Scour the revenue-recognition section of the financial report until you understand how the change impacted 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.
Evaluating 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 (at least) or past three years to see whether any inexplicable swings in seasonal activity exist. For example, extremely high numbers for retail outlets in the last quarter of the year (October to December) aren't unusual. Many retailers make about 40 percent of their profits during that quarter due to holiday sales.

Be sure that you understand the fluctuations in revenue for the company you're investigating and how its results compare with those 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 should go off in your head. Take the time to further investigate the reason for these differences by reading reports by analysts who cover the company and by calling the company's investor relations office. Large shifts in revenue can be a sign of revenue management.
Monitoring 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 change in trend has occurred. If you notice that customers are taking longer to pay their bills, it can be a sign of trouble collecting money, but it can also indicate revenue management. Either way, this should raise 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 may 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 similar companies or 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 or can't get answers that make sense to you, don't buy the stock or consider selling the stock you already have.
Assessing 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 or not the company is accurately reporting revenue. You need to find out if the company truly has the physical capacity to generate the revenue that it's reporting. You do so by comparing the following ratios:

* Revenue per employee (Revenue divided by 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 Web sites, such as Yahoo! Finance.

* Revenue per dollar value of property, plant, and equipment (Revenue divided by 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 divided by 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 divided by 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 statement sections of the annual report or in the profile on a financial Web site.

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. For example, if revenue per employee is much higher, or if revenue per dollar value of property, plant, or equipment far exceeds that of similar companies or that of previous periods, this may be a sign of abusive revenue management.