Revenue is a key factor in determining the strength of demand for a company's products and services. Therefore, it is important to note whether revenue is recognized in an appropriate manner. A company's management may be inclined to aggressively recognize revenue or tweak its accounts receivables to cover up problems in the business.
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WallStreetDarlingCorp. (Ticker: CRASH) continuously posts impressive quarterly revenue performance, forcing analysts to scramble to raise their earnings estimates and price targets. Investors -- sensing that they may be missing an opportunity to invest in a future blue-chip like General Electric (NYSE: GE) or Wal-Mart (NYSE: WMT) -- rush to pile into the stock like a bunch of parents fighting over the last Pokemon card at the local toy store. The result is that the stock is bid to an all-time high, and future expectations are even higher. Then, seemingly out of the blue, WallStreetDarlingCorp. restates its revenue and earnings. The stock price crashes and unsuspecting shareholders are left holding the bag. MicroStrategy (Nasdaq: MSTR) is a real-world example of a company that has seen the obliteration of shareholder value due to a revenue restatement. The stock dropped like a bomb and has not recovered since. However, it is not only rapidly growing, emerging companies that get caught up in accounting problems, as we saw with Lucent Technologies (NYSE: LU) after the Securities and Exchange Commission raised concerns over the company's accounting practices. How can investors avoid this? There are several ways to identify companies that may have potentially overstated revenue. Two of these methods are: 1) knowing a company's revenue recognition policy, and 2) analyzing the growth in accounts receivable.
Revenue should be recognized when it is earned and the sales price is realized (through collection) or realizable (through an enforceable claim for collection). A company's revenue recognition policy is largely at the discretion of its management and it may be swayed into aggressively recognizing revenue in order to boost current sales and net income, bolster the stock price by meeting Wall Street's expectations, or earn higher compensation for themselves as a result of better operating performance. You can find a company's revenue recognition policy in the notes of its Form 10-K. The following is the revenue recognition policy for software licenses of Veritas Software (Nasdaq: VRTS), a leading vendor of storage management software. "The Company recognizes revenue from licensing of software products to an end user upon delivery of the software product to the customer, unless the fee is not fixed or determinable, or collectibility is not considered probable. For licensing of the Company's software to OEMs [original equipment manufacturers], revenue is not recognized until the software is sold by the OEM to an end-user customer. For licensing of the Company's software through our indirect sales channels, revenue is recognized when the software is sold by the reseller, value-added reseller, or distributor to an end-user customer. The Company considers all arrangements with payment terms extending beyond 12 months and other arrangements with payment terms longer than normal not to be fixed or determinable. If collectibility is not considered probable, revenue is recognized when the fee is collected." The revenue recognition policy seems reasonable. Veritas does not recognize revenue unless the fee is fixed or determinable. While management makes an estimate as to the collectibility of the license fee, they also state that extended payment terms are not considered fixed or determinable, therefore revenue is not recognized. Accounts receivable Accounts receivable should grow at the same rate as or preferably slower than revenue. Accounts receivable that are growing much more rapidly than sales are a warning sign that something may be awry. For example, management may be forced to extend credit terms to its customers due to weaker demand, which can decrease the likelihood of collecting on the sales. Or the company may be accepting orders from less-credit-worthy customers in order to maintain revenue growth on the income statement. However, one quarter is not a trend. Investors should look at accounts receivable over four to eight quarters to get a sense of the trends developing in the business. Management can also tweak the allowance for doubtful accounts in order to boost current earnings. The notes to the financial statement provide information about the allowance for doubtful accounts, and it is useful to analyze the trend in this number to determine if management is manipulating it to boost current revenue and lowering the quality of its reported earnings. In addition to the growth of the receivables in relation to sales, investors can resort to the days sales outstanding (DSO) of a company's receivables. The DSO is simply the measure of time it will take the firm to collect its accounts receivable. DSO = accounts receivable / (sales / 90) For example, Veritas' accounts receivable grew 41% compared with sales growth of 64% during 2000. In addition, the DSO at the quarter ending 12/31/00 was 45 compared with 53 in the year-ago period. A growing DSO can be a warning flag, but investors should also be aware of the management's DSO target (Veritas' target is 50 days) as well as the DSOs of the firm's competitors. This will help put the DSO in context and determine whether the movement in the DSO is meaningful. Because revenue is crucial to the activities of a company, it is a good place to start the analysis of the company's financial strength. There are many ways that management can manipulate results, but the revenue recognition policy and an analysis of a company's accounts receivable are two tools that can help you avoid problem stocks before they crash and burn. John Del Vecchio hopes he doesn't have to restate his own revenues anytime soon. At the time of this writing, he did not own shares of any companies mentioned in this article. To see his holdings, visit his personal profile. The Motley Fool is investors writing for investors.
Revenue is a key factor in determining the strength of demand for a company's products and services. Many investors begin their analysis of a company by assessing the growth in the revenue line item of the income statement. Therefore, it is important to note whether revenue is recognized in an appropriate manner.
Another possible trouble spot can be found in accounts receivable on the balance sheet. Accounts receivable represent sales that have been made, but for which cash has not yet been received. The amount on the balance sheet is reported after subtracting an estimate for uncollectable receivables known as an allowance for doubtful accounts.
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