When the market is turbulent and seems to be heading down, I return to my investing roots. You might have noticed that a number of my recent columns discussed financial statement issues. Tonight I'm going to dip into that well one more time with a discussion of how companies recognize revenue.

You might think there's not much to recognizing revenue, and, if you account for transactions on the basis of the exchange of cash for goods or services, there isn't. But, that's not how transactions are accounted for under U.S. Generally Accepted Accounting Principles (GAAP).

Instead, companies account for revenues and expenses using the accrual method of accounting. The result is that revenues can be misstated -- and often are. As a matter of fact, more than half of all financial fraud cases brought by the Securities and Exchange Commission (SEC) last year were based on improper revenue recognition.

Eventually, companies that aggressively record revenue have to pay the piper, which means the stock price will tank. This is what happened to Lucent Technologies (NYSE: LU) when it added to its long list of recent woes last week's announcement that revenues for the fourth quarter had been overstated by at least $125 million.

Other companies with recent problems related to revenue overstatement include MicroStrategy (Nasdaq: MSTR) and Lernout & Hauspie Speech Products (Nasdaq: LHSPE). Another recent case occurred during the tenure of the infamous "Chainsaw" Al Dunlap at Sunbeam Corp. (NYSE: SOC).

Here's a simple example of how this issue can arise:

Suppose that Revenues Are Us Inc. (Ticker: HASTE) signs a contract in late December to provide $50 million of its products to Returns Are Us Inc. (Ticker: WASTE) over a two-year period. HASTE could then report to investors that it has revenues of $50 million this year. Unfortunately, it's not quite that simple. You see, HASTE still hasn't actually provided any products to WASTE. It also hasn't incurred any of the costs related to producing these items. So, if it records all the revenue this year, its revenues will look better than they really are. Its income will also be overstated, as there won't be any expenses related to producing these goods on this year's books.

Theoretically, a company shouldn't report revenue until it has delivered the goods, provided the services, and the customer has accepted them. Companies with the most conservative accounting policies will do just that. Here's why: Say that WASTE determines that the products received from HASTE are defective, and it cancels the contract after one year. In that case, HASTE would have overstated its revenues by as much as $50 million.

An extremely conservative company might not report the revenue until WASTE had accepted and used the entire amount of product that it committed to under the contract. Others might record revenue ratably over the life of the contract, or even based on its estimate of when it expects to deliver the product.

One tool that an investor can use to help determine how quickly a company reports revenue is to look at how long it takes to collect its outstanding receivables [Days Sales Outstanding = Accounts Receivable / (Sales/90)]. The longer it takes to collect, the greater the likelihood that the company is not reporting revenue conservatively.

Fortunately, the SEC has taken action to tighten the rules. These new rules, adopted last year, will finally go into effect starting in 2001. In the case of sales of goods, they will require that revenue recognition be delayed until a number of events have occurred:

  • There must be a bona fide purchase agreement between buyer and seller
  • The product must have been delivered
  • The buyer must have taken title to the product and assumed all risks and rewards of ownership
  • The seller's price to the buyer must be fixed and determinable
  • There can be no side agreement giving the buyer the right to return the product, or obligating the seller to either repurchase it or guarantee the resale value of it
  • Collectability of the sales proceeds must be reasonably assured

It should be noted that other criteria apply to other types of revenue such as services, rental income, and licensing income.

Two groups of companies stand to be affected most by the SEC's new rules: Internet businesses and biotechnology companies.

Under the new rules, Internet businesses that act more like agents taking orders from customers and passing them on to suppliers who ship the goods to customers will no longer be able report the gross value of sales. Instead, only a net figure can be reported.

One company that has been struggling with the prospect of switching from gross to net revenue is B2B exchange Ventro Corporation (Nasdaq: VNTR). In an SEC filing earlier this year, it indicated that this change could cause a decline in its revenue from $131 million to $13 million. It should be noted that priceline.com (Nasdaq: PCLN) records gross revenues in somewhat similar types of transactions and does not feel it will be impacted by this change.

Many companies in the biotech sector could also see revenues substantially affected by these new rules. In the past, these companies have recognized up-front fees they receive when entering into affiliation agreements with big pharmaceutical companies for joint research and development projects at the time the contract is signed.

This treatment is based on the assumption that the payment is for research the firm has already completed. The SEC's view is that the payments should be recognized as revenue ratably over the term of the related agreement. The SEC has not given definitive guidance on how milestone payments should be recognized as revenue in the hands of the recipient.

If you're not sure what a company's revenue recognition policy is, you can check the accounting policies footnote (usually the first footnote) in its annual report or 10-K for a description. When I run companies through the Rule Maker Ranker, one thing I take note of when deciding how many points to give for conservative accounting is the revenue recognition policy. I evaluate this policy based on what I find in the footnotes, as well as how long it takes the company to collect payment from its customers.

In addition, in his book Common Stocks and Uncommon Profits, my favorite investor Philip Fisher evaluates a company's accounting controls in his 10th point of company analysis. Fisher and his methods are primary topics of discussion on Grape's Fisher Kings Discussion Board.

Have a great day.

Phil Weiss, TMF Grape on the Discussion Boards