Reading Financial Reports for Dummies (52 page)

and understate expenses until the deception is exposed. Eventually, the firm will have to admit its game-playing and restate its net income, which will likely result in a profit reduction or possibly even a loss.

Executives and managers just delay the inevitable when they practice this game. Some do it to maintain their bonuses as long as possible. Others do it because they don’t want to face the reality of the company’s financial position. And I’m sure that companies make many more excuses when the game is finally exposed.

Goods shipped but not ordered

Some companies get even more aggressive with their deception, counting goods that they’ve shipped but that customers haven’t ordered yet.

Companies that use this technique commonly ship items for inspection or demonstration purposes in the hope that customers will buy the product.

This tactic can help a company meet its revenue for the upcoming reporting period because it counts these unordered goods as sales, even though the products haven’t really been sold. However, if some customers receive the goods, decide not to purchase them, and return the merchandise, the company must subtract these sales from its revenue during the next period.

As the problem snowballs, the company has to ship more and more orders without actually having the sales to meet its revenue expectations. Each month it has to reverse a greater percentage of its revenue, and as a result, it has to make up the shortfall by shipping an even greater number of units without actual orders. Eventually, the company won’t be able to keep up the deceptive practices and will have to correct its financial statements, lowering the amount it reported as revenue and reducing its net income. That will likely send shockwaves through the stock market, and the stock price will drop dramatically.

Extended reporting period

Some companies try to meet Wall Street’s revenue expectations by keeping their books open for a few days — or even a few weeks — into the next reporting period in order to generate last-minutes sales. This tactic eventually creates major financial reporting problems for the company because it takes the sales from what should have been reported as income during the next reporting period. Eventually, the company has to reveal its deceptive practices because it has to leave its books open longer and longer each period to meet the next period’s expectations.

Pure fiction

The most outrageous acts are the ones that involve reporting purely fictional sales. How do companies do this? Well, they recognize revenue for sales that were never ordered and never shipped. Company insiders fill financial
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records with false order, billing, and shipping information. Eventually, the lack of actual cash forces the company to reveal its games, and the business will probably go bankrupt.

Channel stuffing

Channel stuffing
is a way for companies to get more products out of their manufacturing warehouses and onto distributors’ and retailers’ shelves. The most common method is to offer distributors large discounts so that they stock up on products. Distributors buy more product than they expect to sell because they can get it so much cheaper. Then distributors sell the product to their customers; however, several months or even a year may pass before they sell all the products. If the products don’t sell, in some cases companies are given the right to return the product.

Although this strategy is a legitimate type of revenue, it will come back to haunt the company in later accounting periods, when distributors have so much product on their shelves that they don’t need to order more. At some point in the future, new orders drop, which means fewer sales and a drop in revenue reported on the income statement. Less revenue translates to lower net income, which will be seen as a bad sign by Wall Street, and the stock price will take a dive.

Side letters

Sometimes companies make agreements with their regular customers outside the actual documentation used for the corporate reporting of revenue. This agreement is called a
side letter.
The side letter involves the company and customer changing terms behind the scenes, such as allowing more liberal rights of return or rights to cancel orders at any time that can, essentially, kill the sale. Sometimes these agreements go as far as excusing the customer from paying for the goods.

In all cases, the side letter terms eventually result in turning revenue that was recognized on a previous income statement into a nonsale, either by the return of goods or the extension of credit beyond a 12-month payment period. This practice makes revenue from these sales look better initially, but the revenue is later subtracted when the goods are returned.

Rights of return

Giving customers liberal return rights is another way of getting them to order goods, even when they’re not sure if they’ll be able to resell them. By offering distributors or retailers terms that allow them to order goods for resale that they can return as much as 12 months later if they don’t sell, the sales, in essence, aren’t really sales and shouldn’t be recognized as revenue on a company’s financial report. Rights of return are offered to most customers, but when payment for goods depends on the need for the distributor or retailer to first resell the goods, the recognition of that revenue is questionable.

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Part V: The Many Ways Companies Answer to Others

Related-party revenue

Related-party revenue
comes from a company selling goods to another entity in which the seller controls the management of operating policies. For example, if the parent company of a tissue manufacturer sells the raw materials needed for manufacturing that tissue to its subsidiary, the parent company can’t count that sale of raw materials as revenue. Whenever one party to the transaction can control or significantly influence the decision of the entity that wants to buy the goods, a company can’t recognize the sale as revenue.

These related-party sales don’t meet the SEC’s requirement for an
arm’s-length
transaction,
which is a transaction that involves a buyer and a seller who can act independently of each other and have no relationship to each other. The SEC does require that companies recognize only sales with third parties that are at arm’s length and that can’t be controlled by the party planning to recognize the sale as revenue. Companies aren’t permitted to record sales to their affiliates or other related entities as part of their recognized revenues.

Bill-and-hold transactions

Sometimes a buyer places an order but asks the company to hold onto the goods until it has room in its store or warehouse. So the company has sold the goods but hasn’t shipped them yet. This sale is called a
bill-and-hold
transaction.

The SEC has a set of criteria that a company must meet in order for it to recognize revenue for items it hasn’t shipped yet. These include:

✓

That the seller passes the risks of ownership to the buyer:
This criterion means that if anything happens to the goods while the seller is holding them, the loss is the buyer’s responsibility, not the seller’s.

✓

That the customer makes a fiscal commitment to purchase the goods:
This commitment should
preferably occur in writing.

✓

That the buyer, not the seller, requests the bill-and-hold transaction:
The buyer must have a business purpose, such as planning a future sales event and not wanting to receive the goods until just before the event, to justify ordering the goods on a buy-and-hold basis.

✓

That the buyer and seller set up a fixed schedule for the delivery of
the goods:
Determining dates for delivery indicates that the sale is real rather than a scam.

✓

That the seller separate the ordered goods from its inventory so it
won’t use the goods to fill other orders:
If it doesn’t clearly separate these goods and hold them, the company can’t prove that the goods were actually bought, so the sale can’t be counted.

✓

That the seller has the goods complete and ready for shipment:
Only goods being held and ready for shipment can be counted as a sale.

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Upfront service fees

Companies that collect upfront service fees for services that they provide over a long period of time, such as 12, 24, 36, or 60 months, must be careful about how they recognize this revenue. If the company collects fees to service equipment upfront, these fees can’t be counted as revenue when the money is collected. The SEC requires that such companies recognize their revenue over time as the fees are earned. Companies that recognize this type of revenue all at once are prematurely recognizing revenue.

Detecting creative revenue accounting

With so many tricks up so many corporate sleeves, you may feel that you’re at the mercy of the tricksters. You can get to the bottom of many of the common creative accounting tactics by carefully reading and analyzing the financial reports, but you’ll have to play detective and crunch some numbers.

Reviewing revenue recognition policies

The financial report section called the
notes to the financial statements
is a good source for finding out at what point a company actually recognizes a sale as revenue. 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 its 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 firm 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 find other policies that may 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 firm is having difficulty meeting its Wall Street expectations. It 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 impacts 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.

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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 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.

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. In Chapter 16, I show you how to calculate accounts receivable turnover. Compare the
turnover ratio,
which measures how quickly customers pay their bills, for at least the past five quarters to see whether a major change or trend has occurred. If you notice that customers are taking longer to pay their bills, it can be a sign that the company is having 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.

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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 firm truly has the physical capacity to generate the revenue that it’s reporting. You do so by comparing the following ratios: