By David Harper 
(Contact David)

Revenue recognition refers to a set of accounting rules that governs how a company accounts for its sales. Many corporate accounting scandals have started with companies admitting they have reported "irregular" revenues. This kind of dishonesty is a critical accounting issue. In several high-profile cases, management misled investors - and its own auditors - by deliberately reporting inflated revenues in order to buoy its company's stock price. As of June 2004, the Financial Accounting Standards Board (FASB) has begun working to consolidate and streamline the various accounting rules into a single authoritative pronouncement.

But this series is not concerned with detecting fraud: there are several books that catalog fraudulent accounting practices and the high-profile corporate meltdowns that have resulted from them. The problem is that most of these scams went undetected, even by professional investors, until it was too late. In practice, individual investors can rarely detect bogus revenue schemes; to a large extent, we must trust the financial statements as they are reported. However, when it comes to revenue recognition, there are a few things we can do. 

1. Identify Risky Revenues 
If only cash counted, revenue reporting would not pose any risk of misleading investors. But theaccrual concept allows companies to book revenue before receiving cash. Basically, two conditions must be met: (1) the critical earnings event must be completed (for example, service must be provided or product delivered) and (2) the payment must be measurable in its amount, agreed upon with the buyer, and its ultimate receipt must be reasonably assured (SFAC 5, SEC Bulletin 101). 

For some companies, recording revenue is simple; but for others, the application of the above standards allows for, and even requires, the discretion of management. The first thing an investor can do is identify whether the company poses a high degree of accounting risk due to this discretion. Certain companies are less likely to suffer revenue restatements simply because they operate with more basic, transparent business models. (We could call these "simple revenue" companies.) Below, we list four aspects of a company and outline the degree of accounting risk associated with each aspect: 

Allowance for Doubtful Accounts 
Of course, many sales are offered with credit terms: the product is sold and an accounts receivable is created. Because the product has been delivered (or service has been rendered) and payment is agreed upon, known and reasonably assured, the seller can book revenue. 

However, the company must estimate how much of the receivables will not be collected. For example, it may book $100 in gross receivables but, because the sales were on credit, the company might estimate that $7 will ultimately not be collected. Therefore, a $7 allowance is created and only $93 is booked as revenue. As you can see, a company can report higher revenues by lowering this allowance. 

Therefore, it is important to check that sufficient allowances are made. If the company is growing rapidly and funding this growth with greater accounts receivables, then the allowance for doubtful accounts should be growing too. 

Cash-Based but Temporary Revenue 
When it comes to analyzing the sources of sustainable revenues, it helps to parse the "technical" factors (lower left-hand quadrant). These are often strangely neglected by investors. 

The first technical factor is acquisitions. Take a look at this excerpt from a footnote in Office Depot's annual report: 

…impacting sales in our International Division during 2003 was our acquisition of Guilbert in June which contributed additional sales of $808.8 million. (Item 7)

Therefore, almost all of Office Depot's $1 billion in sales growth can be attributed to an acquisition. Acquisitions are not bad in and of themselves, but they are not organic growth. Here are some key follow-up questions you should ask about an acquisition: How much is the acquired company growing? How will it contribute to the parent company's growth going forward? What was the purchase price? In Office Depot's case, this acquisition should alert us to the fact that the core business (before acquisition) is flat or worse. 

The second technical factor is revenue gains due to currency translation. Here is another footnote from Office Depot: 

As noted above, sales in local currencies have substantially increased in recent years. For U.S. reporting, these sales are translated into U.S. dollars at average exchange rates experienced during the year. International Division sales were positively impacted by foreign exchange rates in 2003 by $253.2 million and $67.0 million in 2002 (International Division).

Here we see one of the benefits of a weaker U.S. dollar: it boosts the international sales numbers of U.S. companies! In Office Depot's case, international sales were boosted by $253 million because the dollar weakened over the year. Why? A weaker dollar means more dollars are required to buy a foreign currency, but conversely, a foreign currency is translated into more dollars. So, even though a product may maintain its price in foreign currency terms, it will translate into a greater number of dollars as the dollar weakens. 

We call this a technical factor because it is a double-edged sword: if the U.S. dollar strengthens, it will hurt international sales. Unless you are a currency expert and mean to bet on the direction of the dollar, you probably want to treat this as a random variable. The follow-up question to the currency factor is this: Does the company hedge its foreign currency? (Office Depot generally does not, so it is exposed to currency risk.) 

http://www.investopedia.com/university/financialstatements/financialstatements5.asp