“There is an old tale, told with great relish by veteran accounting professors to neophytes, regarding a firm in search of an accountant. The field narrowed to three, each of whom was interviewed and then asked to look at the books and calculate the firm’s taxable income for the year. The first candidate replied “$2.3 million,” and the second, after obtaining additional information, thought it would come to $2.4 million. The third glanced around, pulled down the blinds and asked the board, “How much do you want to show?”. Naturally, he got the job.” The above is a joke shared…
“There is an old tale, told with great relish by veteran accounting professors to neophytes, regarding a firm in search of an accountant. The field narrowed to three, each of whom was interviewed and then asked to look at the books and calculate the firm’s taxable income for the year.
The first candidate replied “$2.3 million,” and the second, after obtaining additional information, thought it would come to $2.4 million. The third glanced around, pulled down the blinds and asked the board, “How much do you want to show?”.
Naturally, he got the job.”
The above is a joke shared by investor and author Thornton O’glove. But while it may amuse, there could be a sliver of truth in it. For our investments to work, the quality of assumptions that go into the company’s financials do matter.
And one of these important assumptions would be revenue recognition.
How companies recognise revenue
Companies have to generate revenue before it can earn a profit. Although revenue is critical, not all revenue is recognized in the same way.
“Revenue from the sale of goods is recognised upon the transfer of significant risk and rewards of ownership of the goods to the customer, usually on delivery of goods. Revenue is not recognised to the extent where there are significant uncertainties regarding recovery of the consideration due, associated costs or the possible return of goods.”
As BreadTalk Group collects cash whenever its goods (in this case, tasty pork floss buns) are provided to customers, the assumptions the firm has to make are fairly straight forward.
On the other hand, revenue recognition assumptions would be more complicated for a company like diamond-planning systems manufacturer Sarine Technologies Ltd (SGX: U77). This is how the firm describes its revenue recognition in its 2013 annual report:
“Revenue from the sale of goods in the course of ordinary activities is measured at the fair value of the consideration received or receivable, net of returns and discounts.
Revenue is recognised when persuasive evidence exists, usually in the form of an executed sales agreement, that the significant risks and rewards of ownership have been transferred to the buyer, recovery of the consideration is probable, the associated costs and possible return of goods can be estimated reliably, there is no continuing management involvement with the goods, and the amount of revenue can be measured reliably.
The timing of the transfers of risks and rewards varies depending on the individual terms of the contract of sale.”
Now, this is not to say that one method is better over the other. After all, selling high tech diamond-planning systems is quite different from selling pork floss buns.
That said, it pays to understand the assumptions taken by a company in its revenue recognition policies to observe if the firm has been overly aggressive in recognizing revenue ahead of time.
There are a few things we can do to counter-check against aggressive assumptions in revenue recognition. One way would be through monitoring the growth in accounts receivable and comparing it with the growth in sales.
Simply said, if a company is offering products to its customers but is unable to collect payments on time even though the firm may already have recognized the revenue, it may return to haunt the company in the future.
As my fellow Fool Rex Moore notes:
“It’s a problem if a company is forced to extend more generous payment terms to its customers (from 30 days to 60 days, for example) in order to keep their business. And it’s a problem when customers are dragging their feet and not paying on time — or never pay.
And it’s definitely a problem when unscrupulous management forces more product through the distribution channel than its customers are able to sell. (This is known as “channel stuffing.”)”
I couldn’t agree more. So, start checking, Fools!
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.