3 Ways a Company Can Inflate Its Revenue

When I was younger and more naive, I always thought that accounting is extremely scientific and systematic. I thought that everything in accounting is fixed and all accountants can just follow a fixed set of rules to do their work.

It was only when I started learning about investing and later on, marrying an accountant, did I find out how wrong I was.

In fact, accounting can be full of ambiguity. How a company wants to record its performance is up to the assumptions their accountants are making.

Therefore, when we are looking at the revenue of a company, it might not be a true representation of the actual performance of the company. Sometimes, a company can inflate its revenue, to portray excessive strength in its business.

Here are three ways a company can inflate its revenue.

Reporting Future Revenue

For companies that engage in credit sales, the revenue it generates might not be the cash it would receive from the business. Therefore, a company can boost its revenue by extending longer credit terms to its customers for larger orders. In this way, the company is recording sales that are larger than usual. It might appear that the company is growing its revenue but in actual fact, the company is merely recording its future revenue first by extending its credit terms.

Reporting Cancelled Order As Revenue

For a company that offers some sort of money-back guarantee, it is typical to see a relatively large refund rate for its business. However, some companies might not make provision for possible refunds when it makes a sale. That means it is recording revenue that has a high chance of getting refunded in the future. This would, in turn, overstate its revenue for the period when the trial period of its product or services are still ongoing.

Assignment To Distributors Recorded As Sales

Lastly, for a manufacturer or a wholesaler, sometimes it will provide products to its distributors with a promise to take back any unsold units. This is typically known as consignment sales. The company should only record a sale if its product has truly been sold to the end user by its distributors. However, some companies might record the entire consignment products shipment to its distributors as sales, boosting up its revenue even when it is not accurate. This type of creative accounting has been used quite regularly in the past decade and has caused huge losses to many investors.

Foolish Summary

There are no fixed rules in accounting. There are many assumptions the company needs to take when recording its performance. Some companies might use this ambiguity to engage in very aggressive accounting, to create a higher sales figure for the company in order to show itself as a strong and growing company. It is up to the investors to scrutinise the company’s revenue recognition model.

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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 Stanley Lim doesn’t own shares in any companies mentioned.