The Issue Is Recognition
We’ll begin at the top. We already noted that sales—the top line of an income statement—is also often called revenue. So far so good: only two words for the same thing isn’t too bad, and we’ll use both, just because they’re so common. But watch out: some companies (and many people) call that top line income. In fact, the popular accounting software QuickBooks, a great product for new businesses, labels it income. That’s really confusing because “income” more often means “profit,” which is the bottom line. (Obviously, we have an uphill battle here. Where are the language police when you need them?)
A company can record or recognize a sale when it delivers a product or service to a customer. That’s a simple principle. But as we suggested earlier, putting it into practice immediately runs into complexity. In fact, the issue of when a sale can be recorded is one of the more artful aspects of the income statement. Accountants have significant discretion over it, and entrepreneurs, therefore, must understand it thoroughly. So this is one place where your skills as an educated consumer of the financials will come in handy. If things don’t seem right, ask questions—and if you can’t get satisfactory answers, it might be time to be concerned. Your accountant or finance people might be making inappropriate or poorly thought-out decisions.
Sales or revenue is the dollar value of all the products or services a company provided to its customers during a given period of time.
The guideline that accountants use for recording or recognizing a sale is that the revenue must have been earned. A products company must have shipped the product. A service company must have performed the work. Fair enough—but what would you do about these situations?
We can’t provide exact answers to these questions because accounting practices differ from one company to another. But that’s precisely the point: there are no hard-and-fast answers. Project-based companies typically have rules that allow for partial revenue recognition when a project reaches certain milestones. Those rules, however, can vary. The “sales” figure on a company’s top line always reflects the accountants’ judgments about when they should recognize revenue. And where there is judgment, there is room for dispute—not to mention manipulation.
In fact, the pressures for manipulation can be intense. Say, for instance, that you started a software company. It sells software along with maintenanceand-upgrade contracts extending over a period of five years. So it always had to make a judgment about when to recognize revenue from a sale.
Now suppose your company did well and grew fast. Potential acquirers came shopping, and you sold the business to a large corporation, one that makes earnings predictions to Wall Street. The folks in the corporate office, like the folks in just about every publicly traded company, want to keep Wall Street happy. This quarter, alas, it looks as if the parent corporation is going to miss its earnings-per-share estimate by one penny. If it does, Wall Street will not be happy. And when Wall Street isn’t happy, the company’s stock gets hammered.
Aha! (You can hear the folks in the corporate office thinking.) Here is this new software division. Suppose we change how its revenue is recognized? Suppose we recognize 75 percent up front instead of 50 percent? The logic might be that a sale in this business takes a lot of initial work, so the accounting should reflect the cost and effort of making the sale as well as the cost of providing the product and delivering the service. Make the change—recognize the extra revenue—and suddenly earnings per share are nudged upward and now meet Wall Street’s expectations.
In a publicly traded company, earnings per share (EPS) is a company’s net profit divided by the number of shares outstanding. It’s one of the numbers that Wall Street watches most closely. Wall Street has expectations for many companies’ EPS, and if the expectations aren’t met, the share price is likely to drop.
Interestingly, such a change is not illegal. An explanation might appear in a footnote to the financial statements, but then again it might not. Here is an example of a footnote explaining a change in how short-term investments are classified from IMAX Corporation’s 2006 Form 10-K:
The Company has short-term investments which have maturities of more than three months and less than one year from the date of purchase. During November 2006, the Company changed the classification of these short-term investments from “held to maturity” to “available for sale” because the Company sold an investment (with a carrying value of $6.4 million) before its maturity date in order to meet its cash requirements at the time. The realized gain resulting from that sale was $0.02 million. As a consequence, the Company’s short-term investments are accounted for at fair market value. Prior to November 2006, short-term investments were held at amortized cost and were classified as held to maturity based on the Company’s positive intent and ability to hold the securities to maturity.1
In principle, any accounting change that is material to the bottom line should be footnoted in this manner. But who decides what is material and what isn’t? You guessed it: the accountants. In fact, it could very well be that recognizing 75 percent up front presents a more accurate picture of your software company’s reality. But was the change in accounting method a result of good financial analysis, or did it reflect the need to make the earnings forecast? Could there be a bias lurking in there? Remember, accounting is the art of using limited data to come as close as possible to an accurate description of how well a company is performing. Revenue on the income statement is an estimate, a best guess. This example shows how estimates can introduce bias.
It isn’t just business owners who have to be careful about bias; such decisions can directly affect your managers as well. Say you run a temporary staffing company with a couple of dozen full-time employees, many of them sales reps. Your sales manager focuses on the revenue numbers every month. She manages her people based on those numbers. She talks with them about their performance. Maybe she makes decisions about hiring and firing, and hands out rewards and recognition, all according to the numbers. Now you and your accountant decide to recognize revenue sooner, perhaps on the grounds that the new way better reflects reality. But did you tell the sales manager? If not, she’s suddenly going to think her staff is doing great! Bonuses for everyone! But the underlying revenue figures might not look so good if they were recognized in the same way as before. If she didn’t know the policy had changed and began passing out bonuses, she’d be paying for no real improvement. Financial intelligence in this case means understanding how the revenue is recognized, analyzing the real variances in the sales figures, and paying bonuses (or not) based on true changes in performance.
Just as an aside, the most common source of accounting fraud has been and probably always will be in that top line: sales. Sunbeam, Cendant, Xerox, and Rite Aid all played with revenue recognition in questionable ways. The issue is particularly acute in the software industry. Many software companies sell their products to resellers, who then sell the products to end users. Manufacturers, often under pressure from Wall Street to make their numbers, are frequently tempted to ship unordered software to these distributors at the end of a quarter. (The practice is known as channel stuffing.) One entrepreneurial company that took the high road in regard to this practice is Macromedia (now a part of Adobe), creators of the Internet Flash player and other products. When channel stuffing was becoming a serious problem in the industry, Macromedia voluntarily reported estimates of inventory held by its distributors, thereby showing that the channels for its products were not artificially loaded up. The message was clear to shareholders and employees alike: Macromedia was not going to be dragged into this practice.
The next time you read about a financial scandal in the paper, check first to see whether somebody was messing around with the revenue numbers. Unfortunately, it is all too common.