How to Uncover The Income Statement Problem Most Investors Miss
Evaluating the quality of earnings is just as important as the earnings themselves
It seems like the most intuitive thing on earth—when conducting a fundamental assessment of a new company, start with revenue. Novice investors might have an intuitive suspicion that a company’s earnings (the bottom line number on the income statement) should be taken with a grain of salt. After all, there’s a lot of lines between the top and bottom of an income statement and a lot of potential ways the numbers can be played with.
But the top line? Most investors gloss over this one. After all, it’s just the sales reported by the company. What could be wrong with that?
Big mistake.
A company’s revenue is actually the very first thing investors should evaluate when approaching accounting statements. After all, everything else Is derived from this number. And, if you read my recent peice about how investors should approach management teams, you probably know that I advocate for a healthy amount of skepticism when taking in whatever corporate management teams provide the public.
If you’re a relatively new investor or if you haven’t spend time digesting annual reports, don’t be alarmed—you don’t need to be an accounting guru or forensic expert to detect oddities with a company’s revenue.
You just have to know where to look.
How Does A Company Record Revenue?
The first place to look is the most recent annual report. These normally enormous documents can be very intimidating, but a simple control+f search can alleviate a long and potentially frustrating search.
First, go to the annual report’s section on “Revenue Recognition”. This portion of the 10K will detail exactly how the company records revenue.
Check out this snippet from Apple’s most recent 10K:
Note that the above image is only a portion of Apple’s revenue recognition policy, but the paragraph above gives us a good basic illustration—Apple records a portion of its revenues when products are shipped or transfers control over time as services are delivered.
So, in this case Apple recognizes revenue as reportable on its income statement when it ships a product—like an iPhone or other piece of hardware—after a customer orders is. It’s important to note that Apple doesn’t recognize this revenue when a customer places an order. Apple also recognizes revenue as services are delivered over time. This could be for something like its Apple Care product, or other service where customers pay over time or can pre-pay up front for services that can expect to be delivered over a certain period of time.
It’s important for investors to know that there are a lot of ways that companies can record revenue. Is it a cash business where consumers are individuals who pay on the spot, like a grocer or department store? Or are the company’s customers corporations who have payment terms over, say, 30 days or six months? These are all important things to know, for reasons we’ll discuss below.
Now, reading and understand how a company recognizes revenue is good, but it’s important to go one step further and check previous annual reports to see if anything has changed about how the company recognizes revenue. For example, if a company shifts recognition of revenue from a customer receiving a products versus when the company ships a product, it could mean that the company can recognize revenue much faster than before, and thus can inflate its revenue.
Deferred Revenue & Accounts Receivable
So now that you’ve assessed how a company records its revenue, you can start to make sense of Accounts Receivable and Deferred Revenue (sometimes called unearned revenue).
Accounts receivable consists of revenue that a company has not yet received, but has been counted as revenue.
For example, say a company counts its revenue when a customer receives a product, and the customer has fourteen days to pay the company for said product. The company does not need to wait the full fourteen days in order to count the revenue—it can record the pending customer payment as a receivable since the company has gone through the steps of transferring control (I.e., the customer’s receipt of the product). This is a basic tenet of accrual accounting.
This is also different from unearned revenue, which is recorded as a liability on the company’s balance sheet. Unearned or deferred revenue are commitments, billings, or cash accepted in advance for services yet to be rendered.
Now, imagine that some unscrupulous management team realizes that they are going to come in short of expected earnings estimates. Rather than reporting revenue under the stated recognition parameters, this management team calls some big customers and arranges for some extended payment terms (say, 21 or 30 days instead of 14) at the end of the quarter in exchange for the customer agreeing to take delivery of the product or service early. When earnings come around, the company is now able to satisfy Wall Street.
And just like that, the company has posted a successful quarter by pulling forward sales that were going to happen anyway in the next quarter into the current quarter.
This happens a lot more than people think.
And while it may not be easily detected on a granular basis, investors have a tool at their disposal that will allow them to see whether or not companies are aggressively recognizing revenue: Days Sales Outstanding, or DSO.
You see, unless a management team is engaged in outright fraud or deceit, the company will have to report how much cash from sales has yet to be received, I.e., its accounts receivable. If investors notice that the AR balance is ballooning while sales remain flat, this is a good clue that something is off or that the company has changed how it accounts for revenue.
While most charting and investing services provide the DSO metric at the click of a button, investors can calculate it themselves if they like. Here it is:
DSO = (Accounts Receivable / Sales ) x Days In Reported Period
Since public companies report quarterly, the most common number for days in reported period are 90 or 91.
This metric is quite useful for investors in evaluating a business. The calculated number varies by industry as well. If a company’s business is primarily cash paid at the point of sale (think: Amazon, or a grocery store chain), then DSO is likely to be quite low and shouldn’t fluctuate much.
If a company’s customers are primarily corporations, then the metric becomes much more insightful. Moves upward in DSO can indicate a stretching of customer payment terms or a pulling forward of revenue in a potential robbing-Peter-to-pay-Paul situation (with Peter being a future reporting period and Paul being the current).
A rising DSO—even by a few days—can be indicative of a problem and should merit further research.
Additionally, DSO should be viewed over an appropriate length of time? How long is appropriate, you ask? Oh, I’m sure you already know that the “IT DEPENDS” is coming, but in truth, it depends.
Each business is different, each industry is different, et cetera. If one business in the same industry has a wildly different DSO than a competitor, that’s potentially an important piece of information. If over 10 years a company’s DSO has risen steadily, that’s another important piece of information.
Putting it Together
The point of this is to hammer home the idea to investors that the sacrosanct top-line of the P&L should not—I repeat should not—be taken at face value. Like every other line on a company’s various financial statements, it should be investigated and understood.
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Disclaimer: Nothing in this article is investment advice or a solicitation of any kind. Investments come with a risk of loss. Do your own research or consult a financial advisor.