From Joshua Kennon,
Your Guide to Investing for Beginners.

Five Methods Management Can Use to Smooth Earnings

You learned in one of the investing lessons that the accrual concept – matching revenues with expenses – was the cornerstone of accounting. Only by comparing cash with the cost of generating it can the investor develop an understanding of the profitability of a business. Yet, within Generally Accepted Accounting Principles (GAAP), there are multiple ways to recognize revenue. Depending upon which method is chosen, the financial statements may look drastically different even though economic reality is the same.

Two Tests for Revenue Recognition

For revenue to be recognized, there are two key conditions that must be met according to SFAC 5, Recognition and Measurement in Financial Statements of Business Enterprises. They are: 1.

Completion of the earnings process Under this test, the seller must have no significant remaining obligation to the customer. If an order for five hundred football helmets has been placed and only two hundred delivered, the transaction is not complete. Likewise, if the seller is the manufacturer of appliances and promises extensive warranty coverage, it should not book the sale as revenue unless the cost of providing that service (i.e., warranty repair labor and parts) can be reasonably estimated. Additionally, a company that sells a product with an unconditional return policy cannot book the sale until the window has expired (e.g., a company that promises unrestricted returns for cash until ninety days after the sale should not record the revenue until that period has elapsed.) 2.

Assurance of payment In order to book revenue, the selling company must be able to reasonably estimate the probability that it will be paid for the order.

Revenue Recognition Method 1: Sales Basis

This is the method that probably makes the most sense to investors. Under the sales basis method, revenue is recognized at the time of sale (defined as the moment when the

title of the goods or services is transferred to the buyer.) The sale can be for cash or credit (i.e., accounts receivable.) This means that revenue is not recognized even if cash is received before the transaction is complete. A magazine publisher, for example, that receives $120 a year for an annual subscription, will only recognize $10 of revenue every month. The reason is simple: if they went out of business, they would have to return a pro-rated portion of the annual subscription price to the customer since it had not yet delivered the merchandise for which it had been paid.

Revenue Recognition Method 2: Percentage of Completion

Companies that build bridges or aircraft take years to deliver the product to the customer. In this case, the company responsible for building the product wants to be able to show its shareholders that it is generating revenue and profits even though the project itself is not yet complete. As a result, it will use the percentage of completion method for revenue recognition if two conditions are met: 1.) there is a long-term legally enforceable contract and 2.) it is possible to estimate the percentage of the project complete, revenues and costs.

Under this method, there are two ways revenue recognition can occur: 1.

Using milestones such as number of railway track complete A construction company is paid $100,000 to build fifty miles of highway. For every mile the company completes, it is going to recognize $2,000 in revenue on its income statement ($100,000 / 50 miles = $2,000 per mile.) 2.

Cost incurred to estimated total cost Using this metric, the construction company would approach revenue recognition by comparing the cost incurred to-date by the estimated total cost. For example: The business expects the same $100,000 of highway to cost it $80,000 in parts, material, labor, etc. At the end of the first month, it has spent $5,000 working on the project. $5,000 is 6.25% of $80,000; therefore, it would multiply the total revenue ($100,000) by the percentage of the cost incurred (6.25%), or $6,250, and recognize this amount as revenue on its income statement.

One caveat: if you find yourself reading through the 10K of a company that is utilizing the percentage of completion revenue recognition method, you may want to watch out for premature booking of expenses such as the purchase of raw goods. Until the goods have actually been used in the production cycle (e.g., pouring the actual concrete on the job site, not purchasing the concrete at Home Depot), the cost should not be counted. A business that does not make this distinction is prone to overstate revenue, gross profit, and net income for the period as a result.

Revenue Recognition Method 3: Cost Recoverability Method

The most conservative revenue recognition method of all, the cost recoverability approach is used when a company cannot reasonably estimate the total expense required to complete a project. The result is that no profit is recognized at all until all of the expenses incurred to complete the project have been recouped. Examples would include the development of internal software and certain types of land.

Assume a law firm developed its own software at a total cost of one million dollars. Several years later, the partners decide to start licensing the software to other firms. In the first quarter, they have total sales of $250,000. Under the cost recoverability method of revenue recognition, however, all of this would serve as an offset to the original $1 million in development expense.

Nothing would appear in the income statement as revenue until the entire original balance of $1 million had been wiped out.

Revenue Recognition Method 4: Installment

When the actual collection of cash is suspect, a company should use the installment method of revenue recognition. This is primarily used in some real estate transactions where the sale may be agreed upon but the cash collection is subject to the risk of the buyer's financing falling through. As a result, gross profit is only calculated in proportion to cash received.

For example, assume a developer spent $500,000 improving an apartment. He sold the property for $750,000 but the buyer is going to pay in two installments – one on January 1st and one on July 31st. On the first payment due date, the developer receives a check for half of what he is owed, or $375,000. His income statement is now going to reflect fifty-percent of the revenue and gross profit earned since he has collected fifty-percent of the cash (i.e., $375,000 revenue, $125,000 gross profit ($250,000 total gross profit [$750K selling price - $500K cost = $250K] x 50% = $125,000.) (Realize the actual rules governing accounting for real estate sales are more complex; this example is for simplicity sake only to illustrate the concept of the installment method.)

Ways Management Can Manipulate the Income Statement Using Revenue Recognition

As you can see, management can, with only a change of revenue recognition accounting, drastically alter the appearance of the income statement, over or understating revenue and profit. The exact same contract using the percentage-of-completion method for revenue recognition instead of the completed contract method will result in higher assets, higher stockholder equity, lower liabilities, and a lower debt-to-equity ratio. The income statement will show much smoother earnings over a several year period despite the fact that the economic substance and health of the business would be exactly the same. This is where the investor must dig in and compare the revenue recognition of two companies in the same industry to truly get an idea of who is performing better. The irony is that, with certain exceptions, a business that uses the completed contract method is going to report no income in the first years of the contract, meaning no taxes will be paid. The result is that the shareholders of this business are going to be told they are earning less but their wealth is going to be greater because there is capital being used in the business tax-deferred; a phenomenon very similar to the use of LIFO for inventory valuation.