We discussed financial statements and the importance of financial statement analysis in our previous articles. We will follow those discussions with a more detailed look at each statement. Public financial statements are governed by accounting standards, usually under IFRS or US GAAP, and audited by an external firm for fairness. However, there is still room for subjectivity and judgement in the standards, and management can leverage these to influence investors and therefore their stock price. To deeper understand financial statement analysis, we must know what is subjective, how it would affect ratios and what the incentives are for management to affect these ratios. We will start with the income statement.
The income statement is useful for measuring profitability, with ratios such as gross profit margin and net profit margin. The income statement can also be used with the balance sheet to measure efficiency, with ratios like asset turnover and inventory turnover. Perhaps most importantly, the income statement is used to value companies, with the PE and EV/EBITDA ratios. It is clear that any changes to the top line can have a profound impact on investor expectations, and why management may have an incentive to be either aggressive or conservative on their estimates.
Revenue recognition, like most items on the financial statements, requires judgement. The general rules for revenue recognition are (1) it is probable that future economic benefits will flow to the company and (2) it can be reliably measured. Further guidance is provided for specific streams of revenue, namely from sales of goods, sales of services and non-sales revenue (interest, royalty and dividends).
Sales of Goods
- Transferred significant risks and rewards from owner to buyer
- Retains no involvement and control over goods sold
- Revenue can be reliably measured
- Probable that economic benefits will flow to entity
- Costs can be reliably measured
Sales of Services
- Stage of completion of the transaction can be reliably measured
- Revenue can be reliably measured
- Costs can be reliably measured
- Use the effective interest method
- Accrual basis according to the substance
- Shareholders right to receive payments is established
As you can see, there is significant ambiguity throughout the guidelines (eg. where to draw the line between insignificant and significant risk?). For example, if you are Netflix and you sold a membership contract, should you immediately recognize the revenue? Perhaps Netflix should account for it as unearned revenue, a liability that would transfer to revenue (through retained earnings in equity) every month as service is rendered to fulfill the contract. However, what if the contract stipulates that the sale is final and there would be no refunds given, even if you no longer want the service? Or it could be the opposite – the refund policy is loose, and 50% of the customers break their contract in a month, upon which Netflix refunds all the money back to the customer. Collectibility, contingencies and return policies complicates revenue recognition and management reserves the right to make estimates for these factors.
There are some guidelines for common situations.
- If customers have a right to return, it would be inappropriate to recognize revenue right away. This is becoming more common with e-commerce businesses, where customers could have up to 100-days to return their goods. Amazon, for example, recognizes revenue net of return allowances ($62 million is 2017, with $178 billion in net sales). These return allowances may or may not be significant, but differences in how they are estimated and recognized should be accounted for in financial statement analysis.
- In consignment sale, like in an auction house, the consignor would retain ownership until the product is sold. For e-commerce platforms such as Amazon or Overstock, there is flexibility on whether to report their revenue as gross (how much they sell the goods for) or net (how much they receive in commission). Typically, third party sales are reported as net, but there is judgement involved. When comparing financial performance for different e-commerce companies, it is important to understand how they recognize these sales, as different methods has different impact on margins, revenue and other metrics.
- If a customer buys a product or service prior to delivery, the sale should be recorded on the balance sheet as unearned revenue (or deferred revenue). This is becoming more and more common with the proliferation of subscription-based businesses (Amazon, Netflix, Spotify, WSJ). Anytime when a subscription-based service records revenue right away, it could be interpreted as aggressive revenue recognition, and needs to be adjusted.
- When a sale has multiple components, such selling a computer with Windows 10 already installed, the price will be allocated to each of the components at their fair value. Each component should then be accounted for with the appropriate method. For example, the computer could be recorded as revenue in the period of the sale, but depending on the terms, the software may be allocated over several years.
From these examples, you can see that unadjusted revenue figures may not be the best indicator for performance. If a company is primarily a provider of subscription-based service, you won’t see the uptick in revenue from new customers until the next period. Context and an understanding of the underlying business is important for financial statement analysis.
For long-term projects, revenue should be recognized in the same period costs associated are recognized, as per matching principle. This is known as the percentage of completion method, a relatively more aggressive revenue recognition method. A common example is construction of a building, where the project usually takes place over a couple of years. If 50% of the costs are incurred in the first year, then 50% of the revenue should also be recognized in the first year. However, this works only under the assumption that there is a contract with the customer for a specific price, and that the cost estimates are reasonably reliable. If the total costs are underestimated, the revenue would be over estimated, and you would have better financial performance this period.
If the two conditions for percentage of completion method does not hold, then the cost recovery method should be used. The cost recovery method is very conservative, as it recognizes the same amount of revenue as the costs incurred in that period. No gross profit is recognized until the total cost is fully recovered.