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companies admitting they have reported "irregular" revenues. This kind of


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dishonesty is a critical accounting issue. In several high-profile cases, management
misled investors--and its own auditors--by deliberately reporting inflated revenues in
order to buoy its company's stock price. As of June 2004, the Financial Accounting
Standards Board (FASB) has begun working to consolidate and streamline the
various accounting rules into a single authoritative pronouncement.

But this series is not concerned with detecting fraud: there are several books that
catalog fraudulent accounting practices and the high-profile corporate meltdowns
that have resulted from them. The problem is that most of these scams went
undetected, even by professional investors, until it was too late. In practice,
individual investors can rarely detect bogus revenue schemes; to a large extent, we
must trust the financial statements as they are reported. However, when it comes to
revenue recognition, there are a few things we can do.

1. Identify Risky Revenues
If only cash counted, revenue reporting would not pose any risk of misleading
investors. But the accrual concept allows companies to book revenue before
receiving cash. Basically, two conditions must be met: (1) the critical earnings event
must be completed (for example, service must be provided or product delivered) and
(2) the payment must be measurable in its amount, agreed upon with the buyer, and
its ultimate receipt must be reasonably assured (SFAC 5, SEC Bulletin 101).

For some companies, recording revenue is simple; but for others, the application of
the above standards allows for--and even requires--the discretion of management.
The first thing an investor can do is identify whether the company poses a high
degree of accounting risk due to this discretion. Certain companies are less likely to
suffer revenue restatements simply because they operate with more basic,
transparent business models. (We could call these "simple revenue" companies.)
Below, we list four aspects of a company and outline the degree of accounting risk
associated with each aspect:




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Many of the companies that have restated their revenues sold products or services in
some combination of the modes listed above under "difficult revenues." In other
words, the sales of these companies tended to involve long-term service contracts
(making it difficult to determine how much revenue should be counted in the current
period when the service is not yet fully performed), complex franchise arrangements,
pre-sold memberships or subscriptions, and/or the bundling of multiple products
and/or services.

We're not suggesting that you should avoid these companies--to do so would be
almost impossible! Rather, the idea is to identify the business model, and if you
determine that any risky factors are present, then you should scrutinize the revenue
recognition policies carefully.

For example, Robert Mondavi (ticker: MOND) sells most of its wines in the U.S. to
distributors under terms called 'FOB Shipping Point'. This means that, once the wines
are shipped, the buyers assume most of the risk, which means they generally cannot
return the product. Mondavi collects simple revenue: it owns its product and gets
paid fairly quickly after delivery, and the product is not subject to overly complex
bundling arrangements. Therefore, when it comes to trusting the reported revenues
"as reported," a company such as Robert Mondavi poses low risk. If you were
analyzing Mondavi, you could spend your time focusing on other aspects of its
financial statements.

On the other hand, enterprise software companies such as Oracle or PeopleSoft
naturally pose above-average accounting risk. Their products are often bundled with
intangible services that are tied to long-term contracts and sold through third-party


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resellers. Even the most honest companies in this business cannot avoid making
revenue-reporting judgments and must therefore be scrutinized.

2. Check against Cash Collected
The second thing you can do is to check reported revenues against the actual cash
received from customers. In the section on cash flow, we see that companies can
show cash from operations (CFO) in either the direct or indirect format;
unfortunately, almost all companies use the indirect method. A rare exception is
Collins Industries:




The virtue of the direct method is that it displays a separate line for "cash received
from customers." Such a line is not shown under the indirect method, but we only
need three items to calculate the cash received from customers:

(1) Net sales
(2) Plus the decrease in accounts receivable (or minus the increase)
(3) Plus the increase in cash advances from customers
(or minus the decrease)
____________________________________________________________
= Cash received from customers

We add the decrease in accounts receivable because it signifies cash received to pay
down receivables. 'Cash advances from customers' represents cash received for
services not yet rendered; this is also known as unearned or deferred revenue and is
classified as a current liability on the balance sheet. Below, we do this calculation for
Collins Industries. You can see that our calculated number (shown under "How to
Calculate 'Cash Received from Customers'") equals the reported cash collected from
customers (circled in green above):




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We calculate 'cash received from customers' to compare the growth in cash received
to the growth in reported revenues. If the growth in reported revenues jumps far
ahead of cash received, we need to ask why. For example, a company may induce
revenue growth by offering favorable financing terms--like the ads you often see for
consumer electronics that offer "0% financing for 18 months." A new promotion such
as this will create booked revenue in the current period, but cash won't be collected
until future periods. And of course, some of the customers will default, and their cash
won't be collected. So, the initial revenue growth may or may not be "good" growth-
-in which case, we should pay careful attention to the 'allowance for doubtful
accounts'.

Allowance for Doubtful Accounts
Of course, many sales are offered with credit terms: the product is sold and an
accounts receivable is created. Because the product has been delivered (or service
has been rendered) and payment is agreed upon, known, and reasonably assured,
the seller can book revenue.

However, the company must estimate how much of the receivables will not be
collected. For example, it may book $100 in gross receivables but, because the sales
were on credit, the company might estimate that $7 will ultimately not be collected.
Therefore, a $7 allowance is created and only $93 is booked as revenue. Hopefully,
you can see that a company can report higher revenues by lowering this allowance.

Therefore, it is important to check that sufficient allowances are made. If the
company is growing rapidly and funding this growth with greater accounts
receivables, then the allowance for doubtful accounts should be growing too.


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3. Parse Organic Growth from Other Revenue Sources
The third thing investors can do is scrutinize the sources of revenues. This involves
identifying and then parsing different sources of growth. The goal is to identify the
sources of temporary growth and separate them from organic, sustainable growth.

Let's consider the two dimensions of revenue sources. The first dimension is cash
versus accrual: we call this "cash" versus "maybe cash" (represented on the left side
of the box below). "Maybe cash" refers to any booked revenue that is not collected
as cash in the current period. The second dimension is sustainable versus temporary
revenue (represented on the top row of the box below):




To illustrate the parsing of revenues, we will use the latest annual report from Office
Depot (ticker: ODP), a global retail supplier of office products and services. For fiscal
2003, reported sales of $12.358 billion represented an 8.8% increase over the prior
year.




First, we will parse the accrual (the "maybe cash") from the cash. We can do this by
looking at the receivables. You will see that, from 2002 to 2003, receivables jumped


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from $777.632 million to $1.112 billion. And the allowance for doubtful accounts
increased from $29.149 million in 2002 to $34.173 million in 2003.




Office Depot's receivables jumped more than its allowance. If we divide the
allowance into the receivables (see bottom of exhibit above), you see that the
allowance (as a percentage of receivables) decreased from 3.8% to 3.1%. Perhaps
this is reasonable, but the decrease helped to increase the booked revenues.
Furthermore, we can perform the calculation reviewed above (in #2) to determine
the cash received from customers:




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Cash received did not increase as much as reported sales. This is not a bad thing by
itself. It just means that we should take a closer look to determine whether we have
a quality issue (upper left-hand quadrant of the box above) or a timing issue (upper
right-hand quadrant of the box). A quality issue is a "red flag" and refers to the
upper left-hand quadrant: temporary accruals. We want to look for any one-time
revenue gains that are not cash.

When we read Office Depot's footnotes, we will not find any glaring red flags,
although we will see that same store sales (sales at stores open for at least a year)
actually decreased in the United States. The difference between cash and accrual
appears to be largely due to timing. Office Depot did appear to factor some of its
receivables--that is, sell receivables to a third party in exchange for cash, but
factoring by itself is not a red flag. In Office Depot's case, the company converted
receivables to cash and transferred some (or most) of the credit risk to a third party.
Factoring affects cash flows (and we need to be careful with it, to the extent that it
boosts cash from operations) but, in terms of revenue, factoring should raise a red
flag only when (i) the company retains the entire risk of collections, and/or (ii) the
company factors with an affiliated party that is not at arm's length.

Cash-Based but Temporary Revenue
When it comes to analyzing the sources of sustainable revenues, it helps to parse the
"technical" factors (lower left-hand quadrant). These are often strangely neglected
by investors.

The first technical factor is acquisitions. Take a look at this excerpt from a footnote in
Office Depot's annual report:

¦impacting sales in our International Division during 2003 was our acquisition of
Guilbert in June which contributed additional sales of $808.8 million. (Item 7)



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Therefore, almost all of Office Depot's $1 billion in sales growth can be attributed to
an acquisition. Acquisitions are not bad in and of themselves, but they are not
organic growth. Here are some key follow-up questions you should ask about an
acquisition: How much is the acquired company growing? How will it contribute to
the parent company's growth going forward? What was the purchase price? In Office
Depot's case, this acquisition should alert us to the fact that the core business
(before acquisition) is flat or worse.

The second technical factor is revenue gains due to currency translation. Here is
another footnote from Office Depot:

As noted above, sales in local currencies have substantially increased in recent
years. For U.S. reporting, these sales are translated into U.S. dollars at average
exchange rates experienced during the year. International Division sales were

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