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Subject 4. Evaluate the Earnings Quality of a Company PDF Download
Revenue Recognition

Revenue has a big impact on bottom-line profitability and managers may be tempted to manage revenue. There are three major types of revenue recognition issues:

Revenue Mis-Statement

A firm may over- or under-state revenue for a given period.

  • The allowance method is required to account for bad debts of credit sales. Companies may use different methods to estimate bad debts and there is considerable discretion in this process.
  • What if a project's completion spans several periods? The difficulty lies in measuring the percentage of completing.

Analysts should focus on the balance sheet accounts associated with revenue: accounts receivable and unearned revenue. Large variations in these accounts are warnings signs.

Accelerating Revenue

A firm may record revenue before it has completed all the terms of the contract. Analysts should watch for any sudden increases in receivables versus cash collected.

Under bill and hold accounting, a customer agrees to a future purchase and future payment. The product remains with the seller until the agreed-upon date, and the obligation to pay is deferred until shipment. The seller continues to hold the product in inventory, but it records the sale even though the customer will not receive the product until a later period.

Revenue Classification

Nonrecurring or nonoperating revenue may be classified as operating revenue by management. Whenever a company has one-time income, GAAP requires that it be separated from income that stemmed from ordinary continuing operations. Analysts should be particularly alert when nonoperating gains are included in sales revenue or in operating income - either as sales revenue or as a reduction of an operating expense.

Expense Recognition

This is the other chief area of earnings discretion.

How to depreciate fixed-assets? There are many estimates to be made here: the depreciation method, the residual value, depreciable life, etc. A slow depreciation or amortization keeps assets on the balance sheet longer, resulting in a higher net worth. With slow amortization, expenses are lower and profits higher.

The choice of inventory system affects earnings as well. LIFO or FIFO? Any inventory build-up or liquidation? A good indicator is the number of days of inventory: net inventory / COGS x 360.

Deferring Expenses: Capitalization versus Expensing

Management have considerable discretion in making decisions such as whether to capitalize or expense the cost of an asset, whether to include interest costs incurred during construction in the capitalized cost, and what types of costs to capitalize for intangible assets. The costs that are most often improperly amortized are marketing and solicitation costs, landfill and interest costs, software development costs, store pre-opening costs, and repair and maintenance costs.

One common operating cost that sometimes finds it way to the balance sheet is the cost of software that is either purchased or developed in-house. Early-stage research and development costs for software would typically be expensed. Later-stage costs (those incurred once a project reaches "technological feasibility") typically would be capitalized. Analysts should be alert for companies that capitalize a disproportionately large amount of their software costs or companies that change their accounting policies and begin to capitalize costs.

User Contributed Comments 2

User Comment
giroth Isn't A true? "All investors are risk averse" sounds the same as "All investors have the same tolerance for risk (risk aversion)?
alai2008 No, risk averse means that investors will demand more return for more risky assets ( some inverstors will positionate in low risk investments thus demanding lower returns, and some in higher risk investments thus demanding more return). If investor have the same tolerance for risk they would be positionated in the same point.
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Craig Baugh

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