BRB Bottomline: Are accounting regulations strict enough to avoid managers’ misconduct? And how can executives better meet stakeholders’ expectations? Here, we admonish our readers about how companies can manipulate revenues and current ratios by recognizing revenues before customers are even billed.
Many, if not most companies, record accounts receivables, accounts payables, inventories and so on honestly following the original mandate of accounting standards to accurately measure and report financial information to external users. Yet, not all companies are operating with good intention. There is a difference between managing and manipulating financial statements. The difference lies in intent, which we often don’t know.
Accounting terminologies and standards are different throughout the world. In the U.S., we use Generally-Accepted Accounting Principles (GAAP, pronounced /GAP/); but, in most countries elsewhere, companies that prepare publicly-available financial statements use International Financial Reporting Standards (IFRS). If you’re interested, take a look of the differences between the two methods. Despite different standards, the fundamental ways in which companies have misled and continue to mislead investors remain the same.
Beware of Unbilled Revenues
Unbilled revenues occur when revenues are recorded before billing the customer. You don’t have to be a CPA (Certified Public Accountant) to know that this procedure is aggressive accounting. In the balance sheet, unbilled revenues are included in accounts receivables because, when revenues are recorded on credit, accounts receivables increase. For clarification, we’re not talking about the more-common unearned revenues, which are recorded as liabilities because of an increase in cash for payments of future services. So, why are companies allowed to recognize unbilled revenues in the first place? Some business models strongly rely on this kind of accounting mechanism. For example the service industries (Saas companies, education sector, etc.) account for a large number of unbilled revenues transactions; quite often these services are provided over a week, month, or even year, but are not billed until the job is complete. Let’s say you run a power plant, and the contract you have with the households to whom you provide power is that you’ll bill them for utilities every six months. However, every day you supply them with electricity, and, at the end of the first quarter, you know you’ve provided services worth $100. The utility company, despite never billing the customer, records $100 in revenues and $100 in accounts receivables. The $100 recorded in accounts receivables are our unbilled revenues.
Recording standards accept the use of the item in question if on the day of closing the books there is no obligation on the customer to pay that amount but there exists a reasonable certainty that the customer will be billed, and such future invoice will be paid in the due course of time under the normal business cycle.
The point should be clear by now. “Reasonable certainty” is definitely subjective. Based on its business model, a company can declare to have “reasonable certainty” to collect given receivables.
If management follows certain patterns of deceit, we are forced to be wary. Here are a few recent examples about why a dose of skepticism and cynicism would have benefit investors.
Examples and implications
Some companies present their statements with an enormous percentage of accounts receivable as unbilled revenues. For instance, Fluent Inc. (NASDAQ:FLNT), a firm operating in the advertisement industry, reported in Q2-2018 (here’s the 10-Q) unbilled revenues as high as 51% of accounts receivable.
This is dangerous for two reasons. First, by recording a high quantity of unbilled revenues, the asset side of the balance sheet becomes overstated, which inflates the current ratio (computed as current assets/current liabilities). The current ratio is a common metric that lenders and credit agencies use to measure solvency; managers can therefore be attracted by raising their current ratios in the last juncture of the accounting period in order to meet creditors’ expectations and eventually have more bargaining power in case of a debt restructuring negotiation. However, if the above discussed reasonable certainty turns out not to be so reasonable, firms’ solvency can come into question. Lehman Brothers, a bank that went bankrupt during the financial crisis, was notorious for window-dressing their financial statements right before the quarter-end to make investors think the bank was more solvent than it actually was.
Secondly, and more intuitively, if lots of unbilled revenues are recorded, revenues themselves become overstated and so do retained earnings. This can be a sneaky way to meet investors’ expectations about revenue and earnings growth, as well as creditors’ expectations about solvency; however, it exposes investors to a risk which is not easy to assess.
Take Home Points
If firms honestly benefit from the recording of unbilled revenues, solvency and liquidity won’t probably be an issue. Conversely, if managers operate in bad faith, companies can incur in serious liquidity problems. Since cash cannot be fudged, the statement of cash flows will paint a completely different situation from the one depicted by balance sheet and income statement. Always check the operating cash flow, and be able to evaluate whether the company is generating cash or not. Companies can add and move assets around, but they can’t create cash out of thin air.
