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Income Statement Hide and Seek

Posted by Seth Elliott On September - 28 - 2010

Before we finish with our examination of the Income Statement, it’s worth addressing some of the “games” that can be (and have been) played in reporting. Why is this important? At some point, you will likely be comparing your company to others in the industry for the purposes of analysis and valuation. Understanding some of these nuances can prove valuable when discussing your historical and projected Income Statement in regards to other market participants.

Revenue Recognition

As discussed in a previous post,
most companies choose to report financial performance using the accrual (vs. cash) methodology. As such, reported revenues may not reflect payments that were actually received. In order to recognize revenue, GAAP requires that the following criteria are met:

There is clear and persuasive evidence that a commercial arrangement between the parties exist.

The product or service has been delivered or rendered to the purchaser.

The purchase price is either fixed or readily determinable.

Collectability of the purchase price is reasonably assured.

It appears that revenue recognition is relatively straightforward. Essentially, it sets forth that revenue should not be booked until the seller has fully discharged his obligations to the buyer and has received – or is likely to receive – payment for providing goods or services.

Unfortunately, the last point – collectability – is not always so clear. Throughout the mid to late ‘90’s, a series of accounting scandals came to light around this issue. Without delving into too much detail, you can probably conceive of several ways to manipulate this part of the system. Suppose, for example, you offer to sell a product to a purchaser and structure the terms so that they do not have to pay you for several years and they can readily return the product during that time frame. Is collectability reasonably assured now? Or imagine that you have long-term payment structures (several years) and your customer base is primarily early-stage, small companies. Is there any reasonable assurance that those customers will be around when the time comes to collect?

As you can see, there are some aggressive positions that can be taken in regards to revenue recognition. In many cases, you can identify these issues when comparing against the balance sheet (which we will note in future posts in this series). The key is to be able to question and evaluate the revenue recognition policies of your company vs. your competitors.

Inventory and Cost of Goods

Decisions about assessing the value of inventory have a significant impact on the income statement. Although we will examine this concept in our review of the Balance Sheet in future posts, it’s important to gain a base understanding when evaluating cost of goods (and thus gross margin).

Briefly, there are two primary methods of accounting for inventory: “first in, first out” (known as FIFO) and “last in, first out” (known as LIFO).

Using FIFO, you calculate your cost of goods (including raw materials) based on the oldest inventory you are holding.

Using LIFO, you calculate your cost of goods (including raw materials) based on the newest inventory you are holding.

Let’s use a quick example to make this clear.

Assume your company sells carved marble blocks – which you purchase in finished form from a manufacturer. Now, let’s presume that you have paid the following amounts (we will simplify and pretend you purchase only 1 block each month):

June -$12 / July – $15 / August – $20 / September – $25

Now let’s say that in October, you sell 3 blocks for $30 each. You book your $90 of revenue. What cost of goods should be used in your Income Statement?

If you use FIFO, your cost of goods is $47 ($12 + $15 + $20) – making your gross margin $43.

If you use LIFO, your cost of goods is $60 ($15 +$20 +$25) – making your gross margin only $30.

At first glance, this may not seem particularly relevant. However, now imagine this situation multiplied by thousands (if not tens of thousands) of unit sales. If you extrapolate this same example over the course of 100,000 units – it means a difference in gross margin of $1.3 million!

As you can see, the choices made in regards to inventory recognition can substantively affect the bottom line. Once again, the key as an entrepreneur is to understand these basic nuances and be prepared to examine them. When comparing your company to industry participants, be sure to review the inventory recognition policies and be prepared to describe the differences.

In the next post in this series, we will move on and begin our examination of the Balance Sheet.

You may wish to review other posts in this series, including:

Corporate Finance and the Entrepreneur

Leaping the GAAP

The Entrepreneur and the Income Statement

My EBITDA is Bigger Than Yours.

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About the Author

I have spent the last 15 years advising entrepreneurs on starting and growing their businesses, as well as assisting in financing those growth efforts. I have also been an entrepreneur on several occasions myself. By writing this blog, I hope to provide actionable advice on how to achieve your goals and become more successful.