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Nagging Questions: What to Ask the CFO

Clearly, the rules governing revenue recognition allow plenty of scope for all sorts of game playing—and whenever regulators or vigilant investors close off one loophole, another opens up. No corporate director, analyst, audit partner or investor can be sure of spotting every game. They can, however, ask questions and listen carefully to the answers for any hint of evasion, euphemism, or an attempt to change the subject. It’s not necessary to know every detail of a game to know that games are being played and to react accordingly, either by selling shares or by contacting the chief financial officer or head of the audit committee and demanding an explanation. Don’t trust your money or your reputation to a company that can’t give a straight, comprehensible answer to one or more of these questions:

  • How is revenue defined? And what event triggers its recognition?

  • Does the company’s revenue-recognition policy present a reasonable measure of the revenue earned by the business during the reporting period? Is it consistent with revenue measures used by domestic and global competitors? And is it clearly described in the financial statement footnotes?

  • If revenue is measured in an unusual or new way, is that disclosed? Changes in methods of measuring revenues require careful scrutiny. Are new revenue streams measured in a manner that reflects the risk and nature of the sales? The footnote on lines of business and the geographic distribution of earnings, assets, and revenues always deserves careful scrutiny by investors.

  • For a new industry or for a business beginning to sell to a different set of customers, a different region of the world, or different industries, what is the appropriate method of measuring revenue? Are the company’s existing methods really sufficient and appropriate? Will the answer be the same if the new customers, regions, or industries become the predominant source of revenue? Would the company’s revenue-recognition policies bear up under front-page scrutiny by the financial press?

  • Where revenue substantially exceeds cash received, are there clear business reasons that explain the divergence? If receivables are growing rapidly, has the company made adequate allowances for nonpayment?

  • Are the individuals who evaluate and report on corporate revenue policies knowledgeable and independent? Are the people responsible for audits of fast-growing divisions and subsidiaries applying the same audit standards required of head-office auditors? Are the qualifications of those auditors sufficient, or are additional procedures needed to ensure the reliability of the financial statements?

  • What would be the impact on net income if alternative revenue-recognition methods were applied? If the results would be substantially different, what are the implications for benchmarking, investor and bond-rating analyses, and executive compensation? Would the conclusions of this analysis suggest adoption of different recognition methods?

  • Are the changes in revenue from quarter to quarter and year to year consistent with management’s expectations and the industry environment? Is revenue growing at a time when the industry is stagnating or even declining? If so, what enables the business to run counter to the industry norm?

That last question is crucial. Don’t trust any corporation that says, in effect, “Trust me,” when asked the source of outsized revenue or profits.

As we have emphasized, for every stream of revenue coming in, there should be a related stream of expenses flowing out. Given that many corporate managers commonly resort to games to pump up revenue or book it sooner, is it likely that they’d also play games to make expenses look smaller than they really are? What do you think? In the next chapter we’ll look at the many creative ways in which dishonest companies may hide their costs.

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