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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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