“Like it or not, companies are judged by flawed standards,” according to a recent CFA Institute article that outlines several areas where GAAP revenue recognition “can hit a snag and you can find an opportunity.”
The article reports that revenue is recognized when a contract executed between a business and a customer, so in reality it isn’t truly revenue, but rather “contract timing.” It lists the following as items to focus on in the search for alpha (and offers examples of each):
- Multiparty transactions: Net revenue can become distorted when “multiple parties transact before an end customer receives a product.”
- Changes in performance criteria: When performance criteria change, “reported revenue can become an unstable metric.”
- Multiyear contracts: Companies prefer to report strong year-over-year growth for each period, the article says, adding that investors should review the terms of a business’s contracts. Specifically, annual contract value (ACV), which is the amount of business currently under contract for the current year, and total contract value (TCV), which includes contracts and invoices for future years. Both items would offer transparency regarding revenue recognition and a company’s full sales picture. But, since GAAP effectively hides this information, the article notes that public investors might be overweighting reported revenue—which could provide an opportunity for the savvy investor.
- Cash conversion cycle (CCC) is intended to track working capital efficiency by measuring how long each dollar is invested in the production and sales process and is described as “a mini return on equity.” But GAAP accounting practices lead to two flaws: (1) It is currently calculated in days, but should be measured over a year-long period; and (2) It includes accounts receivable, accounts payable and inventory, but excludes deferred revenue (cash collected in advance from customers). Therefore, investors might misvalue highly cash-efficient companies (those that collect cash ahead of contract performance).
- “Free cash flow” is misleading, as it does not always equal the actual cash generated by a business:
The article underscores that “internally-developed intangible assets are the danger area in today’s market. Most investors agree that we should capitalize some portion of R&D and SG&A expenses, but no one is sure how long these intangible assets will last.” It adds, “properly accounting for internally developed intangibles may be the most significant unsolved problem in GAAP” and that investor opportunities can arise when a “major portion of current capex, R&D, or sales spend flips to an amortizable fixed cost.”