Philipvan Doorn

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A huge new set of rules on revenue recognition from the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board, which was 12 years in the making, made a thump when it was released last week. The complexity, to put it lightly, was overwhelming.

The rules. which will be implemented in 2017, set a uniform standard of revenue recognition that all companies — from utilities to banks — must follow. They will make life easier for chief financial officers and analysts, who will be able to compare revenue trends across industries. But investors still need to take companies’ revenue with a grain of salt, at least until they dig deeper into financial statements to gain a more detailed understanding.

You need to know one thing that isn’t in the new rules: Investors must focus on cash flow when considering buying a stock and reviewing performance. Cash flow is simply the net amount of cash moving into or out of a business within a given time period. Operating cash flow is cash generated by a business’ normal operations. Cash flow is important for investors, since a company can show a profit while its cash dwindles because of debt payments or slowing collections from customers meant to pump up sales.

You may see the term “free cash flow” being used because it measures how much cash flow remains after capital expenditures. This is important for investors relying on dividends, since it shows how much room a company has to raise them, as we recently discussed in five dividend stocks that offset inflation in retirement. A company may also decide to direct free cash flow toward organic expansion or an acquisition.

Aggressive revenue recognition

Here’s an outline of a major problem that’s not addressed in the new rules, from “What’s Behind the Numbers ,” by John Del Vecchio and Tom Jacobs.

“Revenue is ‘realized’ when goods, services, merchandise, or other assets are exchanged for cash or claims on cash. There is a large difference between a dollar deposited in the company checking account and having a claim on one.”

That is why investors need to look at statements of cash flow, in addition to income statements and balance sheets. Investors also must read the footnotes to quarterly and annual filings to gain a better understanding of the “quality” of a company’s revenue growth.

For example, a company could report solid revenue growth, while showing accounts receivables growing at a faster pace. That may not be a problem over a relatively short period, but it cannot go on forever. Eventually something will blow up.

One way to measure the trend, as described by Del Vecchio and Jacobs, is to calculate a company’s days sales outstanding (DSO). This can be done by dividing accounts receivable by quarterly revenue, and multiplying the result by 91.25. You can then compare DSO quarter-over-quarter, as well as year-over-year, “to account for business seasonality.”

“Changes can come from economic slowdowns, poor collection, and so on, but the practice we want to catch is a change in payment terms that borrows revenue from the future to make this quarter look better than it is,” Del Vecchio and Jacobs wrote.

One goal of the authors is to identify stocks to sell short, or betting on a decline in the share price. Shorting stocks is among the riskiest strategies because if a stock price rises, you can lose everything. But learning what short investors look for can help you avoid losing money by selling a stock or not buying it in the first place.

An example of a recent short position for Del Vecchio’s AdvisorShares Ranger Equity Bear ETF HDGE, +0.80%  is 3D Systems Corp. DDD, -2.19% which Del Vecchio said in an article on 247wallst.com had shown DSO rising “eight days year-over-year to the highest level in years,” with “50% of the organic revenue growth … due to building inventory in the sales channel.”

Del Vecchio, in a phone interview, said 3D Systems remains his “favorite short idea.”

“It is our opinion their revenue recognition policy has gotten more aggressive and that they are pushing a lot of product into the channel,” he said.

3D Systems Corp. is headquartered in Rock Hill, S.C. and makes 3D-printing equipment to help manufacturers in various industries using a variety of materials. The stock has plummeted 46% this year, following a 161% gain during 2013. The shares trade for 42.2 times the consensus 2015 EPS estimate of $1.20 and 38.9 times the consensus 2015 cash flow estimate of $1.30 a share.

Despite the sharp drop this year, many short investors haven’t covered their positions yet, as they see greater downside opportunity. According to FactSet, 34% of 3D Systems shares available for trading are currently sold short.

“We take 500 large-cap stocks and score them based on the quality of their earnings sustainability of financial results,” Del Vecchio said. The ones that raise fed flags are shorted by the Ranger Bear ETF. For investors looking to avoid the higher volatility of a short-only ETF, Del Vecchio also runs the Forensic Accounting ETF FLAG, -0.83% which takes long positions in all the screened large-cap stocks not shorted by the Ranger Equity Bear ETF. Neither ETF is leveraged or uses derivatives, according to Del Vecchio.

When discussing the new FASB revenue-recognition guidelines, Del Vecchio said: “Merging standards is a positive, allowing for comparison across regions and sectors, so theoretically that’s good.”

Then again, he expects the hyper-focus on quarterly results to continue, “which may not be good” for a company.

Disclosure

“There is a need for greater disclosure than what was put in [the new revenue reporting standards] because there are a lot of subjective estimates included in these new principles,” Sandy Peters, who heads the Financial Reporting Policy Group at the CFA Institute, said in a phone interview.

According to Peters, for the 30 stocks included in the Dow Jones Industrial Average, there has been “amazingly little disclosure for such an important number.” The new rules include many new disclosure requirements, but Peters says there’s a need for investors and analysts “to ask questions about the underlying assumptions used when recognizing revenue.”

“This standard might change the pattern of revenue recognition, but ultimately investors need to concern themselves with what cash is collected,” Peters added.

Homework for investors includes reviewing earnings releases, the much more detailed quarterly 10-Q filings and annual 10-K filings and, if possible, listening to earnings calls or reviewing transcripts to see how management answers detailed questions and revenue recognition.