© 2000 John Petroff
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© 2000 John Petroff |
B- Sales recognition and sales adjustments
Normally, an analyst works with sales revenue for one, two or three years. Preferably the sales history should cover at least one complete business cycle. Naturally, the more the better. Looking at one year sales without any opportunity for comparison with other years or with competitors is practically meaningless.
A first common distortion in the numbers comes from inflation. An index of inflation rate usually can provide some relief. One should consult a manual that explains how indexes are built, how they are used and what are their limitations. Essentially, one can either deflate current year figures by dividing them by the index where the base year is the initial year of the data, or inflate prior year figures by dividing them by an index where the current year is the base year. Care must be used that the index used is relevant for the product studied, especially if the product is not a mass consumption item. Aggregate indexes can bring in more distortions than unadjusted data has.
| When hyper inflation adds even greater distortions than a moderate inflation, as it has been the case in Russia in the early and mid 1990's, it is advisable to use a monthly index rather than an annual index because sales volumes and price changes can be uneven throughout the year. As mentioned earlier, indexes are published for adjustment of asset values, no official monthly inflation index for sales had yet been issued by Russian authorities in 1995. One alternative would be to convert sales into dollar amounts, since dollar quotations are on record and they have kept pace with inflation (except during the stabilization phase from July 1995 to August 1998). |
| In Russia, in the late 1990's, most sales figures were generally known to be unreliable. The reasons relate to taxes, secretive attitudes of management and lack of concern for all outsiders, including investors and analysts. As discussed in Chapters 6, tax evasion is rampant. Its most important method is to under-report sales, maybe to the extent of 50% or more. Another reason for under reporting sales (and profits) is not to attract the attention of criminal elements. However, criminal elements often facilitate the under reporting itself with smuggling and counterfeiting. |
See review questions Q-9B.1 through Q-9B.4.
1)- Sales recognition:
Sales for a company using a cash method of accounting is that for which the company has been paid, irrespective of shipment or other considerations. Most companies use an accrual method of accounting in which receipt of cash is not the determinant factor for recording sales as such, i.e. sales recognition.
The analyst must be convinced that the sales reported reflect
reality. Remember the pivotal importance of the sales figure.
There are both accounting and tactical methods that can be used
to shrink or boost sales figures. One of the key factors is the
method of sales recognition. A sale
can be recognized when
- a purchase order is written,
- the invoice is prepared,
- the merchandise leaves the seller's premises,
- the merchandise is received at the purchaser's receiving dock,
- the purchaser acknowledges receipt of merchandise and invoice.
Note that in none of these instances, payment is used as a criterion.
Payment can take place before the order is accepted, at the moment
of pick up from the seller, or very commonly some time after delivery
to the purchaser. The terms of the
sale are usually determinant. They appear on the purchase order
and on the invoice. Transfer of ownership
usually takes place when responsibility for loss of merchandise
passes from seller to purchaser. It
is found in such terminology as "free on board" (i.e.
FOB) truck, vessel or location which is often the location of
the seller. Thereafter, freight, insurance
and liability for loss become purchaser's expenses.
But the terms of sale are not always well spelled out, and courts have interpreted sales agreements somewhat differently. The general principle for a sale to be completed and therefore recognizable is that the seller has completed all steps necessary for the purchaser to take possession of the property. Sometimes, an agreement on price, item sold and date of agreement is all it takes. A handshake is sufficient. Nothing written, nothing physically delivered. The most famous such sale was the handshake between chairmen of Texaco and Penske, in the sale of Pennzoil. Texaco ended up owing Penske six billion dollars in damages.
In some industries, a sale is not recognized even after delivery. For instance, in publishing of textbooks in the United States, the textbooks are virtually on consignment with the bookstore which has a right to return all excess manuals. On the contrary, in several industries payment is received in advance and sale is recognized ahead of delivery: for instance, in the case of magazine subscriptions. Another special case is that of construction of major projects where the percent of completion method of sales recognition distributes the revenues over the years of construction rather concentrating it in a single year (as with the completed project method). In banking, as well, earnings are recognized when a loan contract is signed not when interest is actually received with installments over subsequent months or years.
See review questions Q-9B1.1 through Q-9B1.10.
2)- Effects of sales strategy:
The actions of company sales people can modify the theoretical points just presented about when a sale takes place. A salesperson eager to earn a commission can visit a client, phone in an order and have a rush delivery going out the same day. One can imagine that, if a company is dissatisfied with current sales lagging prior years, a quick sales revenue improvement can be accomplished by all sales people rushing shipments out before the last month of the year is over. There is nothing illegal or unethical in seeking to boost sales. Using rush deliveries is far from being the only method. A variety of inducements can be offered to clients to take on a larger last minute order, including price breaks, better assortment, promotion allowance, longer warrantee and right to return.
Strategies to increase last minute sales are probably more troublesome and common than the opposite. But, delaying sales may occur. Remember that showing a stable growth pattern in sales is as important as growth itself. If management can foresee less growth next year compared to the current year, it may be wise to postpone recognition of some revenues. This can be done in a simple and legal way by postponing shipments of goods and mailing of invoice for a few weeks.
See review questions Q-9B2.1 through Q-9B2.3.
3)- Discounts, rebates, allowances and returns:
There are several price inducements that affect sales differently,
and need, therefore, to be distinguished:
- price or quantity discounts: usually
offered on large quantities;
- rebates: given to regular customers,
or on merchandise of poor quality, or with conditions that benefit
the seller;
- allowances: payment by the seller
back to the buyer some time after the sale is completed for promotion,
advertisement, defective merchandise, or other such reasons;
- cash discount: reduction in price
for prompt payment or prepayment.
One must remember that offering terms, or time to pay, to customers
on open account is the equivalent of giving them an interest free
loan and is also part of the spectrum of inducements for purchasers
to buy more.
Sales revenues should be reported as gross and net figures by showing the deductions for the amount of quantity discounts and rebates given to customers, as well as returns. Allowances given to customers will usually not appear as an adjustment to gross sales, but as part of selling expenses. Cash discounts also do not usually reduce gross sales, but are part of other general expenses. So is the allowance for bad debt, which is a reserve set up for customers on open account who fail to pay. Each of these amounts can alert the analyst to the excessive efforts expanded by the firm to generate the sales it reports. How does the analyst know that the efforts are excessive? The only way is to compare current year amounts to those of prior years, and to those of other companies in the same industry. What can the analyst do once the sales efforts have been determined to be excessive? Probably nothing as far as the reported figures are concerned. The analyst cannot substitute for either management or auditor. As long as the opinion of the outside auditor is not qualified, there is no choice but to accept that the steps taken are part of a marketing strategy the company has chosen. However, the analyst will certainly use that knowledge in evaluating the sales potential of the firm, and in making projections.
See review questions Q-9B3.1 through Q-9B3.10.
4)- Product line break down:
As argue in Chapter 6 Section D-3b, it is highly desirable for sales of the company (as well as all analytical work) to be conducted for each product line separately because sales patterns, growth and strategies vary from market to market. Because balance sheet data is never broken down by product line, an analyst is limited to just a breakdown of sales, profits, assets, new capital expenditure and new investment by major segment of activity for American firms. That is still much better than having no breakdown at all, which would make an evaluation of the future of company's different segments of revenue impossible. And that is a great deal better than what used to be the norm in annual reports before Statement of Financial Accounting Standards N0. 131 (that came into effect in 1998). In the United States, the SEC requires that registered firms give data on product lines in their 10-K filing, but that isn't much better than what appears in annual reports.
For large conglomerates, sales breakdown by products is difficult to handle even when it is available. For instance, at Sara Lee, an American conglomerate engaged in food production, food services, household products, apparel and accessories, a Forbes article by Brandon Copple says that "Sara Lee has so many different brands - 150 at last count - that no one can figure out what kind of company it is". For even larger conglomerates such as Proctor & Gamble and Unilever, even the largest product lines only represent a few percentage points of total sales. Yet, the three conglomerates mentioned so far have all their sales in consumer goods. There are numerous conglomerates that mix manufacturing with banking and consumer goods. Visualizing a marketing focus for such companies is naturally challenging.
See review questions Q-9B4.1 through Q-9B4.6.
5)- Monthly sales breakdown:
Few are the markets that experience identical demand in every month of the year. Many industries earn half or more of their revenues in just a few months: such industries as toys, gift items, tourism and leisure. For most companies, analysts would gain important knowledge if sales were reported monthly because what takes place in just a small portion of the year may or not repeat itself in future years. Such information is rarely shown in annual reports or publicly available data, and even when interim quarterly data is given it is never audited. Yet, that does not seem to be a limiting problem, as suggested in Section E below that deals with sales analysis.
| Russian analysts have an advantage in this respect over their Western counterparts because audited quarterly reports are required of Russian firms for income tax purposes, and are, therefore, available; all that analysts have to do is ask. |
See review questions .Q-9B4.1 through Q-9B4.4
See research assignments R-9B.1 through R-9B.4.
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