Thread by @bharatbetpf

How to get away with fraud - Episode 1

Revenue & Receivables

For businesses there is often a difference between when a good/service is delivered & the payment for it is received. Shady promoters can use this to project a view of the business that isn't in line with its reality.

Before we get into the details of how financials can be manipulated - let's clear some basics so that all our readers are on equal footing.

Accrual accounting is a method of accounting where revenues and expenses are recorded when they are earned, regardless of when the money is actually received or paid

Still sounds like jargon? Let's start with two businesses to make this simpler

Ramu sells you milk everyday - he however doesn't collect money from you daily, choosing instead to collect at the end of the month for ease of business.

Shamu is a local painter who has agreed to paint your house. Your house has four rooms of equal size that will each take a week to paint, but Shamu will be paid by you at the end of the month for ease of business.

Now since Ramu has actually sold you one litre of milk every day, he will record that as his revenue. However, he hasn't received any cash for the milk provided. Hence he will record this as receivables - amount that he will receive from you in the future.

Shamu records his revenue based on completion of every room - so he records a quarter of the total painting revenue every week - and the same amount is added to his receivables. The revenue he will generate from the month of service is his current order book.

The listed stocks generally fall into one of the two categories - with product companies relying on model 1 and services companies relying on model 2.

1. Record revenue early: Shamu could record revenue for painting two rooms, or even the whole house when he has actually painted just one room. This will lead to a spike in revenue in the current period - but depressed revenues in subsequent periods.

This technique is generally used by shady services companies, who try to manage their revenue by recording it in ways inconsistent with how they are actually earning it.

This could lead to exuberance in periods where they are receiving orders, and recording it completely - with sharp drops in subsequent periods.

Every firm has a revenue recognition segment in its annual report. Go through that and see if the rate at which the firm is recording revenue makes logical sense. A firm that sells a 5 year subscription, recording the entire value in year 1 for example could be a red flag.

Also look at how fast the revenue is growing vs the orderbook. When business is going as usual, revenue growing significantly faster than orderbook is a red flag.

2. Stuff the channel: Ramu can tell you that milk will be scarce for the next few days and sell you 1.5L of milk per day for a week. This will lead to a spike in revenue for a week, but subsequent depressed sales as you being accumulating surplus milk.

This technique is generally used by consumer and auto companies to stuff the distributor with inventory, and record the sales on their books.

The best way to check for this is to do regular channel checks on the distributors - to see if any of the distribution channels are being stuffed with excess inventory.

3. Fradulent sales: Ramu can drink a litre of milk every day, and tell his owner that two liters of milk have been consumed by you. This will drive a spike in sales, but you will naturally pay only for the milk you've consumed, leading to a bad debt in the receivables.

This is probably the worst type of manipulation, when the management is effectively creating revenue out of thin air.

This will start reflecting in the firm's books as either balooning receivables or as receivable bad debt - both of which should be red flags. Also look at receivables that have been pending for long periods of time (180+ days).

4. Sales to subprime counterparties: Ramu could start selling more milk than people can afford - selling 1 litre to a family that can only afford half. This will eventually catchup, again in terms of bad debt in receivables when the poor family isn't able to pay up for the milk.

This will generally happen with tier 2 competitors who don't have access to the cream client base, and have to lend up serving the ones the leaders refuse to serve. This again can be detected by abnormal spikes in receivables and receivable bad debt.

Summing up, here's some factors you need to watch out for:
1.Receivables growing substantially faster than sales
2.Sales growing substantially faster than order book
3.Excess inventory piling up with channel partners

4.Revenue recognition policies of the firm
5.Receivables pending for 180+ days/Gross receivables
6. Receivables bad debt/Gross receivables

@dmuthuk @Vivek_Investor @10kdiver @safiranand