Stability sure has a large fan base. Companies with stable revenues attract premium pricing as a large number of investors appreciate stable, predictable revenue flow rather than a volatile, unpredictable one. One can understand why stability is a good thing to have. But because of it's huge fan base, it incentivizes certain bad apples with no stability to create an illusion of stability. This post throws some light on one of the millions of ways to create an illusion of stability.
Lets consider 2 real estate firms, Company A and company B. Both are involved in real estate development and sale. Company A has a steady revenue stream of 500 Crores since the past 5 years whereas company B has delivered fluctuating revenues of 1500 crores in the 1st year, 150 in 2nd 500 in 3rd , 750 in 4th and 75 in 5th. Looking at just these numbers one might conveniently announce the 1st company as a better operator. But the reality is, these numbers are nowhere near an apt representation of ground operations.
This is where accounting comes in. There are various ways to recognize revenue and book profits but when it comes to realty firms, there are 2 major methods of revenue recognition.
1. Percentage of completion method (POCM)
2. Project completion method (PCM)
Percentage of completion method is where a company estimates the total cost of a project and recognizes revenue over a period of time as the project attains certain thresholds of completion. The cost incurred is recorded as a % of total estimate as well. For example, If the initial threshold of 30% construction is completed, all revenue from sales and bookings will be recorded and cost will be 30% of the estimated total cost of the project. The catch here is, there are obligations to be fulfilled by the developer even after the revenue is recognized. Typical thresholds are 25%, 50, 75% and so forth which means the company recognizes revenue after attaining all these threshold levels. This in effect enables companies to record revenue over a period of time, without looking wobbly to the markets. But, as this method involves a fair bit of estimation on part of the management, it remains exposed to all kinds of aggressive accounting tricks to lure investors.
Project completion method recognizes revenue when all obligations by the developer are fulfilled and the rights to property are transferred to customers. It inherently attributes revenue to the completion of the project. Costs incurred are not an estimation but recorded at a point in time.
A company with conservative accounting practices may look bad for quite a while as it doesn't record revenue till the completion of projects ( in this case company B) while a company with aggressive accounting, although perfectly legal, can seem stable and can also show a misleading ground reality.
This is one of the the many ways different accounting can color the picture. Paying attention to just hot numbers will certainly result in unexpected outcomes. Finer details can prove to be investors' life savers.