A supermarket chain, a trucking and logistics company, Turkish fruit packaging, the most overhyped VC investment of all time, it’s not likely that they’ll have all that much in common. OK, parts of a capitalist economy perhaps, things that ultimately disappointed investors maybe, but at a more detailed level we’d not really spot much similarity. Except all four – two allegedly so far – fell foul of the same problem, revenue recognition.
The point is, when is money coming in actually yours? A useful idea being that it really belongs to you when you’ve done whatever it was that you said you would in order to gain that cash. So, if a builder takes an advance payment to get the bricks to build the extension then it’s not actually his until he’s built the extension. Or delivered the bricks at least.
When we get into corporate accounts the concept becomes more difficult. Even the definition of what is income can be hazy. At which point a little story from the distant past, Polly Peck. This was a stock market darling that purported to be making billions (in current day cash) from growing and packaging fruit in Turkey. Seems an odd thing to be making a vast fortune from. The trick was that the company would lend the farmers money at the beginning of the year, at interest. High interest too, maybe 50% per annum. This was OK to the farmers as Turkish inflation was maybe 50%, as were interest rates in Turkish lira.
They harvest the fruit, promised to Polly Peck as a result of the loan, pay off their loan and they’re happy. Polly Peck books that 50% interest as income and that feeds through the profit and loss to the bottom line – a vastly profitable company.
Except, except, if you’ve a currency with 50% inflation a year you can also expect significant exchange rate deterioration – perhaps even 50% a year. Polly Peck was borrowing in dollars and Swiss francs to fund this lending. And, obviously, making that stonking FX loss each year. But, under the rules at the time, that didn’t have to go through the P&L. Instead it was on the balance sheet as capital losses. Of course, like all good schemes, this came to an end. They really were making a lovely profit but also horrendous losses, it’s just that the two didn’t quite meet at any point in the books. For a listed company too.
For what actually is income isn’t a hard and fast thing. Let alone when you recognise it.
Which brings us to Eddie Stobart. The name means something to anyone who drives on the British motorways, the trucks rolling by with the name emblazoned upon them. It’s had a tough time recently financially. And now there’s a real problem. They’re having to restate their accounts and it’s possible that they’ll go bust in the process. Here’s the news:
Scandal-hit trucking firm Eddie Stobart Logistics has been forced to accept an emergency high-interest loan to avoid a collapse before Christmas that would put more than 6,500 jobs at risk.
The firm is taking a £55m loan from investment firm Dbay Advisors – with interest charged at an initial rate of 25pc. The deal will give Dbay a majority stake in the company, saddling existing shareholders with massive losses.
The cash injection came after Eddie Stobart’s banks refused to lend it more money, as it grapples with a multimillion-pound accounting black hole.
Since 2014, the Company’s focus has been on developing a full-service logistics business aligned to the needs of its road transport and e-commerce focused customers, in part by expanding its warehouse footprint and capacity. Since 2016, a material proportion of the Group’s profits have been derived from property related-transactions, with the Company acting as anchor tenant for completed developments, and receiving income from what it viewed as property consultancy services relating to development activities (including consultancy advice on process, planning, facilitation and debt structuring). The Board considered these activities to be integral to the Group’s logistics activities.
Since the Group’s announcement on 16 September 2019, the Board, having considered the past recognition of property-related revenue together with the relevant accounting standards, has concluded that a more appropriate way to account for these amounts is as lease incentives allocated pro rata to the relevant unexpired lease terms. This has the impact of reducing forecast EBIT for HY19 by approximately £12m (being £14m of profits on HY19 transactions previously expected to be recognised net of £2m of benefit from lease incentives now recognised, in HY19).
When do you recognise the income?
To unravel that quote for a moment. Stobart was booking the money as consultancy fees which are income in that specific period and flow through the P&L in that specific period. That makes profits look pretty good. The more modern view – a month backs view in fact – is that these aren’t consultancy fees, they’re rent free periods on a lease. Those don’t flow through the P&L in the year of lease signing, instead they arrive allocated year by year over the life of the lease. At the end of the term of the lease the position is exactly the same. But when you’ve recognised the income makes a difference to your equity to debt ratios, the profit in any one year, any covenants you’ve got with your bankers over such things etc.
Recognising revenue at the correct time is a tricky thing.
This is also what tripped up Tesco in that big accounting scandal of theirs a couple of years back. Supermarkets don’t just sell things to us consumers. They also “sell” shelf space to the brands. You want your product to be in the right place, at eye level, in the aisle that everyone goes down? Then you’re going to have to pay for that position. That payment might be actual cash, might be greater discounts on the product, co-advertising money, all sorts of things. And this is often done on multiyear contracts.
So, when is such income actually income? The year you sign the contract? The year you gain the discount, or the cash payment to perform the activity? Or is it when you’ve actually done whatever it is you should do in order to gain the money? The rules here aren’t so hard and fast. It’s on a best practice basis, what the directors think is the right way to do it. Given that the story hasn’t ended yet let’s just put it, possibly wrongly, that certain of such revenue recognition policies were a little too aggressive in pulling future income forward into the current reporting period.
We as investors need to be aware of the temptation for people to do this. It’ll be there, in the notes to the accounts, what people are doing and how they’re doing it. At least, it will be for a publicly listed company. Meaning we can go look.
All of which brings us to a lovely rumour – I’ll not put the veracity any higher than that – about that wonder of the world, WeWork. As with everyone else there are rent free periods at the beginning of the leases they signed. Eddie Stobart thought this was consultancy income until they were readvised. WeWork was – so the rumour goes – booking this as actual income. As if it were cash coming in from tenants. This isn’t something that will survive the books examining that goes on in an IPO. Public market accounts aren’t perfect but they’re often better than private company ones.
It’s this last which brings us to the moral of the story. WeWork is now being prosecuted – at least investigated by varied publicity hungry people – as a failure of public market capitalism. Which is exactly what the opposite of what the tale actually shows. As a private company it needed to produce accounts just good enough to keep the money flowing in. That’s largely a tale of whether the investors believe the overall story and or hype. When it came to floating onto a public market accounting in that manner simply isn’t good enough. More clarity must be on offer there are rules about which details must be revealed and how.
That is, coming to a public market means opening up about what is really happening. It’s not a perfect process, certainly, listed companies appear in that list of people making – let us put this kindly – mistakes over revenue recognition. But the process of moving from entirely private over to listed, through the sort of semi-restricted markets that we’re interested in here, does mean abiding ever more strongly to publicly acceptable modes and methods of accounting. The process itself is one of offering ever greater clarity and proof about those corporate numbers.