Which of the following is an indication that a company may be recognizing revenue prematurely? Relative to its competitors, the company’s:
A. total asset turnover is decreasing
B. receivables turnover is increasing
C. Days of sales outstanding is increasing.
The answer was C. I got confused. What is it not B? If revenue is recognized prematurely, then it's higher. So if it's higher, total asset turnover should be higher, so A is wrong. But B appears to be right. DSO = 365 * (avg receivables/annual sales), if revenue is higher, shouldn't DSO become lower?
Thanks.
What is the formula for receivables turnover? Also your formula for DSO is wrong.
Uh I copied the formula from the book...
This might be a case of overthinking formulas at the expense of working through what happens in the real world.
If a business is recognizing revenue early, it is taking longer from revenue recognition to get paid. (For example, if all industry customers all take 30 days to pay, and one company is recognizing revenue 5 days early, it will now have its receivables outstanding for 35 days instead of 30). So, DSOs go up.
As to your confusion, if revenue is recognized "early" it's not necessarily higher, it is just pulled forward. Imagine I have 0% revenue growth in my business and I have revenue of $5MM per month. If I recognize all revenue a month prematurely, I still have $5MM per month recognized. However, as described above, it will take me artificially long from revenue recognition to customer payment, so my DSOs will be higher than industry norms.
Thank you
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