Identifying Industries from Financial Statements: A Case Study

Introduction: Revenue Recognition and Unearned Revenue

Companies using the accrual accounting method must adhere to revenue recognition principles proposed by Generally Accepted Accounting Principles (GAAP). The method states that companies may recognize revenue and income only in the same accounting period in which they were earned. Consequently, when companies accept deposits or advance payments, they should record them as unearned revenues. Then, in the future, when the goods or services are provided to customers, they may adjust the entries as earned income.

For instance, an airline that receives advance payment for tickets should record those transactions as unearned revenue. Professional service providers — such as accounting, legal, and contracting firms — that accept deposits should likewise record them as unearned revenue. However, after the services and products are delivered, they should adjust the entries and report them as earned revenue (Gandevani, n.d.). A passenger airline is a company that would show a high value of unearned revenue because passengers normally book tickets in advance so they can plan their vacations or arrange other services related to their journeys.

Defense Contractor and Airline Identification

A defense contractor (or security contractor) is a business organization or individual that provides products or services to a military or intelligence department of a government. Products typically include military or civilian aircraft, ships, vehicles, weaponry, and electronic systems. Services can include logistics, technical support and training, communications support, and in some cases team-based engineering in cooperation with the government.

Typically, a defense contractor will carry unearned revenue because of long-term contracts with the government. Contractors generally require a buyer to post a deposit on a contract. In reality, this deposit is unearned revenue. Depending on the terms of the contract, this unearned revenue can be allocated or prorated over the life of the contract to the profit and loss statement, or considered earned at some point in the early stages of construction. The contract terms determine the exact point at which the deposit is transferred to revenue on the income statement.

Under contract law, in a simple contract, both the buyer and the seller agree to terms of exchange. In order for a contract to be valid, one of the two parties must act. Traditionally, the seller hands over the product to the customer, who then owes for the product. However, sometimes the customer prepays for the product; in this situation, the seller owes a product to the customer (Dave, 2013). Column B is the only company left with unearned revenue stated on its balance sheet; therefore, we conclude it belongs to a defense contractor. A comparison with the real balance sheets of the three largest defense contractors in the world — Lockheed Martin Corporation, Boeing, and Raytheon Company (Appendix B) — confirms that they all show similar ratios to Column B.

An upscale department store sells high-quality products. According to Ahmad (2009), upscale department stores have three key characteristics. First, they sell brand-name perfumes and beauty supplies and employ cosmetic specialists to assist customers with applying and selecting makeup. Second, they generally sell name-brand clothing above an average price level, such as Dior and Chanel. Third, when items are on sale, the prices resemble those of average-priced items at lower-scale department stores. Examples of upscale department stores operating in the United States include Neiman Marcus and Nordstrom.

Retail Industry Identification: Upscale and Discount Department Stores

In this case study, we conclude that an upscale department store is a non-service industry. Therefore, we eliminate all companies that carry no inventory or very low inventory — columns A, E, and K. In addition, the inventory-to-total-assets ratio should be higher for retail companies, given the need to stock inventory for various products across all retail locations. We are then left with columns B, D, F, and L. Plant, equipment, and land values for the retail industry should also be significant, reflecting the construction of new stores or the remodeling of existing ones.

According to Wang and Ha (2011), high-end department stores such as Neiman Marcus and Nordstrom are likely to devote greater effort to intangible offerings — such as interpersonal communication and the physical attributes of the retail environment — while other department stores such as Kohl's and Sears are more likely to use management of core offerings (e.g., merchandise) to attract customers and encourage relationship formation. Therefore, we exclude column B, which has a low plant and equipment ratio (16.1%). Additionally, inventory turnover in this industry should be low, as high-end products do not sell as quickly as grocery items. Thus, we identify column D, with an inventory turnover of 4.5, as the upscale department store, compared to column L's turnover of 11.9.

According to Mulhern and Leone (1990), discount department stores run periodic sales featuring discounted prices for selected merchandise during holidays or weekends to boost store sales and profits and generate store traffic. The temporary price reductions are intended to draw customers into the store and stimulate the sales of items at regular prices. For example, Walmart is one of the most well-known discount department stores, operating retail and other stores in various formats worldwide. It earns the trust of customers by providing a broad assortment of quality merchandise and services at everyday low prices (EDLP), while fostering a culture that rewards mutual respect, integrity, and diversity.

Brown et al. (2005) stated that retailers can obtain lower prices, more sales, and a virtuous cycle by generating buying economies and higher inventory turnover. According to the Walmart annual report (1996), the company valued inventories at the lower of cost or market as determined by the retail method of accounting, using the last-in, first-out (LIFO) method for substantially all of Walmart's U.S. segment merchandise inventories. The retail method of accounting results in inventory being valued at the lower of cost or market, since permanent markdowns are taken as a reduction of the retail value of inventory. A key benefit of effective supply chain management is its ability to help retailers better manage their assets — most notably their investments in accounts receivable, inventories, and physical infrastructure.

In this case, the top three columns with the highest inventory ratios are column B (37.8%), column F (42.6%), and column L (30.6%). Firms hold inventory for numerous reasons, including smoothing production levels, inhibiting costs of adjusting production capacity when demand is variable, achieving high customer service levels, preventing stock-out costs, buffering against uncertain supply and demand, keeping the manufacturing process running during breakdowns or rework situations, speculating on price movements, or realizing economies of scale (Blanchard, 1983; Blinder and Maccini, 1991; Rotemberg and Saloner, 1989; Cuthbertson and Gasparro, 1993).

Column F has the highest probability of being the discount department store chain because its inventory turnover (5.0) is considerably higher than column B's (2.5). Inventory turnover focuses on the efficiency of a firm's inventory management practices. Cost of goods sold is used in the numerator because inventories are carried at cost, not selling price. Inventory turnover can be kept at a high level by focusing inventory on products that are widely acceptable and move quickly. In conclusion, we identify column F as the discount department store chain.