This is an article in the Financial Times dated 11/22. It discusses the effect of Nestle shifting from one method of revenue recognition to another. This example shows how companies have different ways of reporting and the effects/ repercussions of shifting from one method to another.
“Some SFr16bn ($16.1bn) of turnover will vanish from Nestlé’s top line when the world’s biggest food group changes the way it reports revenues on January 1 next year. But the move, which brings it into line with the rest of the industry on accounting for promotional discounts, would have the benefit of boosting Nestlé’s emerging market exposure from about 35 per cent to about 40 per cent, said Jamie Isenwater, analyst at Deutsche Bank.
The reporting shift will put the proportion of Nestlé’s revenues from emerging markets level with that of Danone, the French dairy products group, although still below Unilever’s 50 per cent. Nestlé has been an outlier among peers by reporting revenues without deducting promotional discounts. This means, for example, a two-for-one deal on Kit Kats is reported on the top line as two packs even though the second one generates no revenues.
From January these promotional discounts will be subtracted from the proceeds of sales. The move will reduce Nestlé’s reported sales, which came in at SFr108bn last year, by about 15 per cent, the company said. Mr Isenwater said: “So the purely mathematical impact is that developed market sales fall by SFr16bn and those in emerging markets don’t change.”
In a statement, Nestlé said the changes would “reduce reported sales by about 15 per cent as expenses such as discounts … and promotions for retailers will in future be deducted from proceeds of sales”. It added: “The change will, however, have no impact on absolute net profit, earnings per share, cash flows or items on the Group’s balance sheet.”
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One of the reason why Nestle finally might be going in for this accounting practice is because the analysts who track retail companies essentially look at ratios like
1. Net Profit margin, which is calculated by dividing the Net Profit by the sales for the sales for the said period. This ratio would invariably represent the bottom line profitability of the business. and
2.Operating Profit which is calculated as Operating Profit / Sales
This ratio is an indicator of the ability of the business to control its other operating costs or overheads.
Now if Nestle continued with its old method while its competitors followed the method where the free goods are not included in sales, it almost appears like Nestle is not efficient in controlling its overhead costs (from Operating Profit) and that its Bottom line profitability is low. Now no corporation would want its Income statement to look any less lacklustre than it actually is! Especially when it might just be doing better than its peers.. This could possibly be a move to counter that disadvantage that they might have faced so far..
Retailers are always competing for the bottom line and it is amazing to me that Nestle would inflate their unit sales knowing that it would have no impact on their revenue. One could argue that they are accounting for the product being made which involves production costs so by counting the “free” unit, you are tracking total units “consumed”. Promotions have always been a way to win a customer over from one’s competitor with the trade off of hurting the margin of the company. Retailers set their margin expectations including these promotions so I find it surprising that Nestle, a huge multi-billion dollar corporation would inflate their sales, recognize the revenue on unsold merchandise just so they would have a higher turnover. They must have benefited on a cash flow perspective as well otherwise they would not have practiced this method. Now that they are on the same playing field with their competitors, one can make an apples to apples comparison on their performance. It sounds like they switched right when they are going after emerging markets, clearly seeing how the change would benefit them.