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Revenue Recognition

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To understand financial statements prepared under the accrual system of accounting, it is necessary to understand how accountants recognize revenue. Unlike with the cash-basis system of accounting, Generally Accepted Accounting Principles (GAAP) state that revenues must be allocated to the proper time period, regardless of when cash is actually received. This distinction may seem like a moot point until you realize that many accounting scandals have resulted from inappropriate revenue recognition. Remember, the way a company reports its revenue will ultimately affect its net income, which will ultimately influence its stock price.

Before diving into abstract principles, I want to first use an illustration to show how GAAP revenue recognition differs from the more intuitive, cash-basis method:

Suppose that in 20X3, I decide to subscribe to National Geographic magazine. As part of my subscription, I agree to pay $100 upfront to receive a year’s worth of magazine issues starting from January 1st of 20X4. Under cash-basis accounting, the company would recognize the full $100 as revenue the moment they deposited my check payment. The result is that net income for 20X3 would increase by $100.

This method is certainly easy to understand and seems harmless enough until you consider the fact that it actually overstates profits in 20X3 and understates profits next year in 20X4. Although the company did in fact collect the cash in 20X3, it has not yet written or delivered my magazine. The extra revenues it recorded in 20X3 were not matched with the associated expenses that it will take to generate the $100 revenue. The company has not yet spent money to hire writers, print the magazine, and deliver the issues to my doorstep. Next year in 20X4, however, those payments will be made and so 20X4′s income statement will understate income. It will record all the expenses but without the subscription revenue that those expenses helped produce.

What we need here is a consistent, logical method for allocating revenues across multiple time periods. A company must rationally allocate revenue across distinct time periods (fiscal quarters or years) in a way that allows investors a way to compare historical financial statements. Allocating revenues in a consistent and logical manner, however, is not as easy as it seems. Entire books (long and boring ones!) have been written about the subject when controversial issues arise. For most simple situations, however, a few key guiding principles suffice.

Revenues are recognized when:

  1. there is a verifiable exchange transaction,
  2. services are performed or goods have been delivered,
  3. and there is a reasonable likelihood of getting paid –
  4. regardless of when cash is actually received.

The first requirement helps clarify that revenue should be recognized even if cash has not yet been received. A verifiable exchange transaction results when there is a transfer of ownership and the seller now has the legal right to collect cash, either immediately or in the future. Cash does not have to be collected right away; a contract promising cash in the future will suffice for the exchange transaction.

For example, a clothing store might offer customers the ability to purchase on credit (to entice shoppers to spend on impulse). A shopper might decide to splurge on a $500 dress which she purchases from the store on credit. She signs the receipt where she makes a promise to pay, then walks out the door with the new dress. That very same day, the company can report an extra $500 in sales even though it might not receive a single cash payment from the customer until next year. This is because a verifiable exchange has taken place (the dress is now the customer’s property) and the company now has a legal right to collect on debts owed by the customer (indicated by the signed receipt).

The second condition of the revenue recognition principle clarifies that cash received in advance of goods or services rendered should not be recognized as revenue. Returning to our magazine example, if National Geographic receives a cash prepayment for a magazine that it has not yet delivered, it cannot classify this as revenue. Instead, this cash should be counted as unearned revenue (also known as deferred revenue). Only when the magazines are finally delivered can these revenues be considered earned. In a similar manner, a company cannot claim gift card sales as revenue; they must instead wait until the gift cards are redeemed before the cash can be considered revenue.

The third condition only needs to be explained in passing. If a company sells an item for which it does not reasonably expect to collect payment, it should not record it as revenue. Because of the uncertain nature of collection, the company should wait until cash is finally received before recording it as revenue. This may occur if the item sold has a high probability of being refunded, or if the customer is known to be unlikely to pay his debt.

As we can see, the timing differences between when cash is received and when revenues are recognized can work both ways. Cash might be received first, then services performed and goods delivered later (deferred revenue). On the other hand, goods might be sold and services performed first, then cash received later (accrued revenue). Deferred revenue is properly reported as a liability on the balance sheet because the company still has a future obligation to perform services or deliver goods. Deferred revenue does not show up on the income statement, so even though cash has been received, profit does not increase. On the other hand, accrued revenue is reported as revenue on the income statement; it increases profit right away, even though cash has yet to be received.

That last sentence should be a cause for concern! Because GAAP states that revenues should be recognized immediately when earned, a company may report revenues before it actually receives cash. This will make it seem more profitable on the income statement than it truly is. For example, a department clothing store might promote its own store-brand credit card to enable sales on credit. If it loosens lending restrictions (and makes loans to deadbeat customers!), it can achieve record profits, which will drive up the company’s stock price. The following year, however, the company may have difficulty collecting its accounts receivable. Customers might end up paying their debts late, if they pay at all. For this reason, investors should always investigate not just reported earnings but also the quality of those earnings. Always consult the statement of cash flows along with the income statement to learn about the details of the actual cash flows.

At times, the revenue recognition principle may not be straightforward to apply. A few years ago, my dad purchased a lifetime gym membership for $2000. Every month thereafter, he only needed to make additional payments of $50 per month to maintain the lifetime membership. These terms are not difficult to understand from a customer’s perspective, but it is no trivial task for accountants to properly allocate this revenue. My parents might live for several decades, yet to prepare timely financial reports, the gym’s accountants must assign a certain figure for each year’s revenue, long before it is clear how many years my parents might use their membership. In such complex situations, an investor should always consult the footnotes of the company’s financial statements to learn about the company’s accounting methodology.

Ultimately, the goal of GAAP’s revenue recognition principle is to create clear and consistent rules for how to calculate income. Without this principle, there would be many distortions that reflect inconsistencies in accounting methodology rather than any real underlying changes in a business’ performance.  Only after you understand how revenue recognition works can you fully understand a company’s income statement. Even in complex situations, where the basic principles are difficult to apply, you are in a much better position to understand the subtle nuances in accounting methods that can make a huge difference in the way profits are reported on the income statement.


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