Revenue is the total income a company earns from all its sales within a given period. A company may provide goods or services and revenue will reflect the earnings the company has generated. Revenue recognition is an accounting principle which looks at when revenue can be recognized in an accounting period. As revenue is the fundamental earnings of the business, deciding which particular accounting period to report revenue can greatly influence the earnings and profits of a company.
International and US accounting rules (IFRS and US GAAP) lay out clear principles on when revenue can be reported in order to prevent the misstatement of income. These rules were updated in 2018 to improve consistency between industries and to reflect modern business practices; all companies in every industry must follow the new accounting rules.
The Criteria for Recognizing Revenue
The rules for recognizing revenues are based on the overriding principle that revenue can only be recognized once a promised good or service has been delivered to a customer. To help determine the moment when a good or service is delivered to a customer, the accounting standards set out five criteria which determine when revenue from a sale can be recognized:
- The seller has a right to payment for the goods or services
- The customer has legal title over any physical goods
- The customer has physical possession of any physical goods
- All risks and rewards have been passed over by the seller
- The customer has accepted the goods or services
Recognizing Revenue in a Typical Sale
Let’s first look at an example of a typical sale to understand the importance of revenue recognition. On Day 0, a customer walks into a tailor’s and places an order for a custom suit. The suit cost $750 and cash was paid upfront. On Day 10, the customer comes in to collect the suit. When can revenue be recognized?
An exchange of cash has been made for a product on day 0, in this case, a suit. However, the customer does not receive the product for another 10 days. At first glance, you might assume revenue is recognized when the cash of $750 was received. However, the company can only recognize the revenue when the control of a promised good or service is transferred to the customer. This will mean revenue can only be recognized on day 10 when the suit has been delivered to the customer, even though cash has been transferred.
Recognizing Revenue in a Long Term Contract
So far, we have assumed that revenue can be recognized at a certain point in time. However, services are often delivered to customers over a period of time under a long-term contract, the revenue recognition therefore needs to reflect this.
The accounting rules require that the revenue recognized in a given period reflects the work (or ‘service’) performed in each period. For long-term contracts, this is determined using the following formula:
Revenue recognized in period = % progress on contract x total contract revenue
Above demonstrates a typical example for how a company records revenue for a service delivered to a customer. Here, a football season ticket is purchased prior to the start of the football season and cash is received. However, revenue can only be recorded when the service is delivered to the customer i.e. as each match occurs. There may be many games included in the ticket and each match contributes a percentage towards the total revenue generated from the season ticket sale.
Revenue Recognition from More Complex Contracts
The timing of revenue recognition in the examples above are relatively straight forward. However, there can be additional complexities when a contract requires delivery of a number of different goods or requires delivery of both goods and services.
To help deal with these complexities, the accounting rules set out five steps which explain how revenues should be recognized for all the goods and services promised in a single contract:
- Identify the contract with the customer
This determines the rights and obligations of a company and customer
- Identify the separate performance obligations in the contract
Performance obligations are the distinct goods and services promised to a customer
- Determine the transaction price
This is the amount the company expects to receive from the customer. The contract will usually outline the price beforehand.
- Allocate the transaction price to each separate performance obligation
An estimation is made on the relative standalone values of each good or service. Even if the goods are never sold separately, the values still need to be estimated and allocated to each good and service.
- Recognize revenue when each performance obligation is satisfied
As each good or service is delivered to the customer, the revenue can then be satisfied. Taking our suit example again, let’s say that the suit jacket takes a bit longer to make and the trousers are made first. This would mean that these are separate performance obligations and as each item is delivered to the customer, only then can the revenue be recognized. Revenue is never recognized based on cash being transferred.
Importance of Revenue Recognition
Revenue has a direct impact on the earnings of a company which is why it is important that accounting principles are set in place to govern how revenues are reported. Revenue has a direct impact on the earnings and growth, hence, it sets the standard for the performance of the company. It’s important that the company’s figures and reports are accurate as this will have a direct effect on the stakeholders.
To understand how the change in accounting principle for revenue recognition might affect a company’s reported income, let’s consider Apple Inc. In 2009, Apple Inc reported the following figures for the year ended September 2009.
Extract from Apple’s Income Statement 2009
We notice the company reported a net sales figure of $36,537 million for the year ended 2009. However, between the year 2009 and 2010, Apple Inc made a change to its accounting policy when recognizing revenue. This change in policy related to how revenue would be recognized for arrangements with multiple deliverables and arrangements that include software elements.
Until 2009, Apple Inc recognized the sale of hardware (e.g. Macs and iphones) as ‘service revenues’, due to the company also providing future software upgrades for free under the same contract. This meant the revenue was deferred at the time of sale and instead recognized over a straight-line basis for the duration of the products economic life (24 months).
In 2010, Apple Inc started to recognize the sale of their hardware and provision of software upgrades as two separate deliverables.
“The first deliverable is the hardware and software delivered at the time of sale, and the second deliverable is the right included with the purchase of iPhone and Apple TV to receive on a when-and-if-available basis future unspecified software upgrades and features relating to the product’s software.”
Note 2 – Explanatory Note from Amended FY 2009 10-K reports for Apple Inc
Extract from Apple’s Income Statement 2010
This retrospective accounting policy allowed Apple Inc to amend its sales and cost of sales for the year 2009. In the report above, we can see the newly reported figure for net sales is $42,905 compared to the original $36,537. This one accounting policy change has increased the revenue recognized by over $6 billion.