In a broad sense, the term revenue refers to sources of income for a business enterprise. Most forms of business activity generate revenues from a range of different sources. For good purposes it is useful to distinguish between operating and non-operating revenues. This post provides information and guidelines about Revenue Recognition by GAAP under IFRS. Through this post, we talk about; some broad principles of revenue recognition, IAS 18, US GAAP focus, financial analysis implications, top 11 revenue recognition issues outlined for light-weighted reading, and A basic analytical steps that you [as an analyst] should take to help gain a reasonable understanding of such a broad and important area of revenue recognition. A case example [Property Company Revenue Recognition] closes this post. Read On…
When interpreting historical accounts, importance is generally ascribed to revenue because it is seen as a key driver of both profitability and cash flow. But it is important to recognize that revenue does not actually equate to a stream of cash inflow. This is why, for example, the widely-used EBITDA figure should not be treated as a measure of cash flow. It includes sales made on non-cash terms, provisions and accrued expenses, to name but a few, none of which are cash flow items. This is not a problem that can be addressed by reverting to cash-based measures, since if a company is actually accruing revenue that will be paid subsequently this is clearly material to its value. Moreover, some businesses, such as publications, receive cash up front as consideration for a stream of product that will be delivered over the rest of a year, or longer. In that situation, it would clearly be inappropriate to allocate all of the revenue to the quarter in which it was received.
So we need a realistic measure of accrued revenue, not of cash received. Obviously, this creates a risk – that the measure of revenue that is accrued in a company’s accounts, and possibly extrapolated in forecasting models, is not realistic. During the severe downturn in the telecommunications industry after the Millennium, there were several cases of companies that booked large amounts of revenue, and therefore of profit, that were subsequently reversed in later quarters. The message for the user of accounts, therefore, is that we need a measure of accrual, but one that is realistic.
Although revenue recognition complexities are often associated with new economy or high-tech businesses, issues still arise in the most traditional of sectors. For example: some analysts may argue that a supermarket is a simple business and that its revenue streams are well defined and revenue manipulation is not a significant issue. The Dutch retailer, A hold, shattered this illusion. A hold, in common with many other retailers, offers a variety of promotional enticements to customers such as vouchers, volume discounts (e.g. 3 for the price of 2) and loyalty reward schemes. The accounting for these marketing techniques is not clear cut under most GAAPs (see below). A hold’s misdemeanors, in the view of the SEC, were so significant that operating earnings for 2001 and 2002 had to be adjusted for a $500 million overstatement. Ultimately many of the key members of the board had to leave, such was the reaction to such startling revelations. The message is clear – an analyst must be very familiar with the revenue recognition issues in their sector in order to understand and value companies properly.
Sources of Income
- Related income [e.g. royalty income]
- Foreign exchange gains
- Government grants
- Leasing [lessor activity]
For most analysts the key topic for analysis is those streams of income derived from core business activity, i.e. sales of core products and services. Therefore this section will focus on this topic. This is not to say that non-operating revenues may not be important. A summary of the accounting treatments that apply to such ancillary revenue sources is provided below:
Source of revenue Accounting treatment
Government grants Revenue grants treated as income as related
expense is incurred.
Capital grants treated as deferred credits.
Foreign exchange Gains on trading transactions are reported as reductions
in gains operating expenses.
Gains on financing transactions are reported as part of
Leasing If capital leases then immediate recognition of total
sale value of assets under lease treated as revenue.
If operating lease then spread profit over lease term
giving revenue, in the form of rental receipts,
in each year of the lease term
I ascribe the term revenue recognition to the issue of when a particular source of revenue should be recognized. This timing issue is of crucial importance for calculating profit margins and for gaining an appreciation of historical performance. This is especially so where the product of the historical analysis will be a view about future sales and growth. Almost all valuations for industrial concerns entail a forecast of revenues. Indeed many other facets of valuations and associated models are driven off the sales forecasts. For example operating costs are typically linked to sales forecasts. Furthermore most models also use revenue figures as drivers for less obvious items such as property, plant and equipment.
Therefore revenue numbers and related information, such as segmental disaggregation, are of significant importance to valuers. An analyst must have a strong knowledge of the revenue recognition issues in his/her sector in order to forecast this core number competently.
In addition to the issue of timing we also have the issue of measurement of the revenue i.e. what number appears in the financials. This tends to be less problematic than the recognition point. In common with many other accounting topics, fair values should be used in the measurement of revenues. This would mean that revenue would have to be discounted if the terms of the transaction where such that the time value of money is material. Given the relatively straightforward nature of the measurement issue the remaining parts of this chapter will concentrate on the timing issue.
Some Broad Principles Of Revenue Recognition
There are two broad approaches to revenue recognition: the critical event approach and some approach based on the passage of time. The critical event approach essentially recognizes revenues when a significant event occurs. For example in the real estate sector the critical event might be when contracts are exchanged or when transactions are legally complete. The passage of time approach might also be used in the property sector to recognize rental income as time passes. Companies can employ both approaches for different sources of revenue.
Historically revenue recognition derived from industry practice rather than being addressed explicitly by accounting standards. Two basic conditions have emerged as the drivers for revenue recognition timing which supplement the more general approaches outlined above. The first condition is that prior to recognizing revenue the ‘sale’ must be realized i.e. either the company has received the cash or expects to (for example, the customer is of good credit worthiness). This condition could be satisfied by a company having an appropriate credit control system in operation. The second condition is that the revenues must be earned. In other words the work relating to the revenue under consideration for recognition must be complete.
In many ways GAAP based on these principles existed without many difficulties for a considerable period of time. However, increasingly complex business activity eventually exposed the simple conditions as being inadequate. Those bemoaning the obsession of GAAP with rules and favoring a more principles based system might express disappointment that further detailed rules have evolved. However, further guidance is almost certainly required given the diversity of business activity. This inevitably leads to rules and so in many ways some level of detail is necessary to ensure an adequate level of comparability of application. For example consider the case of a mobile phone company selling a one year contract to an individual. The contract encompasses both the provision of call services and the mobile phone itself. Applying our principles based approach the realized condition will be met as credit worthiness checks will have been performed. Furthermore, the mobile phone sale is also complete whereas the call services are quite obviously not.
The issue is: what amount of revenue is to be recognized at the point where the customer signs the contract? It is obvious that a simple model is inadequate. It would provide the mobile phone company with significant latitude for recognition. In an international context the required further guidance is provided in the form of IAS 18 Revenue.
IAS 18 accepts that any approach to revenue recognition cannot hope to encapsulate the complexities of all types of commercial activity. Therefore it provides a generic approach but provides exceptions to it – for example, long term contracts which are covered by IAS 11 Construction contracts.
IAS 18 sets out various conditions that must be satisfied before revenue can be recognized. It has distinct criteria for both services and goods.
IAS 18 Revenue recognition criteria:
- Significant risks and rewards transferred
- Seller retains no control
- Revenue can be measured*
- Economic benefits will probably flow to the seller*
- Costs can be measured*
- Stage of completion can be measured**
* Criteria apply to both goods and services
** Applies to services only.
The simpler the business activity the more straightforward the application of the conditions. The standard makes it particularly clear that for the sale of goods the first criteria is most critical. This reflects the essentially economic (‘risk and reward’) approach adopted in many international accounting standards.
US GAAP Focus On Revenuw Recognition
In broad terms US GAAP and IFRS are consistent. The key difference is that US GAAP contains lots of explicit guidance including sector specific examples whereas IAS 18 is much more general in nature. This may well lead to different revenue treatments in very particular circumstances. It is worth noting that the IASB and FASB continue to work on a joint project regarding revenue recognition concepts.
Some guidance under US GAAP is based on rules issued by the SEC, in particular Staff Accounting Bulletin (SAB) 101. A summary of this is provided below. SAB 101 was issued in late 1999 and it proposed four requirements prior to the recognition of revenues:
Persuasive evidence of an arrangement (e.g. orders, customer agreements etc) –> Delivery has taken place or services rendered –> Seller’s price is fixed and can be determined –> Collectability is reasonably assured
Here are some of the more important areas of SAB 101:
Issue Description Accounting treatment
1. Consignment Inventory transferred to a Not recognized as revenue
sales third party (typically customer) until transfer of risks and
but seller retains risks and rewards irrespective of legal
2. Non-refundable Up front payments Only recognize if the up front
payments portion represents payment
for a discrete earnings process.
3. Set-up fees For example a telecom Do not recognize
company charges a phone immediately, Instead, spread
set-up fee. over the longer of the term of
the arrangement or
expected period of service.
4. Right of- If a right of return exists then SAB 101 sets out the
return revenues can only be recognized relevant issues to be
if the amount of future returns considered when assessing
can be estimated. if this is the case.
Given that it is such a crucial number the guidance in IAS 18 is fairly light and it is no surprise that both the FASB and the IASB have an ongoing project to develop further detailed accounting guidance on revenue recognition to tighten up the entire area. Many of the accounting scandals of 2000 et seq were grounded in revenue recognition abuses. For example see the extract from the Wall Street Journal below:
Global Crossing (Source: Wall Street Journal)
Analysts Say Global Crossing Used Aggressive Accounting
These contracts were attractive to upstart telecom firms such as Global Crossing because they could book most of the 20-year revenue upfront as one lump sum. Meanwhile, Global Crossing would offer to buy similar capacity in another area from the same carrier. Then it would book those costs as a capital expense, allowing it to show large revenue increases with little or no operating expenses.
Top 11 Revenue Recognition Issues
Analysts need to be aware that there are a number of different areas where revenue recognition issues are complex and deserve some attention. These include the following:
- Warranties – It would appear that the problem is how much of the initial revenues should be allocated to the warranty and spread over its lifetime. In essence the question is: has the warranty been earned? If it has been earned at the point of sale then all of the warranty revenue would qualify for immediate recognition, with a provision being made for the potential future costs of the repairs. For example the accounting policy note for The Dixons Group plc in the 2002/03 financials categorically states that ‘extended warranty and service contracts are included in turnover in the period in which they are sold’.
- Vouchers – These are used extensively in the retail sector. For example, if a two for the price of one product promotion is offered is it appropriate to recognize the revenues from the sale of both products with the free element being recorded as a cost? There is a lack of specificity about the accounting treatment of vouchers and in many ways this may have led to the significant problems at the US subsidiary of A hold. One would expect the treatment of this issue would be similar to that for discounts. Trade discounts (i.e those that are 95 guaranteed) are typically treated as a reduction in revenues whereas those discounts that depend on another event are treated as a cost if they occur (e.g. a settlement discount for early payment). IAS 18 is not explicit on this point.
- Subscriptions – Subscriptions (for example a magazine) are realized immediately but are not actually earned until the magazines are issued. In the meantime the cash received is classified as deferred income (unearned income) and classified in liabilities.
- Advertising Revenues – Again establishing realisation is typically not a problem. However, the issue that then requires analysis is has the revenue been earned. Is it earned when the advertising is complete (i.e. ready for publication)? Normal practice is to recognize the revenues as the production process proceeds. For other advertising management services the ‘earnings’ event will normally be the advertising going public.
- Software Revenues – Again this is an area where judgment is required. For example a software contract often contains both software installation and maintenance components. The initial part of the contract (that relates to installation) can be recognized immediately, but the maintenance component must be spread on a time basis. This permits a wide range of flexibility.
- Real Estate Transactions – Revenue can be recognized either at the point of contract exchange or on the completion of contracts. To many familiar with property transactions this appears reasonable enough. However, be aware of the flexibility this provides. For example the directors of a company might change their accounting policy to reflect contract revenues on an exchange basis as against the previous completion policy. This would result in an influx of profits that would otherwise have been deferred to future periods.
- Barter Transactions – If similar goods/services are exchanged then no revenue would be recognized. For dissimilar goods/services fair values are used for revenue recognition purposes. This is designed to avoid transactions such as capacity swaps (see exhibit 4.5 above).
- Non-refundable Up Front Payments – Typically the non-refundable dimension is irrelevant for the more economic approach under IFRS. The critical event will still be the provision of the service/goods. If the revenue has not been earned then up-front fees are, in essence, deferred income. Upfront fees for arranging loans in the financial sector are one example. Under IFRS these will have to be deferred and recognized as part of ‘interest.’
- Installation Fees – The treatment depends upon whether the installation fees are significant. If not then merely include the fees in the sales price of the goods. Therefore the revenue recognition point will be that for the sale of goods, which is normally delivered.
- Right of return – The risk here is that revenues are recognized and then the customer effectively cancels the sale, thereby challenging the assumption that the revenue recognition criteria have been met. If an enterprise is exposed to predictable returns then it is probable that the full amount of revenue can be recognized and a provision made separately for the cost of the returns. If however there is a significant amount of unpredictable returns then it may be that revenue recognition must be postponed until the patterns of return become more predictable.
- Consignment Sales – This is a situation where sales are made but the goods remain with the seller. In general terms, once legal title passes then a sale can be recorded. However, further conditions such as payment terms should be normal and the goods are on hand and ready for delivery. These conditions should really only be an issue in very unusual circumstances.
A Basic Analytical Steps
So, what can users actually do to help gain a reasonable understanding of such a broad and important area? The following identifies some basic analytical steps:
Step 1. Gain a thorough understanding of the revenue recognition issues in their sector.
Step 2. Understand the accepted practice and related GAAP support (or lack thereof) in the sector.
Step 3. Document the accounting policy chosen by each entity in the sector and consider any divergence and how this might impact on comparable company analysis.
Step 4. Watch out for signs of trouble relating to revenues:
- Unexpected changes in revenues
- Increasing disparity between profit and cash
- Unexpected ballooning of accounts receivable in working capital
- Change in the segment mix, especially if unexpected and or inconsistent with strategy
Significant revenues or increasing proportion coming from a related party
Revenue Recognition Case Examples
It is actually quite difficult to use case studies to illustrate revenue recognition points as the disclosures under various GAAPs tend to be somewhat limited. The main issue to look at, as outlined in the paragraph above, is the revenue recognition policy for the company. To illustrate the point we have reproduced extracts from the accounting policies of two property companies:
Property Company Revenue Recognition
- Turnover (Source: Crest Nicholson Annual Report) – Turnover represents amounts received and receivable in respect of housing, land and commercial property sold and amounts receivable in respect of construction and other work completed during the year. Turnover excludes the sale of properties taken in part exchange. In the case of long term contracts turnover is recognized on a percentage of completion basis.
- Profits on Sale of Properties (Source: Hammerson Directors’ Report and Financial Statements) – Profits on sale of properties are taken into account on the completion of contract. Profits arising from the sale of trading properties acquired with a view to resale are included in the profit and loss account as part of the operating profit of the group. Profits or losses arising from the sale of investment properties are calculated by reference to book value at the end of the previous year, adjusted for subsequent capital expenditure, and treated as exceptional items.
As we can see Hammerson recognises the revenues based on completion whereas another choice would be on the basis of exchange of contracts. In certain circumstances these events may be months apart. The absence of detailed rules leaves the choice to the company. Furthermore Crest Nicholson employs the ‘percentage complete’ methodology for long term contracts. This is consistent with IFRS. Under other GAAPs the completed contract method is used. This will change with the advent of IFRS.
We can also see this in the context of a telecoms business such as Deutsche Telekom below. This policy reflects the basic principle that irrespective of when the company will actually receive the cash it is the ‘performance’ (called delivery here) that drives recognition.
Deutsche Telekom revenue recognition (Source: Deutsche Telekom AG Financial statements)
Accounting Policies – Net revenues contain all revenues from the ordinary business activities of Deutsche Telekom. For example, these include revenues from the rendering of services and the sale of goods and products that are typical for Deutsche Telekom. Net revenues are recorded net of value-added tax (VAT) and sales related reductions. They are recognized in the accounting period concerned in accordance with the realization principle. The T-Com division, which accounts for the major proportion of Deutsche Telekom AG’s sales, recognizes its revenues as follows:
T-Com provides customers with narrow and broadband access to its fixed-line network. It also sells, leases, and services telecommunications equipment for its customers and provides other ancillary telecommunications services. T-Com recognizes service revenues when the services are provided in accordance with contract terms. The revenue and related expenses associated with the sale of telecommunications equipment and accessories are recognized when the products are delivered, provided there are no unfulfilled company obligations that affect the customer’s final acceptance of the arrangement. Revenue from rentals and lease payments is recognized monthly as the fees accrue.