Revenue recognition

Revenue recognition, the choice of which transactions a company should consider to be part of its sales, can be extremely straightforward. It can also be complex, uncertain and subject to manipulation.

Revenue recognition is very simple for companies that sell goods in single standalone transactions. Customers either pay or are invoiced and become debtors. In both cases the value of the sale is added to the company's revenues.

As terms of payment become more complex, so does deciding when revenue should be recognised.

Examples of such situations include:

  1. An advertising company that buys advertising space or airtime on behalf of clients.
  2. A software company that sells a customer a license, customisation services and support under a single long term contract.
  3. A construction company working on a large project that will take several years to complete.
  4. A company that gives the customers interest free credit.

The accounting standards dealing with this (principally IAS 18) use a number of criteria to decide when revenue should be recognised:

  • In the case of goods, that ownership has genuinely been transferred; that the economic benefits and risks of ownership lie with the buyer.
  • The revenue the seller gains must be measurable.
  • The costs of supplying the goods or services can be measured.
  • It is probable that the revenue will be received.
  • The stage of completion of a partially completed contract for services can be determined.

There are special rules for recognising revenues from interest payments, dividends and royalties, barter and for adjusting revenues for delayed payments. There are also disclosure requirements for each type of revenue source.

Applying these principals to the examples above:

  1. An advertising company should only recognise revenues from the supply of its own services, not for acting as a buying agent for customers (of course the commission or mark-up it receives for this buying is part of its revenues).
  2. Revenues should be recognised for the license and each service separately as payment for them becomes probable. This is likely to depend on contract terms that allow a customer to approve, reject or cancel.
  3. Revenue can usually be recognised as pre-agreed mileposts in the project are passed.
  4. Revenue can be recognised when the sale takes place but the amount recognised may need to be adjusted for the economic value of the interest foregone.

While the rules are complex, investors analysing a particular company do not need to make the judgements accountants do. The notes to the accounts should explain the revenue recognition policy. This should alert investors to any potential over-optimism.

Comparing a company's revenue recognition policy with others in its industry can be useful, but there have been times when almost all companies in a sector adopted weak policies (such as software in the 1990s).

Although new rules have improved the situation, revenues remain one of the most easily manipulated numbers in the accounts. Any manipulation of the revenues will be reflected all the way down the P & L.