Revenue Recognition Policies

Shell Revenue Recognition

Now that we have looked over how accounts are constructed in tutorials here and here, we can start to examine why and how components of the income statement are disconnected from real cash inflows and outflows. In some cases, this can even extend to companies adopting revenue recognition policies that are not suitable to its line of business, and this can cause serious problems for investors down the line. It makes sense to start with the first line of most income statements - revenues (or sales) - and to look at the four types of revenue recognition policies that exist with relevant examples. In a future tutorial we will look at how revenue recognition policies can be a red flag if they are unsuitable for a company's business model, and also how one company entered bubble territory as a result of the market not understanding its revenue recognition policy.

So what are revenues, or sales? Put simply its the expected cash value of the sale of a product or service that is booked for a particular period. It can be very simple for some businesses; if you are a retailer and you sell a football, the price of the football would be the revenue for that sale. Total revenues would just be the total of all the footballs you sell in a particular period.

However, it can also be much more difficult. What if you operate an infrastructure company and are building a stadium for Football FC. You sign a contract with Football FC who agree to pay you at the end of the construction, when the stadium is built. Would you book all the revenues when the cash is handed over? The answer is probably not.  as it would lead to an incredibly volatile earnings profile.

There are various considerations that a company looks at when deciding, with its accountants, the revenue recognition policy it will apply. The core questions to ask relate to how reliably the revenue can be quantified, how probable it is that the economic benefits will flow to the seller, and what is most appropriate to the industry of operation.

Let's look at a range of different revenue recognition policies. For reference, this information can be readily found in a company's annual report.

4 Types of Revenue Recognition Policy

Sales-based Recognition: This is the retailer selling a football analogy that is discussed above and is one of the most transparent revenue recognition policies. Naturally, it does not fit every company's business model. Revenues are booked at the point that the goods or services are transferred into the buyers possession. However, this is not necessarily cash since it is possible to buy goods/services on credit. Below is the revenue recognition policy that clothing retailer Bonmarche uses for retail sales.

Sales based revenue recognition example

Percentage-Completed Recognition: This is a far more common revenue recognition policy for construction companies with high-value projects, because it far more accurately reflects typical contract structures within the industry. Revenues and expenses are booked according to the percentage of the project that has been completed. In reality, many construction companies are also paid through a similar structure, to provide working capital throughout the construction process.

For this method to be used, it's necessary to be able to calculate, with some accuracy, the percentage of the project that has been completed. The example below is for Keller Group, and gives you a glimpse of the potential problems with types of revenue recognition.

Cost Recovery Recognition: This type of revenue recognition involves offsetting expenses by revenues in the early stages of a contract. It's easiest to see with an example.

Cost Recovery Revenue Recognition

However, it may be apparent that this method of revenue recognition can really skew reality. This scenario attributes zero profit to years 1 and 2 and overloads the cost of sales, thereby understating gross profits. In addition, it underloads cost of sales in years 4 and 5 (it's not £0m in reality as there is still materials being used), thereby exaggerating gross profit for those two years.

Completed-contract Recognition: This is an uncommon policy given the way that it disperses (or fails to) revenues and expenses over the entire life of a contract. Put simply, if construction starts on a building now and payment is received in two years time when it has been completed, then there is zero revenue and zero cost of sales received in year 1. This ultimately leads to revenues and expenses in year 1 being understated and revenues and expenses in year 2 being overstated.

The example below sets out the basic framework, although in reality, it is very rare for it to be used for any project of scale given that the seller has to fully fund the project at the start.

This revenue recognition policy is more common for projects of a far smaller scale, such as under £100,000 (for large companies).

1 comment:

  1. Really liked the article and it flows on nicely from the previous 2 tutorials mentioned above.