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