Mastering Revenue Recognition | CFA Level I FSA
In this study note, we’ll cover revenue recognition, a crucial topic for understanding financial statements. We’ll dive into the five-step process for recognizing revenue and explore some examples to help solidify your understanding. So let’s jump right in!
Revenue Recognition and Accrual Accounting
Under the accrual method of accounting, revenue is recognized when earned, regardless of cash payment. To illustrate:
- When a firm provides goods or services before receiving cash payment, the revenue is recorded in the income statement, and accounts receivable in the balance sheet increases.
- When a customer pays cash first before receiving goods or services, cash is recorded, and unearned revenue is recorded as a liability in the balance sheet. Revenue is not recognized at this point.
- When the goods or service is fulfilled, the revenue is recognized on the income statement, and the liability is reduced.
It’s essential to have accounting standards in place to prevent companies from manipulating net income using accrual methods.
IASB and FASB’s Converged Standards for Revenue Recognition
The IASB and FASB issued converged standards for revenue recognition in 2018. The new standards use a principles-based approach with a central principle: a firm should recognize revenue when it has transferred a good or service to a customer. The converged standards involve a five-step process for recognizing revenue:
- Identify the contract(s) with a customer.
- Identify the distinct performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when the performance obligation is satisfied.
Step 1: Identify the Contract(s) with a Customer
A contract is an agreement between two or more parties specifying their obligations and rights. A contract exists only if collectability is probable. However, “probable” is defined differently under IFRS and US GAAP:
Step 2: Identify the Distinct Performance Obligations
A performance obligation is a promise to deliver a distinct good or service. A good or service is distinct if the customer can benefit from it on its own or in combination with readily available resources, and if it can be separated from other obligations in the contract.
Step 3: Determine the Transaction Price
The transaction price is the amount the seller expects to receive in exchange for the goods or services identified in the contract. It can be a fixed amount or variable (e.g., including a bonus for early delivery).
Step 4: Allocate the Transaction Price to the Performance Obligations
The transaction price is allocated to each identified performance obligation.
Step 5: Recognize Revenue When the Performance Obligation is Satisfied
Revenue is recognized when the obligation is satisfied, and the seller is relatively certain the sale won’t be reversed. If the revenue is uncertain due to refund obligations, the seller may need to recognize a liability in its balance sheet to account for the likelihood of a refund.
A construction company enters into a contract with a customer to construct an office building for $10 million. The contractor intends to itemize the contract into separate performance obligations, such as plumbing, electrical wiring, and interior finishes so that revenue can be recognized as they are finished. Is this consistent with the revenue recognition standard that we’ve just learned?
Answer: The contractor should treat the delivery of the entire building as one single distinct performance obligation, as the separate items cannot be used by the customer on their own or be separated from the contract.
Long-term Contracts and Revenue Recognition
For long-term contracts, revenue is recognized based on the progress toward completion of a performance obligation. Progress can be measured from the input side (e.g., percentage of completion costs incurred) or the output side (e.g., engineering milestones or percentage of total output delivered).
A contractor estimates the total cost of construction to be $6 million. During the first year of construction, the contractor incurs $3.6 million of costs, which is 60% of the estimated total costs of completion. Based on this expenditure and a belief that the costs incurred represent an appropriate measure of progress, the contractor recognizes 60% of the transaction price as revenue for the first year.
Variable Consideration and Revenue Recognition
Under the converged standards, a company can recognize variable consideration (e.g., a performance bonus) only if it can conclude that it won’t have to reverse it in the future.
Contract Modifications and Revenue Recognition
When contracts are modified, the converged standards specify how to treat the change. If the change involves goods or services that are distinct from the goods or services already transferred, it’s considered a new contract with a separate transaction price. Otherwise, it’s considered a modification of the existing contract.
Capitalizing Costs to Secure a Contract
One notable change to the standards is that the costs to secure a contract and certain other costs must be capitalized. Such expenses are not recognized as expenses on the income statement but are recorded on the balance sheet as an asset.
Agent Revenue Recognition
When a company isn’t primarily responsible for fulfilling the contract, doesn’t take inventory or credit risk, doesn’t have discretion in setting the price, and receives compensation as a commission, it’s considered an agent in the contract. The agent should recognize only the amount of commission received as revenue.
Franchising or Licensing Models
In the world of franchising, revenue streams can be quite diverse. Let’s take a closer look at a convenience store chain operating under this model. The chain earns through direct store operations, equipment and inventory supplies to franchisees, and through fixed license and royalty fees. Accounting standards mandate that these revenue sources be classified based on their nature, amount, timing, and associated risk factors.
EXAMPLE: A convenience store chain collects a fixed license fee plus a royalty fee based on the franchisee’s turnover. The license fee, covering multiple periods, is initially recorded as unearned revenue and recognized over the license’s life.
The software industry often employs licensing models that further illustrate the principles of revenue recognition. Consider a developer offering software under a subscription model versus a one-time license purchase.
- Subscription Model: With updates and enhancements included, the $1000 annual subscription fee is recognized over the contract’s duration, translating to $250 per quarter.
- One-Time License: When software is sold “as is” for $800, revenue is recognized upfront, at the contract’s commencement.
EXAMPLE: A software firm offers a yearly subscription with free updates for $1000, recognizing $250 quarterly, versus an $800 one-time license fee recognized immediately.
The bill-and-hold scenario represents another complex aspect of revenue recognition. Typically, revenue is recognized when goods are delivered to the customer. Yet, under certain conditions outlined by IFRS, revenue can be recognized prior to shipment.
EXAMPLE: If a customer pre-pays for goods not yet shipped but specified for them and ready for dispatch — and these goods cannot be redirected — revenue can be recognized before shipping.
Required Disclosures under Converged Standards
Companies are required to disclose information about contracts with customers, arranged by category, assets and liabilities related to contracts, the remaining performance obligations and transaction price allocated to those obligations, and any significant judgments and changes in judgments used to determine the amount and timing of revenue recognition.
Key Takeaways for Analysts
Understanding revenue recognition across different business models is crucial for financial analysts. It not only aids in accurate financial analysis but also ensures compliance with evolving accounting standards. Here are some tips:
- Always consider the nature, timing, and risk factors of revenue streams in diverse business models.
- Be vigilant about the specifics of contracts and customer agreements to correctly apply revenue recognition principles.
- Keep abreast of changes in accounting standards that might affect revenue recognition practices.
And that wraps up our lesson on revenue recognition. Keep this information in mind as you continue to learn about financial statement analysis, and best of luck with your CFA exam preparations!