What is revenue recognition and why is it important?

The principles of "revenue recognition" in company accounting are vague and open to interpretation.

As a result, many businesses are confused, while others use creative accounting practices to take advantage of the grey areas which lawyers need to be aware of to avoid unwittingly being caught up in bad behaviour. For this reason IFRS 15, which came into effect in 2018, will force businesses into greater transparency and fuller disclosure.

Recording revenue – not as straightforward as you may think 

Revenue is the first line on an organisation’s statement of income and expenses. And on the face of it, nothing could be simpler than entering into this line the total amount of money the business earned from providing its goods and services. 

However, there are complex considerations that can affect this number. 

The key principle in accounting is that an organisation recognises revenue when it’s earned, not when the money is received. This means the model accounts for revenue when control of goods or services transfers to the customer, whether or not money has changed hands. 

This creates several grey areas. Let’s look at the three most common of these. 

Multi-year transactions 

The first major problem area for revenue recognition is multi-year transactions. Here are two examples: 

1: A building contractor agrees to build a house extension over eighteen months for a fixed fee. Should the contractor: 

• Record all the revenue in the first year, even though it hasn’t finished the work? 
• Split the revenues across all the accounting periods? or 
• Wait until the project is complete before entering the revenue? 

2: A major engineering firm wins a bid to deliver a five-year infrastructure project. From an accounting point of view, this will involve: 

• Fixed and variable costs; 
• Multiple deadlines; and 
• Uneven cash receipts and expense payments, often uncorrelated. 

These factors make it difficult to estimate when to record revenue, and how much in each accounting period.

In both of these types of case, accountants generally record revenue on completion of the project, whether or not the business has received any payments. 

Nevertheless, it’s clear that, with the level of interpretation and judgement these scenarios permit, there’s considerable scope for manipulating revenue recognition. 

Multi-component transactions 

A second problem area for revenue recognition is where a company offers a combination of goods and services.

A great example of this is a technology company providing a bundled package that includes: 

• Hardware; 
• Software; 
• Consulting: 
• Service and maintenance; 
• Technical support; 
• System upgrades; 
• The impact on the revenue on any one product from any volume based sales discounts in place; and 
• Warranties. 

As these products and services are often interdependent, it can be difficult to separate them and measure the revenue that each element contributes by quarter over an extended period. 

To solve this problem, companies are increasingly deferring a proportion of the revenue related to each device sold to reflect factors such as what percentage of the items sold are returned under warranty and at what point in the warranty period. While this is a forward-looking option, it affects reported revenue growth and profit margins, factors that market analysts monitor closely. It also normally requires the product or service to have a track record of sales from which these deferral assumptions can be based. This can make revenue recognition decisions on new products and services which have no track record very difficult. 

Year-end cut-off, "teaming and lading" or channel stuffing 

This third key area of contention in revenue recognition is about short-term revenue inflation.

If a company is allowed to record revenue for the products it delivers, it can take advantage of an opportunity to superficially inflate its figures and give a misleading picture of its financial performance. 

Known as channel stuffing, or trade loading, the process works like this: 

• Towards financial year end, a company ships excess stock to customers, whether those customers has asked for it or not; 
• The company offers discounts or incentives such as extended credit on a sale or return basis; and 
• The company records the value of this stock as revenue on its financial statement. 

A tell-tale sign of channel stuffing is an unusually high level of returns at the beginning of the next financial year as the unwanted products start arriving back at businesses involved in this practice. 

Another key sign is when the buyer and the seller - for different reasons  - want the effective date of the contract, the delivery, the service or goods acceptance etc. to be different. This is sometimes suggestive that the two parties want to treat the transactions differently in their respective accounting books i.e. the seller wants to "sell" it this financial year to meet targets; and the buyer wants to "buy" next financial year as they have no budget left this year. 

New accounting rules 

With business becoming ever more complex and accounting guidelines increasingly open to interpretation, regulators have been working to reduce the scope for the more creative techniques adopted by finance departments. 

The result of this is the International Financial Reporting Standard 15 (IFRS 15) published by the International Accounting Standards Board. 

This will align accounting standards in all major geographies. It will force businesses to adhere to strict and harmonised rules for revenue recognition and fuller disclosure on their financial statements. 

It also provides a single principle, based on a five-step model, that they’ll need to include in all their contracts with customers. 

These five steps are: 

1. Identify the contract with a customer 
2. Identify all the individual performance obligations within the contract 
3. Determine the transaction price 
4. Allocate the price to the performance obligations 
5. Recognise revenue as the performance obligations are fulfilled.

Further information on the steps can be found at https://en.wikipedia.org/wiki/IFRS_15

IFRS 15 will apply to companies with annual reporting periods that began on or after 1 January 2018. 

It is clear that good in-house lawyers will need to ensure that existing and new contracts that run past that date are modified proactively in conjunction with their accountants to ensure that there no accounting problems are being stored up for the future.

Conclusion

Revenue recognition means being able to record revenue in the pipeline as well as payments received. It can create confusion, especially for businesses involved in long-term contracts and those who provide a combination of products and services as part of a package. It also provides the opportunity for some businesses to inflate their revenues in their financial statements. IFRS 15, standard published by the International Accounting Standards Board and came into effect in 2018, is designed to clarify revenue recognition and close loopholes.