Revenue Recognition

Revenue is the value of all sales of goods and services recognized by a company in a period. Revenue (also referred to as Sales or Income) forms the beginning of a company’s income statement and is often considered the “Top Line” of a business. Expenses are deducted from a company’s revenue to arrive at its Profit or Net Income.

According to the revenue recognition principle in accounting, revenue is recorded when the benefits and risks of ownership have transferred from seller to buyer, or when the delivery of services has been completed.
Notice that this definition doesn’t include anything about payment for goods/services actually being received. This is because companies often sell their products on credit to customers, meaning that they won’t receive payment until later.
When goods or services are sold on credit, they are recorded as revenue, but since cash payment is not received yet, the value is also recorded on the balance sheet as accounts receivable.
When cash payment is finally received later, there is no additional income recorded, but the cash balance goes up, and accounts receivable goes down.

The revenue formula may be simple or complicated, depending on the business. For product sales, it is calculated by taking the average price at which goods are sold and multiplying it by the total number of products sold. For service companies, it is calculated as the value of all service contracts, or by the number of customers multiplied by the average price of services.
Revenue = No. of Units Sold x Average Price
or
Revenue = No. of Customers x Average Price of Services
The formulas above can be significantly expanded to include more detail. For example, many companies will model their revenue forecast all the way down to the individual product level or individual customer level.

Sales are the lifeblood of a company, as it’s what allows the company to pay its employees, purchase inventory, pay suppliers, invest in research and development, build new property, plant, and equipment (PP&E), and be self-sustaining.
If a company doesn’t have sufficient revenue to cover the above items, it will need to use an existing cash balance on its balance sheet. The cash can come from financing, meaning that the company borrowed the money (in the case of debt), or raised it (in the case of equity).
In order to perform a comprehensive analysis of a business, it’s important to know how the three financial statements are linked and see how a company either uses its sales to fund the business or must turn to financing alternatives to fund the business.

Salaries
Bonuses
Hourly wages
Dividends
Interest
Rental income

Income tax
Corporate tax
Sales tax
Duties and tariffs

Sale of goods
Sales of services
Dividends
Interest

Membership Dues
Fundraising
Sponsorships
Product/service sales

Revenue recognition is an accounting principle that outlines the specific conditions under which revenue is recognized. In theory, there is a wide range of potential points at which revenue can be recognized. This guide addresses recognition principles for both IFRS and U.S. GAAP.

According to the IFRS criteria, for revenue to be recognized, the following conditions must be satisfied:
1. Risks and rewards of ownership have been transferred from the seller to the buyer.
2. The seller loses control over the goods sold.
3. The collection of payment from goods or services is reasonably assured.
4. The amount of revenue can be reasonably measured.
5. Costs of revenue can be reasonably measured.

IFRS 15, revenue from contracts with customers, establishes the specific steps for revenue recognition. It is important to note that there are some exclusions from IFRS 15 such as:

Lease contracts (IAS 17)
Insurance contracts (IFRS 4)
Financial instruments (IFRS 9)

All conditions must be satisfied for a contract to form:

Both parties must have approved the contract (whether it be written, verbal, or implied).
The point of transfer of goods and services can be identified.
Payment terms are identified.
The contract has commercial substance.
Collection of payment is probable.

Some contracts may involve more than one performance obligation. For example, the sale of a car with a complementary driving lesson would be considered as two performance obligations – the first being the car itself and the second being the driving lesson.

Performance obligations must be distinct from each other. The following conditions must be satisfied for a good or service to be distinct:

The buyer (customer) can benefit from the goods or services on its own.
The good or service is separately identified in the contract.

The transaction price is usually readily determined; most contracts involve a fixed amount. For example, a price of $20,000 for the sale of a car with a complementary driving lesson. The transaction price, in this case, would be $20,000.

The allocation of the transaction price to more than one performance obligation should be based on the standalone selling prices of the performance obligations.

Recall the conditions for revenue recognition. Conditions (1) and (2) state that revenue would be recognized when the seller has done what is expected to be entitled to payment. Therefore, revenue is recognized either:
At a point in time; or Over time
In the example above, the revenue associated with the car would be recognized at the point in time when the buyer takes possession of the car. On the other hand, the complementary driving lesson would be recognized when the service is provided.

The Financial Accounting Standards Board (FASB) which sets the standards for U.S. GAAP has the following 5 principles for recognizing revenue:
Identify the customer contract
Identify the obligations in the customer contract
Determine the transaction price
Allocate the transaction price according to the performance obligations in the contract
Recognize revenue when the performance obligations are met

The revenue recognition principle dictates the process and timing by which revenue is recorded and recognized as an item in a company’s financial statements. Theoretically, there are multiple points in time at which revenue could be recognized by companies. Generally speaking, the earlier revenue is recognized, it is said to be more valuable to the company, yet a risk to reliability.

According to IFRS standards, all of the following five conditions must be met for a company to recognize revenue:

There is a transfer of the risks and rewards of ownership.
The seller loses continuing managerial involvement or control of the goods sold.
The amount of revenue can be reasonably measured.
Collection of payment is reasonably assured.
The costs incurred can be reasonably measured.

Typical journal entries look like:

DR Cash
CR Deferred Revenue
DR Deferred COGS
CR Inventory

Revenue streams are the various sources from which a business earns money from the sale of goods or the provision of services. The types of revenue that a business records on its accounts depend on the types of activities carried out by the business. Generally speaking, the revenue accounts of retail businesses are more diverse, as compared to businesses that provide services.

Revenue from goods sales or service fees: This is the core operating revenue account for most businesses, and it is usually given a specific name, such as sales revenue or service revenue.
Interest revenue: This account records the interest earned on investments such as debt securities. This is usually a non-operating revenue.
Rent revenue: This account records the amount earned from renting out buildings or equipment, and is considered non-operating revenue.
Dividend revenue: The amount of dividends earned from holding stocks of other companies. This is also non-operating revenue.

Transaction-based revenue: Proceeds from sales of goods that are usually one-time customer payments.
Service revenue: Revenues are generated by providing service to customers and are calculated based on time. For example, the number of hours of consulting services provided.
Project revenue: Revenues earned through one-time projects with existing or new customers.
Recurring revenue: Earnings from ongoing payments for continuing services or after-sale services to customers. The recurring revenue model is the model most commonly used by businesses because it is predictable and it assures the company’s source of revenue as ongoing.

As a financial analyst, analyzing a company’s performance in terms of revenue is always one of the crucial tasks. Therefore, an analyst must be able to recognize the different revenue streams from which the company generates cash and interpret the revenue figures on financial statements.
When a financial analyst looks at financial statements, the revenue number reflects the amount recognized by the company when goods are sold or services rendered, regardless of whether cash is received at that time.

Out of the four revenue streams discussed, recurring revenue is the most predictable income to a business because it is expected that the cash inflow remains consistent with a stable customer base. In contrast, transaction-based and service revenues tend to fluctuate with customer demand and are more difficult to foresee. Seasonality is also often a major factor contributing to the variability in sales of goods and services.
Project revenue is the most volatile and risky revenue stream out of the four because it is largely contingent on customer relationships. Therefore, businesses need to invest a considerable amount of time in managing their relationships to maintain this revenue source.
Understanding the revenue stream enables a financial analyst to realize the pattern of cash inflows, and therefore be able to quickly observe unusual movement or changes in revenue trend, and identify the causes. This is when an analyst performs financial analysis and provides a meaningful explanation for variances.

Depending on the type of revenue models a company employs, a financial analyst develops different forecasting models and carries out different procedures to obtain necessary information when performing financial forecasting. For companies with a recurring revenue stream, a forecast model should have a uniform structure and a similar pattern in revenue predictions.
For a project-based revenue stream, it is essential for an analyst to keep track of the latest project opportunities and continuously modify the forecast model to produce an accurate forecast. The forecast model might look very different each month, due to the constant renewal of projects taking place and the inclusion of various risk factors.

Revenue Variance Analysis is used to measure differences between actual sales and expected sales, based on sales volume metrics, sales mix metrics, and contribution margin calculations.
Information obtained from Revenue Variance Analysis is important to organizations because it enables management to determine actual sales performance in relation to the projected or perceived performance of the company for specific products. It helps businesses identify which products are performing better in the market. Overall, variance analysis helps management make better strategic and business-level decisions to maximize profitability.

companies can also take their analysis one step further to determine market share and market size variances. Market share variance is the difference between actual market share and the estimated/standard market share at the same volume of sales.

On the other hand, market size variance is the difference between actual industry sales and estimated industry sales at a constant market share percentage. When the market share and market size variances are added together, they will be equal to the total sales quantity variance of all products sold by the company.

Variance analysis, as a whole, is imperative for companies because it gives management information that may not necessarily be obvious. By actually examining all individual costs, sales information, and contribution margin figures, companies can better measure the effectiveness of production methods and the performance of specific products relative to others.

For example, even though a certain product may provide a larger contribution margin, leading to higher profitability, it may actually be performing worse than a lower contribution product. Although in the short run the higher CM product may be more appealing, companies should consider which products to focus their efforts on if they intend to maintain longevity in today’s highly competitive market.

This guide provides an overview of the main differences between revenue vs income. Revenue is the sales amount a company earns from providing services or selling products (the “top line”). Income can sometimes be used to mean revenue, or it can also be used to refer to net income, which is revenue less operating expenses (the “bottom line”).

The sale of goods, products, or merchandise
The sale of services, such as consulting
Rental income from a commercial property (notice the use of “income”)
The sale of tickets to a concert
Interest income from lending

The term “income” can sometimes be confusing, as accountants often use it to refer to a revenue. The term net income clearly means after all expenses have been deducted.

Types of income include:

Gross income (before any expenses are deducted)
Net income (after all expenses are deducted)