What do you consider as revenue?
Most people equate revenue with cash coming in. And certainly that is usually the ultimate measure of what value a business gets from its customers.
Like many things in life, timing is everything, as they say. How many of you over the years marveled at the “coincidence” of meeting your present-day spouse or long-time companion?
Timing played a significant role.
Away from the philosophy and back to the matter at hand. Accounting can be confusing to people. I have found across my years of experience in the finance and accounting world that the confusion for non-accountants boils down one thing: timing.
Revenue recognition, like many other areas of accounting, is especially affected by timing. The month in which a company shows on its income statement how much revenue it has earned.
Many business managers and owners understand the concept of accounts receivable. These are amounts you are owned, usually from doing something for a customer for which they agreed to pay you a certain rate or amount. Often when thinking of accounts receivable, it is accompanied by the pain of the thought of the money you made that you don’t yet have.
Question: Have you ever had to wait longer for the cash from an account receivable? What was the longest? How about being short-paid? Was it because of a dispute with customer over quality, breakage, or unmet expectation? Did they apply a coupon of some sort?
Well, the fact that you have answers to these questions are the reason why both the US Financial Accounting Standards Board and the International Accounting Standards Board have issued a new revenue standard, which was ten years in the making.
The main questions addressed in this standard are when should a company show the revenue on the income statement? And how much?
Because revenue is important to every business, there is natural tendency for people to be overly optimistic about it. There are many complex principles in this standard, and implementing it will require a significant amount of work for many organizations. This is something for which you will need help from an accounting professional (perhaps myself?).
If you keep the “timing” objective in your sights, you will be less apt to go down blind alleys, a rat-hole, or engage in any other activity that is essentially unproductive work.
So with this in mind, I present to you here the ultimate objective of this new masterpiece of accounting literature (its formal name is Accounting Standards Codification section 606 –
Revenue for Contracts with Customers (ASC 606):
The core principle of this Topic is that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.
So let’s break that down a bit, shall we? Some of the paragraph is easy to understand, things like “transfers of goods and services,” “promises” (a.k.a. contracts).
But what is “consideration”?
Lawyers use this term a lot to mean “value given,” which can include money, but also other assets and even actions to be taken. This is what consideration basically means in ASC 606.
What about the word “expects”? Because expectation is a notion that varies with a person’s knowledge and experience of a transaction (a transfer), ASC 606 puts some rules around this concept. While ASC 606 is a set of rules, it is principle-based and requires some judgment.
This requires analyzing customer history, considering how competitors account for the same type of transactions, and many other fun things.
Most companies, when the standard becomes effective (the date by which the standard must be applied), will opt to restate prior years’ revenue. It is generally easier to deal with facts currently than to try to recall them later. This is causing some companies to start the work on applying ASC 606 on current transactions so that the information will be ready.