Revenue and cost recognition

Before diving in further it is critical to understand certain revenue and cost recognition principles.

Let’s take a simple example: Suppose the company from the previous chapter sells about 50 motorcycles today, but receives the remuneration only after 30 days, when does the company record this transaction? On the day of the sale or when the cash is received?

There are two primary types of accounting principles - cash and accrual accounting.

In cash accounting, any transaction is recorded only when the money changes hands. So in our example, the sale would only be recorded on the 30th day when the cash is received.

In accrual accounting the entry is made or the transaction is recognised when the invoice is raised and the company has reasonable certainty that the transaction will be successfully completed. In the case of our example - on the day the sale is conducted.

Modern-day accounting is mostly accrual accounting. Why? Accrual accounting provides a more accurate description of business realities as well helps smoothen out the ups and downs of cash accounting. For instance, a month with many cash receipts might appear very profitable, while a month with large cash payments might look like a loss, even if the underlying business activity is consistent. It therefore fails to accurately reflect the true economic activity of a business during a specific period.

What do you do in the case of a long term contract? Say, for example, a company has received a contract to build a dam which will take about five years. Does this mean, the company can't recognise any sales for 5 years?

For long term contracts, revenue is recognised basis of the company’s progress towards completing a performance obligation (in this case building a dam). Using methods like percentage of method completion, the company can systematically record revenues. For example, if the contract says, the first tranche of revenue can be recognised, after 20% of the dam is completed. So, in this case, assuming the company completes this work in one year, they can record 20% of the total revenue since the project has been completed or the service has been rendered.

Moving now to expenses. As part of accrual accounting, expenses follow what is called the matching principle. Under the matching principle, expenses to generate the revenue are recorded in the same period as the revenue. Let’s take inventory (raw materials) as an example.

Suppose you purchased raw materials in the current quarter, but were only able to make a sale in the next one. As such, both the sales and cost of sales are recorded during the time of the sale.

Basically, the matching principle says that the cost incurred to generate revenue should be matched with the revenue and recognised at the same time.

This ensures that the comparison of cost and revenue is accurate and provides a correct picture not just of the cost incurred to generate said revenue, but also helps calculate the profits earned on any transactions.

Certain expenses are however not linked to any business activity, but are costs that must be spent in a particular period. Think of audit expenses. Audits are legal requirements that are independent of the business activity in any period. Such costs are called period costs and they must be recognised in the period in which they were incurred.

Finally, coming to why an analyst or investor pays attention to these things.

To a certain extent, both revenue and expense recognition involve some estimates from the management. For example, the management of a garment company may assume a sale occurred when they ship the product out to the customer. But in case the customer (with a legitimate grievance) returns the products, the entire sale and by extension the costs around it, may need to be reversed.

Since estimates are involved, it is possible for firms to delay or accelerate the recognition of these items. Delayed expenses for example increase the current net income and provide a more optimistic picture of the business and vice versa.

Similarly one must question any sharp change in revenue or expense recognition. Is revenue growth increasing (in a particular period) because the company is selling more products or has it lowered the credit period from 45 days to 30 days?

Analysts should also compare the firm's estimates to those of other firms within the same industry, to ensure that there are no major discrepancies between the firm and the rest of the industry.