‘The sweeping revisions in revenue-recognition rules will represent a change for many industries.’
Christine Klimek, spokeswoman for the Financial Accounting Standards Board as reported in The Wall Street Journal
In a nutshell
Revenue recognition determines both when and how much revenue can be recognised in a company’s accounts.
For most companies, revenue is recognised at the point of sale in business transactions. This is usually the point at which legal title to goods passes from a seller to a buyer. In complex transactions or those that involve judgement there is scope for error or manipulation of revenue numbers.
Every company will need to determine (and disclose) its revenue recognition policies. For companies requiring external audit (see Chapter 20 External financial audit), these policies are subject to careful scrutiny.
Need to know 
A company’s revenue recognition policy is critical to understanding its performance.
Why is this important? 
Mistakes in revenue recognition can significantly impact a company’s reported results and reputation. In one of the most high-profile cases of revenue misstatement in recent years, Tesco announced that it had overstated revenue by around £250 million in its 2015 financial statements. The announcement caused the company’s market value to fall by £2 billion (equivalent to an 11.5% fall in its share price) and this in turn resulted in significant boardroom changes, including the departure of the chief executive.
Revenue (known also as turnover, sales or income) is the first line in the profit and loss account and is typically the largest single number in the financial statements. A business must earn sufficient revenue to cover costs and generate profits.
Revenue is a ‘headline’ number that attracts investor attention as it signals how a business is performing in its markets and against competitors. Investors, analysts, employees and others are interested in the revenue metric to help assess business performance. Year-on-year growth in revenue is used as a key metric to assess company prosperity. Directors’ performance rewards may also be linked to revenue or revenue growth.
Revenue data are also used at a macro level by industry and government to understand trends, which may in turn help with strategy or policy formulation.
When is this important? 
Determining the point of sale should be straightforward for most business transactions. Revenue should only be recognised when it has been earned. This is an application of the accruals concept (see Chapter 1 Business accounting) and typically results in a sale being recognised at the point at which goods are transferred to the buyer.
In the case of sellers of goods such as clothing retailers, revenue is recognised at the point of sale, which is when the buyer takes possession of the goods (or accepts delivery), having committed to paying for them.
In the case of service providers such as mobile operators, revenue should be recognised over the period in which the service is provided.
Revenue recognition becomes more complicated in transactions that combine both product and service (known as multi-component transactions) or where a transaction covers more than one year (multi-year transactions). In such situations, the product revenue element should be recognised when it is delivered while the service revenue element should be recognised over the period(s) during which the service is provided.
Example (multi-component, multi-year contract)
A pay-monthly two-year mobile phone contract package, comprising a mobile handset plus data service package, was sold on 1 July for £1,020. The retail price of the handset-only (product) was £700.
In this example, revenue for the service (i.e. data package) would amount to £320 (£1,020 minus £700 handset price). Revenue would be earned by the company over 24 months, the period over which the service is provided.
Assuming the vendor has a year end of 31 December, the seller would recognise revenue in each year as follows:
Year one
| Handset | £700 (revenue recognised immediately at point of sale/delivery) |
| Service | ¨£80 (6 months/24 months × £320 total service cost) |
| £780 |
Year two (onwards)
Service revenue for the remainder of the contract would be recognised as follows:
| Year 2 | £160 (12 months/24 months × £320) |
| Year 3 | ¨£80 (the remainder of the 24-month period, i.e. 6 months) |
Profit (the difference between revenue and cost) in each year would be calculated by matching related costs against revenue (see Chapter 3 Profit and loss (P&L)). In this example, the cost of the handset would be recognised against revenue at the point of sale, i.e. in year one, whereas the costs of providing the ongoing service would be matched against revenue over the 24-month contract term.
In practice 
Despite the requirement for a company to follow clear revenue recognition policies, revenue is, perhaps surprisingly, still open to manipulation. The temptation to misstate revenue may be particularly acute in listed companies, where company (and directors’) success is measured against market expectations of revenue growth.
In the case of Tesco plc, a listed company, its revenue recognition policies allegedly enabled the company to misstate a key component of revenue known as ‘commercial income’ (essentially rebates from suppliers) by ‘estimating’ the revenue due from likely future sales of products in its stores. By over-estimating the future sales, Tesco was able to overstate the estimated commercial income due from suppliers.
It is noteworthy that Tesco’s financial statements had been externally audited and received no comment from its auditors regarding recognition of commercial income (see Chapter 20 External financial audit).
Nice to know 
Revenue is reported in the financial statements net of VAT and other sales taxes. This is because a company collects taxes on behalf of tax authorities (see Chapter 8 Business tax). These monies represent revenue for the Exchequer rather than income for the company.
Revenue is also reported net of trade and volume discounts.
For companies operating as agents, revenue is calculated as the commission receivable for providing a service rather than the full value of the goods sold. For example, eBay provides a shop window for thousands of retailers in its role as agent. While normal accrual principles apply to determine at what point a sale is made, it is only the value of commissions that are recognised as revenue in the accounts of the agent (eBay).
Revenue is also recognised net of sales returns (see below).
Optional detail 
It is common for a business to expect some products to be returned, for example because a customer is not satisfied with the quality of the product or has changed their mind. In accounting terms, a returned good is reflected by reversing the original sale, which has the effect of cancelling the transaction. A company’s reported revenue is therefore shown net of sales returns. There is no reason, however, why goods bought in one year will be returned by the customer in the same accounting period and therefore a company may need to estimate the likely level of returns when reporting annual revenue.
For goods bought in one accounting period but returned in a subsequent (accounting) period, the company will have to estimate the expected level of returns and, unless the value of returns is expected to be immaterial, this will create a provision against revenue to estimate their value. This is a principle known as prudence or conservatism, which states that a business should not overestimate its revenues (and assets) nor underestimate its expenses (and liabilities). This concept underpins how financial statements should be drawn up by accountants.
The example of returns highlights a common misconception among readers of accounts, that financial statements represent an accurate or precise reflection of past performance. Financial statements, by necessity, require estimates (based typically on management judgement) and therefore should be interpreted in this light (see Chapter 20 External financial audit). Equally, it may be argued that it is because financial statements require or permit directors to make such judgements and estimates that financial statements are open to abuse or manipulation, as the Tesco example perhaps illustrates.
Buyback agreements are another example of how a business can artificially inflate its reported turnover. Revenue is recognised in the year a business sells goods only to be reversed in a future year when it ‘buys back’ the same goods. In reality, these are financing arrangements as they do not create genuine ‘sales’ and should therefore be removed (excluded) from revenue. In practice, however, they can be difficult to spot because the reversing of the transaction is only identified at a later date, i.e. in a future year’s accounts.
Where a sale is made but monies are not due until a future date (more than a year), it may be necessary to discount future monies to present value. Discounting reflects the reality that tomorrow’s pound is worth less than a pound today due to the opportunity cost of money (see Chapter 35 Investment appraisal). Discounting is particularly relevant in accounting for ‘buy now pay later’ arrangements, e.g. four-year (or other term) interest-free credit payment terms, prevalent particularly in furniture retailing. In such arrangements, the sales price is split into an equivalent price for goods (revenue) if sold for cash today plus an amount for interest receivable.
Further detail on the accounting treatment and disclosures for revenue recognition are set out in IFRS 15.
Globally, US (GAAP) and international (IFRS) standards on revenue recognition have in recent years become more closely aligned and this should make it easier for investors to compare companies internationally (see Chapter 19 Accounting and financial reporting standards).
Reflect and embed your understanding 
- 1Why might two businesses, that are identical in all respects, nevertheless report different revenue figures?
- 2A listed company, expected to deliver on revenue growth targets set by the market, is facing challenging trading conditions. It is planning to launch several new products during the final few months of the year. How might directors’ judgements affect the reported revenue of the business for the year?
- 3Review the disclosed revenue recognition policy for an example listed company. Is the policy clear and does it include explanations of significant judgements required in reporting the revenue number?
- 4Reflect on this chapter and consider the extent to which financial statements provide an accurate reflection of the performance of a business. Consider, in particular, how important the revenue figure is in assessing that performance.
For the authors’ reflections on these questions, please go to financebook.co.uk
Where to spot in company accounts 
Read the Accounting Policy note in any set of accounts. This should summarise clearly a company’s revenue recognition policies and include explanations of significant judgements required in reporting the revenue number.
The audit report should highlight significant judgements associated with revenue.
Extract from Greggs plc 2020 financial statements, Appendix p. 458
(r) Revenue
(i) Retail sales
Revenue from the sale of goods is recognised as income on receipt of cash or card payment. Revenue is measured net of discounts, promotions and value added taxation. Revenue from delivery services is included in retail sales and recognised on delivery.
(ii) Franchise sales
Franchise sales are recognised when goods are delivered to franchisees. Additional franchise royalty fee income, generally calculated as a percentage of gross sales income, is recognised in line with the franchisees’ product sales in accordance with the relevant agreement. Pre-opening capital fit-out costs are recharged to the franchisee and represent a key performance obligation of the overall franchise sales agreement. These recharges are recognised as income on completion of the related fit-out. Sales are invoiced to customers in credit terms of less than three months.
(iii) Wholesale sales
Wholesale sales are recognised when goods are delivered to customers. Separate disclosure of wholesale sales is not made where the information disclosed would be commercially sensitive, e.g. if there is a single wholesale customer. Sales are invoiced to customers in credit terms of less than three months.
(iv) Loyalty programme/gift cards
Amounts received for gift cards or as part of the loyalty programme are deferred. They are recognised as revenue when the Group has fulfilled its obligation to supply products under the terms of the programme or when it is no longer probable that these amounts will be redeemed. Where customers are entitled to a free product after a set number of purchases under the loyalty programme, a proportion of the consideration received is deferred so that the revenue is recognised evenly across all of the linked transactions.
(r) Revenue (continued)
The nature, timing and uncertainty of revenues arising from the above transaction types do not differ significantly from each other.
(s) Government grants
Government grants are recognised in the balance sheet initially as deferred income when there is a reasonable assurance that they will be received and that the Group will comply with the conditions attaching to them. Grants that compensate the Group for expenses incurred are recognised net of the related expenses in the income statement on a systematic basis in the same periods in which the expenses are incurred. Grants that compensate the Group for the cost of an asset are recognised in the income statement over the useful life of the asset.
(t) Finance income and expense
Interest income or expense is recognised using the effective interest method.
(u) Income tax
Income tax comprises current and deferred tax. Income tax is recognised in the income statement except to the extent that it relates to items recognised directly in equity, in which case it is recognised in equity.
Consolidate and apply
To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 384.
Watch out for in practice 
- →Revenue recognition policy in the notes to the accounts and changes to policy.
- →Risks of revenue recognition misstatement highlighted in the audit report.
- →The nature of the product/service sold and if this is reflected in the revenue recognition policy.
- →Sales returns and how they are calculated. Changes to how a business estimates sales returns can reduce/boost reported turnover and provide scope for manipulation or error.
- →Buyback agreements in which a company sells an asset only to buy it back at a higher price in the future.