What Does Revenue Recognition Really Mean?

May 31, 2017

Author: Tony Tauro, Performance Architects

What does the term “revenue recognition” actually mean?

Companies sell things. The money that organizations get from selling things is called “revenue.” The question becomes at what point in the sales cycle does that money become revenue?  That’s when revenue is “recognized.”  Is it…

When the customer sends the company a signed Purchase Order (PO)?
When the goods are dispatched by the company?
When the goods are received by the customer?
When the customer sends in the payment?

The answer to all these questions is…maybe.

If you are selling to a customer with very bad credit, it is prudent to wait until the payment is received before you account for it as revenue. If the goods are particularly high value, you’d want to ensure the customer received them before accounting for the revenue. If the product has low availability, you want to wait until you’ve dispatched the goods before you recognize the revenue.

The date on which the revenue is recognized has huge implications, and there are stringent rules and guidelines around this. A famous example is how Apple recognized revenue from its phones sold through the carriers. The carriers would “subsidize” the iPhone for customers, and recover the difference over two years. The carriers, however, had to pay Apple the full price. Apple would get $650 in cash per iPhone right away, but had to recognize the revenue over 24 months. Savvy analysts learned early how this discrepancy between cash flow and revenue would affect the value of the company and made a killing on the stock market as a result.

Another example is Microsoft’s 2015 decision to change how it recognized license revenue from the sales of Windows 10 licenses. Instead of recognizing the entire license as revenue immediately (as it used to do), Microsoft decided to defer the recognition over the lifetime of the device to account for the cost of providing periodic support in the form of upgrades. The “lifetime” itself depended on the form factor, so a tablet could have a two-year lifetime while a PC could have a four-year lifetime. While this reduced the company’s revenue, investors recognized the change for what it was and did not punish the stock price.

Not all revenue recognition requirements are complex. Sometimes it is as simple as accounting for logistics (in other words, letting the real world catch up with the virtual world). If an order is received after your logistics company has picked up all deliveries for the day, then you may have to recognize the revenue the next (working) day. If the product must cross borders and there is customs processing (which can be unpredictable at times), then you must wait for an extra event which often is not electronically communicated to your application. Thus, you need a mechanism (like a form) for a user to enter the date manually. These cases are especially relevant when the dates span “periods” like a month-end, quarter-end or year-end.

Revenue recognition is a simple concept, and like typical accounting practices can get rather complicated. The exact rules and how they are implemented vary by industry and by organization. The key is to be aware of the basic principle and know to ask enough questions to gather a comprehensive set of requirements.

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