CFA Level 1
Financial Statements - Revenue Recognition
I. What is Revenue Recognition?
The Matching Principle
The matching principle of GAAP dictates that revenues must be matched with expenses. Thus, income and expenses are reported when they are earned and incurred, even if no cash transaction has been recorded.
For example, say a company made a sale for $30,000 within an accounting period but has not received payment. Even though the company was not paid, the sale is recorded as revenue. This revenue has to be matched with the expenses that the company incurred in the accounting period to generate that revenue (revenues and expanses must match).
If revenues were not matched with their related expenses, companies would produce financial statements that provide little information to the readers and themselves. (This is a fundamental principle of accrual-basis accounting)
SFAS 5 specifies that two conditions must be met for revenue recognition to take place:
Completion of the Earnings Process
This means the company has provided all or virtually all of the goods and services for which it is to be paid. Furthermore, it means the company can measure the total expected cost of providing the goods and services, and the company must have no significant remaining obligations to its customers. Both must be true for this condition to be met.
Assurance of Payment
There must be a quantification of the cash or assets that will be received for realized goods and services. Furthermore, the company must be able to accurately estimate the reliability of payment. Both must be true for this requirement to be met.
Under gross revenue reporting, sales and the cost of goods sold are reported separately. With net revenue reporting only the net revenue, calculated by subtracting cost of goods sold from gross sales, is reported. Since the only the net revenue is reported, revenues will be less than under gross revenue reporting.
Under U.S. GAAP, a firm using gross revenue reporting must be the primary party to any contract, take on both inventory and credit risk, be able to choose its suppliers, and have the ability to set price.
When analyzing the financial statements analysts should be aware of how aggressive or conservative a firm's revenue recognition policies are. A firm's that has a very aggressive revenue recognition policy runs the risk of over stating its revenues and its earnings performance. Analysts should also be aware of any assumptions or judgments that are made in reporting revenues