Corporate Financial Reporting and Analysis, 3rd Edition

Chapter 4

Revenue Recognition

Introduction

This chapter discusses revenue-recognition practices under US GAAP and IFRS. Revenue is one of the most important figures in a company’s financial statements, and is often the largest. Not only is it the starting point for calculating profit, but sales forecasts are typically the first step in performing corporate valuations. But what exactly is “revenue” and how should companies measure and report it?

To begin, let’s consider the operating cycle for a typical manufacturer. The cycle begins with the ordering of the raw materials, parts, and components needed to produce the company’s products. These materials are then converted into finished products in the firm’s manufacturing facilities. Meanwhile, orders are received from wholesalers, retailers, and other customers. The finished product is delivered and, usually a few weeks later, cash is collected from the customer.

So, when should revenue be recognized in this cycle? Perhaps when the order is received? Probably not, especially if the order is received before the product is produced. Common sense suggests that revenue should not be recognized from the sale of a product unless that product has already been manufactured.

Why not recognize revenue when the manufacturing process is complete? Again, too soon. Merely producing a product, without a willing buyer, is not sufficient to claim that revenue has been earned.

Perhaps we should go to the opposite end of the cycle and wait until the ...