7 March 2016
Revenue Recognition – Is it really necessary?

We have all heard of Sales, Billings and Revenue but how much consideration has been given to how and where these are reported and what they are used to managed.

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A brick and mortar retailer of shoes knows precisely when they have earned revenue and how much. Recording the sale in the cash register is the sale event and the amount of money in the register determines the sale value. For this retailer the sale event is also the time at which income or revenue has been earned.

For a professional services organisation however it is not quite so simple. A scenario for a Fixed Price services project may go something like this:-

• Account manager sells a custom software development project to a customer
• Customer provides a Purchase Order (P/O) to the vendor
• Finance office bills the project 25% up front and 75% on project completion
• Services team completes the project 3 months after the P/O was received
• Services team worked on the project sporadically over the 3 months

In this scenario the sale occurred when the customer provided the purchase order to the vendor, billings occurred when the 2 invoices were raised. But what about revenue and why is it important?

Revenue is important because it is required to be able to report Gross Profit Margin on a period by period basis. To report Gross Profit Margin there are two pieces of information required Revenue less Costs Incurred equals Gross Profit Margin.

Costs Incurred is reasonably easy to determine as it is primarily labour costs incurred during the period. Revenue on the other hand is somewhat more difficult. The scenario above requires the calculation of revenue at the end of each period. This calculation needs to be appropriate and consistently applied across projects and periods. It also needs to be consistent across organisations so that people reading financial statements are able to compare one organisation to another and rely on the information presenting a true and accurate picture of the organisations performance.

Fortunately there are standards for defining, recognising and reporting revenue by financial periods in financial statements e.g. the Profit and Loss Statement. These standards are determined and managed by the ‘Australian Accounting Standards Board’ (AASB). For international readers these standards are somewhat consistent with those developed by the ‘International Accounting Standards Board’ (IASB).

Below in the ‘Reporting Standards’ section in this post are excerpts from the applicable Australian Standard for ‘Revenue’. These excerpts have been chosen due to their relevance to Professional Service organisations. Comments have been provided for each to elaborate on what each means for professional services organisations.

In summary the key points are:-

Defining revenue:
Revenue is the inflow of economic benefits during the period arising in the course of ordinary activities. In the case of professional service organisations this translates into to revenue earned from provision of services during a period, usually a ‘Financial Reporting Period’.

Measuring revenue:
Revenue shall be measured at the fair value of the consideration received or receivable.

The amount of revenue arising on a transaction is usually determined by agreement between the entity and the buyer or user of the asset. It is typical to have some form of an agreement that defines the deliverables and states the cost of the project.

Recognising revenue:
The primary issue in accounting for revenue is determining when to recognise revenue.

Revenue is to be recognised over the period in which the services were performed. This is fairly straightforward for services provided on a Time and Material basis.

When a project involves delivery of a product that has required services to develop the product, e.g. software, and the provision of services to the project can be estimated reliably, revenue associated with the project shall be recognised by reference to the stage of completion of the project at the end of the reporting period.

An “effective internal financial budgeting and reporting system” is identified in the accounting standard as being important for tracking work performed and estimating or calculating revenue.

Revenue Earned But Not Yet Invoiced V’s Revenue Invoiced But Not Yet Earned

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As a result of determining Revenue for a period the organisation is then able to calculate a couple of important pieces of information that are also then included in the Financial Statements. These are:

• Revenue Earned But Not Yet Invoiced
• Revenue Invoiced But Not Yet Earned

Revenue Earned But Not Yet Invoiced

This is where total Revenue earned for the project as at the end of the period is greater than all invoices raised on the customer up to the end of the period.

It is calculated as:
If All Revenue earned less all Customer Billings > zero then calculate
All Revenue earned less all Customer Billings = Revenue Earned But Not Yet Invoiced

This figure is treated and reported in the organisations balance sheet financial statement an ‘Asset’. This is because the business has earned this revenue even though it has not yet invoiced the customer for all revenue earned.

Revenue Invoiced But Not Yet Earned
This is where total Revenue earned for the project as at the end of the period is less than all invoices raised on the customer up to the end of the period.

It is calculated as:
If All Revenue earned less all Customer Billings < zero then calculate
All Customer Billings less Revenue earned = Revenue Invoiced But Not Yet Earned

This figure is treated and reported in the organisations balance sheet financial statement a ‘Liability’. This is because the business has raised an invoice on the customer, and even possibly received payment, even though it has not yet earned the revenue i.e. has not yet performed services to the value hat has already been invoiced.

Business Management Systems
Calculating and reporting Revenue, Costs Incurred, Revenue Earned But Not Yet  Invoiced and Revenue Invoiced But Not Yet Earned on a period by period basis can be daunting prospect. These calculations need to be consistent, at sufficient level of detail, auditable and preferably automatic.

Ideally this information should be available at a Project level as well as summarised. The calculations require running balances to be maintained for each period and for each project. This is because the ‘Revenue Earned But Not Yet Invoiced’ and Revenue Invoiced But Not Yet Earned’ figures represented balances or totals as at the end of each period.

Fortunately there are business management systems that are available to professional service organisations for manage Revenue and reporting as required by the Accounting Standards. ‘Alert’ is one of these.

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Alert not only manages billings, both ‘Time and Material’ and ‘Agreed Charge’, but simultaneously and automatically manages the calculation and reporting of Revenue, Costs Incurred, Revenue Earned But Not Yet Invoiced and Revenue Invoiced But Not Yet Earned on a period by period basis.

These are determined at the individual project level and this is very important as it provides project profitability reporting on a period by period basis. Tracking project profitability is critical for organisations to effectively manage their way to profitability.

For more information on how Alert can help your organisation to calculate and report revenue contact sales@AlertIT.com

Reporting Standards

http://www.aasb.gov.au/admin/file/content105/c9/AASB118_07-04_FP_COMPdec12_01-13.pdf

The Australian Accounting Standards Board (AASB) develop Accounting Standards to improve the quality of financial reporting by Australian reporting entities. Australian reporting entities under the Corporations Law are required to apply these standards when reporting.

Under the “Framework for the Preparation and Presentation of Financial Statements” the AASB has issued the accounting standard AASB118 ‘Revenue’.

AASB 118 ‘Revenue’ as amended incorporates IAS 18 Revenue as issued and amended by the International Accounting Standards Board (IASB). This means that there is some international consistency in these standards.

The Objective of this standard are:
Income is defined in the ‘Framework for the Preparation and Presentation of Financial Statements’ as increases in economic benefits during the reporting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. Revenue is income that arises in the course of ordinary activities of an entity and is referred to by a variety of different names including sales, fees, interest, dividends and royalties. The objective of this Standard is to prescribe the accounting treatment of revenue arising from certain types of transactions and events.

The primary issue in accounting for revenue is determining when to recognise revenue. Revenue is recognised when it is probable that future economic benefits will flow to the entity and these benefits can be measured reliably. This Standard identifies the circumstances in which these criteria will be met and, therefore, revenue will be recognised. It also provides practical guidance on the application of these criteria.

AASB118 should therefore be referred to when determining when and how to report revenue.

Definition of Revenue
The definition of Revenue according to AASB118 is:

Section 7
Revenue is the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants.

Comment: For an organisation providing services this means that revenue should be recognised for work performed during the period.

Measurement of Revenue
Measurement of Revenue according to AASB118 is:

Section 9
Revenue shall be measured at the fair value of the consideration received or receivable.

Section 10
The amount of revenue arising on a transaction is usually determined by agreement between the entity and the buyer or user of the asset. It is measured at the fair value of the consideration received or receivable taking into account the amount of any trade discounts and volume rebates allowed by the entity.

Comment: The amount of revenue is based on the service contract between the supplier and the customer. This may be ‘Fixed Price’, ‘Time and Material’ or a hybrid of both with additional clauses.

Identification of the Transaction

Section 13
The recognition criteria in this Standard are usually applied separately to each transaction. However, in certain circumstances, it is necessary to apply the recognition criteria to the separately identifiable components of a single transaction in order to reflect the substance of the transaction. For example, when the selling price of a product includes an identifiable amount for subsequent servicing, that amount is deferred and recognised as revenue over the period during which the service is performed. Conversely, the recognition criteria are applied to two or more transactions together when they are linked in such a way that the commercial effect cannot be understood without reference to the series of transactions as a whole. For example, an entity may sell goods and, at the same time, enter into a separate agreement to repurchase the goods at a later date, thus negating the substantive effect of the transaction; in such a case, the two transactions are dealt with together.

Comment: The important part of this statement is that revenue for services performed is to be recognised during the period in which the services were performed regardless of if services were bundled with sales or products or non-service related items.

Rendering of Services

Section 20
When the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction shall be recognised by reference to the stage of completion of the transaction at the end of the reporting period. The outcome of a transaction can be estimated reliably when all the following conditions are satisfied:

(a) the amount of revenue can be measured reliably;
(b) it is probable that the economic benefits associated with the transaction will flow to the entity;
(c) the stage of completion of the transaction at the end of the reporting period can be measured reliably; and
(d) the costs incurred for the transaction and the costs to complete the transaction can be measured reliably.

Comment: The main point here is that revenue is to be recognised based on the stage of completion. For services provided on an hourly ‘Time and Material’ basis this is reasonably easy to achieve however is somewhat problematic for services provided on a ‘Fixed Price’ basis.

Section 21
The recognition of revenue by reference to the stage of completion of a transaction is often referred to as the percentage of completion method. Under this method, revenue is recognised in the reporting periods in which the services are rendered. The recognition of revenue on this basis provides useful information on the extent of service activity and performance during a period. AASB 111 also requires the recognition of revenue on this basis. The requirements of that Standard are generally applicable to the recognition of revenue and the associated expenses for a transaction involving the rendering of services.

Comment: This statement refers to ‘stage of completion’ as ‘percentage of completion method’. This typically applies to ‘Fixed Price’ projects where the percentage of completion is required to be calculated at the end of each period.

Section 22
Revenue is recognised only when it is probable that the economic benefits associated with the transaction will flow to the entity. However, when an uncertainty arises about the collectability of an amount already included in revenue, the uncollectable amount, or the amount in respect of which recovery has ceased to be probable, is recognised as an expense, rather than as an adjustment of the amount of revenue originally recognised.

No Comment

Section 23
An entity is generally able to make reliable estimates after it has agreed to the following with the other parties to the transaction:
(a) each party’s enforceable rights regarding the service to be provided and received by the parties;
(b) the consideration to be exchanged; and
(c) the manner and terms of settlement.

It is also usually necessary for the entity to have an effective internal financial budgeting and reporting system. The entity reviews and, when necessary, revises the estimates of revenue as the service is performed. The need for such revisions does not necessarily indicate that the outcome of the transaction cannot be estimated reliably.

Comment: An “effective internal financial budgeting and reporting system” is identified in this statement as being important for tracking work performed and estimating or calculating revenue.

Section 24
The stage of completion of a transaction may be determined by a variety of methods. An entity uses the method that measures reliably the services performed. Depending on the nature of the transaction, the methods may include:
(a) surveys of work performed;
(b) services performed to date as a percentage of total services to be performed; or
(c) the proportion that costs incurred to date bear to the estimated total costs of the transaction. Only costs that reflect services performed to date are included in costs incurred to date. Only costs that reflect services performed or to be performed are included in the estimated total costs of the transaction.

Progress payments and advances received from customers often do not reflect the services performed.

Comment: “Services performed to date as a percentage of total services to be performed”. Total services to be performed may change as the project progresses. The initial budget of Total Hours for a Fixed Price project may increase as complications arise during the project. It is important to revise the Total Work for a project each period. This should be done by determining ‘Remaining Work’ and adding to ‘Work Already Performed’ to determine Total Work. Only then can percentage completion be determined and Revenue calculated for the period. It is also interesting to note that customer payments have nothing to do with revenue.

Section 25
For practical purposes, when services are performed by an indeterminate number of acts over a specified period of time, revenue is recognised on a straight-line basis over the specified period unless there is evidence that some other method better represents the stage of completion. When a specific act is much more significant than any other acts, the recognition of revenue is postponed until the significant act is executed.

Comment: It is usual for services provided to a project to be piecemeal and not a consistent number of hours over the duration of the project. Due to this recognising revenue on a regular ‘$ per day’ basis would be inaccurate. Calculation of revenue on a percentage completion basis at the end of each period is, in the large majority of cases, much more accurate.

Section 26
When the outcome of the transaction involving the rendering of services cannot be estimated reliably, revenue shall be recognised only to the extent of the expenses recognised that are recoverable.

Comment: In the large majority of cases for professional service projects the contract for supply of services explicitly details the cost for services provided and the basis on which these costs are incurred e.g. Time and Material or Fixed Price. These terms are agreed before the project is commenced. It is unlikely therefore for revenue ever to be recognised based on only the costs incurred being recovered.

Section 27
During the early stages of a transaction, it is often the case that the outcome of the transaction cannot be estimated reliably. Nevertheless, it may be probable that the entity will recover the transaction costs incurred. Therefore, revenue is recognised only to the extent of costs incurred that are expected to be recoverable. As the outcome of the transaction cannot be estimated reliably, no profit is recognised.

Comment: It is not likely that a professional services organisation will commence a project without the terms of the project being fully agreed and disclosed between the supplier and customer. It is unlikely therefore for revenue ever to be recognised based on only the costs incurred being recovered.

Section 28
When the outcome of a transaction cannot be estimated reliably and it is not probable that the costs incurred will be recovered, revenue is not recognised and the costs incurred are recognised as an expense. When the uncertainties that prevented the outcome of the contract being estimated reliably no longer exist, revenue is recognised in accordance

Comment: Same comment as for Section 28.