Summary: Depending on the nature of business, companies use different approaches to recognize revenue. As an investor if one has to understand the business of a company, one has to keep an eye on what sort of contracts the company enters into its daily operations and how that dictates its financials. To do so, one needs to know about the revenue recognition logic to make sure that the company is reporting the right numbers.
In this article, I am trying to mention what does recognition mean, how it dictates the measure of success of a company and how one can confirm if the company’s revenue numbers are obtained using the right approach.
Difference between money received and recognized
When I elaborate on this, it will sound too fundamental, but one can cite instances where major corporations have not complied with these simple fundamentals and have duped their investors.
The key difference between what money a company receives and what it earns is that irrespective of when the actual cash transaction takes place a company cannot show it as revenue Right To Earn tat revenue is not established.
Scenario 1:
Suppose you are a contractor and you have obtained a 10 Cr contract from Govt. to make a NEW road of 10 KMs. The work is to commence right now and is to be completed 20 months hence.
Now you have an option of designing your contract yourself. You can choose to:
1) Take all Rs. 10 Cr as advance at the beginning of the project
2) Take all Rs. 10 Cr at the completion of the project
3) Take 5 Cr. Before the project starts, and 5 Cr. After the project ends
In any of the above scenarios, you cannot report the money you have obtained from Govt. as your earned revenue. For e.g., in option 1, when you start your project, the entire 10 Cr. is a liability on your balance sheet and there is no entry on revenue side. In the second scenario, you start with no liability and no revenue. In the 3rd scenario, you start with 5 Cr. as liability and again, no revenue.
Suppose, as per your project plan you are to do equal amounts of road work in each month. In this case, at the end of the 1st month, you can assume that you have done Rs. 50 Lakh worth of work (Rs. 10 Cr. Divided over 20 months worth of effort) and so this is the amount of revenue that you have earned. This is because in case the contract is terminated at that moment, you can at least go back to the govt. and ask for this amount as a just payment of your effort spent.
Each of the 3 contract options earlier, after 1st month your revenue remains as Rs. 50 Lakh. The only difference happens in the Balance Sheet side. Your Balance sheet in option 1 will now show a liability of Rs. 9.5 Cr after 1st month. In 2nd Scenario, your balance sheet will show an asset of Rs. 50 Lakh and in the 3rd scenario, your balance sheet will show a liability of Rs. 4.5 Cr.
It can be seen above how Right To Earn the revenue impacts revenues of a company. It has to be noted that the Right To Earn can be established only when the company has executed a certain amount of contract that has been accepted by the customer. It has got NO RELEVANCE with the actual money that is exchanged.
Scenario 2:
In the above example, suppose you have got a contract of Rs. 10 Cr to only MAINTAIN a 10 KM. long road for 25 months. In this scenario, if the government has given you a basic contract for the entire duration, then the Right To Earn any amount of money is established as and when time passes by. For e.g, each month you are entitled to Rs. 40 Lakh of revenue (10 cr. Over 25 months time frame) as the contract is to Maintain and has got little relevance with the actual work that is needed to be done. What I mean is that irrespective of whether it is Monsoon month and you need to spend a lot of money and effort or if it is a winter month with low maintenance cost, you earn money in equal installments of Rs. 50 Lakh each.
Again, no matter how the contract is designed, the revenue recognition principle remains the same.
To reiterate, in order to understand how the company is supposed to make money, one has to establish how the Right To Earn that money is established. That is the only way even the accounting policy of any firm is supposed to work, and if it does not work that way then something is seriously amiss in the company’s books.
Some examples of revenue recognition logic
Following are some examples of how companies in some industries are supposed to recognize revenue. Along with the logic I am mentioning some of the regular terms that one would find in the Annual Reports, what message that conveys w.r.t. future revenue guidance and how reliable that measure is.
| Industry | How The Right To Earn Is Established | Remarks |
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Money from a contract is recognized in terms of the % of the project effort spent times the overall contract value | Companies often report “Order book”. Take the order book with a pinch of salt. Order book only mentions the size of contracts in pipeline. As described above, it is not the size of the contract alone that determines the amount of money made. It is the amount of effort spent as a % of overall planned effort for the project. A Rs. 10 Cr. Contract over 1 year is generally better than Rs. 20 Cr. Contract over 3 years.Personally, I believe Order Book hides more than it helps. |
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Money from a contract is generally earned on a monthly/quarterly basis. | Such companies often highlight employee strength in reports. Employee strength is a proxy for effort the company is expecting to spend and for a maintenance business, is also a proxy for size of the business. The hiring guidance, if any, should be a decent indicator of revenue prospects |
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Money is earned on the basis of:1) License revenue: when the license is sold and the free trial duration (if any) is over2) Subscription revenue: on the completion of the contract | Look at the accounting principles section on what it says. If there is any deviation from the expected principles, the company should really have a solid reason for that. Generally, this reason will be found in the way contracts are designed for a company. |
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Right to earn is established when the customer crosses the no-cancellation allowed timeline. | Look at the accounting principles section on what it says. If there is any deviation from the expected principles, the company should really have a solid reason for that. Generally, this reason will be found in the way contracts are designed for a company. |
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Right to earn from an advertisement is established when the company has run the required no. of Ads over a required no. of days. | Look at the accounting principles section on what it says. If there is any deviation from the expected principles, the company should really have a solid reason for that. Generally, this reason will be found in the way contracts are designed for a company. |
Conclusion
As individual investors, the one thing that we avoid studying is the section on accounting principles. I can say that because I’ve been through that journey. However, I have learnt that more often than not rather than looking at the precise accounting principles, we need to look for consistency in their application – both in terms of their historical application over successive years and their applicability to the nature of business. In this article, I have just documented how one can apply general logic to understand the concept of revenue recognition. Alternatively, investigating whether the company is recognizing the revenue in an appropriate way should give an investor an idea on whether the company deserves a consideration as a viable investment.
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