In our previous two pieces, we discussed how companies Present and Calculate Revenue figures. In this piece, we would like to discuss how companies define what should be included in revenue and what shouldn't.
We know that revenue is a consideration a company has received or expects in rendering services or selling a product to customers. Let’s take a couple of examples: If a company created a product which it hasn't delivered yet to the customer for which the company may have received advance and its non-refundable, should it be considered as revenue? Would the answer change if the company has not yet received advance for the same?
Well thankfully, we don't have to worry about these things, as we have Accounting Standards setting up rules on what should be recognised/ recorded as revenue by companies and what shouldn’t.
These accounting policies are set by Accounting Standards which every company has to stick to post customising it to their business environment and model. That’s a really important catch for an analyst. We are not trying to say that companies will cheat by putting up a policy which suits them and keeps changing it every year, but a changing business model/ changing accounting standards may demand for a change in the revenue recognition policy.
What an analyst should always keep an eye out for is a change in these revenue recognition policies, understand the reason behind the same and see if they lead to any impact on financials and should he or she make any changes to the data before hitting the ground for analysis (time-series or cross sectional).
Let’s take various examples of Revenue recognition policies of different models.
As a first step, let’s learn where to find how companies record revenue? You will find this under the Accounting Policies section just after the Financial statements, mostly under the title “Revenue Recognition”. One may observe that since a company may engage into different natures of product and service rendering to customers, the same company may have different revenue recognition policies for each of these revenue generating activities. Let’s take a couple of examples:
Asian Paints: manufacturing and sales of paints and related services
Source: Asian Pains AR2020
Asian Paints defines revenue to be recognised for sale of paint products upon shipment of the product to its customer, that's when the company loses control of their product to the customer! This is a simple format which the majority of the companies have to follow while analysing what to report as revenues. Even here subtle changes can be present in the definition of control.
Whereas for rendering of services, it recognises revenue based on milestones which are achieved. Such contracts tend to have milestones where, service renderer is entitled to a payment upon achievement of a pre decided and agreed upon milestone. Example: Contract states explicitly that the customer would be liable to pay 25% of overall contract value upon reaching a particular stage of the project.
Taking another interesting example of EROS. It engages in multiple activities and below are the revenue recognition policies for these activities:
Theatre sales: Upon ticket sales of movies and if there are any minimum contracted guarantees provided by any exhibitors, recognise it upon release. Example, if there is a minimum contractual guarantee provided by an exhibitor of lets say 1 Cr, They are liable to pay that amount to EROS as soon as they get movie screening rights even if they may or may not be able to sell the tickets for whatsoever reasons.
Sale of film rights: Upon delivery of rights (In this segment, the company sells its movie rights/ exclusivities to different distributors/ networks). One may also notice the term, pre-agreed transfer pricing norms. We will discuss this in much detail when we walk you through analysis of Related Party transactions.
Sale of satellite rights: Same as above
Production fee: Milestone approach which we discussed in Asian Paints.
Taking example of Just dial as next:
Just Dial Recognises revenues across multiple segments using different recognition policies.
Search related services are basically long term arrangements for digital presence of customers on Just Dial’s website for lead generation. It's a fixed cost paid by customers to JD for a tenure of one year or more. Generally, Just Dial is known to sell 1-5 year contracts to their customers to avail this digital presence service on JD’s website. This payment is usually made upfront or in a periodical manner by the customer to JD.
As a result, sometimes this leads to items such as Contract Assets/ Contract Liabilities on JD’s balance sheet. More on these items would be covered in our next blog where we teach you how to analyse Revenues of such companies which engage in long term contracts with their customers.
Meanwhile, focussing on the issue at hand, to understand how JD recognises the revenue for such long term contractual arrangements? Answer is pro-rata basis over the contract period.
Example: On 1st april, 2018, If a 5 year contract is sold for 3 lakh rupees by JD to a customer, after one year of service delivered as per the contractual terms, the firm would be able to recognise 1/5th or 20% revenue of 3 lakh rupees which is INR 60 thousand for the FY19 financial year. At the end of FY19, the remaining 2.4 lakh rupees (if already paid in advance by the customer) would sit in the Contract Liabilities/ Deferred Revenue account on Liabilities side, as mentioned earlier, we will understand these items in more detail in next blog.
This is why when you take a look at the Income statement, you would notice it says revenue from contract with customers instead of sale of goods and you will find very high Contract Liabilities/ Deferred revenue figures on JD’s Balance sheet. In fact, more than 75% of Total liabilities are these Deferred Revenues i.e. undelivered contracts for which payment has already been made and services are to be rendered in the upcoming timeframe.