Recognizing revenue and understanding the revenue recognition principle

- We all like making money. I love making money. In fact, selling goods and services to make a profit is the number one reason most for-profit businesses exist. Sales, revenue, profit. Many use these words interchangeably, but they're not always the same. The only time they would be is if revenue could be recognized at the time of the sale and there are no costs to offset that revenue. The income statement tells this revenue story for a given period, usually a year. And we're going to look at a couple of scenarios to illustrate my primary goal for you in this video, which is a sale today does not necessarily equal revenue today. In fact, the revenue recognition principle states that for revenue to be recognized, the performance obligation must be satisfied. That's it. It doesn't matter if payment's been made, just that we've performed the obligation. Let's imagine a grocery store purchase we made this weekend. For that grocery store, revenue can be recognized at the point of the sale. And if we consider the income statement for that grocery store, we would see a revenue section that would include the sales for that reporting period. There may be some offsetting returns to consider, but for the most part, the revenue section represents the sales for the period. But let's explore another scenario. Imagine you're a salesperson for a construction company and you're so pumped because you just landed the largest sale of your career. The paperwork is signed, and the timetable is established. This construction project is so large that it will take three years to complete. Can the income statement for this period show the full amount of the sale for revenue for this period? No. Because the income statement is for a period of time, and because sometimes that good or service being sold crosses more than one fiscal year or takes longer to produce, the revenue shown on the income statement cannot always be the same as the sales for the period. So let's return to the large construction project example. This example will take multiple years, and in each of these years, we'll incur expenses to complete our work. For our performance obligations that must be satisfied over a long period of time, we're recognizing revenue as the project progresses. Let's put some numbers to this example. Assume the large three-year construction contract is for $12 million. We expect total costs of the three-year project to be $8 million, which gives us a gross profit of $4 million. Assume that in year one, we incur $4 million of costs. That's half of the total costs. And the cost-to-cost method of recognizing revenue allows us to show half of the total revenue then, or $6 million, this period. That's 50% of the total revenues in year one because half of the costs are incurred in year one. I want you to also notice that in years two and three, we recognize revenue proportionate to the costs incurred. This approach allows the income statement to tell a story more consistent with what's actually happening in the organization. If we wait to recognize the full $12 million of revenue until year three when the project is complete, the income statements for years one and two would show over 80% of the project costs with no offsetting revenue. There are more complications to recognizing revenue than I can possibly cover here. The revenue recognition principle is quite simple on paper but much more difficult for businesses to put in practice because of the nature of a sales transaction. The goal here is to help you look at revenue differently and appreciate the complexities of identifying, measuring, and recording revenues. Take a moment to think about the nature of the sales transactions where you and those you know work. Ask yourself, when is the performance obligation satisfied so that they can recognize revenues on their income statement? And if you can get your hands on their income statement, even better.