Financial Education

 

In our general post on sales analysis we offered the example of a bookstore. It seemed easy enough to understand that when a customer bought a book it counted as a sale. However, suppose the customer paid by check. Can the store count the sale as revenue before the check clears? How about a layaway sale? In this case the store has received a portion of the eventual purchase price. Does that portion count as revenue?

These are two simple examples of timing issues that businesses must consider when reporting their financial performance. Accounting rules (called Generally Accepted Accounting Principles, or GAAP, in the US) have developed to answer those questions. These rules have their foundation in what is known as the matching principle: financial statements should be prepared so that revenues earned and the expenses associated with those revenues should be reported in the same period.

There are also specific rules governing when a company can report revenue. According to Financial Statement Analysis: A Global Perspective, revenue can be recognized when all of the following criteria are met:

For goods	For services
The significant risks and rewards of ownership have been transferred to the buyer	The amount of revenue can be measured reliably
The seller no longer retains managerial involvement typically associated with ownership nor effective control of the goods	It is probable that the economic benefits of the transaction will flow to the service provider
The amount of revenue can be measured reliably	The stage of completion of the transaction can be reliably measured as of the financial statement reporting date
It is probable that the economic benefits of the transaction will flow to the seller	The related costs incurred or to be incurred can be reliably measured
The related costs incurred or to be incurred can be reliably measured

In the case of layaway sales, the sale cannot be recognized until the buyer takes the product. In the case of checks that have not cleared, as long as it is likely to clear the revenue can be reported at the time of sale. There are a number of other considerations the company must factor into a report of revenue, which are addressed by a number of ways the company can choose to report sales. In their financial documents a company must disclose the method it uses for reporting revenue. Investors should be on the lookout for any of the following terms, which require additional understanding:

Percentage of completion

Gain on sale

Multiple deliverables

For more information, see all articles on: Financial Statement Analysis, Fundamental Analysis, Investing in Stocks

See also:

Percentage of Completion Accounting

Postretirement Obligations

The Accrual Method of Accounting

Cumulative Effect of Accounting Changes

Operating Leverage