Financial Education

 

 

Revenue should be recorded on the basis of the net proceeds received from customers. Intermediaries who sell the products and services of other firms should count only the fees they charge for their own services.

For example, consider Priceline.com, which sells surplus hotel rooms and airline seats. It it sells a seat for $250 and the earns $25, is revenue $25 or $250 (with a related $225 cost)? 

According to Financial Statement Analysis : A Global Perspective, the EITF has provided a series of indicators that should be used to determine if the transaction should be recorded on a gross basis:

• The company is the primary obligor in the arrangement (for example, responsible for fulfillment and acceptance).
• The company has general inventory risk (for example, takes title before the customer orders the product or service).
• The company has latitude in establishing price.
• The company alters the product or provides part of the service.
• The company has discretion in supplier selection.
• The company is involved in product or service specifications.
• The company has physical loss inventory risk.
• The company has credit risk.

Based on the preponderance of the evidence of these indicators, the company makes a determination as to whether revenue should be reported on a gross as opposed to a net basis. As it turns out, Priceline characterizes its revenue on a transaction by transaction basis, as explained in their 2005 10K:

Merchant Revenues and Merchant Cost of Revenues

Name Your Own Price® Services:  Merchant revenues and related cost of revenues are derived from transactions where we are the merchant of record and are responsible for, among other things, collecting receipts from our customers, remitting payments to our suppliers and establishing the price of the services we offer. We recognize such revenue and costs if and when we accept and fulfill the customer’s non-refundable offer. Merchant revenues and cost of merchant revenues include the selling price and cost, respectively, of the travel services and are reported on a gross basis.  Pursuant to the terms of our hotel service, our hotel suppliers are permitted to bill us for the underlying cost of the service during a specified period of time.  In the event that we are not billed by our hotel supplier within the specified time period, we reduce our cost of revenues by the unbilled amounts.

Merchant Price-Disclosed Hotel Service:  Merchant revenues for our merchant price-disclosed hotel service are derived from transactions where customers use our service to purchase hotel rooms from hotel suppliers at rates which are subject to contractual arrangements.  Charges are billed to customers at the time of booking and are included in Deferred Merchant Bookings until the customer completes his or her stay. Such amounts are generally refundable upon cancellation prior to stay, subject to cancellation penalties in certain cases. Merchant revenues and accounts payable to the hotel supplier are recognized at the conclusion of the customer’s stay at the hotel. We record the difference between the selling price and the cost of the hotel room as merchant revenue.

Agency Revenues and Cost of Revenues.

Agency revenues are derived from travel related transactions where we are not the merchant of record and where the prices of the products sold are determined by third parties. Agency revenues include travel commissions, customer processing fees and Worldspan, L.P. reservation booking fees and are reported at the net amounts received, without any associated cost of revenue. Such revenues are recognized at the conclusion of the customer’s travel.

Sometimes companies report revenues on a gross basis in order to appear larger.  In Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Howard Schilit discussed Papa John’s pizza, which reported $171.8 million of revenue during the first nine months of 1995, of which $78.7 million represented equipment sales to franchisees. Such sales are of weak quality, as once the franchisee has an oven it is unlikely to need another. Given the magnitude of such sales as a percentage of the total, investors in Papa John’s should have been anticipating a sudden slowdown in sales growth as the number of franchises approached saturation.

 

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

See also:

Analyzing Sales

Inventory Cycles in Business

Gross Profit Defined

Accounts Receivable Turnover and Days Sales Outstanding

The 3-Stage DuPont Model