Revenue - All About Profit & Loss Statement

Updated: May 14



Welcome to the All About The Profit & Loss Statement series! We aim to help readers better understand the major components that go into the Income Statement. You are probably not a stranger to revenue but ever wonder what is its impact on businesses? Revenue is the income received from the business's everyday operations, such as the selling of goods and the provision of service. It is commonly referred to as Sales or the Top-line, as it resides at the top line of the income statement before any expense is deducted.


Want to learn more beyond the surface? Without further ado, let us embark on this exciting journey. Do leave a like or comment should you have any inquiry or would like to add to the learning experience!


TABLE OF CONTENT

  1. What is Revenue?

  2. Revenue vs Profit vs Cash?

  3. The 5-Step Revenue Recognition Process

  4. The Order Management Process

  5. Revenue for a Merchandising Company (Case Study)

  6. Revenue for a Long-Term Project

  7. Forecasting Revenue

  8. Variance Analysis of Budgeted & Actual Revenue

  9. Difference from Income

  10. Revenue and the Economy


WHAT IS REVENUE?


Revenues are recorded when earned, regardless of when the cash is received under accrual accounting. Sales for the financial year are then totalled and reported in the top-line of the income statement net of returns, discounts, allowances for bad debt, warranty, etc. The exhibit below illustrates how revenue is recorded in the journal.



From an analytical perspective, revenue represents more than a single top-line figure on the P&L statement. By digging deeper into the footnotes, management discussion and analysis (MD&A) in the financial statement and earning guidance, issued quarterly by investor relations, it will yield deeper insights.


OPERATING VS NON-OPERATING REVENUE


Firstly, an analyst has to differentiate operating and non-operating revenue. Operating revenue is sales from core business activities such as goods and services, while non-operating revenue is from non-core sources such as rental, interest and dividend incomes. The top-line typically presents operating revenue, while non-operating revenue typically comes after operating income. One should eliminate non-operating revenue if one is to do analysis and financial modelling as such items are non-core and/or non-recurring in nature and may distort the company's actual financial performances.


REVENUE MODEL


A revenue model is a framework for generating revenue. Understanding the corporation's revenue model is important due to the model's sensitivity to external factors, which causes them to react differently to external stimulants. For example, transaction-based revenue such as those derived from the sale of goods and transnational services are sensitive to customer demand. Project-based revenue, such as those earned by an audit or construction firm, is also influenced by factors such as time and complexity of the task but is less sensitive to demand fluctuation as they are long-term in nature. However, as such projects are longer-term, customer's bargaining power is increased and thus, the relationship with key customers also plays a significant role in revenue. While the demand in subscription model is more sticky as it is longer-term in nature.



ANALYZING REVENUE


To better comprehend the revenue-generating ability of a business, it is insufficient to merely focus on the revenue model. We have to look beyond the surface by going into the footnotes,, MD&A and quarterly releases to get a fuller picture of revenue.



REVENUE VS PROFIT VS CASH?


It is important for managers to be able to differentiate revenue and profits from cash. Revenue is the top-line item before any expenses are deducted and it helps the organization generates cash to pay its operating and capital expenditures and return to investors.

Profit is the residual amount after expenses are subtracted, which represents how effective and efficient are in optimizing revenue and expenses. A portion of profit still remains as on-paper earnings due to accrual accounting until it is realized after the cash on credit purchases and accrued expenses are paid and cash on credit sale is collected.


Cash is the function of profitability, working capital management, capital assets investment, and financing activities. A profitable company might run into a cash crisis if it has difficulty collecting cash from customers. Therefore, although revenue and profit are pretty on paper, cash is still the king.


THE 5-STEP REVENUE RECOGNITION PROCESS


IFRS 15 has specified how revenue is reported and recognized. Being acquainted with the requirements of the standard allows an accountant or manager to help formulate the appropriate accounting and internal control procedures to better create a compliant financial statement. It also helps analysts to identify irregularities of the revenue recognition policy disclosed in the financial statement.


Step 1 - Identify Contract with Customers

  • ☑ The contract of interest has to be approved by all parties.

  • ☑ Each party's rights and obligations to the goods and services are clearly stated.

  • ☑ The payment terms for goods and services can be identified.

  • ☑ The contract must possess commercial substance.

  • It is not revenue if any party has a unilateral right to terminate.

  • It is not revenue if the collection is not probable.

Step 2 - Identify Separate Performance Obligations


If the contract as more than 1 performance obligations, it is mandatory to separate them, unless the separate performance is immaterial. For example, a $100 processing fee is material in a contract worth $1,000 so it must be separately stated. But it is deemed immaterial and need not be separated if the contract is worth $1 million.


Step 3 - Determine Transaction Price


The transaction price is the revenue the seller expects to receive. For example, if the $100 contract has variable considerations, such as the right to return, normal rebate and discount, the seller has to reduce revenue by the probable amount. The probable amount is deemed to be 2% based on historical records, therefore, the revenue of $98 can be recognized.


Step 4 - Allocate Price to Performance Obligations


If the standalone price for the performance obligation is observable, allocate the price based on individual selling price. If it cannot be observed, the price of individual performance obligations can be assigned using 2 methods.



Step 5 - Revenue Recognition


One can recognize the revenue when the title is transferred with formal acceptance, along with the risk and reward that comes with ownership. The seller must also have an enforceable right to payment before recording the transaction as revenue. Revenue can also be recognized at a point or over a period of time, for subscription and project-based models. If it occurs over a period of time, the seller may choose between the INPUT or OUTPUT methods. Both methods will be discussed in our case study.


THE ORDER MANAGEMENT PROCESS


Order management is the system of efficiently tracking and fulfilling sales orders. It aligns people, processes, inventory management, logistics, and suppliers with the goals of order fulfilment, revenue recognition, and creating a positive customer experience. The process starts when a customer places an order and ends when the order is fulfilled. It also aims to keep track of the purchase history, payment method, marketing effectiveness, sale volume, and other data points, which could be used in data analysis to yield useful information.



When a sale order is issued, the sales department notifies the warehouse to fulfil the order, and the order is then shipped to the customer. This process looks seemingly straightforward but underneath the surface, different functions work beautifully together to fulfil the order. Accountants and managers are also interested in this as it is tied to revenue recognition.


REVENUE FOR A MERCHANDISING COMPANY (CASE STUDY)


Elizabeth is the owner of Soapy Bathrooms Inc., a company that supplies and installs bathtubs. To better run the company, she adopts the Order Management system and it can be described as Sales Order >> Delivery Order >> Job Order >> Tax Invoice.


1 - WHEN CUSTOMER PLACES ORDER


When a customer places an order for a bathtub, Elizabeth enters a Sales Order (S/O). He then checks the inventory availability and for any outstanding balance before confirming the delivery and installation timings. No accounting entry is needed at this stage. Steps 1 to 3 of the Revenue Recognition principles lists the finer details that must be fulfilled for revenue to be recognized in the accounting book. So it is important for accountants and managers to incorporate the principles into the design of the 4 forms.


2 - ON THE DELIVERY OF THE PRODUCT


On the day of the scheduled delivery, the logistic team picks up the Delivery Order (D/O) and inventory from the warehouse before delivering it to the customer. Upon receipt of the goods, the customer acknowledges the D/O. The installation team will visit the premise another day to install the bathtub. When the logistic team returns to the office, they pass the D/O to Elizabeth.



Only the revenues associated with the bathtub, mixer and delivery can be recognized in the accounting books, as they are supported by the endorsed delivery order. No revenue from the installation can be recognized yet. An estimated 2% of sales is also set aside as Bad Debt Allowance, to cover the possible default of account receivables.

3 - COMPLETING THE INSTALLATION


The installation team follows-up and makes a visit to complete the installation of the bathtub. The customer then acknowledges it in a Job Order (J/O). Elizabeth subsequently makes the accounting entry to recognize the installation revenue, supported by the duly-endorsed J/O.



Again, 2% of sales are set aside as bad debt allowance. In the event of a default, the Account Receivables is credited (or written off) and the amount deducted from Bad Debt Allowance, leaving the revenue unmolested. This is done in adherence to Step 3, the determination of transaction price to a probable amount.


4 - SENDING THE INVOICE


After the supply and installation is completed, Elizabeth proceeds to send an invoice to the customer, along with carbon copies of the S/O, D/O and J/O. The invoice functions as a claim for the payment.


5 - COLLECTION OF PAYMENT


After 20 days, Elizabeth receives the cash payment from her customer. He then proceeds to make the appropriate journal entry by 1) Increasing the cash balance, 2) Reduce the accounts receivables, 3) Undo the bad debt expense entries, and formally close the transaction 100404G.



REVENUE FROM LONG-TERM PROJECTS


Revenues can also be earned from long-term projects, defined as projects which revenue is earned over multiple reporting periods, such as construction projects, service maintenance contracts, subscriptions, etc. We will be discussing ways to account for the revenues of long-term projects, and how to account for revenue recognition and billing mismatches.


INPUT METHOD


For revenues recognized over a period of time, a business may choose the input and output method. The input method is measured by determining the amount of effort that has been invested in satisfying a contract. To use the method, a manager must estimate the number of inputs required to satisfy a performance obligation. Input expended-to-date is then compared with the initially estimated inputs to measure progress.


Soapy Bathrooms Inc. has secured a contract to supply and install 100 bathtubs in a condominium development for $200,000. Elizabeth estimates that the undertaking requires 500 labour hours. In the first month, the business dedicates 300 labour hours and Elizabeth can recognize $120,000 worth of revenue or (300 labour hours ÷ 500 total labour hours) x $200,000.


OUTPUT METHOD


The output method is a relatively straightforward method that measures progression. To implement this method, a manager should first estimate the number of outputs needed to fulfil the performance obligation. Progression toward completion is then measured using the output-till-date.


Using this method, Elizabeth decides to use the percentage-of-completion output method to measure progress. In the first month, although the company spent 300 labour hour hours, the actual progress is deemed to be only 40%. If Elizabeth adopts this technique, he may recognize only $80,000 worth of sales or 40% x $200,000.


COST IN EXCESS OF BILLINGS


The Cost in Excess of Billings is when the billings on uncompleted contracts are less than the revenue recognized till date. It is a periodic adjustment to adjust revenue to the level recognized. These adjustments are common if the business adopts a project or subscription revenue model and the under-billing creates a current asset.


For another long-term project worth $1,000, the completion currently stands 80% at $800 on 31 Dec 20X1. When Elizabeth billed her customer last week, the completion was only 50% at $500. The Cost in Excess of Billings allows her to reflect the actual revenue of $800 earned for the project on the financial statement.


BILLING IN EXCESS OF COST


Billing in excess of cost is another common adjusting entry for long-term projects to decrease revenue recognized. In another project, Elizabeth requested a 50% prepayment before the project's commencement. On 31 Dec 20X1, the actual progress stands at 25% for the project, which contract is valued at $1,000. The Billing in Excess of Cost allows her to reflect the actual revenue of $250 earned for the project on the financial statement.



FORECASTING REVENUE


Revenue is typically the important and most challenging item to forecast. The revenue forecast is the starting point for all budgeting exercises, as spending plans such as purchasing, payroll budgets, etc, are based on this single critical input.


The burden of forecasting revenue is typically shared with marketing and sales, as it requires substantial basis to back the estimate such as market research, sales target and marketing strategy, and that can only be worked out with their valued assistance. For public companies, issuing revenue forecast is done periodically and it has a material impact on the company's share prices.

Revenue is also one of the key performance indicators (KPI) that investors and financial institutions keep a close watch, due to its close links to profitability, cash flow and value.

But external stakeholders do not share the same level of access to inside information that managers and accountants possess, so they have to rely on proprietary research, expert opinions, and publicly available data to infer the revenue for future periods.


VARIANCE ANALYSIS OF BUDGETED & ACTUAL REVENUE


Unlike external stakeholders, managers and accountants possess more data to forecast and analyze revenue. For example, an accountant might possess data such as the number of customers and sales transactions, selling prices, sales mix, etc, which will allow them to conduct variance analysis on budgeted and actual revenue numbers. More information on variance analysis will be shared in our article on budgeting so stay tuned.


DIFFERENCE FROM INCOME


Revenue represents the sales before any expenses are deducted. Different incomes appear after revenue and is a reflection of how efficiently each cost is managed at each stage. In short, revenue assesses how effective the organization earns money while income also takes into account how efficiently the firm manages its expenses.


REVENUE AND THE ECONOMY


Dependent on the revenue model and the product the business is selling, revenue is affected by the level of economic activity on a varying degree.


SENSITIVITY TO BUSINESS CYCLE

GDP is the gross domestic product of a nation. The expenditure approach estimates GDP as the sum of consumption, investment, government spending, and net export. Although the long-term GDP trend lines of healthy nations are smoothed and upward-sloping, they demonstrate volatility in the short and intermediate-term due to business cycle fluctuations such as expansions and recessions. It is essential for managers to make sense of the business cycle.


INFLATION


Inflation is a numerical measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over time. Inflation can be cost-pushed or demand-pulled. For a business to achieve meaningful real growth in revenue, it has to outgrow inflation.


For example, Soapy Bathtubs Inc. records a sales growth of 5% for the year 20X1 while the inflation for the period is 3%. The real growth rate is important for managers as it seeks to eliminate the effect of an across-the-board price increase to derive real revenue growth.

Real growth = { [ 1 + Nominal Growth ] ÷ [ 1 + Inflation Rate ] } - 1

= {1.05 ÷ 1.03 } - 1

= 1.95%


MARKET STRUCTURE


There are 4 kinds of market structures, namely pure competition, monopolistic, oligopolistic and monopoly. Each structure uniquely impacts the product pricing model which affects revenue. Other than a monopoly, which a company enjoys 100% market share, the vast majority of businesses are price-takers. The magnitude of profit margin is typically determined by the market concentration and the number of participants. Typically, the higher the concentration and lower the number of participants, the higher the profit margin. We will discuss in-depth on the topic of the economy in a later article.

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