When you think about how to work out revenue, it helps to remember that the primary goal is merely to show the income that a business generates from its ordinary activities over a given period. That’s it.
Nevertheless, the premise of how to calculate sales revenue is a topic that can seem deceptively simple or fiendishly tricky, depending on the complexity of the business and how much detail you delve into. To fix this, here’s a primer on everything you need to know to work out revenue correctly.
Revenue: why it’s bad practice to cross the streams
Revenue means the income that a business receives from selling its products or services, as opposed to, for instance, profit from its investments in other companies or a one-off transaction unrelated to its everyday trading. An example here is selling-off obsolete machinery previously used in the business.
A business should describe those types of income as ‘other revenue’ or even ‘extraordinary revenue’. In practice, it’s not uncommon to blend them together but the focus of this post is to discuss the broad principles involved in how to work out total revenues rather than to debate whether to merge streams.
In reality, the main reason some businesses owners bundle various types of revenue together, aside from simplicity, is to make the top-line of their income statements look impressive to investors. This dark art is a shady way to make a meagre gross profit margin suddenly seem more palatable.
How to work out sales revenue?
Revenue is a beast with many faces. It’s often called sales turnover, total sales, or sometimes, sales revenue. These terms are broadly understood to mean the same thing but we cover the precise differences between turnover and revenue here.
The next decision is to decide which flavour of sales revenue suits your purpose. Do you want to see a snapshot of how much revenue the business generated over a given period? Or do you prefer to analyse the precise effect of a specific price promotion within the monthly management accounts?
The raw total for sales revenue is known as the gross revenue. However, once a business deducts the cost of promotional discounts or product refunds, this will reveal a more insightful figure called the net revenue or net sales. We cover the principles of net revenue calculation in full here.
Whenever a business records its revenue for VAT purposes, the net figure is the one to use. The business should also exclude any sums collected on behalf of third parties. Some of these exclusions are obvious (e.g. VAT applied to sales) while others are less so. For example, a travel agency that collects funds on behalf of a boutique hotel should only record as revenue the commission it earns on these transactions. The money the agency collects on behalf of its principal (i.e. hotel) isn’t revenue.
Going back to basics for a moment, many people describe the revenue formula as the number of units that a business sells (or its amount of customers) multiplied by the selling price per unit of its goods or services. This overview of the basic calculation will only provide a credible result once you grasp the mechanics of how and when to record revenue in the business accounts.
Brace yourself, as this next section is a rollercoaster. Ride out the rest of this post and you will understand why revenue and cash are two separate ideas. This knowledge will serve you well.
What is the revenue recognition principle?
If you hand over a fistful of change to your local fruiterer for grapes, it’s obvious when the transaction occurs. The revenue gets formally recognised as the moment the goods and money change hands.
But what if this is a wholesale deal with credit terms? Or an online purchase where the product ships weeks after the payment? And if it’s a contract handled over many months, such as the manufacture of a bespoke drill or the development of custom software, the whole concept grows much less clear.
Here is where the revenue recognition principle kicks-in. These guidelines describe how a business should record a transaction in its accounts and, crucially, in which period it must record this revenue.
Let’s begin simply. Many SMEs choose to run their accounts on a cash basis. This idea means the business recognises its revenue based on the date when it receives the payment for a sale, irrespective of other factors, such as the invoice date for the transaction.
Even so, most businesses prefer the accruals principle of revenue recognition over the cash-based one, as this provides a more accurate picture of financial performance. Despite the cute name, an accrual is not a small, furry, animal. Instead, this describes a flexible method to determine the moment when revenue should be recorded or, sometimes, spread over a period. Here’s how it works…
When is the moment of recognition?
Whenever a business sells its goods or services, there are several key dates in the process, as shown below. The question is: at which point should the business recognise this new revenue?
- Customer accepts a quote and order is confirmed
- Goods shipped to customer
- Invoice sent to customer
- Customer pays first instalment
- Customer pays final instalment
The rules on this head-scratching topic were changed in 2018 by the Financial Reporting Council in its IFRS15 document. For a straightforward transaction, the broad premise is recognition occurs at the point that ownership of the goods transfers to the customer for a mutually agreed amount of revenue.
Naturally, this is a greatly simplified explanation of the actual five-step process outlined in IFRS15, which is designed to cover every type of transaction. All five stages are listed below and also helpfully summarised by ACCA (i.e. Association of Chartered Certified Accountants) here.
1. Identify the contract
2. Identify separate performance obligations
3. Determine the transaction price
4. Allocate the transaction price to performance obligations
5. Recognise revenue when each performance obligation is satisfied
How does revenue recognition work in the real world?
The takeaway is that for complex deals and, in particular, when a business provides a service over an extended period, you need to consider carefully when the revenue is recognised and how to treat this.
In many situations, the date of recognition is academic but not always. If a transaction straddles more than one year, it can affect the annual corporation tax the business owes. This is fiddly when a refund occurs several months after the original transaction. For instance, if you sell a sofa in January and it is returned six months later due to a manufacturing fault, the refund should be reflected in the period this relates to and not applied retrospectively. In other words, the refund is recorded in the June accounts.
There are scenarios when revenue recognition doesn’t happen at a specific moment and is said to occur over a longer period of time instead. We cover this specific point and other aspects of how the new IFRS revenue formula applies to real-world situations here. Meet you on the other side.
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