Lesson 3 of 9
Revenue recognition and its tells
The same sale reported gross or net changes revenue by an order of magnitude and leaves profit exactly the same.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The same sale reported gross, as principal, or net, as agent, changes revenue by an order of magnitude and leaves profit exactly the same.
- A company moving from licences to subscriptions shows revenue flattening, cash rising and deferred revenue building, the same signature as pulling revenue forward, in reverse.
- Every tell here is a reason to open the revenue policy note, never a finding on its own.
One transaction can be reported two ways, with revenue figures an order of magnitude apart and identical profit in both. ASC 606 decides whether a company reports a sale gross, as the principal, or net, as an agent, and that conclusion moves the top line without moving the bottom one.
Same sale, two presentations of revenue
- Reported gross, as principal · cost of revenue $90$100
- Reported net, as agent · cost of revenue $0$10
Two judgements decide the shape
ASC 606 runs a sale through five decisions, and two of them are judgements rather than readings of a document. The number of performance obligations, the distinct promises in a contract, decides how its price is carved up and when each piece is recognised. A licence sold with three years of support and a training package can be one obligation or three.
What the transaction price is requires estimating the variable parts, rebates, refunds, returns, and a revision to that estimate lands in revenue in the period of the revision, not the period it relates to. The last of the five recognises revenue as each obligation is satisfied, which happens when control of the good or service passes to the customer.
Four tells, innocent reading first
| Tell | Innocent reading | Adverse reading |
|---|---|---|
| Days sales outstanding rising faster than revenue | Bigger customers on longer terms, or an acquired business | Sales booked that customers have not agreed to pay for on the old terms |
| Deferred revenue, cash collected for work not yet delivered, falling while revenue rises | Billing moved from annual in advance to monthly | Obligations released into revenue faster than new ones are sold |
| A lower estimate of returns or rebates | Fewer returns than expected | Revenue raised now on the company's own view of the future |
| A shorter recognition period on multi-year contracts | A reassessed service period | Revenue moved forward, to reverse on a schedule you can compute |
An allowance for credit losses that grew with receivables is a company agreeing the collection risk went up.
Gross or net
Whether a company reports gross or net turns on control: does it control the good or service before it reaches the customer. Which party is responsible for fulfilling the promise, and which one carries the inventory risk, are the kind of evidence that decision rests on.
The conclusion is disclosed in the revenue policy inside the significant accounting policies note, one of the few accounting judgements a reader can settle in a single paragraph. Comparing revenue growth, revenue per employee or price to sales between a principal and an agent compares two different measurements wearing the same label.
A legal change that mirrors it
A company moving from licences to subscriptions shows, for about two years, the exact inverse of revenue pulled forward. Run the move the other way, from subscriptions to licences, and it shows the pull-forward signature itself, legally and with disclosure. The tells say which way revenue moved against cash. The policy note says why.
Moving from licences to subscriptions
- Revenue flattens while cash collected runs ahead of it.
- Deferred revenue builds as customers pay in advance.
- Margins compress because the cost lands before the revenue is recognised.
Revenue pulled forward
Its mirror image
- Revenue and receivables rise faster than cash collected.
- Deferred revenue shrinks as future obligations are recognised early.
- Margins look stronger than the cash behind them.
Mirror images. Reverse the left-hand move and it looks like the right-hand one, so the tells are a reading order, not a screen.
Do it on a real 10-K
- Open the revenue recognition policy in the significant accounting policies note, and read last year's version beside it.
- Compute days sales outstanding for five years: receivables divided by revenue, times 365.
- Set that against five years of revenue growth. A collection period lengthening while growth does not is a question for the receivables note.
Check yourself
A company reports one sale as principal instead of agent. What changes?
- Profit changes and revenue stays the same
- Revenue changes and profit stays the same
- Both change by the same amount
Show the answer
Answer: B.
Gross profit is identical either way. Revenue, and every ratio that divides by it, is not.A company moves from selling licences to selling subscriptions. For about two years, revenue flattens, cash collected rises and deferred revenue builds. What does this pattern resemble?
- Clear evidence the company is struggling
- The reverse of a company pulling revenue forward
- A change with no effect on any reported number
Show the answer
Answer: B.
Every tell that flags revenue pulled forward fires the reassuring way here, for a legitimate reason. Reverse the move and they fire the alarming way, which is why only the policy note settles it.Where is a company's choice to report a sale gross or net disclosed?
- It is not disclosed anywhere
- In the revenue policy inside the significant accounting policies note
- Only in the auditor's opinion
Show the answer
Answer: B.
It is one of the few accounting judgements settled in a single paragraph, usually in one of the first notes in Item 8.Sources
- ASC 606, Revenue from Contracts with Customers, on the five-step model and on gross versus net presentation.
What this leaves out
- This lesson names no company, and every tell above has an innocent reading given first, each one a reason to open a note rather than a finding on its own.
- Days sales outstanding from a 10-K uses one year-end receivable balance, so for a seasonal business it describes one day.
- ASC 606 is a US standard, for a domestic filer reporting under US GAAP; a company reporting under another framework follows that framework's own rule.
- The revenue and margin figures are round invented numbers, not any company's filings.
- Nothing here is advice about any security.