Revenue Recognition

So when is a dollar of revenue a dollar of revenue? Well...let's say you own the simplest lemonade stand in the world. You sell drinks only for cash, and for a dollar a drink. At the end of each day, you add up the number of dollar bills in your shoebox and you call that revenues. And that would be accurate and a good way of accounting for your revenues in this context. You collected the dollar. Essentially, nobody is going to ask for it back by the end of the day. No credit risk. Simple.

But what if you guaranteed people that, if they bought the drink and didn't feel happy about their lemonade-drinking experience for at least the next 30 days, they'd get their money back? Can you still recognize the dollar in your shoebox as revenue? Answer? No. You have to wait 30 days before you recognize those dollar sales as revenues. Those dollars are a buffer against the liability of people returning to you 29 days later, noting that they aren't happy-dappy, and wanting their dollar back. That noted, after 30 days, i.e., on the 31st day after that last sale, you can, in fact, then recognize that dollar of sales as revenue.

But most companies aren’t this simple. There have been some famous examples in history on both sides of the revenue recognition conservation line. Remember that GAAP accounting requires accountants to adopt the most conservative approach in assessing the profitability of a given company. At the extreme conservative end of the GAAP spectrum, Microsoft in its heyday was making so much money, and paying so much in taxes, that they offered a 3-year money-back guarantee with their Windows operating system. And, even though they collected the cash upfront (note that the cash flow of Microsoft would then be massive), they did not recognize those revenues until three years later. While cash flow from Windows in a given year might have been $5B, the stated revenues from that product might have only been $2B. This was such an extremely conservative accounting approach that Microsoft actually got censured by the accounting regulatory body for being too conservative in their accounting.

You can imagine that this is a rarity in the real world. Most companies account in the opposite direction, i.e., they take too aggressive an approach in recognizing revenues, because everybody likes to be a hero to the madding crowds on Wall Street. And delaying recognizing revenues often means companies would show GAAP earnings losses instead of profits.

Why on earth would a company so aggressively delay the recognition of revenues on purpose? Like, who is going to return an operating system for a money-back guarantee when there were essentially no other options? At the time, Microsoft had a monopoly on that business. They did it to make their company look less profitable. They were worried about government anti-monopoly regulators raining on their parade. They wanted to defer taxable income, and they wanted to smooth earnings, knowing that business wouldn't always be oh-so-awesome, and that they could probably use those deferred revenues some rainy day. Eventually, the chicanery caught up with Microsoft; they more or less drowned in their own profits, and a judge chastised them for being too conservative in their accounting. Rare phenomenon. But it happened.

The broader point is that money you collect isn't always revenues, and in the real world, there are lots of ways of...tweaking.

The other, not-so-conservative end of the rainbow would look something like this: FunkyLovin.com offers one-year memberships for $240, which gives tickets into every gym facility and night club any time a customer can show a valid pass to the burly bouncer at the door. The sign-up process for Funky Lovin’ is really easy, and the product is marketed as being of 13-month duration, where, for only $1, a customer can sign up initially. The aggressive accountant waits until the credit card has processed the sale of that $1, and then recognizes all of the revenue, i.e., all $241 of it, as having been earned by the company at that moment.

Is it legal? Well, if there is no money-back guarantee, and a customer, whether they like it or not, has filled out the forms properly…and knowingly…and their credit card works, then yeah. It’s probably legal. But what are the odds that at least some customers end up wanting their money back after the first month? And what are the odds that some customers cancel their credit card part way through the year? And what are the odds that, within the next year, U.S. currency will lose all value, and people will only be paying for things with Bitcoin? Well…low…but still something to consider.

So companies will view accounting in different forms and formats, largely based on the culture of the company itself. Are they Slimy McSlimerson? Or Utah boy scouts, hoping to present a picture of the business that suits the needs of management.

So yeah…two ends of the rainbow to keep in mind when doing your accounting. There’s everything from uber-conservative accounting, as in the case of Microsoft…to the very aggressive accounting style of, um…Microhard.

Yeah, that company didn’t last long.