Revenue and gross margin

Companies have their distinct revenue recognition policies and, in the M&A space this can present quite a challenge especially if they are in different jurisdictions. Aligning their individual revenue recognition policies can prove to be a time-consuming task. This will require a thorough understanding of the companies’ practices, applicable accounting standards and local laws; and can be a tight rope to walk since any change in revenue recognition impacts financial metrics and can make it challenging for stakeholders to compare performance – historical and post-merger. IASB’s (International accounting standard board) international accounting standards and it adoption by an increasing number of accounting boards has been pivotal in enhancing comparability and reliability of financial statements across different jurisdictions. However, the impact of local best practices and laws may need to be determined.

Revenue recognition is an accounting principle which defines when and how a business’s revenue should be recognised, it also defines the accounting period to which a business’s revenue and expenses should be recorded. The principle behind revenue recognition can be summed up as – A company will recognise revenue to show the transfer of good or services to the customer for an amount that reflects the consideration to which it believes itself to be entitled and the collection of such consideration is reasonably assured. This has been explained in the five-step model of revenue recognition.

The Five-step model

1.      Identifying of Contract

2.      Identifying performance obligations

3.      Determine transaction price

4.      Allocate transaction price

5.      Satisfaction of performance obligation (Recognition of revenue)

The standard for revenue recognition per IFRS 15, ASC 606 and Ind AS 115 are pretty much similar in their scope and application except for a few differences. 

Click here for the Five step model for revenue recognition.

Some terms to know:

1.     Principal vs Agent – Principal controls the goods and services. Agent arranges for other parties to provide the goods or services. The entity is an agent if:

a.     Another party is responsible to satisfy the performance obligation

b.     They are paid a fee or commission

c.     Does not control pricing

d.     No inventory risks

e.     Not exposed to credit risk

2.     Repurchase agreements – a contract where an entity sells an item and also has the right or option to buy-back.

a.     If it can or has to repurchase the sold item for less than the original sale value it’s classified as a lease.

b.     If the repurchase price is equal to or greater than the original sale price its classified as a financing arrangement.

                                               i.     The entity must continue to recognise the asset

                                              ii.     Recognise a financial liability for consideration received from customer

                                             iii.     Recognise difference between consideration received and to be paid as interest expense

3.     Bill and hold arrangement – is a contract in which the entity bills the customer for a product that it still hasn’t delivered to the customer. Revenue cannot be recognised until the customer has obtained control of the goods, therefore there are special conditions for revenue to be recognised in this arrangement and all of these should be met.

a.     There should be a very good reason to hold on to the goods (e.g. customer’s request due to lack of space).

b.     The goods have separately identified as the customer’s property

c.     The product is ready for transfer to the customer

d.     The entity cannot use the product for any other purpose or re-sell to another customer

4.     Consignment – When an entity delivers a product to its dealers or distributors for sale to end customers it needs to determine if it’s a sale or a consignment. Below are indicators of a consignment:

a.     The entity controls the product until it’s sold to the customer or a specified period expires.

b.     The entity can transfer the product to another party or ask for it to be returned.

c.     The dealer or distributor does not have an unconditional obligation to pay.

Decoding a customer contract

1.   Identify the distinct performance obligations to transfer goods or services or a bundle of goods or     services.

2.     Identify the transaction price associated with each distinct performance obligation.

3.     Determine if the performance obligation is satisfied at a point in time or over a period of time.

4.     Identify the criteria for transfer of control to customer

 

Identifying the drivers:

1.     Revenue and gross margin by customer, by product offerings, by geography and by distribution channels.

a.     Identify the most profitable customers and those that generate the most revenue for the company and their concentration.

b.    Identify which goods/services are most profitable; same for geographies and distribution channels.

c.     Identify customers, goods/services, geography and distribution channels with high revenue share but low gross margins.

d.     Gross profit tells us the amount of money a company retains after accounting for the direct costs of production.

e.     Therefore, it is a key metrics in understanding the potential value of a business model and how sustainable it will be.

f.      A high gross margin could mean the company is operating efficiently while a low gross margin is evidence that there are areas that need improvement. 

g.     A low gross margin could mean:

                                               i.     Revenue may have gone down and/or direct costs may have gone up

                                              ii.     Revenue may have gone up but the cost went up higher

                                             iii.     Revenue have decreased but cost did not decrease in the same proportion

h.     One of the common issues witnessed is in regard to recording payroll. Such expenses should be allocated in the proportion they go towards generating revenue. In some cases, it is highly unlikely that 100% of an employees’ time will be spent in activities directly linked to revenue generation (for example a software engineer may divide their time between billable work and R&D). It therefore becomes imperative that such expenses be carefully allocated above and below gross margin.

2.   Price-volume-mix analysis – Price volume mix analysis provides a high-level overview of the past performance and breaks down the changes in revenue or margin into key components. These components help explain how much of the overall change in revenue was caused by the price change and the impact from change in volume. It can also be used to explain the impact of change in total costs, any currency fluctuation or etc. Below is a simple graphical representation of revenue by price-volume with price/unit on y-axis and quantity on x-axis. We can do the same with cost of sales with cost/unit on y-axis and quantity on x-axis.



3.     Recurring revenue (if applicable) – Recurring revenue can be defined as regular payments over a period of time as in a subscription business (performance obligation satisfied over time). Recurring revenue are stable and with a higher probability of collection at regular intervals. Annual recurring revenue analysis looks at the increase in revenue from sales to new customers and increase in sales to existing customers, and decrease in revenue from revenue loss from lost/churned customers and decrease in sales to existing customers. It provides a good measure of the quality of revenue generated from a subscription model businesses.

 

In conclusion the quality of revenue allows for an accurate determination of the fair value of the entity.  A thorough evaluation of quality of revenue will help determine the viability of the business model, the quality of cash flow – and their sustainability; and therefore, aids in establishing whether the objectives of the acquisition can be expected to be met.

 

More to follow....

Disclaimer: This is purely an academic pursuit. The views/opinions expressed above are my own and does not reflect the views of my employer.

 

 

 

 

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