Financial statements - Revenue recognition and expense capit...

Learning Outcomes

This article explains how revenue and expenses are recognized under accrual accounting for CFA Level 1, including:

• applying the five-step revenue recognition model under IFRS and US GAAP, with emphasis on identifying contracts, performance obligations, transaction price allocation, and timing of recognition
• distinguishing between contract assets, trade receivables, and contract liabilities, and determining when deferred revenue and receivables appear on the balance sheet
• analyzing principal-versus-agent relationships in multi-party transactions and their impact on reported gross versus net revenue and margins
• distinguishing between expensing and capitalization decisions, including product, period, and capitalized costs and their alignment with the matching principle
• evaluating how immediate expensing versus capitalization affects net income trends, margins, return on equity, debt ratios, and cash flow classifications over multiple periods
• interpreting worked numerical examples on subscriptions, long-term projects, borrowing costs, and fixed-asset purchases to calculate recognized revenue, expenses, depreciation or amortization, and resulting changes in profitability ratios
• identifying typical exam traps, such as confusing cash collections with revenue, misclassifying contract balances, or overlooking timing differences between recognition and cash flows, and using a structured approach to decode question wording

These outcomes focus on the calculations, classifications, and analytical judgments most frequently tested in the Financial Reporting and Analysis section.

CFA Level 1 Syllabus

For the CFA Level 1 exam, you are required to understand the principles and key impacts of revenue and expense recognition, with a focus on the following syllabus points:

• Recognizing revenue according to the five-step model, including the difference between principal and agent approaches
• The matching principle and how expense recognition is timed relative to revenue
• The impact of capitalizing (capitalization) versus expensing on profit trends, net income, and financial ratios
• Differences between common expense types: product costs, period costs, and capitalized costs
• Identification and interpretation of contract assets and contract liabilities arising from revenue contracts

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Under the converged IFRS/US GAAP revenue standard, revenue is recognized primarily when:
   1. Cash is collected from the customer.
   2. The contract is signed, regardless of performance.
   3. Control of goods or services passes to the customer as performance obligations are satisfied.
   4. The invoice is issued at the end of the month.
2. Compared with immediately expensing an asset purchase, capitalizing the cost in the year of acquisition will most likely result in:
   1. Lower net income, lower total assets, and lower equity.
   2. Higher net income, higher total assets, and higher equity.
   3. Higher net income, lower total assets, and lower equity.
   4. Lower net income, higher total assets, and higher equity.
3. A company receives a non‑refundable annual subscription payment of $1,200 on 1 October for a 12‑month service beginning immediately. At 31 December, three months of service have been provided. On the 31 December balance sheet, the company will report:
   1. A contract asset of $900.
   2. A contract liability (deferred revenue) of $900.
   3. A trade receivable of $900.
   4. No balance sheet item related to this contract.
4. In a transaction where an online platform arranges for a third-party seller to deliver goods directly to a customer, and the platform never controls the goods, the platform should:
   1. Report revenue at the gross selling price of the goods.
   2. Report revenue equal only to its commission or fee.
   3. Defer all revenue until the third party is paid.
   4. Recognize no revenue because it is not the legal seller.
5. Product costs are most accurately described as:
   1. All manufacturing and non‑manufacturing costs incurred during the period.
   2. Costs that can be directly or indirectly matched with specific units sold and capitalized as inventory until sale.
   3. Any cost that benefits more than one accounting period and is therefore capitalized.
   4. Administrative and selling expenses that are expensed when incurred.

Introduction

Recognition of revenue and expenses is fundamental to understanding a company’s performance. International accounting standards require companies to apply accrual accounting, with revenue recognized when performance obligations are met, not when cash is received, and expenses recognized when the related revenue is earned or as incurred. For analysts, this means that income statement figures often do not align with cash receipts and payments shown in the cash flow statement.

Key Term: accrual accounting
Recording revenues when earned and expenses when incurred, regardless of when cash is received or paid.

In a typical operating cycle, firms purchase inventory (often on credit), convert it into finished goods, sell to customers (again often on credit), and collect cash later. During this cycle:

• inventory and accounts receivable are recognized as assets before cash is collected
• accounts payable are recognized as liabilities before cash is paid

This article details the rules for when to record income and costs, focuses on key concepts such as capitalization versus expensing, and clarifies how these rules impact reported profits and ratios.

Revenue Recognition Principles

Revenue is recognized in financial statements when the company transfers promised goods or services to a customer, in an amount that reflects what it expects to receive. Both IFRS and US GAAP use a converged five-step model for revenue recognition:

1. Identify the contract with a customer.
2. Identify the separate performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations.
5. Recognize revenue as each obligation is satisfied.

Key Term: performance obligation
A promise in a contract to transfer a specific good or service (or bundle of goods and services) to a customer that is distinct from other promises in the contract.

Step 1: Identify the contract

A contract exists when there is a legally enforceable agreement with commercial substance, clearly defined rights and payment terms, and it is probable that the entity will collect the consideration. Note that the threshold for “probable” is interpreted somewhat differently under IFRS and US GAAP, but the principle is the same: if collection is highly uncertain, revenue is not recognized.

Step 2: Identify performance obligations

Many modern contracts bundle multiple goods and services. Each distinct good or service that the customer can benefit from separately (or together with other readily available resources) and that is separately identifiable in the contract is a separate performance obligation. Examples:

• A mobile phone sold with a two‑year service plan: the handset and the service are often separate obligations.
• A software license plus one year of support: the license and support may be separate obligations, depending on the nature of the software and support.

Correctly identifying performance obligations is important because revenue is recognized as each obligation is satisfied, not necessarily on a single date.

Step 3: Determine the transaction price

The transaction price is the amount of consideration the seller expects to be entitled to in exchange for transferring goods or services. It may be:

• fixed (e.g., a list price)
• variable (e.g., performance bonuses, volume discounts, rebates, rights of return)

When consideration is variable, firms estimate the amount (using expected value or most likely amount) and include only the portion that is highly probable not to reverse later. This protects against recognizing revenue that will later be refunded or reduced.

Step 4: Allocate the transaction price

If a contract has multiple performance obligations, the transaction price is allocated to each obligation based on the relative stand‑alone selling prices of the goods or services. If stand‑alone selling prices are not directly observable, they are estimated. Discounts and variable amounts are generally allocated proportionally unless clearly related to a specific performance obligation.

Step 5: Recognize revenue when (or as) performance obligations are satisfied

Revenue is recognized when control of the promised goods or services passes to the customer. Control refers to the ability to direct the use of the asset and obtain substantially all of its remaining benefits.

Performance obligations are satisfied either:

• over time – if one of the following applies:
  • the customer simultaneously receives and consumes the benefits (e.g., routine cleaning services)
  • the entity’s performance creates or enhances an asset that the customer controls as it is created (e.g., building an extension on a customer’s property)
  • the asset created has no alternative use to the entity and the entity has an enforceable right to payment for performance to date
• at a point in time – in all other cases (e.g., most retail sales of goods)

For over‑time recognition, companies use a method to measure progress, such as:

• cost‑to‑cost (proportion of total expected costs incurred to date)
• physical completion milestones
• units delivered

The chosen method must faithfully depict the transfer of control.

Contract assets, receivables, and contract liabilities

Transactions are recognized on the balance sheet as follows:

• Trade receivable: the right to unconditional consideration – only the passage of time is required before payment is due (invoice has been sent and only waiting for cash).
• Contract asset: the entity has performed and is entitled to consideration, but the right is conditional on something other than the passage of time (e.g., completing additional milestones or customer approval).
• Contract liability (deferred revenue): the entity has received consideration (or has a right to consideration) before transferring goods or services.

Key Term: contract liability
A liability recognized when consideration is received (or receivable) in advance of performance; also called deferred or unearned revenue.

Key Term: contract asset
An asset representing the right to consideration from a customer for goods or services transferred but not yet billed as a trade receivable.

A common exam pattern is to compare revenue recognized to billings and cash collections:

• Revenue recognized > billings → often a contract asset.
• Cash received > revenue recognized → contract liability (deferred revenue).

Agent versus Principal

In multi-party sales arrangements, a principal reports gross revenue for the full sales value, while an agent recognizes only the fee or commission earned.

Key Term: principal (revenue recognition)
An entity that controls the goods or services before transfer to the customer and therefore recognizes revenue at the gross amount received from the customer.

Key Term: agent (revenue recognition)
An entity that arranges for another party to provide goods or services and recognizes revenue only for its commission or fee.

Key indicators that an entity is a principal include:

• it controls the inventory before transfer
• it bears primary responsibility for fulfilling the contract
• it has discretion in setting prices
• it bears inventory and credit risk

If these are absent and the entity mainly connects buyers and sellers, it is usually an agent.

Illustration of principal vs agent margins

Consider an online marketplace (adapted from the MegaDigital example):

• As principal: buys a product for $70, sells to customer for $100, incurs $10 other costs.
• As agent: customer still pays $100 to the third‑party seller, marketplace earns a $30 commission, incurs $10 other costs.

Reported income statements:

Total profit is the same, but:

• recorded revenue is much lower as an agent
• profit margin appears much higher

This significantly affects common-size analysis and ratios such as asset turnover and margins.

Timing and Control

Revenue is recorded when control of the goods or services passes to the customer, usually when delivery occurs and significant risks and rewards are transferred. For long-term projects that meet the over‑time criteria, revenue is recognized over time as performance occurs, often using a proportion-of-costs-incurred method.

Analysts must carefully distinguish:

• Revenue recognition pattern – over time vs at a point in time
• Cash collection pattern – sometimes upfront (leading to contract liabilities), sometimes later (leading to receivables or contract assets)

Worked Example 1.1

A software company sells annual cloud subscriptions for $1,200, paid upfront. Service begins immediately. At the balance sheet date, four months have elapsed. What is the recognized revenue and contract liability?

Answer:
The subscription relates evenly to 12 months of service.
Revenue per month = $1,200 ÷ 12 = $100.

1. Revenue recognized to date = $100 × 4 = $400.
2. Contract liability (deferred revenue) = $1,200 − $400 = $800 (for the remaining eight months of service).

On the balance sheet, the company reports a contract liability of $800. No receivable remains, because cash was received upfront.

Worked Example 1.2

A firm enters into a two-year service contract with a customer for total consideration of $2,400. The customer pays $1,000 upfront at contract inception and will pay $1,400 at the end of the contract if the service is completed satisfactorily. At the end of Year 1, the firm has completed 60% of the service (based on hours worked) and has an enforceable right to payment for performance completed to date.

Required: Determine the contract asset or contract liability at the end of Year 1.

Answer:
Total transaction price = $2,400.
Revenue for Year 1 (60% complete) = 0.60 × $2,400 = $1,440.

Cash received to date = $1,000. The customer is not yet billed for the balance, and the remaining payment is conditional on completing the service.

• Revenue recognized ($1,440) > cash received ($1,000) → the difference ($440) represents an unbilled right to consideration, a contract asset.

At the end of Year 1, the firm reports a contract asset of $440. No trade receivable is recognized yet because the amount is not yet unconditional (still conditional on completion of the service).

Expense Recognition and Capitalization

Expenses must be recognized in the same period as the revenue to which they relate—a principle known as matching. If costs cannot be reliably matched with specific revenue, they are typically expensed as incurred.

Key Term: matching principle
Recognize expenses in the same accounting period as the related revenue, or when the expense is incurred if no direct link to specific revenue exists.

Types of expenses

Expenses fall into several classes:

• Product costs: Directly tied to goods produced or purchased for resale (e.g., materials, direct labor, manufacturing overhead). These are initially capitalized as inventory and then matched to revenue as cost of goods sold when the goods are sold.
• Period costs: Not directly tied to specific sales; expensed in the period incurred (e.g., administrative salaries, most marketing costs, rent, and under US GAAP most research and development).
• Capitalized costs: Expenditures recorded as assets (capitalization) and expensed over time through depreciation or amortization when the benefit extends beyond the current period (e.g., equipment, buildings, certain software, and qualifying development expenditures under IFRS).

Key Term: product costs
Costs that can be directly or indirectly traced to producing or acquiring inventory and are capitalized until the related goods are sold.

Key Term: period costs
Costs that cannot be directly matched with specific revenue and are expensed in the period in which they are incurred.

Key Term: capitalization
Recording the cost of an asset on the balance sheet and allocating the expense over its useful life, rather than expensing immediately.

When future benefits are uncertain or cannot be reliably measured, standards typically require immediate expensing. For example:

• Under IFRS, research costs are expensed, while development costs may be capitalized only if strict criteria are met (technical feasibility, intention and ability to use or sell, probable future economic benefits, reliable measurement of costs).
• Under US GAAP, most research and development costs are expensed as incurred.

Capitalized borrowing costs (capitalized interest)

When a company constructs a qualifying long-lived asset (such as a factory) over time and finances it with debt, part of the borrowing cost is capitalized.

Key Term: capitalized borrowing costs
Interest costs incurred during the construction of a qualifying asset that are added to the asset’s cost and subsequently expensed through depreciation.

Under both IFRS and US GAAP:

• Borrowing costs directly attributable to the construction of a qualifying asset are added to the asset’s carrying amount.
• After the asset is ready for use, interest is expensed as incurred.
• On the cash flow statement, interest that is capitalized is usually classified as an investing cash outflow (construction cost), whereas expensed interest is an operating cash outflow under US GAAP and either operating or financing under IFRS.

Capitalizing borrowing costs increases the cost basis of the asset and defers recognition of interest expense into future periods via higher depreciation.

Immediate Expense versus Capitalization

Expensing costs immediately reduces current net income more than capitalizing, but leads to higher future profits because there is no future depreciation or amortization from the past expense.

Capitalizing an expenditure:

• increases assets and equity in the year of expenditure
• increases net income initially (only a portion is expensed via depreciation)
• shifts the related cash outflow to the investing section (if it is a long-lived asset purchase) rather than the operating section of the cash flow statement

Expensing an expenditure:

• reports lower assets and equity
• reduces current net income by the full amount of the expenditure
• typically classifies the cash outflow as an operating cash outflow

Worked Example 1.3

A retailer buys display equipment costing $60,000 in January. The equipment has a useful life of 3 years and no salvage value. Ignore taxes and any financing.

Required:

a) Show the impact on net income over the three years if the equipment is expensed immediately.
b) Show the impact if it is capitalized and depreciated straight-line.
c) Compare total expenses over three years and comment on the pattern of profitability.

Answer:
a) If expensed immediately (treated as a period cost):

1. Year 1: Expense = $60,000 → Net income decreases by $60,000.
2. Years 2 and 3: No expense related to this equipment.

b) If capitalized and depreciated straight-line:

1. Annual depreciation = $60,000 ÷ 3 = $20,000.
2. Net income decreases by $20,000 in each of Years 1, 2, and 3.

c) Total expense over three years is the same in both cases ($60,000). The timing differs:

1. Immediate expensing: lower Year 1 profit, higher Year 2–3 profit.
2. Capitalization: smoother profit pattern, higher profit in Year 1 but lower profit in Years 2–3 compared with immediate expensing.

In Year 1, capitalization also results in higher total assets (the equipment’s carrying amount of $40,000 at year-end) and higher equity. Ratios such as return on assets and profit margin are higher in Year 1 under capitalization, all else equal.

Depreciation and amortization

Once costs are capitalized, they are allocated over future periods.

Key Term: depreciation
The systematic allocation of the cost of a tangible fixed asset as an expense over its useful life.

Key Term: amortization
The systematic allocation of the cost of an intangible asset as an expense over its useful life.

Common depreciation methods:

• Straight-line: equal expense each year.
• Accelerated methods (e.g., declining balance): higher expense in earlier years.
• Units-of-production: expense linked to actual usage (e.g., hours or units produced).

The choice of method affects the timing of expense, carrying amount of assets, and ratios such as operating margin, asset turnover, and return on assets.

Impacts on Profitability and Ratios

The choice between expensing and capitalizing affects not just net income, but also profit trends, growth rates, and key ratios.

In the early years (year of expenditure):

• Capitalization → higher net income (only depreciation hits the income statement), higher total assets and equity, lower debt-to-equity, and often higher return on assets and return on equity.
• Expensing → lower net income, lower assets and equity, higher debt ratios, and lower profitability ratios.

On the cash flow statement:

• Capitalizing a long-lived asset:
  • operating cash flow is higher (the cash payment is in investing, not operating)
  • investing cash flow is more negative
• Expensing:
  • operating cash flow is lower (expense is reflected in CFO)
  • investing cash flow is unaffected

Over the asset’s life, total profit and total cash flows are the same under both approaches; only the timing differs. In later periods, capitalizing tends to result in lower net income (because of ongoing depreciation) compared with the scenario where the cost was fully expensed earlier.

Analysts comparing companies must therefore understand policy choices:

• A firm that aggressively capitalizes costs may appear more profitable in the short run but has higher future depreciation and higher reported assets.
• Differences in capitalization policies (e.g., development costs under IFRS vs US GAAP) can make cross-company comparisons challenging.

Revenue and Expense Recognition in Practice

Some industries and contracts present specific recognition challenges—such as long-term construction, software and cloud subscriptions, telecom contracts, and licenses with multiple elements. For complex contracts, substantial judgment is required, and accounting choices and estimates must be disclosed in the notes.

Worked Example 1.4

A construction company signs a fixed-price contract to build a warehouse for $5,000,000. The project meets the criteria for over‑time revenue recognition. Expected total costs are $4,000,000. At the end of Year 1, the company has incurred $1,000,000 of costs.

Required:

a) Calculate revenue and gross profit recognized in Year 1.
b) Determine whether a contract asset or contract liability is likely, assuming the customer has paid $800,000 to date.

Answer:
a) Measure progress using cost‑to‑cost:

1. Percent complete = Costs incurred to date ÷ Total expected costs = $1,000,000 ÷ $4,000,000 = 25%.
2. Revenue recognized in Year 1 = 25% × $5,000,000 = $1,250,000.
3. Gross profit for Year 1 = Revenue − Costs = $1,250,000 − $1,000,000 = $250,000.

b) Cash received = $800,000 while revenue recognized is $1,250,000. The difference of $450,000 represents performance that has not yet been billed/paid. This amount is a contract asset (unbilled revenue).

Exam-focused issues and common traps

Several recurring pitfalls appear in Level 1 questions:

• Confusing cash and revenue: Cash received ≠ revenue recognized. Always ask: “Has control of goods/services passed?”
• Misclassifying balances:
  • Cash received in advance → contract liability (deferred revenue), not revenue.
  • Performance ahead of billing → contract asset, not trade receivable.
• Ignoring over‑time recognition: For long-term services or construction that meet over‑time criteria, revenue is recognized gradually, not only at completion.
• Overlooking capitalization effects: When comparing profitability, remember that firms with more capitalization will often have:
  • higher assets and equity
  • higher net income in early years and lower in later years
  • different operating vs investing cash flow patterns

A structured approach to exam questions:

• Identify what is being recognized (revenue vs cash vs expense).
• Identify the timing (current vs future periods).
• Identify the classification (asset, liability, revenue, or expense).
• Check whether the numbers refer to cash flows or accrual amounts.

Summary

Revenue is recognized when control over promised goods or services is transferred to the customer and performance obligations are satisfied, not when cash is received. The five-step model under IFRS and US GAAP guides identification of contracts, performance obligations, transaction price, allocation, and timing of recognition. Contract assets, trade receivables, and contract liabilities capture timing differences between performance and billing or cash collection.

Expenses are recorded when incurred or matched to the revenue they generate, consistent with the matching principle. Capitalization of costs delays the recognition of expenses and increases current profits while creating future depreciation or amortization charges. These choices affect trends in profitability, capital structure, and the classification of cash flows. Accrual accounting smooths income but requires careful analysis of company policies and contract structures for accurate interpretation.

Key Point Checklist

This article has covered the following key knowledge points:

• Recognize revenue using the five-step model based on performance obligations and control transfer.
• Distinguish between trade receivables, contract assets, and contract liabilities.
• Explain principal versus agent revenue reporting and how it affects gross vs net revenue and margins.
• Distinguish between product, period, and capitalized costs and apply the matching principle.
• Describe capitalized borrowing costs and their effect on asset values and future expenses.
• Analyze how capitalization versus expensing affects net income, equity, debt ratios, and cash flow classifications over multiple periods.
• Identify common exam traps around timing and classification of revenue and expenses and apply a structured approach to question wording.

Key Terms and Concepts

• accrual accounting
• performance obligation
• contract liability
• contract asset
• principal (revenue recognition)
• agent (revenue recognition)
• matching principle
• product costs
• period costs
• capitalization
• capitalized borrowing costs
• depreciation
• amortization