Measuring Value-Added as a Revenue Recognition Approach
I’ve been thinking about something Jeff Wilks said during this week’s FASRI Roundtable and something that occurred to me during the conference. In short, it is the notion that it might be useful to consider perspectives other than the customer consideration model for revenue recognition. (Forgive me, Jeff, if I misunderstood your comments Wednesday, and of course feel free to correct me.)
One alternative perspective that I believe is consistent with the conjecture that Jeff made is the idea that maybe what we should be trying to measure is value-added activities. This seems consistent to me with what equity investors are really after in thinking about performance during a period: How much value did the firm create during the period? Such a definition of revenue is, I think, consistent with the conceptual framework, in that it embraces the notion that revenue is equal to the non-owner-related increase in net assets during the period. I believe it is also consistent with the revenue recognition methods currently employed in the agriculture industry, as well as in the application of the percentage of completion method used for long-term contracts.
This approach is not inconsistent with the customer-consideration/performance obligation approach, in that satisfaction of a performance obligation, which is the trigger for revenue recognition in the proposed model, would also be considered a value-adding activity. But it seems that the value-added approach might be more general, in that it would not necessarily require a customer relationship to recognize revenue.
One simple example that occurs to me is that of a retailer, who buys merchandise from a supplier at “wholesale” prices. By the act of locating such goods and “re-locating” those goods to a specific retail location, the retailer has created value that its customers could not readily do (i.e., they do not have access to wholesale prices). Abstracting from errors in judgment as to how many items to acquire, spoilage, etc., one could argue that once the goods are in the store, offered for sale, the value-creating activity has been completed, even before any customers actually purchase the goods. The retailer could conceptually recognize revenue under this approach upon the act of putting the items on display in the store. This would make retail accounting similar to that of the timber or farming industries under current practice, where the sale to the customer is considered less critical than the production of the saleable items.
There are serious measurement issues, and non-trivial issues about the prospect of recording “sales” revenue prior to a sale taking place, but I’m wondering if the “value-added model” might overall have more or fewer complicated issues overall than the customer consideration model. I’m also wondering what sorts of approaches taxing authorities use in jurisdictions where there are value-added taxes. Might those approaches be used as a means of building a revenue recognition model for financial reporting purposes?
I think Ray is on to something with his value added approach. If you think about the decisions that people make with the aid of financial statements, the decisions generally involve assessments of (a) current resources owned or owed, and (b) the prospect of creating value in the future. Creating value in the past is often used in predicting future value creation.
That said, I am not sure how value creation ties to revenue. In Ray’s example, is the retailer’s revenue the value added (price customer willing to pay minus wholesale cost of merchandise) or is it the entire price the customer paid? If the retailer is Walmart, we get one answer, but if the retailer is a travel agent booking flights, their revenue is limited to the fee rather than the price of the ticket.
Still, value added certainly seems like a prerequisite for recording revenue. If evidence of value creation is reasonably available (agricultural crops or this year’s work on a long-term contract), then revenue recognition does not have to await the receipt of customer consideration. However, in the vast majority of cases, the price the market is willing to pay for a company’s added value will only become apparent as sales are made, and thus we get more traditional revenue recognition.
Question for Ray – what value does an insurer create when he locates a customer willing pay more than market for a one-year life insurance policy because it contains unlimited options to renew? Will value added work in this setting?
Ray, as you can imagine, I agree with a lot of what you have written here. The framework definition of revenue is much more broad than most people realize. It takes into account more value-creation activities than just sales to customers. I think that is the primary reason we are okay with recognizing revenue for the creation of a building (regardless of when control of that building transfers to a customer). Bob’s point about value-creation not being the same thing as revenue is important because it highlights how many people have come to think of revenue as simply sales. And perhaps that’s where we should end up. But we’re not really there in a lot of areas of accounting today, and moving construction and biological assets more toward a contract-based obligation-satisfaction model may lead to less useful information for investors than they already have today.