Welcome. In this video we're going to discuss revenue recognition. If you spent much time around accountants or even looked at an income statement, you've seen this word revenue. Well, what do accountants mean when they say revenue? It's the term that we use to talk about how the firms creating value by interacting with its customers in its primary line of business. For example, if you're in the business of say making chairs. It's the value you create through making those chairs and getting customers to take those chairs and give you value back for them. Now, if revenue is all about figuring out how we've created value. The question becomes, how do I know if it's revenue? That is, when can I really say that I've had a sale? When can I really say that my company has created value for itself? And even if I decide that it is a sale, how do I know how much value was created? Now these might seem like simple questions to you but you're going to see that with some companies it becomes kind of difficult to figure this sort of stuff out. It might help if we look at a few examples. Let's start with a relatively simple one. Let's talk about one you're all familiar with, your local coffee shop. So when you show up to the coffee shop, you walk up to a register and you order and probably pay that person. At that point the company has gotten cash from you or something of value but they haven't given you anything back. So they next need to produce that item, make your coffee for you. They're then going to bring it to the front desk and deliver it to you and then you're going to taste it, and if it's the right thing probably walk away and if not you may return it. So the question becomes, at what point has the company actually created value for itself? Now, as I said, when you give them the cash at the payment period. Well, they already have something of value. But what if they never produce it? You're going to want that cash back. Or what if the barista makes a great coffee but spills it on the way to the desk, if they don't deliver it to you then you're going to want your money back again. Or what if they deliver it, you ordered a latte and they gave you an espresso. You're going to take one taste of that and you're going to return it. You're either going to want your money back or you're going to want a new coffee. So do they have to wait till the time that you use or discard it. Well, right now you're probably thinking come on, in this situation the delivery and payment are so simultaneous. Why does it really matter? At which point? All of this happens within a couple of minutes and when it's all done we know we have a sale. Well truthfully, I'm a tea drinker and I actually prefer to get my tea by ordering it online from a company that's in Glen Arbor Michigan which is several hours from here. Let's think about that company. Now, what they do is they go out and they get tea from all around the world and they'll combine it in a way to produce a product that people might want. So they have some idea that people want to get this product but as they put it all together they're not sure that it's going to sell. They list that online. Somebody like me sees that, I order it and I pay for it at that time. Then the company has to go back into their warehouse and they package it. Now even though they have my money if when they start to package they realize oh no we just package the last of that tea and send it off to somebody else and say Chicago. Then they're going to have to come back and give me my money back. Now they may have it all and they get it packaged and they put it in the mail truck and send it off for delivery. At that point, they may feel like they've already finished their part, but if the mail person leaves it on my front porch and it gets rained all over or if my neighbor steals it off the front porch. I'm still going to come back and tell them that they still owe me tea. So they still have some sorts of risk there until I actually have that in my hand. In fact, even when I opened the box it may turn out that it's not the tea that I thought it was or after I brew it I may get upset and decide that I'm going to have to return it because it doesn't taste the way it's supposed to. So should they wait until I've completely used the tea or discarded it because it's gotten old? You can see it's a little tougher here because the value creation process has been spread out over time from their initial conception of this product and put it all together until I'm actually brewing a cup of tea and drinking it from my cup. Now we can take this even further and move away from coffee and tea and think about a company, let's say one that makes custom electronic component. And just to stick with our theme, let's say that these people work with the customer to design a product. And in this case, it's a part that's going to be used in creating a brand new type of espresso machine that is going to be sold to coffeehouses throughout America. So they work hard to get this order and they take the order and then they have to actually design and produce the product, which they've never done before. You can see that even after getting the order there's a lot of uncertainty about are they going to be able to design it. What's going to happen when they produce it? Now let's say they delivered on their own trucks but with a custom order like this, there's a part of the contract that says people get the right to inspect this and if their customer is not happy with it they'll give it back. Well, at this point even though we think we're all done if the customer doesn't accept it with the inspection, we've got a problem. So there's still uncertainty there. But let's imagine we did a great job and the customer says this is exactly what we wanted. We still haven't been paid. What happens if the customer can't sell any of these espresso machines and tells us because of that they're unable to pay us? Even though we've done our part, we haven't gotten anything from the customer in this situation. Let's imagine the customer does pay us, those espresso machines sell like crazy. And then as people start to use them they find they're breaking, and our customer figures out it's because of our part. They want to return all of them and get us to make new ones. Should we wait until we're sure that that hasn't happened before we're sure we've created value? Should we wait until the espresso machine has been completely used up and discarded? You can see that in this situation, the value creation process has been spread out quite a bit over an extended period of time and there's much greater uncertainty both as we produce it and then because we didn't get paid upfront about the payment. Now, so far I focused on physical things that you manufacture but we can switch to a different business model, let's think of a consultant. Now just like our custom manufacturer, consultants work really hard in order to get that initial order and a lot of work's gone into that. But then even after the customers agreed to it. Let's say it's the customer who wants help and figuring out a strategy of how to roll out a brand new espresso machine. We still have to produce that for them, go out do all that market research pull it all together. We have to deliver it say in the form of a report and a presentation. And until we've done all that the customer doesn't really think that we've done anything for them. And then even after we've done that, we still have this issue with payment. Perhaps we come out with a great strategy, but again the customers not able to sell the espresso machines and they're not able to pass. In this situation, relative to making that component part, we can see the value creation still is spread over time and there's still a little bit of uncertainty but at least we don't have a return concern here. So we've got a little different situation. Now this was a very simple consulting project. Imagine something that gets more complicated than this say a multi-stage consulting product, where you're going to, not only get the big order from them, but there's multiple deliverables that you're going to give them over time, perhaps the initial market strategy, which is then going to be followed by some follow up work where you do market analysis once people have gotten this and a report on ways to branch out into international situations. Well, here we may have said given that this is going to take several years, we're going to want some milestone payments. We can't just keep paying our workers without paying us etc.. Imagine that sort of a process, even after we get the order we have to produce, we'll get some milestone payment, maybe deliver a little bit of the product project but then they want more from us. And if we haven't finished the project completely, they may even come back and say we want the payments back that we gave you for the stuff that already delivered because really we need a complete strategy here not just a piece of it. You can see here the value creation process is spread over time. The payment process is spread over time. Some time the customer may have paid us more than the work we've done. Other times the customer has behind us in payment, we've done more for them than they've done for us. It gets pretty complicated in a situation like this. In fact, it gets pretty complicated in most these situations, but there are a couple of things we can take from them. If we really want to talk about how do we know whether our firms created value. Well, we can think about two criteria here. The first is did we provide something of value to others outside of the firm and it's not just do we think we did but do they agree that they receive that value. For example, think back to our tea company, even once we've loaded everything packed it up and sent it off for delivery. Until the customer are sure that they got something of value, we're not really finished with that part. And then even if we've done our whole part, you saw on a couple of these situations there's a question that remains of are we going to get something of value from our customer? Then if we do. Can we really figure out how much that value is? So now we see some of the issues we're going to struggle with and figuring out the economics of value creation. In the next video, I'm going to talk about how accountants take these issues and put them together to provide guidance to firms across many different business models about how they should reflect value creation in their financial statements.
