CFA Level 1

AAA

Financial Statements - Revenue Recognition and Accounting Entries

Accounting Entries
The best way to identify the appropriate accounting entries is to consider an example:

Construction Company ABC, has just obtained a $50 million contract to build a five-building resort in the Bahamas for Meridian Vacations. Company ABC estimates that each building will take a full year to build. Meridian Vacations has agreed to pay Company ABC according to the following schedule: $5m in year 1, $10m in year 2, $10m in year 3, $10m in year 4 and $15m in year 5. Company ABC has estimated that the total cost of this contact will be $35m, and will occur over the five years in this way; $5m in year 1, $4m in year 2, $10m in year 3, $10m in year 4 and $6m in year 5. Equal monthly payments will be made to ABC, and Meridian will have a 30-day grace period except for the last payment in year 5.

Figure 6.6: Illustration of Construction Company ABC's expected figures

Total Revenue: $50M
Total Cost: $35M
Year 1 Year 2 Year 3 Year 4 Year 5 Total
Cost 5,000,000 4,000,000 10,000,000 10,000,000 6,000,000 35,000,000
Payment Terms 5,000,000 10,000,000 15,000,000 8,000,000 12,000,000 50,000,000
Cash Received 4,583,333 9,583,333 14,583,333 8,583,333 12,666,667 50,000,000
Accounts Receivable 416,667 833,333 1,250,000 666,667 -



Percentage-of-Completed-Contract Method
We first need to estimate the revenues Company ABC will declare each year. Remember we are using the percentage-of-completion method based on estimated cost.

Figure 6.7: Construction Company ABC's Estimated Revenues

Year 1 Year 2 Year 3 Year 4 Year 5 Total
Cost 5,000,000 4,000,000 10,000,000 10,000,000 6,000,000 35,000,000
% of Completion 14.29% 11.43% 28.57% 28.57% 17.14% 100%
Cumulative 14.29% 25.71% 54.29% 82.86% 100%
Revenue 7,142,857 5,714,286 14,285,714 14,285,714 8,571,429 50,000,000



Step 1:
Revenues to be declared
We first need to extrapolate how much each annual cost represents as a percentage of the total cost. Armed with this information we multiply the percentage of completion with the total expected revenue for the project for each period.

Recall that one of the basic accounting principles is assurance of payment, and here is the formula used to determine amount of revenues to be recognized at any given point in time:

Formula 6.4

(Services Provided to Date/Total Expected Services) x Total Expected Inflow

This is basically the same formula used in the percentage-of-completion method.

Step 2:
Cost to be declared
Since this is the basic assumption of this accounting methodology, the expenses remain the same as the ones that were estimated.

Results:
1. Annual Income Statement Entries
In each year, the revenues, expenses would be entered as seen on the following table.

Note: For simplicity, taxes were not considered.

Figure 6.8: Construction Company ABC's Income Statement (% of Completion Method)

2. Balance Sheet Statement Entries

Figure 6.9: Construction Company ABC's Balance Sheet (% of Completion Method)

Explanation of Balance Sheet Entries:

  • Cash:It is the total cash Company ABC has on hand at the end of the year, and is defined as the total cash inflow minus the total cash outflow. If the result of this equation were negative, the company would have to borrow from its line of credit additional funds to cover its total expenses.
  • Accounts Receivable:The total amount billed less the cash received by Meridian.
  • Net construction in progress (asset) and net advance billing (liability):
    These accounts offset each other and are composed of construction in progress less total billings.
    • If the result of this equation were negative, the company would have billed its client for more than what has delivered. This would have constituted a liability for the construction company, and would have been reported as net advance billings.
    • If this equation were positive, then the company would have built more than the client has paid for it, and the result of the equation would have constituted an asset and would be recorded as net construction in progress.
    • In most cases, companies only report net construction in progress or net advance billing on their balance sheet.
  • Retained earnings -The cumulative shares of the total profit to date. This item is not shown on the balance sheet above. It normally appears after shareholders equity.

Formula 6.5

Construction in progress = the cumulative cost incurred since inception + (cumulative percentage of completion x total estimated net profit of the project)

Less

Total billings = cumulative amount billed to the client since inception


Look Out!

Remember, if the result of the above equation is:
Positive (asset) = net construction in progress

Negative (liability) = net advance billings

Figure 6.10: Other Items on Company ABC's Balance Sheet (% of Completion Method)



Completed-Contract Method
Under this accounting methodology, revenues and expenses are not recognized until the contract is completed and the title is transferred to the client.

Annual Income Statements
In this case, nothing would be reported on the annual income statements until Year 5.

Figure 6.11: Company ABC's Income Statement (Completed Contract Method)

Balance Sheet Statements
Under this method, the balance sheet entries are the same as the percentage-of -completion method, except for the Net Advance Billing account.

Figure 6.12: Company ABC's Balance Sheet (Completed Contract Method)

Balance Sheet Entries

  • Cash and accounts receivables stay the same under both the percentage of completion and completed contract methods.
    • This is normal because, no matter which method you use, you always know how mush cash you have in the bank, and you how much credit you have extended to your client.
  • Net construction in progress (asset) / net advance billing - The basic concepts are the same, except that under this methodology, construction in progress does not include the cumulative effect of gross profits in the formula (i.e. excludes cumulative percentage of completion x total estimated net profit of the project).
Revenue Recognition Effects on Cash Flows and Financial Ratios
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