• Sales-basis Method
    • Under the sales-basis method, revenue is recognized at the time of sale, which is defined as the moment when the title of the goods or services is transferred to the buyer.
    • The sale can be made for cash or credit. This means that, under this method, revenue is not recognized even if cash is received before the transaction is complete.
    • For example, a monthly magazine publisher that receives $240 a year for an annual subscription will recognize only $20 of revenue every month (assuming that it delivered the magazine).
    • Implication: This is the most accurate form of revenue recognition.
  • Percentage-of-completion method
    • This method is popular with construction and engineering companies, who may take years to deliver a product to a customer.
    • With this method, the company responsible for delivering the product wants to be able to show its shareholders that it is generating revenue and profits even though the project itself is not yet complete.
    • A company will use the percentage-of-completion method for revenue recognition if two conditions are met:
      1. There is a long-term legally enforceable contract
      2. It is possible to estimate the percentage of the project that is complete, its revenues and its costs.
    • Under this method, there are two ways revenue recognition can occur:
      1. Using milestones - A milestone can be, for example, a number of stories completed, or a number of miles built for a railway.
      2. Cost incurred to estimated total cost- Using this method, a construction company would approach revenue recognition by comparing the cost incurred to date by the estimated total cost.)
    • Implication:This can overstate revenues and gross profits if expenditures are recognized before they contribute to completed work.
  • Completed-contract method
    • Under this method, revenues and expenses are recorded only at the end of the contract.
    • This method must be used if the two basic conditions needed to use the percentage-of-completion method are not met (there is no long-term legally enforceable contract and/or it is not possible to estimate the percentage of the project that is complete, its revenues and its costs.)
    • Implication: This can understate revenues and gross profit within an accounting period because the contract is not accounted for until it is completed.
  • Cost-recoverability method
    • Under the cost-recoverability method, no profit is recognized until all of the expenses incurred to complete the project have been recouped.
    • For example, a company develops an application for $200,000. In the first year, the company licenses the application to several companies and generates $150,000.
    • Under this method, the company recognizes sales of $150,000 and expenses related to the development of $150,000 (assuming no other costs were incurred). As a result, nothing would appear in net income until the total cost is offset by sales.
    • Implication: This can understate gross profits initially and overstate profits in future years.
  • Installment method
    • If customer collections are unreliable, a company should use the installment method of revenue recognition.
    • This is primarily used in some real estate transactions where the sale may be agreed upon but the cash collection is subject to the risk of the buyer's financing falling through. As a result, gross profit is calculated only in proportion to cash received.
    • For example, a company sells a development project for $100,000 that cost $50,000. The buyer will pay in equal installments over six months. Once the first payment is received, the company will record sales of $50,000, expenses of $25,000 and a net profit of $25,000.
    • Implication: This can overstate gross profits if the last payment is not received.

      Summary of Revenue Recognition Methods
      Method First Condition: Completion of Earning Progress Second Condition: Assurance of Payment
      Goods/Services Provided Measurable Cost Quantification Reliability
      Sales Basis Yes Yes Yes Yes
      Percentage of Completion Incomplete Yes Yes Yes
      Completed Contract Incomplete Yes or No Yes/No Yes/No
      Cost Recoverability Yes Yes with Contingency Yes/No Yes/No
      Installment Method Yes Yes Yes No

Revenue Recognition and Accounting Entries

Related Articles
  1. Investing

    Understanding Revenue Recognition

    Revenue recognition is an accounting term describing how and when a company records revenue in its accounting records.
  2. Investing

    Don't Lose Your Shirt On Mutual Fund Sales

    Mutual funds aren't guaranteed profit-makers, but with the right calculations and timing, you can avoid major losses.
  3. Investing

    Accounting For Differences In Oil And Gas Accounting

    How a company accounts for its expenses affects how its net income and cash flow numbers are reported.
  4. Managing Wealth

    Cost Basis Basics

    The term "cost basis" refers to the original value of a security you own. When you sell a stock, bond or mutual fund, you use the cost basis to determine your profit or loss, which in turn affects ...
  5. Investing

    What is Cash Basis Accounting?

    Cash basis accounting recognizes revenues and expenses at the time cash is paid or received.
  6. Investing

    Understanding Cost of Revenue

    The cost of revenue is the total costs a business incurs to manufacture and deliver a product or service.
  7. Investing

    Reverse Mortgage

    Learn more about this method of borrowing money against the value of your home.
  8. Investing

    The Difference Between Gross and Net Profit Margin

    To calculate gross profit margin, subtract the cost of goods sold from a company’s revenue; then divide by revenue.
  9. Investing

    What does Deferred Revenue Mean?

    Deferred revenue is advanced payments received by a company for products or services that it has not yet rendered or shipped. Another term for deferred revenue is unearned revenue. Whereas normal ...
  10. Investing

    What Is The Difference Between Revenue And Profit?

    Think of revenue as the top line of a company’s income statement. Profit is the infamous bottom line.
Frequently Asked Questions
  1. Depreciation Can Shield Taxes, Bolster Cash Flow

    Depreciation can be used as a tax-deductible expense to reduce tax costs, bolstering cash flow
  2. What schools did Warren Buffett attend on his way to getting his science and economics degrees?

    Learn how Warren Buffett became so successful through his attendance at multiple prestigious schools and his real-world experiences.
  3. How many attempts at each CFA exam is a candidate permitted?

    The CFA Institute allows an individual an unlimited amount of attempts at each examination.Although you can attempt the examination ...
  4. What's the average salary of a market research analyst?

    Learn about average stock market analyst salaries in the U.S. and different factors that affect salaries and overall levels ...
Trading Center