Financial Statements - Revenue Recognition Methods and Implications

  • 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
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