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


Related Articles
  1. Professionals

    Revenue Recognition Effects on Cash Flows and Financial Ratios

    CFA Level 1 - Revenue Recognition Effects on Cash Flows and Financial Ratios. This topic contrasts the two styles of revenue recognition by showing their impacts on cash flow and various financial ...
  2. Professionals

    Long-term Contracts

    Long-term Contracts
  3. Economics

    Understanding Revenue Recognition

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

    Revenue Recognition

    CFA Level 1 - Revenue Recognition. Learn about revenue recognition and the importance of the matching principle. Includes calculations and principles of revenue recognition.
  5. Professionals

    Revenue Recognition and Accounting Entries

    CFA Level 1 - Revenue Recognition and Accounting Entries. Step by step examples showcasing how to apply revenue recognition to accounting entries. Illustrates two methods of revenue recognition.
  6. Professionals

    Accounting Methods

    Accounting Methods
  7. Professionals

    Compliance

    Compliance
  8. Professionals

    Installment Sales

    Installment Sales
  9. Professionals

    Introduction

    CFA Level 1 - Section 6: Financial Statements. Introduction to financial statements. Briefly introduces the concept of financial statement analysis and two main accounting methods.
  10. Markets

    Understanding Profit Margin

    Learn a primary method investors use to analyze a company's profitability.
RELATED TERMS
  1. Percentage Of Completion Method

    An accounting method in which the revenues and expenses of long-term ...
  2. Modified Cash Basis

    An accounting method that combines elements of the two major ...
  3. Accounting Method

    The method by which income and expenses are reported for taxation ...
  4. Cash Cost

    A cash basis accounting cost recognition process that classifies ...
  5. Revenue Recognition

    An accounting principle under generally accepted accounting principles ...
  6. Cash Basis

    A major accounting method that recognizes revenues and expenses ...
RELATED FAQS
  1. What are the differences between the installment method and percentage of completion ...

    Learn how businesses recognize revenues and report them under the installment method and percentage-of-completion method, ... Read Answer >>
  2. When do you use installment sales method vs. the cost recovery method?

    Take a deeper look at the installment sales method and the cost recovery method of recognizing business sales revenue and ... Read Answer >>
  3. What are the differences between percentage of completion and the completed contract ...

    Learn the advantages and disadvantages businesses face when using either the percentage-of-completion or completed contract ... Read Answer >>
  4. How is deferred revenue treated under accrual accounting?

    Learn deferred revenue and its treatment under accrual accounting and why various revenue recognition methods result in different ... Read Answer >>
  5. How does accrual accounting differ from cash basis accounting?

    The main difference between accrual and cash basis accounting is the timing of when revenue and expenses are recognized. ... Read Answer >>
  6. How do companies calculate revenue?

    Revenue is the amount of money a company receives in exchange for its goods and services. The revenue received by a company ... Read Answer >>
Hot Definitions
  1. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  2. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  3. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  4. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  5. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  6. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
Trading Center