April 02, 2022 April 02, 2022/ Steven Bragg
There are a number of ways in which revenue can be recognized in an organization's income statement. The method chosen depends on the industry and the specific circumstances. In the following sections, we note a number of recognition methods, how they work, and when they can be used.
Completed Contract Method
The completed contract method is used to recognize all of the revenue and profit associated with a project only after the project has been completed. This method is used when there is uncertainty about the collection of funds due from a customer under the terms of a contract.
Cost Recovery Method
Under the cost recovery method, a business does not recognize any profit related to a sale transaction until such time as the cost element of the sale has been paid in cash by the customer. Once the cash payments have recovered the seller's costs, all remaining cash receipts (if any) are recorded in income as received. This approach is to be used when there is considerable uncertainty regarding the collection of a receivable.
When a seller allows a customer to pay for a sale over multiple years, the transaction is frequently accounted for by the seller using the installment method - and especially where it is not possible to determine the collectability of cash from the customer. Someone using it defers the gross margin on a sale transaction until the actual receipt of cash. This is an ideal recognition method for large-dollar items, such as real estate, machinery, and consumer appliances.
Percentage of Completion Method
The percentage of completion method involves, as the name implies, the ongoing recognition of revenue and profits related to longer-term projects. By doing so, the seller can recognize some gain or loss related to a project in every reporting period in which the project continues to be active. The method works best when it is reasonably possible to estimate the stages of project completion on an ongoing basis, or at least to estimate the remaining costs to complete a project. In essence, the percentage of completion method allows you to recognize as income that percentage of total income that matches the percentage of completion of a project.
Sales-Basis Method
Under the sales-basis approach, sales are recognized at the time of sale. This method works best when payment is assured, and all deliverables have been made. The sales-basis method is used for most types of retail sales.
Problems with Revenue Recognition Methods
The problem with revenue recognition is that many companies are valued based on the revenues they report, so there is an incentive to report excessively high revenue levels. This can take many forms, such as applying more generous recognition methods that do not really apply to a company’s circumstances, or making use of gray areas of the regulations to falsely accelerate the reporting of revenue. Given these concerns, auditors tend to allocate more of their time to the examination of clients’ revenue recognition methods.
April 02, 2022/ Steven Bragg/
While most receivable reporting is straightforward when recognizing revenue and matching expenses in the same period, a few unique situations require special revenue distribution for long-term projects. Long-term construction-company projects, real estate installment sales, multi-year magazine subscriptions, and a combined equipment sale with an accompanying service contract have special reporting requirements to meet revenue recognition and matching principles.
Long-term construction projects, such as construction of a major sports stadium, can take several years to complete. Typically, revenue is recognized when the earnings process is complete; however, if the construction project did not begin work immediately, this could delay recognition of revenue, and expenses accumulated during the period would be unmatched. These unmatched expenses can misstate financial statements (particularly the income statement) and mislead stakeholders. There are also tax implications, where a company may benefit from tax breaks with reduced earnings.
Two methods can be applied to long-term construction projects that are consistent with the revenue recognition criteria you’ve learned about. The methods commonly utilized by construction contractors are the percentage of completion and completed contract (see Figure 9.6). The percentage of completion method takes the percentage of work completed for the period and divides that by the total revenues from the contract. The percentage of work completed for the period distributes the estimated total project costs over the contract term based on the actual completion amount, up to that point. The percentage can be based on such factors as percentage of anticipated final costs incurred at a given point or an engineering report that estimates the percentage of completion of the project at a stage of production.
Figure 9.6 Long-Term Construction Project. Revenue recognition requires use of the percentage of completion or completion contract method. (credit: modification of “Construction of Millennium Stadium, Cardiff” by Seth Whales/Wikimedia Commons, CC BY 2.0)
The completed contract method delays reporting of both revenues and expenses until the entire contract is complete. This can create reporting issues and is typically used only where cost and earnings cannot be reasonably estimated throughout the contract term.
Unlike most residential home loan transactions (usually labeled as mortgage loans), which tend to require monthly payments, commercial real estate sales are often structured as an installment sale (see Figure 9.7) and usually involve periodic installment payments from buyers. These payments can be structured with annual payments, interest-only payments, or any other payment format to which the parties agree.
Figure 9.7 Real Estate Installment Sales. Revenue recognition requires use of the installment method to account for long-term risk. (credit: modification of “Boost-the-Market-Value-of-Your-Home_L” by Dan Moyle/Flickr, CC BY 2.0)
However, a seller/lender has no guarantee that the buyer will pay the debt in its entirety. In this event, the property serves as security for the seller/lender if legal action is taken. The longer the debt remains outstanding, the higher the risk the buyer will not complete payment. With traditional accrual accounting, risk is not considered and revenue is reported immediately. The installment method accounts for risk and defers revenue using a gross profit percentage. As installment payments are made, this percentage is applied to the current period.
Multi-year magazine subscriptions are long-term service contracts with payment usually occurring in advance of any provided service. The company may not recognize this revenue until the subscription has been provided, but there is also no guarantee that the contract will be honored in its entirety at the conditions expected. Financial Accounting Standards Board, Topic 606, Revenue from Contracts with Customers, requires businesses to report revenue “in an amount that reflects the consideration to which the entity expects to be entitled in exchange for the goods or services.” Thus, once a change occurs to the expected revenue distribution, this new amount is recorded going forward.
A combined equipment purchase with an accompanying service contract requires separate reporting of the sale and service contract. An example of this is a cell phone purchase that has a service contract (warranty) for any damage to the unit. There is no guarantee that damage will occur or that service will be provided, but the customer has purchased this policy as insurance. Thus, the company must reasonably estimate this revenue each period and distribute this estimation over the life of the service contract. Or, the company may wait until the contract expires before reporting any revenue or expenses associated with the service contract.
HKS, Inc. received a construction contract from the Minnesota Sports Facilities Authority to build the new U.S. Bank Stadium. The construction contract services began in 2012, but the stadium was not complete until 2016. The total construction cost was approximately $1.129 billion.
The portion of construction revenues earned by HKS, Inc. could not be reported upon initial receipt of funds but were instead distributed using the percentage of completion method. Much of the costs and completion associated with building the stadium occurred in the later years of the project (specifically 2015); thus, the company experienced a sharp increase in percentage of completion in the 2015 period. This showed a substantial increase to revenues during this period.
When Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) began their joint work to create converged standards, a primary goal was to develop a single, comprehensive revenue recognition standard. At the time work began, International Financial Reporting Stands (IFRS) had one general standard that was applied to all companies with little guidance for various industries or different revenue scenarios. On the other hand, U.S. generally accepted accounting principles (GAAP) had more than 100 standards that applied to revenue recognition. Because of the global nature of business, including investing and borrowing, it was important to increase the comparability of revenue measurement and reporting. After years of work, a new standard was agreed upon; both FASB and IASB released a revenue recognition standard that is essentially the same, with only a few differences. In the United States, the new revenue recognition standards became effective for reporting in 2018 for publicly traded companies.
A few differences remain in the reporting of revenue. In accounting for long-term projects, IFRS does not allow the completed contract method. If estimating the percentage of completion of the project is not possible, IFRS allows revenues equal to costs to be recognized. This results in no profit recognized in the current period, but rather all profit being deferred until the completion of the project.
Receivables represent amounts owed to the business from sales or service activities that have been charged or loans that have been made to customers or others. Proper reporting of receivables is important because it affects ratios used in the analysis of a company’s solvency and liquidity, and also because reporting of receivables should reflect future cash receipts.
Under both U.S. GAAP and IFRS, receivables are reported as either current or noncurrent assets depending on when they are due. Also, receivables that do not have an interest component are carried at net realizable value or the amount the company expects to receive for the receivable. This requires estimation and reporting of an allowance for uncollectible accounts (sometimes referred to as “provisions” under IFRS). However, receivables that do have a significant financing component are reported at amortized cost adjusted for an estimate of uncollectible accounts.
GAAP and IFRS can differ in the financial statement presentation of receivables. GAAP requires a liquidity presentation on the balance sheet, meaning assets are listed in order of liquidity (those assets most easily converted into cash to those assets least easily converted to cash). Thus, receivables—particularly accounts receivable, which are highly liquid—are presented right after cash. However, IFRS allows reverse liquidity presentation. Therefore, receivables may appear as one of the last items in the asset section of the balance sheet under IFRS. This requires careful observance of the presentation being used when comparing a company reporting under U.S. GAAP to one using IFRS when assessing receivables.
In the case of notes receivable, the method for estimating uncollectible accounts differs between U.S. GAAP and IFRS. IFRS estimates uncollectible accounts on notes receivable in a three-level process, depending upon whether the note receivable has maintained its original credit risk, increased slightly in credit risk, or increased significantly in riskiness. For companies using U.S. GAAP, estimated uncollectible accounts are based on the overall lifetime riskiness.