This article describes the four ways companies can recognize revenue generated from long term contracts.
The main characteristic of accrual accounting is that revenue can be recognized independently of cash movements, which is why sometimes companies need to use accruals. Under IFRS, revenue related to the sale of goods is recognized when the seller no longer bears any risk and has transferred legal title to the buyer. Revenue related to the sale of services can be recognized when it is certain that the economic benefits of the service will be transferred to the entity selling the service. If the company is reporting under GAAP standards, then revenue should be recognized when it is realized, or realizable and earned. There are many intricacies involved with determining if you should recognize revenue or not, but that is for a different article.
This article, however, will explain how companies recognize revenue generated from long-term contracts, which are contracts that span several accounting periods. Companies need to determine which accounting period to recognize the revenue in, and there are several options: percentage of completion method, completed contract method, the installment method, and the cost recovery method. If you are a candidate studying for any level of the CFA program, I would strongly recommend familiarizing yourself with these concepts.
Percentage of Completion Method
This way of recognizing revenue works best when you are reasonably able to estimate the stages of project completion as well as the remaining costs of completing the project. If you are unable to calculate these two things, then it might be best to use a different method. According to this method, you would calculate the total expenses for the accounting period as a percentage of the overall cost to complete the contract, and multiple that by the total revenue created by the contract.
An example would be a building company constructing municipal facilities for their local town. The company estimates that it will cost them $2,000,000 to complete the task from start to finish over the course of three years, and they will be paid $3,500,000 for their services. The company estimates costs for the first, second, and third year as $1 million, $250K, and $750K, respectively. To calculate the amount of revenue recognized, you would divide the recognized expense per year by the total cost of the project, and then multiple this by the total amount paid to the company constructing the building.
Completed Contract Method
This method of revenue recognition does not report any income until the contract is finished because there is uncertainty about the collection of funds from the customer under the terms of the contract. The completed contract method should be used if it is difficult to estimate costs and the associated percent of total expenses, and if there are inherent hazards that may interfere with project completion.
IFRS and GAAP both acknowledge this method, however they differ slightly. If reporting using IFRS, the company will record a revenue and an expense, which will offset each other, and will only record a profit once the contract has been completed (in the last year, the revenue will be higher than the cost of construction). Under GAAP, no expense or revenue is reported until the contract is completed. Instead, an asset will be created and a decrease in cash will occur equal to the amount of contract-related expenses incurred during the year. When the contract has been completed revenue and expenses will be realized.
Installment Method
The installment method of revenue recognition allocates a percentage of cash received to the current year. To calculate the percent, you will divide the profit made from the contract by the total price paid by the buyer. After, multiply the amount of cash received by this amount.
For example, LandCo Real Estate Investors is selling of a piece of commercial property and just received a $500,000 down payment for it. The total cost of the undeveloped lot is $2,500,000, which LandCo purchased for $1,000,000, and the remaining balance will be paid in full by the end of the following year. To calculate the recorded revenue, divide the total profit for the sale by the sale value of the property:
Next, multiply the cash payment received by the Profit to Sales Price ratio:
LandCo will recognize $300,000 of revenue for this transaction in the current period.
Cost Recovery Method
This method only recognizes revenue once when cash paid by the buyer to the seller is greater than the amount the seller has spent on the contract. The seller needs to break even before they can report any revenue. This approach can be used when there is considerable uncertainty that the receivables will be collected, which begs the question: if there is considerable uncertainty that payments will be collected, why is the seller in business with the buyer in the first place?
LandCo, from the previous example, would only recognize any revenue once they have received over $1,000,000 from the buyer. Once this amount has been paid back, all remaining cash receipts can be recorded as income.
Summary
Being able to understand how a company recognizes revenue, as well as knowing the different methods companies use to recognize revenue from long-term contracts will be beneficial for candidates studying for any level of the CFA exams.