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101 Concepts for the Level I Exam

Concept 42: Revenue Recognition


Criteria for revenue recognition: According to the accrual method of accounting, revenue is recognized when earned and expenses are recognized when incurred. Accrual accounting allows firms to manipulate net income through their choices about revenue and expense recognition. Hence to reduce manipulation, standard setting bodies have defined a criteria for revenue recognition. As per U.S. GAAP, revenue can be recognized if the following conditions are met:

  • There is evidence of an arrangement between the buyer and seller.
  • The product has been delivered or the service has been rendered.
  • The price is determined or determinable.
  • The seller is reasonably sure of collecting money.

There is a similar criteria for IFRS. From an exam perspective, knowing the U.S. GAAP criteria is good enough.

Long-term contracts extend beyond one accounting period. For example, the construction of a building that takes five years. The revenue recognition methods to be used for long-term contracts are:

  • If costs and revenues can be reliably measured: Both IFRS and U.S. GAAP require percentage of completion method. The revenue to be recognized in a year is given by:

Revenue recognized in a yeacosts incurred in that year / total cost of the projec× total revenue

Company ABC has a contract to construct a building. This project will take 5 years to complete. The expected total revenue from the project is $10 million and the expected total cost is $8 million. In year 1, the cost incurred by the company was $2 million. In year 2, the cost incurred by the company was $1 million. Using the percentage of completion method, what amount of revenue will the company recognize in year 1 and year 2?

Solution:

Revenue recognized in year $2 million / $8 millio× $10 millio$2.5 million

Revenue recognized in year $1 million / $8 millio× $10 millio$1.25 million

  • If costs and revenues cannot be reliably measured: IFRS states that revenue can be recognized to the extent of contract costs incurred.

Company ABC has a contract to construct a building. This project will take 5 years to complete. The expected total revenue from the project is $10 million and the expected total cost is $8 million. In year 1, the cost incurred by the company was $2 million. In year 2, the cost incurred by the company was $1 million. The costs and revenues cannot be reliably measured and the company follows IFRS standards, what amount of revenue will the company recognize in year 1 and year 2?

Solution:

Revenue recognized in year $2 million
Revenue recognized in year $million

U.S. GAAP requires the completed contract method in which the company does not report any income until the contract is complete.

Company ABC has a contract to construct a building. This project will take 5 years to complete. The expected total revenue from the project is $10 million and the expected total cost is $8 million. In year 1, the cost incurred by the company was $2 million. In year 2, the cost incurred by the company was $1 million. The costs and revenues cannot be reliably measured and the company follows U.S. GAAP standards, what amount of revenue will the company recognize in year 1 and year 2?

Solution:

Revenurecognizeiyea0 million

Revenue recognized in year 2 = million

Installment sales: In installment sales the company finances a sale and the sales proceeds are paid in installments over multiple accounting periods. For example, sale of an apartment in which the customer will pay the sale price in installments over the next 10 years. The revenue recognition methods to be used for installment sales are:

  • If the company is reasonably sure of collecting payments: Separate installments into two components: Sales price (present value of installments) and interest component. Revenue attributable to the sales price is recognized immediately, and revenue attributable to the interest component is recognized over time.
  • If the collectability cannot be reasonably estimated, the installment method is used. The profit for a period is calculated as:

Profit for a periocash collected in that period / total revenu× total profit

Company ABC sold a property at a sales price of $100,000. The cost of the property to the company was $80,000. The buyer made a down payment of $25,000 in year 1. He will be paying the remaining amount in installments over the next 10 years. For year 1, how much profit can be recognized using the installment method?

Solution:

Profit for year $25,000 / $100,000 × $20,000 $5,000

  • If the collectability is highly uncertain, the cost recovery method is used. Under this method, profits are recognized only once the total cash collections exceed total costs.

Company ABC sold a property at a sales price of $100,000. The cost of the property to the company was $80,000. The buyer made a down payment of $25,000 in year 1. He will be paying the remaining amount in installments over the next 10 years. For year 1, how much profit can be recognized using the cost recovery method?

Solution:

Profit for year 1 = $0.

Since the total cash collected ($25,000) did not exceed the total cost ($80,000), we cannot recognize any profits in year 1.

Note: We can start recognizing profits only from year 8 onward, when the total cash collected ($85,000) exceeds the total cost.

Cash collected till year 8: $85,000 à Profit for year 8 = $5,000.

Cash collected till year 9: $92,500 à Profit for year 9 = $7,500.

Cash collected till year 10: $100,000 à Profit for year 10 = $7,500

Barter transaction: In a barter transaction, two parties exchange goods or services without any cash payment. A round trip transaction is a special type of barter transaction in which the goods/services exchanged are identical to each other. Under IFRS, revenue from barter transactions can be measured using the fair value from a similar non-barter transaction with an unrelated party. Under U.S. GAAP, revenue can be recognized at fair value only if the firm has historically received cash payments for such goods.

Gross v/s net revenue reporting: Under gross revenue reporting, the selling firm reports sales revenue and cost of goods sold separately. Under net revenue reporting, only the difference between sales and cost of goods sold is reported. Thought the profit reported is the same under both methods, using gross reporting gives us higher reported sales. Gross reporting can only be used if:

  • The company is the primary obligor under the contract.
  • The company bears inventory and credit risk.
  • The company can choose its suppliers.
  • The company has reasonable latitude to establish price.

For example, an airline company would use gross reporting for tickets sold, whereas a travel agent who sells airline ticket will use net reporting.

Implications for financial analysis: Companies disclose their revenue recognition policies in the footnotes. An analyst should be able to determine the policies as conservative or aggressive. An aggressive policy would recognize revenue sooner rather than later. An analyst should also determine how difference in policies of two similar companies can impact their financial ratios.