Question

Revenues are at the core of a firm’s ability to grow and prosper; thus, they are central to the analysis of a firm’s profitability. Although the time-of-sale is the most common technique employed to recognize revenues, in some instances, a strong argument can be made for recognizing revenue using other methods.

In a comprehensive presentation of the various revenue recognition methods, please discuss different circumstances where methods might be used and the rationale behind your answer.

Answer 1

Various revenue recognition methods commonly used are

Sales Basis Method

With the sales basis revenue recognition methods, revenue is recorded at the time of sale. Sale is defined as the period of time where goods and services change hands, which may or may not be at the same time as payment.

For example, if a customer makes payment before they receive delivery of the product, the revenue isn’t recognized until the product is delivered.

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.

Percentage of Completion Method

The percentage of completion method for recognizing revenue is typically used in large or long-term projects. Firms that provide construction services, engineering services or other services with long projects are most likely to use this method. Providers of these services need to be able to demonstrate that they are generating revenue even though projects are not yet complete.

The percentage of completion method may only be used if both of the following requirements are met:

• There is a long-term contract in place that is enforceable by law.
• The project is set up in a way that allows for the percentage of completion to be estimated in order to allocate both revenue and expenses.

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.

Completed Contract Method

When the completed contract method is used, revenue is recognized only once the project is complete and the contract is fulfilled. This method applies to both revenue and expenses. The only time this revenue recognition method is used is when the requirements of the percentage of completion method are unable to be met. For example, if a contract is not enforceable or if completion percentage cannot be calculated.

Since revenues are not recognized until a project is complete, the completed contract method runs the risk of under-reporting revenue at the time it is earned and overstating revenue once it is recognized.

Cost Recoverability Method

The cost recoverability method takes a completely different approach to revenue recognition. Rather than recording revenue and offsetting those revenues by expenses, the cost recoverability method does not record any revenue until all of the project costs are accounted for.

This revenue recognition method has the potential to understate revenue early on and overstate revenue in future years. This approach is to be used when there is considerable uncertainty regarding the collection of a receivable.

Installment method

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 collectibility 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.