Revenue Recognition

Deciding when to recognize revenue is an important decision for accountants. If revenue is recognized too early, the income statement will report net income sooner than it should and the business looks more profitable, in the short run, than it should. On the other hand, if revenue is reported too late, the net income will be lower than it should be. Financial statement users need to have accurate information in order to make good decisions.

When to recognize revenue?

Two conditions must be met:

1. It is realizable - the amount of cash is known and there is a reasonable chance that it will be collected.
2. It is earned - the earnings process is complete or almost complete. The company has performed what it was required to do.

Four types of revenue transactions:

1. Revenue from selling products - recognized at the date of sale which usually means the date of delivery to the customer.
2. Revenue from performing services - recognized after services have been performed.
3. Revenue from the use of assets (such as interest revenue, rent revenue and royalties) - is recognized as time passes or as the assets are used.
4. Revenue from sale of assets (not inventory) - recognized at the date of sale.

Practice Exercise

Special situations for long term construction contracts

Two methods:

1. Percentage of completion method

Revenue and gross profit on the contract are recognized as the construction takes place based on the percentage of completion of the project.

Percentage of completion is the preferred method because it more appropriately shows the revenue as the work is performed.

All of the following conditions must be met in order to use this method:

1. The contract price is fixed and the costs can be estimated
2. The buyer will be likely to fulfill the contract
3. The seller will be likely to fulfill the contract

2. Completed Contract method

Revenue and gross profit are recognized only when the contract is completed. This is a more conservative method.

The completed contract method should be used when:

1. The conditions for the percentage of completion method are not met.
2. Contracts are short term (less than 1 year).

There are many journal entries that need to be recorded for construction projects. As the building is constructed, expenses are incurred and the customer is sent bills and is expected to make cash payments. These events need to be recorded in addition to recording revenue.

Assume the following facts for a three-year contract with a fixed price of AED 300,000.

As construction expenses are incurred, the following entry is made:

Construction in progress* 60,000

                        Cash 60,000

* this is an inventory account that will remain on the balance sheet until the building is complete.

As bills are sent to the customer (usually based on agreements in the contract), the following entry is made:

Accounts receivable 100,000

                    Billings on Contract** 100,000

**this is a liability account that will remain on the balance sheet until the building is complete. (similar to an unearned revenue account)

As the customer pays cash for their bills, the following entry is made:

Cash 80,000

                Accounts receivable 80,000

In the percentage of completion method, revenue is earned on each year as the building is being built. The amount of revenue is calculated using the amount of costs incurred to estimate the percentage of completion of the building. The following journal entry is made to show the amount of revenue to be recognized:

Construction in Progress* gross profit for this period

Construction expenses** actual construction costs this period

                            Construction revenue** revenue for this period

*this account is an inventory account which appears on the balance sheet as discussed earlier.

**both construction expenses and construction revenue appear on the income statement for the current period and are closed at the end of the period.

Step 1

Costs are used to determine the percentage of completion of the project by using the following formula:

Costs incurred to date                         = percentage complete

Most recent estimate of total costs

60,000/(140,000+60,000) = .3 or 30%

(35,000 + 60,000)/ (95,000 + 95,000) = .5 or 50%

(35,000 + 60,000 + 80,000)/ 175,000 = 1 or 100%

The building is finished in 1998.

Step 2

The total revenue to be recognized to date is calculated with the following formula:

Percentage complete * estimated total                 =                 revenue to be

                                        revenue for the contract                     recognized to date

.3 * 300,000 = 90,000

.5 * 300,000 = 150,000

1 * 300,000 = 300,000

Step 3

To find the amounts of revenue to be recognized in the current period, the amount of revenue recognized in previous periods must be deducted.

Revenue to be          -             Revenue recognized = Current period revenue

recognized to date                 in prior periods

90,000 - 0 = 90,000

150,000 - 90,000 = 60,000

300,000 - 90,000 - 60,000 = 150,000

Step 4

To calculate the amount of gross profit to be recorded, the costs for the current period must be subtracted from the revenues for the period.

The journal entry looks like this:

Construction in Progress gross profit for this period

Construction expenses actual construction costs this period

                            Construction revenue revenue for this period

Construction in Progress 30,000

Construction expenses 60,000

                        Construction revenue 90,000

Construction in Progress 25,000

Construction expenses 35,000

                        Construction revenue 60,000

Construction in Progress 70,000

Construction expenses 80,000

                    Construction revenue 150,000

Income Statement Disclosure:

Notice that the billings and collections do not have any influence on the amount of revenue to be recognized.

When the contract is completed in 1998, the two accounts relating to the contract must be closed. At the end of the contract, they will equal each other and the following entry would be made.

Billings on Contract (100,000 + 100,000 + 100,000) 300,000

                                            Construction in progress* 300,000

*this account would have the following activity:

Balance sheet disclosure:

Important: If the billings are less than the construction in progress, then the two accounts would appear in the current asset section as inventory. The Construction in Progress account would come first and the Billings on Contract account would be deducted from it. The net amount would be called "Unbilled Contract Costs".

The journal entries for this method are the same as for the percentage of completion method other than the entries for recognizing revenue. Under the completed contract method, no revenue is recognized until the contract is complete.

At the end of the contract, the following entries would be made (assuming the same facts as the previous example)

To record the revenue earned and close the Billings account:

Billings on Contract 300,000

                Construction revenue 300,000

To record the construction expenses and close the construction in progress account:

Construction expenses 175,000

                Construction in progress 175,000

Note that the Construction in progress account in this method only contains the expenses and not the gross profit on the contract.

Notice that the billings and collections still do not have any influence on the amount of revenue to be recognized.

Important: Again, if the billings are less than the construction in progress, then the two accounts would appear in the current asset section as inventory.

Practice questions