Revenue Recognition Methods & Implications

revenue recognition methodsCorrectly recognizing revenue is an important accounting function for all organizations. Often, it is not as simple as recording a sale when it is made. 

In order to conform to generally approved accounting practices (GAAP), organizations must account for their revenue in specific ways. For consistency, once an organization begins using a revenue recognition method, it should continue to use that method. 

There are several revenue recognition methods that may be used:

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.

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 percentage of completion method can be computed in two ways:

  • Revenue may be recognized at specific milestones. For a building, that could be a specific number of square feet, or a web design firm may have milestones of a specific number of pages for a website.
  • The percentage of completion may also be calculated based on cost. For example, if a firm expects costs to total $1,000,000 and they have incurred $300,000 in cost, the project would be seen as 30 percent complete.

While this revenue recognition method provides an alternative for long-term contracts, revenues may be overstated if the timing for expenses and completion of work are not properly aligned.

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. 

Installment Method

When companies cannot rely on their customer’s ability to pay in a timely manner, the installment revenue recognition method may be best suited for the organization. With the installment method, revenue is only recorded once the organization has received payment. 

For example, if a car is sold for $5,000 on an installment plan, the revenue from that sale is only recognized as payments are received. If a $1,000 down payment is made, the $1,000 revenue is recorded at the time of receipt. Each of the subsequent payments of $1,000 will generate an equal amount of revenue, and then be offset by related costs. 

Updated Revenue Recognition Method

The standard for revenue recognition was updated in May 2014 with the release of Accounting Standards Update 2014-09 addressing Revenue from Contracts with Customers. While the old standard had rules with different requirements for revenue recognition by industry, the updated standard now has a principled approach to revenue recognition for all organizations. 

While the updated standard will likely touch all organizations, those organizations with business operations driven by customer contracts will see the greatest impact. This includes businesses with long term-contracts that have traditionally used the percentage of completion or completed contract revenue recognition methods.  

While the standards provided in the updated criteria do not take effect until December 2016, most organizations must take steps now to prepare for the change in revenue recognition methods.

The major change in revenue recognition was the addition of the following five-step-process to identify, and ultimately record revenue from contracts.

  1. Identify contracts with customers including oral, written and implied contracts.
  2. Identify distinct performance obligations under the contract.
  3. Determine the total price of the contract.
  4. Allocate the contract price across the performance obligations.
  5. Recognize revenue as the obligations are completed.

Making the necessary changes to report on the changed revenue recognition methods is complex and requires a great deal of planning and understanding. 

To ensure that these changes are handled correctly, it is best to use the services of a qualified accounting firm that is familiar with the new revenue recognition roles and can support your organization through the transition.  

 

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