William F. Bentz 1

Revenue Recognition

Revenue recognition is a crucial concept in accounting. It is the stage in the production cycle that revenue--and thus income--is recognized. Premature revenue recognition tends to overstate the profitability and growth prospects of a firm, while very conservative methods tend to understate a firm’s current profitability.

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Revenue Recognized When

Revenue is substantially earned– Remaining costs reasonably estimable– Remaining costs and obligations minor

relative to total costs and obligations– Critical event has been completed

Revenue is realized in – Cash, or assets easily convertible to cash– Collections are reasonably estimable

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Examples

Sale of a car with warranties Sale of house with warranties Completion of a software project Sale of clothing when returns

accepted

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Revenue Recognition

For revenue to be recognized, it must be both earned and realized (or realizable). Both conditions must be met before there is realization. A few revenue recognition practices are industry-specific, but the criteria for recognition are universal.

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Consider the Collection Issue

Realization is deemed to have occurred if the seller has received a valid claim to a determinable amount of money subject to reasonable payment terms by a buyer that is capable of paying the amount due.

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Consider the buyers

Without a financially sound buyer, we do not have realization even if all the other terms are met. Consider the example of Prosoft I-Net Solutions, Inc.

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Practical Example

Prosoft and their auditors, Ernst & Young are parting company.

Prosoft-IE&Y

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Prosoft/E&Y Issues

“...Under the accrual method of accounting, the Company reported the entire amounts to be received under those contracts as revenue in the quarter in which the contract was entered into, based on the terms and conditions of such contracts. The Former Accountants raised concerns as to whether these contracts with the two customers represented currently recognizable revenue and income under generally accepted accounting principles. Of particular concern to the Former Accountants was the lack of information available to evaluate the creditworthiness of these customers.”

Form 8-K, dated 4/6/1998

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Disposition

Cash basis adopted for recognition of licensing contract revenue

Ernst & Young LLP no longer to serve as Prosoft's independent auditor

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Earning Revenue

What is the earning process and what does it mean for the earning process to be “substantially complete”?

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Cash

Buy Land

Buy Materials

Build House

Sell House

Close Sale

House Construction Cycle

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Get Cash

Buy Land

Buy Materials

Plant Crop

Harvest

Sell Crop

Grain Farming

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Get Cash

Hire people

Proposals

Sign ContractDesign Appl.

Code Appl.

Software Development

Testing

Customer Acceptance

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Long-term Contracts

Many projects take more than a year or two to complete. Since many of these projects involve the provision of goods and services in accordance with a contract, they are called long-term contracts. They are long-term when the operating cycle is over 1 year.

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Examples

Construction of office buildings Construction of a factory Fabrication of equipment such as

the luggage-handling equipment in the Denver Airport

Development of enterprise software systems.

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Examples

Building a cruise ship Constructing a power plant Making an animated film

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The Reporting Problem

The problem is that a company’s main activity may involve relatively few large projects, none of which may be completed in a particular period. How can we report to investors the results of operations if no contracts are completed?

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Revenue Recognition - Long-term Contracts

Objective: To recognize revenue period-by-period as the revenue from a long-term contract is earned. The key criteria for revenue recognition are still:Earning of the revenue

– Reasonably estimable project costsRealization

– Doubtful accounts estimable

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Revenue Recognition Methods

Revenue is recognized on long-term projects on one of two bases:– Completed contract method– Percentage-of-completion method

Annual revenues, expenses, income, and asset values are affected by the choice of method.

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Completed Contract Method

With the completed contract method, project costs are accumulated in a Construction-in-Process account. The cumulative cost is matched against revenues when the contract is completed. The amount of revenue recognized is the final contract price.

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Percentage Completion Method

With the percentage-of-completion method, a portion of the total contract price is recognized each period. That portion is the percentage of the work completed to date, less the revenue already recognized.

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Percentage-of-completion

To use the percentage-of-completion method, one must have some way of determining the percentage of completion for each project! The percentage of the costs incurred, relative to total expected project cost, is one measure of completion.

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Calculating the Percent

Total project costs incurred to date

Total project costs incurred to date

+ Total estimated costs to complete the project or contract

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Cost as a Measure of Effort

Warranties & warranty contracts Construction costs (long-term

contracts) Franchise agreements Other cases where the amount of

revenue can be determined when a contract is signed

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Annual Revenue

Annual revenue =

[Cumulative revenue earned - revenue recognized previously]

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Cumulative Revenue

Cumulative revenue earned =

Cumulative cost incurred

Total estimated costX Contract

Price

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What Investors Can Learn

In many businesses, investors monitor gross margins.

Margins will increase if:– Contract prices are increased by

incentives, etc.– Costs are less than expected earlier– New projects are more profitable than

earlier contracts

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What Investors Can Learn

Margins will decrease if:– Contract prices are decreased by

penalties, etc.

– Costs are higher that expected earlier

– New projects are less profitable that earlier contracts

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What Investors Can Learn

Margins will stay the same so long as:– Project costs are consistent with

estimates.– Contract modifications do not result in

changed project profit margins– New projects are equally profitable as

earlier projects.

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Important Considerations

Revenue must be known or subject to little variation (i.e., a contract exists and the final price can be reasonably estimated)

The amount of effort (cost) determines the recognition of revenue, not the total contract value. Annual gross margin amounts will vary with the work done, even when the contract price is constant.

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THE END