Revenue Recognition Methods and Implications

Sales-basis Method

• Revenue is recognized at the time of sale, i.e. the moment when the title of the goods or services is transferred to the buyer.

Implication:

• the most common and accurate form of revenue recognition.

Percentage-of-completion method

• Logistically extended by sales basis method
• Recognize revenues and expenses in proportion to work completed.
• Used by contractors and service firms for long-term projects.
• Use this method if two conditions are met: (1) a long-term legally enforceable contract (2)
• can estimate the percentage of the project that is complete, its revenues and its costs.
• Two conditions to estimate the %: (1) engineering estimation or physical milestone 2) ratio of incurred cost to the total estimated cost even if the total estimated cost has changed.
  
  Revenue = (cost incurred / total cost) x (total revenue)
  Income = Revenue - cost incurred

Implication:

• can overstate revenues and gross profits if expenditures are recognized before they contribute to completed work.

Completed-contract method

• Recognize revenues and expenses upon the full completion of contract
• Used if the two basic conditions needed to use the percentage-of-completion method are not met
• More conversative than and revenue lag behind %-of completion method
• Cannot guage profitability from income statement & must analyse through cash flows

Implication:

• can understate revenues and gross profit within an accounting period because the contract is not accounted for until it is completed.

Installment sales method

• Recognize gross profit in proportion to cash collected.
• Used in case customer collections are unreliable but the cost of goods & services are available.
• Similar to %-of completion and revenue lag behind sales basis. Should analyse cash flow.
  
  Cost =(cash collected / total revenue) x (total cost)
  Income = cash collected – cost.

Implication:

• can overstate gross profits if the last payment is not received.

Cost-recoverability method

• No profit is recognized until all of the expenses incurred to complete the project have been recouped.
• Used when cost are not known
• Conservative form of installment sales method.

Implication:

• can understate gross profits initially and overstate profits in future years.

Notes:

• Under IFRS, if the firm cannot reliably measure the outcome of the project, revenue is recognized to the extend of contract costs, costs are expensed when incurred, and prodit is recoginized at completion
• %-of-completion is a more aggressive method than completed contract as the revenue is reported earlier. Cash flows are same under both methods.

Barter transaction

• Two parties exchange goods or services without any cash payment.
• According to US GAAP, recognize revenue at fair value only if the firm has historically received cash payments and can use this experience to determine the fair value.
• According to IFRS, revenue must be measured based on the fair value from similar non-barter transaction with unrelated parties.