Write on Generally Acceptable Method of Revenue Recognition of Long Term Contract
INTRODUCTION
Typically, revenue is recognized when a critical event has occurred, and the dollar amount is easily measurable to the company. For almost all entities other than financial institutions, revenue is the largest single number in the financial statements. It is also a number that attracts a great deal of user attention. Whilst it might be accepted that profit is the most important single indicator of corporate financial performance revenue does not fall far behind. Indeed in many sectors, for example the retail food sector, revenue is a ‘headline number’ that is often announced first when results are communicated externally. In sectors where this is true, the remuneration packages of senior executives often include a ‘performance related element’ with revenue growth as the key determinant of ‘performance’.
Long-term construction projects, such as construction of a major sports stadium, can take several years to complete. Typically, revenue is recognized when the earnings process is complete; however, if the construction project did not begin work immediately, this could delay recognition of revenue, and expenses accumulated during the period would be unmatched.
GENERALLY ACCEPTABLE METHOD OF REVENUE RECOGNITION OF LONG TERM CONTRACT
The following are the generally acceptable methods of revenue recognition of long term contract:
- Percentage of Completion Method
The percentage of completion method takes the percentage of work completed for the period and divides that by the total revenues from the contract. The percentage of work completed for the period distributes the estimated total project costs over the contract term based on the actual completion amount, up to that point. The percentage can be based on such factors as percentage of anticipated final costs incurred at a given point or an engineering report that estimates the percentage of completion of the project at a stage of production.
According to this method, you would calculate the total expenses for the accounting period as a percentage of the overall cost to complete the contract, and multiple that by the total revenue created by the contract.
In addition, the percentage-of-completion method says that if the contract clearly specifies the price and payment options with transfer of ownership, the buyer is expected to pay the whole amount and the seller is expected to complete the project, then revenues, costs, and gross profit can be recognized each period based upon the progress of construction (that is, percentage of completion). For example, if during the year, 25% of the building was completed, the builder can recognize 25% of the expected total profit on the contract.
- Completed Contract Method
This method of revenue recognition does not report any income until the contract is finished because there is uncertainty about the collection of funds from the customer under the terms of the contract. The completed contract method should be used if it is difficult to estimate costs and the associated percent of total expenses, and if there are inherent hazards that may interfere with project completion.
The completed-contract method should be used only if percentage-of-completion is not applicable or the contract involves extremely high risks. Under this method, revenues, costs, and gross profit are recognized only after the project is fully completed. Thus, if a company is working only on one project, its income statement will show $0 revenues and $0 construction-related costs until the final year. However, expected loss should be recognized fully and immediately due to conservatism constraint.
The completed contract method delays reporting of both revenues and expenses until the entire contract is complete. This can create reporting issues and is typically used only where cost and earnings cannot be reasonably estimated throughout the contract term.
- Installment Method
The installment method of revenue recognition allocates a percentage of cash received to the current year. To calculate the percent, you will divide the profit made from the contract by the total price paid by the buyer. After, multiply the amount of cash received by this amount.
- Cost Recovery Method
This method only recognizes revenue once when cash paid by the buyer to the seller is greater than the amount the seller has spent on the contract. The seller needs to break even before they can report any revenue. This approach can be used when there is considerable uncertainty that the receivables will be collected, which begs the question: if there is considerable uncertainty that payments will be collected, why is the seller in business with the buyer in the first place?
CONCLUSION
From the foregoing, it has been explain how companies recognize revenue generated from long-term contracts, which are contracts that span several accounting periods. Companies need to determine which accounting period to recognize the revenue in, and there are several options: percentage of completion method, completed contract method.
REFERENCES
Financial Accounting Standards Board (2008). “Statement of Financial Accounting Standards No. 66, Paragraph 65.
Write on Generally Acceptable Method of Revenue Recognition of Long Term Contract
Revsine, Lawrence (2002), Financial reporting & analysis, Prentice Hall.
