Revenue Recognition

One of the most difficult issues facing accountants concerns the recognition of revenue and
expenses by a business enterprise. The recognition issue refers to the difficulty of deciding when
a business transaction should be recorded
Revenue Recognition
The objective of any business enterprise is to generate income that will provide owners with a
return on their investment. The major source of income for most enterprises is from its operation
- the process of generating revenue by providing goods and services to outsiders. Operations
involve the incurring of costs and expenses, and unless a satisfactory level of revenue is
generated a loss or a low level of income will result, no matter how carefully costs and expenses
are controlled. Consequently, the meaning of revenue and the criteria for its recognition are
important not only toacc accountants but also to enterprise and to the users of its financial
statements. In today’s more complex and uncertain business environment, accountants are faced
with two tasks relating to revenue i.e. to determine when revenue is realized and the birr amount
at which it is recognized in the accounting records. SFAC No 5 defines recognition as the
recording of an item in the accounts and financial statements as an asset, liability, revenue,
expense, gain, or loss. Recognition includes depiction of an item in both words and numbers,
with the amount included in the summarized figures reported in the financial statements
Four fundamental criteria must be met before an item can be recognized. These are definition
(the item or the event must meet the definition of one of the financial statement elements (asset,
revenue, expense etc), measurability (the item or event must have a relevant attribute that is
reliably measurable, that is, a characteristic, trait, or aspect that can be quantified and measured.
Examples are historical cost, current cost, market value etc), Relevance (information about the
item or event is capable of making a difference in users decisions), Reliability (information about
the item is representational faithful, verifiable, and neutral).
In addition to the above four general recognition criteria, the revenue principle provides that
revenue should be recognized in the financial statements when it is earned and it is realized or
realizable. Revenues are earned when the company has substantially accomplished all that it
must do to be entitled to receive the associated benefits of the revenue. In general, revenue is
recognizable when the earning process is completed or virtually completed.
Earning process is the profit – directed activities of a business enterprise through which revenue
is earned; such activities may include purchasing, manufacturing, selling, rendering services,
delivering and servicing products sold, allowing others to use enterprise resources, etc. Revenue
is realized when cash is received for the goods or services sold. Revenue is considered realizable
when claims to cash (for example, non cash assets such as accounts or notes receivable) are
received that are determined to be readily comfortable into known amount of cash. This criterion
is also met if the product is a commodity, such as gold or wheat, for which there is a public
market in which essentially unlimited amounts of the product can be bought or sold at the known
market price. In the measurement of revenue, realization generally means that a measurable
transaction (such as sale) or an event (such as the rendering of services) has been completed or is
sufficiently finalized to warrant the recording of earned revenue in the accounting records. The
selection of the critical event indicating that revenue has been realized (earned) is the foundation
of the revenue realization principle. In addition, revenue to be recognized collection of the
claims from customers and clients who have purchased goods and services should be reasonably
assured.

In general, revenues are recognized (formally recorded in the accounting records) as soon as all
criteria are met. An accounting issue is to determine when the criteria are met for different types
of revenue – generating transactions.
In making many revenue & expense recognition decisions, accountants may rely on estimates
and professional judgments. For example, the amount spent for material, labor, and other
services may be measured objectively, however, the continuous transformation of these cost
inputs into more valuable outputs is an internal process that requires estimates based on
subjective judgment. In tracing the effect of this process and portraying it in terms of birr,
accountants do not have objective external evidence supporting market transactions as a basis for
measurement and recording. However, generally accepted accounting principles provide few
guidelines for making estimates and for exercising professional judgment in specific revenue &
expense recognition situations.
Stages at which revenues are recognized
The delivery of goods or services to a customer is a significant event that occurs in virtually all
revenue – generating transitions. Given this fact, three broad timing categories of revenue
recognition can be identified:
1. Revenue recognized on delivery of the product or service (the point of sale)
2. Revenue recognized before delivery of the product or service.
3. Revenue recognized after delivery of the product or service.
For most companies and for most goods and services, however, revenue is recognized at the time
of delivery of the goods or services to the customer: Revenue is them considered both earned and
realized or realizable when the product or service is delivered.
Revenue is sometimes recognized before delivery when the earning process extends over several
accounting periods and it is considered important (i.e. relevant) to provide revenue information
before the earning process is complete. For example, when there is a contract to produce a
product for a known birr amount that will be received when the product is delivered (i.e. it is
realizable), revenue can be recognized as it is earned, before the product is delivered to the
customer. Revenue is sometimes recognized after delivery when there are concerns about the
amount of revenue that will be realized. Revenue has been earned, but recognition is delayed
until the amount realizable is determined. In these situations, providing reliable revenue
information is considered more important than early, potentially more relevant but less reliable,
revenue information

Revenue Recognized at Delivery (Point of Sale)

The conditions for revenue recognition are usually met at the time goods or services are
delivered. Thus, revenue from the sale of goods is usually recognized at the date of sale, which
is the date the goods are delivered to the customer. Revenue from services rendered is likewise
recognized when the services have been performed. This is the point – of – sale method,
sometimes called the sales method or the delivery methods of revenue recognition.
Some costs associated with servicing a product or service sold with a guarantee or warranty may
be incurred after delivery. When these costs can be reasonably estimated, revenue is still
recognized at the date of sale, with a provision made for future warranty cost. In this case,
revenue is considered earned and realizable.
Revenue Recognition before Delivery
In some instances the earning process extends over several accounting periods. Delivery of the
final products may occur years after the initiation of the product. Examples are construction of
large ships, bridges, office buildings, and development of space exploration equipment.
Contracts for these projects often provide for progress billings at various points in the
construction process. If the builder (seller) waits until the constriction is completed to recognize
revenue, the information on revenue and expense included in the financial statements will be
reliable, but may not be relevant for decision making because the – information is not timely. In
such instances, it often is worthwhile to trade – off reliability in order to provide more timely,
relevant earnings information. This is the case for a company engaging in long – construction
contracts.
GAAP provides two methods of accounting for revenue on long – term constructs:
1. Completed – contract method: under this method revenues, expenses, and gross profit are
recognized only when the contract is completed. As construction costs are incurred they are
accumulated in an inventory account (construction in progress). Progress billings are not
recorded as revenues but are accumulated in a contra inventory account (billings on
construction progress. At the completion of the contract, all the accounts are closed and the
entire gross profit from the construction project is recognized.
2. Percentage of completion method: Under this method revenue, expenses and gross profit are
recognized each accounting period based on the estimate of the percentage of completion of
the construction project.
The percentage -of - completion method recognizes revenue on a long – term project as the
contract is being completed, thus timely information is provided. However, it contains estimates
and is not as reliable as information in the completed – contract method.
Management of a company has little freedom of choice in deciding between these alternative
methods of accounting for long – term contracts. When estimate of costs to complete and extent
of progress toward completion of long-term construction contracts are reasonably dependable,
the percentage – of - completion method is preferable. When lack of dependable estimates or
inherent hazards cause forecasts to be doubtful, the completed – contract method is preferable.
Measuring progress toward completion of a long – term construction project is accomplished
with input measures or out put measures.
1. Input measures:
The effort devoted to a project to date is compared with the total effort expected to be required in
order to complete the project. Examples are cost incurred to date compared with total estimated
costs for the project and labor hours worked compared with total estimated labor required to
complete the project. Among input measures, the cost – to – cost method is the most common.
The cost – to - cost method measures the percentage completed by the ratio of the costs incurred
to date to the current estimate of the total cost required to complete the project:

Total costs incurred to date

Percent complete = -------------------------------------------------
Most recent estimate of total costs of the project
The most recent estimate of total project costs is the sum of the total costs incurred to date plus
the estimated costs yet to be incurred to complete the project. Once the percentage completed
has been computed, the amount of revenue to be recognized in the current period is determined
as:
Current period revenue = (percent complete X total revenue from contract) – total revenue
Recognized in
prior periods
2. Output measures:
Results to date are compared with total results when the project is completed. Examples are
number of stories to be built and miles of highway completed compared with total miles to be
completed.
Illustration: FENOTE Construction Company engaged into contract with a municipality to
construct a 10 kilometer highway. Total contract price is Br. 900,000.
Additional data: Year 1 year 2 year 3
Construction costs incurred during the year .......Br.125, 000 Br. 495,000 Br. 145,000
Estimated cost to complete the project
at the end of the year ............................................. Br.625, 000 Br. 155,000 0
Operating costs incurred (selling, Administrative) Br. 15,000 Br. 30,000 12,000
Required: using the above data compute the realized profit on contract revenue for each year
under the following methods of accounting for construction – type contracts:
 (a) Percentage - of –completion method (cost – to cost)
(b) Completed – contract method.
Solution:
(a) Percentage – of – completion method
 Revenue recognized to date = Actual cost incurred to date X contract price
Newly estimated total cost to
complete the projects
 revenue recognized for=Revenue recognized to date _ Revenue recognized until the
end of the previous year
There fore,
Revenue recognized for year 1 = 125,000 X 900,000
750,000
= Br. 150,000
Revenue recognized for year 2 = 620,000 X 900,000 - 150,000
775,000
= 720,000 – 150,000
= Br. 570,000
Revenue recognized for year 3 = 765,000 X 900,000 - (150,000 X 570,000)
765,000
= Br. 180,000
Fenote Construction Company
Realized Gross Profit on Contract Revenue; Percentage of Completion Method.
For Years 1, 2 and3
YEAR 1 YEAR 2 YEAR 3
Contract Revenue Br. 150,000 Br. 570,000 Br. 180,000
Costs Incurred 125,000 495,000 145,000
Realized Gross Profit On Contract Revenue Br. 25,000 Br. 75,000 Br. 35,000
Operating Expenses 15,000 30,000 12,000
Net Income Br. 10,000 Br. 45,000 Br.23,000
(B) Completed – contract method.
YEAR 1 YEAR 2 YEAR 3
Contract revenue Br. 0 Br. 0 Br. 0
construction costs incurred............................... 0 0 0
Gross profit Br. 0 Br. 0 Br. 0
Operating expenses Br. 15,000 Br. 30,000 Br.12,000
Net income Br. (15,000) Br. (30,000) Br.(123,000)
Some additional methods that have been proposed, and generally rejected, for the realization of
revenue prior to delivery of the product are production, accretion, discovery, receipt of order, and
billing. The recognition of revenue prior to delivery generally is viewed as a departure from the
revenue realization principle. Recognition of revenue on construction – type contracts under the
percentage – 0f completion or on completion of “special order” goods has considerable
theoretical and practical support. In general, when a sale of goods is not considered to result in
revenue realization, the revenue might be recognized at the following stages of the productive
(earning) process prior to delivery of goods to customers:
1. Prior to production.
2. During production
3. on competition of production
4. At some other stage based, for example, on production, accretion , discovery, receipt
of orders from customers, or billing of customers.
Revenue Recognition after Delivery
Under some circumstances the revenue recognition criteria are not met until some time after
delivery of the goods or service to the customer. Such is the case when:
1. The substance of the transaction if different from the form, such as in product – financing
arrangements.
2. The ultimate collectablity of the sales price is highly uncertain, such as with some long –
term installment sales. In such instance revenue may be recorded under the installment
method, the cost recovery method, or some other method based on cash collection.
Cost Recovery method.
The cost recovery method is sometimes called the sunk cost method. Under this method a
company recovers all the related costs incurred (the sunk costs) before it recognizes any profit.
The cost recovery method is used only for highly speculative transactions when the ultimate
realization of revenue or profit is unpredictable. The cost recovery method is also justified when
there is uncertainty regarding the ultimate collectiblity of an installment sale.
Under the cost recovery method, no profit is recognized until the cost of the products sold is fully
recovered. In the period of sale, the cost of the products is deducted from sales (net of the
deferred gross profit) in the income statement. The deferred gross profit also is deducted from
the related receivable in the balance sheet. Collections of principal reduce the receivable, and
any collections of interest are credited to the deferred gross profit ledger account. Deferred gross
profit subsequently recognized as earned is presented as a separate item of revenue in the income
statement.
Illustration: For installment method and cost recovery method.
On June 1, 1997, Booker productions sell a large amount of unusual merchandise to a retailer.
The demand for the merchandise is unknown; the retailer is of questionable financial strength,
and thus it is highly uncertain as to whether Booker will ever be paid the full sales price. The
facts regarding the transaction and subsequent events are:
Sales price for merchandise Br. 140,000 100%
Cost of merchandise sold 84,000 60%
Gross margin Br. 56,000
Cash Collected in 1997 Br. 40,000
Cash collected in 1998 Br. 55,000
Cash collected in 1999 Br. 15,000
Total cash inflows Br. 110,000
At December 31, 1999, it is determined that no more cash will be collected from this transaction.
Required:
1. Show the entries to account for this transaction using the installment sales method.
2. Shaw the entries to account for this transaction using the cost recovery method
3. Show summary comparative income statements for all three years for both methods.
Solution: Requirements 1 and 2 are shown in side –by – side columns to illustrate the difference
between the two methods. Entries that differ between the two methods are shown in bold face.
Installment Method Cost recovery method
To record sales and cost of sales:
Installment sales receivable 140,000 140,000
 Installment sales 140,000 140,000
Cost of installment sales 84,000 84,000
Merchandise inventory 84,000 84,000

To record cash payments received during 1997:

Cash 40,000 40,000
Installment sales receivable 40,000 40,000
At December 31, 1997, to record deferred gross margin and amount of realized gross margin
during 1997, and to close temporary accounts:
Installment Method Cost recovery method
Installment sales $ 140,000 $ 140,000
Cost of installment sales 84,000 84,000
Deferred gross margin 56,000 56,000
Deferred gross margin (Br. 40,000 X 0.4) 16,000
Realized gross margin 16,000
1998 entries to record cash received and to record realized gross margin
Installment Method Cost recovery Method
Cash 55,000 55,000
Installment sales receivable 55,000 55,000
Deferred gross margin 22,000+ 11,000*
Realized gross margin 22,000 11,000
1999 entries to record cash received and to record realized gross margin
Installment Method Cost recovery Method
Cash 15,000 15,000
Installment sales receivable 15,000 15,000
Deferred gross margin 6,000+ 15,000*
Realized gross margin 6,000 15,000
+ Br. 15,000 X 0.4 =Br.6, 000
* Since all costs have been recovered, the full amount of cash represents realized gross margin.
To record write off of amount not expected to be collected.
Deferred gross, margin 12,000+ 30,000*
Loss on write –off of installment sale receivable 18,000 -0-
Installment sales receivable 30,000 30,000

3. Comparative income statement under the two methods is:

(In all cases, for years ending December 31)
Installment Method Cost Recovery Method
1997 1998 1999 Total 1997 1998 1999 Total
Installment sales Br.140 Br. 0 Br. 0 Br. 140,000 Br.140 Br. 0 Br. 0 Br.140,000
Cost of sales 84 0 0 84 84 0 0 84
Gross margin 56 0 0 56 56 0 0 56
Less: Deferred margin (56) 0 0 (56) 56 0 0 (56)
Add: Realized gross margin 16 22 6 44 0 11 15 26
Income (before write – off) 16 22 6 44 0 11 15 26
Write-off of un collectible receivable - - (18) (18) - - 0 0
Income Br. 16 Br.22 Br.(12) Br.26 Br. 0 Br.11 Br.15 Br.26
In general, revenue recognition under the installment and cost recovery methods of accounting is
based to a considerable extent on the timing of cash receipts.