revenue recognition methods
5 Revenue Recognition Methods
Revenue recognition policy impacts the representation of your financial statements as well as the tax liability to be computed thereon. There are various revenue recognition methods which have to be adopted as per the peculiarity of the business. Buzzle furnishes information about the different types of revenue recognition methods.
Did You Know?
Revenue recognition policies are guided by the accepted accounting standards followed by the nation, in which your entity is registered. A new converged standard 'Revenue from contracts with customers' has been released by the FASB1 (Financial Accounting Standards Board) and IASB 2 (International Accounting Standards Board) on May 28,2014, along with its implementation dates.Sales basis method
The most commonly used method of revenue recognition, it prescribes revenue to be recognized at the time when the ownership rights of the goods or services have been transferred to the buyer. It implies that the entity follows the accrual system of accounting.Cost Recovery Method
As the name suggests, cost recovery method implies that profit should not be recognized until and unless all the expenses incurred for the transaction have been recovered. Thus, initially, no profits are recorded, and its accounting is deferred until payments from the customer exceed your costs incurred for the project. This results in initial understating of profits and overstating of profits in the future.
When is it implemented?
This method is adopted when there is an uncertainty regarding the recoverability of revenue from the customer.Installment sales method
Similar to the cost recoverability method, the installment method is implemented in those circumstances where the recovery from the customer is to be spread over in installments. Typically used by the real estate industry, where returns from the customer are expected over a series of payments.
Example:
Company LMN sells to its customer an asset of USD 100,000. Cost of Asset is USD 90,000. The customer is required to make a down payment of USD 10,000 and pay in 4 installments, an amount equal to USD 22,500.
Gross profit to the company = Sale value - Cost = USD 10,000
Gross profit percentage = Gross profit / Sale value = 10%
Gross profit to be recognized = Gross profit received × Amount received in the respective year
Thus, the gross profit to be recognized every year as per the installment method of accounting is:
| Year 1 | Year 2 | Year 3 | Year 4 |
| 3,250 (32,500 × 10%) | 2,250 (22,500 × 10%) | 2,250 (22,500 × 10%) | 2250 (22,500 × 10%) |
Percentage-of-Completion Method
Peculiar to the real estate and construction industry, this method prescribes accounting of revenue and expenses of any particular contract on the basis of percentage of completion of the contract.
Example:
Company RST has a construction contract worth USD 400 million. The contract has completed 1 year, and at its end, actual cost incurred is USD 50 million. The estimated costs to complete the contract, at the end of year 1 is USD 200 millions. For calculating revenue to be recognized, following steps should be considered -
Step 1: Calculate the percentage completed.
Percentage completed = Total cost incurred up to that period / Total Estimated Cost of the Contract
Step 2: Calculate revenue to be recognized
Revenue to be recognized = Total Contract Revenue × Percentage Completed
Gross Profit recognized by Company RST at the end of Year 1 is as follows :
Percentage of Completion = 50/250 = 20%
Revenue to be recognized = 400 × 20% = USD 80
Gross Profit recorded for Year 1 = 80 - 50 = USD 30Completed-Contract-Method
This is another method prescribed along with percentage-completion method especially for construction contracts. However, as the name suggests, in this method, accounting is done after the contract is completed. Obviously, an advantage is that the tax liabilities are deferred for the corresponding period. However, the tax liability gets increased in the year in which it gets recognized. This method can be adopted by small contractors, or if it is not possible to reliably estimate the result of the project.