Professor Paul Zarowin - NYU Stern School of Business
Financial Reporting and Analysis - B10.2302/C10.0021 - Class Notes
Revenue Recognition - Special Issues
In most cases, revenue recognition is straightforward. Revenue is recognized when two
conditions are met: (1) it is earned (i.e., performance is complete), and (2) cash collection is
(reasonably) assured. RCJ (pg. 46) refer to these as the critical event and the measurable
conditions, respectively. In this module we will discuss some exceptions to the general case. We
will focus on cases where either of the two assumptions breaks down.
These cases fall into two categories. In the first category, performance takes place over more
than one accounting period; thus, revenue must be allocated across the periods. This is referred
to as Along-term contracting@. There are two accounting methods used in this case, the
percentage of completion method and the completed contract method. In the second category,
cash collection is uncertain, and revenue recognition defaults to a de facto cash basis. There are
also two accounting methods used in this case, the installment method and the cost recovery
method.
The important point to remember in each situation is that the accounting method choice affects
both the B/S and the I/S, and thus any performance measures or ratios constructed from the
financial statements. Thus, analysts must understand how the accounting method choice affects
the reported numbers.
Percentage of Completion (PCT) and Completed Contract (CC) methods
These two methods are very similar, and are used mainly for construction projects that take more
than one period. The methods are comprised of the same 5 journal entries. The entries (and
related data) are shown in Exhibit 2.6 on page 76. Entries 1,3,4, and 5 are transaction entries that
account for actual construction costs, billings, cash collections, and culmination of the job. These
four entries are identical for both accounting methods and only affect the B/S accounts. Note that
the AConstruction in Progress@ (CP) account is an inventory account, and the ABillings on
Construction in Progress@ (BCP) is its contra-asset account. Note that CP can be greater or less
than BCP; i.e., there can be a net asset or liability position.
The key journal entry is the second (to recognize revenue and gross profit). It is the only one that
differs between the two methods. It is an adjusting entry that records the periodic revenue. The
journal entry is:
DR
CR
(B/S) construction in progress-GP
(I/S) construction expenses
(I/S)revenue from LT contract
Note that the construction in progress account is the same B/S account used in the periodic
transaction entry. For the CC method, this adjusting entry is only made once, when the work is
completed (unless the job is unprofitable, see below); i.e., no revenue or expense is recognized
until the final period. Thus, the construction project does not affect the I/S until this time. For the
PCT method, this entry is made each period, according to the following algorithm, which is
based on the year-to-year change in estimated total construction costs (this is an example of an
accounting estimate, like bad debts %).
1. % complete = costs incurred so far/estimated total costs
2. Total revenue so far = % x total contract price
3. This period=s revenue = total - revenue previously recognized
4. This period=s expenses are actual expenses
5. Gross Profit (GP) = revenue - expenses
The estimates are usually based on engineering/construction estimates. While the CC method has
the advantage that it requires no such estimates, it has the disadvantage that it does not reflect
periodic performance as well as the PCT method.
Note that this method automatically accounts for year-to-year changes in estimated total costs
(have you ever heard of cost overruns?) by the % in 1. No further adjustment is necessary. Also
note that negative GP is possible just by following the algorithm.
long term contract losses
1. Periodic losses (expenses > revenues) within an overall profitable job require no change in the
method described above. The PCT method makes the usual calculation (it just happens to
produce negative GP for the period - this happens when there is a large increase in estimated
costs), and the CC method bypasses the entry altogether, as described above.
2. The only change in the above method comes when the overall job is judged to be unprofitable.
This occurs when the total cost estimate increases above the contracted revenues. In this case, the
expected total loss from the job must be recognized immediately (remember, accounting is
conservative).
For the CC method, just make the following entry, which records the loss and decreases the
construction in progress account:
DR
CR
Loss from LT contracts
Construction in Progress (loss)
The loss (CR to construction in progress) equals the overall expected loss (since zero GP was
recognized previously). This is the only time when the CC method makes a profit or loss entry
before the job is complete. If the estimated total loss increases, the entry must be made again for
the additional loss. If there are no further estimate changes, no additional entries are made, even
in the last year (because the correct total GP has already been recognized). If the estimated total
loss decreases, the positive GP is recognized only in the last year (conservatism).
For the PCT method, the negative GP must wipe out the positive GP recognized so far plus the
total loss expected for the job. For example, if the positive GP recognized previously was 100
and the overall loss is expected to be 150, the negative GP this period is 250 (for the CC
method, this period=s negative GP is 150).The recognized revenue this period is computed as per
the above algorithm, and this period=s expenses are a plug (to achieve the desired negative GP).
Like the CC method, only further changes in estimates require additional revenue, expense, and
GP entries.
In summary, until a project=s last year, the PCT method will generally show both higher NI and
thus higher O/E (because of the periodic revenue recognition, and its affect on R/E) and higher
Total Assets (because of the higher inventory balance, Construction in Progress). In the last
year, the CC method will show higher NI, and both methods will show the same B/S figures.
Installment (IN) and Cost Recovery (CREC) Methods
These methods recognize revenue after delivery, essentially on a cash basis. They are also a
tandem, like the PCT and CC methods, and only differ by the one (adjusting) entry that records
the periodic revenue.
There are five entries shown (with related data) on page 83. All except entry #5 are the same for
both methods (except that the CREC method does not use the term Ainstallment@). Entries 1-4
are standard entries for sales, cash collections, and CGS that you should all know. The only new
twist is the term Ainstallment@. Note that deferred gross profit is a liability account (unearned
revenue).
The key entry is entry #5:
DR
CR
(B/S) deferred GP
(I/S) realized GP
When the sale is first made, all of the GP is deferred, and it becomes realized later. The IN
method is analogous to the PCT method in that it makes this entry and recognizes (realizes) GP
each period. The CREC method is analogous to the CC method in that it makes this entry and
recognizes (realizes) GP later (only after all of the costs have been covered - there may be more
than one period with realized gross profit).
For the IN method, realized GP = GP% x cash received; GP% = (sales price-CGS)/sales price.
For the CREC method, no GP is realized until total cash collected exceeds CGS, and then cash
collected equals realized GP.
Installment sales often have an interest component, since the cash is collected over time. The
present value (PV) of the cash received equals the sales price. Assume for example, installment
sales for $200K, and that the cash is collected evenly (the usual way) over 3 years and that the
interest rate = 10%. Thus, the PV of the 3 year annuity equals $200. At r=10%, each period=s
cash collection equals $80.42 (total cash collected = 3 x $80.42 = $241.26). You should
understand the annuity calculation. The cash collected is composed of Installment A/R of $200
and interest revenue of $41.26. Each period=s interest revenue equals the interest rate x the
balance of the Installment A/R. The CR to the A/R is a plug. For the CREC method, interest is
handled in the same way; (i.e., interest revenue = r% x A/R balance) and the CR to A/R is a plug
so that the total equals the cash collected. The periodic journal entries are as follows:1
Year 1:
DR
Cash 80.42
Year 2:
DR
Cash 80.42
CR
Installment A/R 60.42
Interest revenue 20.00
CR
Installment A/R 66.46
Interest revenue 13.96
Year 3:
DR
Cash 80.42
(20.00 = 10% x 200.00)
[13.96 = 10% x (200.00-60.42)]
CR
Installment A/R 73.11
Interest revenue 7.31 [7.31 = 10% x (200.00-60.42-66.46)]
When there is interest, the realized GP each period equals the GP% x the CR to the A/R (not
GP% x cash received). This is easy to see if you remember that it is the total CR=s to the A/R
that equal $200, whereas the total cash collected equals $241.26. Thus, the realized GP=s each
period in this example (GP% = 25%) are: $15.10, $16.62, and $18.28.
Sometimes merchandise sold under the installment method is repossessed (the buyer can=t make
the payments). The repossessed merchandise is an inventory account, and it should be recorded
at fair market value (FMV). The journal entry records the acquisition of the merchandise and
wipes out the remaining balances in the Deferred GP and Installment A/R balances. A gain or
loss (usually a loss, as shown) is usually needed to balance the entry. In the above example,
assume that merchandise with an FMV of $20 is repossessed after the second period. At this
time, the remaining Installment A/R and Deferred GP balances are $73.12 and $18.28,
respectively (you should be able to derive these balances for yourself). The repossession journal
entry is:
DR
CR
(B/S) repossessed merchandise 20.00 FMV
(B/S) Deferred GP
18.28
(I/S) Loss on repossession
34.84 (plug)
(B/S) Installment A/R
73.12
1
My example here assumes an annuity in arrears (cash collected at the end of the year).