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Revenue Recognition
Revenue recognition is a crucial concept in accounting. It is the stage in the production cycle that revenue--and thus income--is recognized. Premature revenue recognition tends to overstate the profitability and growth prospects of a firm, while very conservative methods tend to understate a firm’s current profitability.
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Revenue Recognized When
Revenue is substantially earned– Remaining costs reasonably estimable– Remaining costs and obligations minor
relative to total costs and obligations– Critical event has been completed
Revenue is realized in – Cash, or assets easily convertible to cash– Collections are reasonably estimable
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Examples
Sale of a car with warranties Sale of house with warranties Completion of a software project Sale of clothing when returns
accepted
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Revenue Recognition
For revenue to be recognized, it must be both earned and realized (or realizable). Both conditions must be met before there is realization. A few revenue recognition practices are industry-specific, but the criteria for recognition are universal.
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Consider the Collection Issue
Realization is deemed to have occurred if the seller has received a valid claim to a determinable amount of money subject to reasonable payment terms by a buyer that is capable of paying the amount due.
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Consider the buyers
Without a financially sound buyer, we do not have realization even if all the other terms are met. Consider the example of Prosoft I-Net Solutions, Inc.
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Practical Example
Prosoft and their auditors, Ernst & Young are parting company.
Prosoft-IE&Y
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Prosoft/E&Y Issues
“...Under the accrual method of accounting, the Company reported the entire amounts to be received under those contracts as revenue in the quarter in which the contract was entered into, based on the terms and conditions of such contracts. The Former Accountants raised concerns as to whether these contracts with the two customers represented currently recognizable revenue and income under generally accepted accounting principles. Of particular concern to the Former Accountants was the lack of information available to evaluate the creditworthiness of these customers.”
Form 8-K, dated 4/6/1998
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Disposition
Cash basis adopted for recognition of licensing contract revenue
Ernst & Young LLP no longer to serve as Prosoft's independent auditor
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Earning Revenue
What is the earning process and what does it mean for the earning process to be “substantially complete”?
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Cash
Buy Land
Buy Materials
Build House
Sell House
Close Sale
House Construction Cycle
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Get Cash
Buy Land
Buy Materials
Plant Crop
Harvest
Sell Crop
Grain Farming
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Get Cash
Hire people
Proposals
Sign ContractDesign Appl.
Code Appl.
Software Development
Testing
Customer Acceptance
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Long-term Contracts
Many projects take more than a year or two to complete. Since many of these projects involve the provision of goods and services in accordance with a contract, they are called long-term contracts. They are long-term when the operating cycle is over 1 year.
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Examples
Construction of office buildings Construction of a factory Fabrication of equipment such as
the luggage-handling equipment in the Denver Airport
Development of enterprise software systems.
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Examples
Building a cruise ship Constructing a power plant Making an animated film
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The Reporting Problem
The problem is that a company’s main activity may involve relatively few large projects, none of which may be completed in a particular period. How can we report to investors the results of operations if no contracts are completed?
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Revenue Recognition - Long-term Contracts
Objective: To recognize revenue period-by-period as the revenue from a long-term contract is earned. The key criteria for revenue recognition are still:Earning of the revenue
– Reasonably estimable project costsRealization
– Doubtful accounts estimable
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Revenue Recognition Methods
Revenue is recognized on long-term projects on one of two bases:– Completed contract method– Percentage-of-completion method
Annual revenues, expenses, income, and asset values are affected by the choice of method.
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Completed Contract Method
With the completed contract method, project costs are accumulated in a Construction-in-Process account. The cumulative cost is matched against revenues when the contract is completed. The amount of revenue recognized is the final contract price.
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Percentage Completion Method
With the percentage-of-completion method, a portion of the total contract price is recognized each period. That portion is the percentage of the work completed to date, less the revenue already recognized.
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Percentage-of-completion
To use the percentage-of-completion method, one must have some way of determining the percentage of completion for each project! The percentage of the costs incurred, relative to total expected project cost, is one measure of completion.
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Calculating the Percent
Total project costs incurred to date
Total project costs incurred to date
+ Total estimated costs to complete the project or contract
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Cost as a Measure of Effort
Warranties & warranty contracts Construction costs (long-term
contracts) Franchise agreements Other cases where the amount of
revenue can be determined when a contract is signed
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Annual Revenue
Annual revenue =
[Cumulative revenue earned - revenue recognized previously]
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Cumulative Revenue
Cumulative revenue earned =
Cumulative cost incurred
Total estimated costX Contract
Price
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What Investors Can Learn
In many businesses, investors monitor gross margins.
Margins will increase if:– Contract prices are increased by
incentives, etc.– Costs are less than expected earlier– New projects are more profitable than
earlier contracts
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What Investors Can Learn
Margins will decrease if:– Contract prices are decreased by
penalties, etc.
– Costs are higher that expected earlier
– New projects are less profitable that earlier contracts
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What Investors Can Learn
Margins will stay the same so long as:– Project costs are consistent with
estimates.– Contract modifications do not result in
changed project profit margins– New projects are equally profitable as
earlier projects.
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Important Considerations
Revenue must be known or subject to little variation (i.e., a contract exists and the final price can be reasonably estimated)
The amount of effort (cost) determines the recognition of revenue, not the total contract value. Annual gross margin amounts will vary with the work done, even when the contract price is constant.
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THE END
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