Revenue recognition methods
/There are a number of ways in which revenue can be recognized in an organization's income statement. The method chosen depends on the industry and the specific circumstances. In the following sections, we note a number of recognition methods, how they work, and when they can be used.
Completed Contract Method
The completed contract method is used to recognize all of the revenue and profit associated with a project only after the project has been completed. This method is used when there is uncertainty about the collection of funds due from a customer under the terms of a contract.
Cost Recovery Method
Under the cost recovery method, a business does not recognize any profit related to a sale transaction until such time as the cost element of the sale has been paid in cash by the customer. Once the cash payments have recovered the seller's costs, all remaining cash receipts (if any) are recorded in income as received. This approach is to be used when there is considerable uncertainty regarding the collection of a receivable.
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Installment Method
When a seller allows a customer to pay for a sale over multiple years, the transaction is frequently accounted for by the seller using the installment method - and especially where it is not possible to determine the collectability of cash from the customer. Someone using it defers the gross margin on a sale transaction until the actual receipt of cash. This is an ideal recognition method for large-dollar items, such as real estate, machinery, and consumer appliances.
Percentage of Completion Method
The percentage of completion method involves, as the name implies, the ongoing recognition of revenue and profits related to longer-term projects. By doing so, the seller can recognize some gain or loss related to a project in every reporting period in which the project continues to be active. The method works best when it is reasonably possible to estimate the stages of project completion on an ongoing basis, or at least to estimate the remaining costs to complete a project. In essence, the percentage of completion method allows you to recognize as income that percentage of total income that matches the percentage of completion of a project.
Sales-Basis Method
Under the sales-basis approach, sales are recognized at the time of sale. This method works best when payment is assured, and all deliverables have been made. The sales-basis method is used for most types of retail sales.
Problems with Revenue Recognition Methods
The problem with revenue recognition is that many companies are valued based on the revenues they report, so there is an incentive to report excessively high revenue levels. This can take many forms, such as applying more generous recognition methods that do not really apply to a company’s circumstances, or making use of gray areas of the regulations to falsely accelerate the reporting of revenue. Given these concerns, auditors tend to allocate more of their time to the examination of clients’ revenue recognition methods.