Revenue Recognition Methods and RulesWhen considering revenue, the accountant typically assumes that there is only one point at which revenue is recognized, which is when the completed product or service is delivered to the customer. That is not totally wrong neither is completely correct. There are a number of rules regarding exactly when revenue can be recognized.

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Through this post I will cover 10 revenue recognition methods, all of which can be used under specific circumstances, and few of which precisely conform to this accounting rule. Consequently, the accountant should be aware of which of the revenue recognition scenarios presented in this post are most applicable to his or her situation, and report revenues accordingly. Read on…

 

Revenue Presentation

Revenue is the inflow of funds or related accounts receivable or other assets from other business entities in exchange for the provision of products or services by a company. It may also include incidental revenues from financing activities, such as dividends, interest income, or rent, or through the sale of assets. However, gains and losses that have little to do with the ongoing activities of the corporation (such as through an asset sale) should not be combined with revenues garnered from standard operations, because this would improperly show revenues that do not reveal the scale of ongoing operations.

A gain or loss on a transaction that is essentially unrelated to a company’s ongoing operations should not be recorded as revenue at the top of the income statement, but rather as a separate line item below the results of continuing operations.

 

However, if the amount of the gain or loss is not material, it can be offset against other operating expenses and lumped into the results from continuing operations. The “Other Income” category on the income statement typically includes all revenues not directly associated with operations, and that do not include gains or losses on other transactions, as just noted. This category includes income from financing activities, such as dividends or interest income (unless this is a primary activity of the business, such as would be the case for a mutual fund or insurance company). It can also include any profits earned on the sale of those assets not normally offered for sale (typically fixed asset sales).

 

Revenue Recognition Rules

The accountant should not recognize revenue until it has been earned. There are a number of rules regarding exactly when revenue can be recognized, but the key point is that revenue occurs at the point when substantially all services and deliveries related to the sale transaction have been completed.

Within this broad requirement, here are a number of more precise rules regarding revenue recognition:

[1]. Recognition at point of delivery. One should recognize revenue when the product is delivered to the customer. For example, revenue is recognized in a retail store when a customer pays for a product and walks out of the store with it in hand. Alternatively, a manufacturer recognizes revenue when its products are placed on board a conveyance owned by a common carrier for delivery to a customer; however, this point of delivery can change if the company owns the method of conveyance, since the product is still under company control until it reaches the customer’s receiving dock.

[2]. Recognition when customer acceptance is secured. The Securities and Exchange Commission has become increasingly disturbed by the amount of abuse in the area of revenue recognition by public companies, and accordingly issued Staff Accounting Bulletin Number 101 in 1999 to tighten the rules under which revenues may be recognized. For example, if there is any uncertainty about customer acceptance after a product or service has been delivered, then revenue should not be recognized until acceptance occurs.

[3]. Recognition at time of payment. If payment by the customer is not assured, even after delivery of the product or service has been completed, then the most appropriate time to recognize revenue is upon receipt of cash. For example, if a book publisher issues new editions of books to the buyers of the last edition without any indication that they will accept the new shipments, then waiting for the receipt of cash is the most prudent approach to the recognition of revenue.

[4]. Other rules. In addition to the above rules, there are a few others that should be applicable in all instances:

  • The seller should have no obligation to assist the buyer in reselling the product to a third party; if this were the case, then the seller would have an outstanding obligation to assist in further sales, which would imply that the initial sale had not yet been completed.
  • Any damage to the product subsequent to the point of sale will have no impact on the buyer’s obligation to pay the seller for the full price of the product; if this were the case, one would reasonably assume that at least some portion of the sale price either includes a paid warranty that should be separated from the initial sale price and recognized at some later date, or that the sale cannot be recognized until the implied warranty period has been completed.
  • The buying and selling entities cannot be the same entity, or so closely related that the transaction might be construed as an inter-company sale; if this were the case, the inter-company sale would have to be eliminated from the financial statements of both the buyer and the seller for reporting purposes, since the presumption would be that the sale had not really occurred.

 

Next let’s go to the 10 most used revenue recognition method

 

Revenue Recognition Under The Cash Method

Revenue recognition under the cash method simply means that revenues are recognized at the point when cash is received from a customer that is in payment of a sale to that customer.  There is no difference between the accrual and cash methods if sales are over-the-counter, but there can be a significant difference if the majority of sales are billed to customers, for which payment is received at some later date. The cash basis of revenue recognition is not recognized as an acceptable reporting method by GAAP, since it does not match revenues to related expenses. Instead, the matching of revenues and expenses is entirely dependent upon the timing of cash receipts and expenses, which are subject to manipulation.

This method is acceptable to the Internal Revenue Service for tax reporting purposes, but only in a limited number of cases and for smaller companies.

 

Revenue Recognition Under The Accrual Method

The most common revenue recognition system is based on the accrual method. Under this approach, if the revenue recognition rules presented in the last section have been met, then revenue may be recognized in full. In addition, expenses related to that revenue, even if supplier invoices have not yet been received should be recognized and matched against the revenue. The name of this method does not imply that the revenue should be accrued—the name of this approach only applies to the accrual of expenses.

For example: If the Lie Dharma Putra Company sells a set of face masks for $500 and recognizes the revenue at the point of shipment, then it must also recognize at the same time the $325 cost of those masks, even if it has not yet received a billing from the supplier that sold it the masks. In the absence of the billing, the cost can be accrued based on a purchase order value, market value, or supplier price list.

 

Revenue Recognition Under The Installment Sales Method

The installment method is used when there is a long string of expected payments from a customer that are related to a sale, and for which the level of collectibility of individual payments cannot be reasonably estimated. This approach is particularly applicable in the case of multi-year payments by a customer. Under this approach, revenue is recognized only in the amount of each cash receipt, and for as long as cash is received. Expenses can be proportionally recognized to match the amount of each cash receipt, creating a small profit or loss at the time of each receipt.

An alternative approach, called the “cost recovery method” uses the same revenue recognition criterion as the installment sales method, but the amount of revenue recognized is exactly offset by the cost of the product or service until all related costs have been recognized; all remaining revenues then have no offsetting cost, which effectively pushes all profit recognition out until near the end of the installment sale contract.

 

Revenue Recognition Under The Completed Contract Method

In the construction industry, one option for revenue recognition is to wait until a construction project has been completed in all respects before recognizing any related revenue. This method makes the most sense when the costs and revenues associated with a project cannot be reasonably tracked, or when there is some uncertainty regarding either the addition of costs to the project or the receipt of payments from the customer.

However, this approach does not reveal the earning of any revenue on the financial statements of a construction company until its projects are substantially complete, which gives the reader of its financial statements very poor information about its ability to generate a continuing stream of revenues. Consequently, the percentage of completion method (see next section) is to be preferred when costs and revenues can be reasonably estimated.

 

Revenue Recognition Under The Percentage Of Completion Method

This method is most commonly used in the construction industry, where very long-term construction projects would otherwise keep a company from revealing any revenues or expenses on its financial statements until its projects are completed, which might occur only at long intervals.

Under the percentage of completion method, the accountant develops a percentage of project completion based on the total costs incurred as a percentage of the estimated total cost of the project, and multiplies this percentage by the total revenue to be earned under the contract (even if the revenue has not yet been billed to the customer). The resulting amount is recognized as revenue. The gross profit associated with the project is proportionally recognized at the same time that revenue is recognized.

The trouble with this method is that one must have good cost tracking and project planning systems in order to ensure that all related costs are being properly accumulated for each project, and that cost overruns are accounted for when deriving the percentage of completion.

For example: If poor management results in a doubling of the costs incurred at the half-way point of a construction project, from $5,000 up to $10,000, this means that the total estimated cost for the entire project (of $10,000) would already have been reached when half of the project had not yet been completed. In such a case, one should review the remaining costs left to be incurred and change this estimate to ensure that the resulting percentage of completion is accurate.

 

If the percentage of completion calculation appears to be suspect when based on costs incurred, one can also use a percentage of completion that is based on a Gantt chart or some other planning tool that reveals how much of the project has actually been completed.

For example: if a Microsoft Project plan reveals that a construction project has reached the 60% milestone, then one can reasonably assume that 60% of the project has been completed, even if the proportion of costs incurred may result in a different calculation.

 

If the estimate of costs left to be incurred, plus actual costs already incurred, exceeds the total revenue to be expected from a contract, then the full amount of the difference should be recognized in the current period as a loss, and presented on the balance sheet as a current liability.

 

Revenue Recognition Under The Proportional Performance Method

This method is only applicable to service sales. It is used when a number of specific and clearly identifiable actions are taken as part of an overall service to a customer. Rather than waiting until all services have been performed to recognize any revenue, this approach allows one to proportionally recognize revenue as each individual action is completed. The amount of revenue recognized is based on the proportional amount of direct costs incurred for each action to the estimated total amount of direct costs required to complete the entire service.

For example: If a service contract for $100,000 involved the completion of a single step that required $8,000 of direct costs to complete, and the total direct cost estimate for the entire job were $52,000, then the amount of revenue that could be recognized at the completion of that one action would be $15,385 ( ($8,000/$52,000) x $100,000).

 

Revenue Recognition Under The Production Method

It is generally not allowable to record inventory at market prices at the time when production has been completed. However, this is allowed in the few cases where the item produced is a commodity, has a ready market, and can be easily sold at the market price.

Examples of such items are gold, silver, and wheat. In these cases, the producer can mark up the cost of the item to the market rate at the point when production has been completed. However, this amount must then be reduced by the estimated amount of any remaining selling costs, such as would be required to transport the commodity to market. In practice, most companies prefer to record the cost of commodities at cost, and recognize revenue at the point of sale. Consequently, this practice tends to be limited to those companies that produce commodities, but which have difficulty in calculating an internal cost at which they can record the cost of their production (and so are forced to use the market price instead).

 

Revenue Recognition Under The Deposit Method

When property is sold on a conditional basis, whereby the buyer has the right to cancel the contract and receive a refund up until a pre-specified date, the seller cannot recognize any revenue until the date when cancellation is no longer allowed. Until that time, all funds are recorded as a deposit liability. If only portions of the contract can be canceled by the buyer, then revenue can be recognized at once by the seller for just those portions that are not subject to cancellation.

 

Revenue Recognition Under Bill And Hold Transactions

When a company is striving to reach difficult revenue goals, it will sometimes resort to bill and hold transactions, under which it completes a product and bills the customer, but then stores the product rather than sending it to the customer (who may not want it yet).

Though there are a limited number of situations in which this treatment is legitimate (perhaps the customer has no storage space available), there have also been a number of cases in which bill and hold transactions have subsequently been proven to be a fraudulent method for recognizing revenue.

Consequently, the following rules must now be met before a bill and hold transaction will be considered valid:

  • Completion. The product that is being stored under the agreement must be ready for shipment. This means that the seller cannot have production staff in the storage area, making changes to the product subsequent to the billing date.
  • Delivery schedule. The products cannot be stored indefinitely. Instead, there must be a schedule in place for the eventual delivery of the goods to the customer.
  • Documentation. The buyer must have signed a document in advance that clearly states that it is buying the products being stored by the seller.
  • Origination. The buyer must have requested that the bill and hold transaction be completed, and have a good reason for doing so.
  • Ownership. The buyer must have taken on all risks of ownership, so that the seller is now simply the provider of storage space.
  • Performance. The terms of the sales agreement must not state that there are  any unfulfilled obligations on the part of the seller at the time when revenue is recognized.
  • Segregation. The products involved in the transaction must have been split away from all other inventory and stored separately. They must also not be made available for the filling of orders from other customers.

 

Revenue Recognition For Brokered Transactions

Some companies that act as brokers will over-report their revenue by recognizing not just the commission they earn on brokered sales, but also the revenue earned by their clients.

For example: If a brokered transaction for an airline ticket involves a $1,000 ticket and a $20 brokerage fee, the company will claim that it has earned revenue of $1,000, rather than the $20 commission.

 

This results in the appearance of enormous revenue (albeit with very small gross margins), which can be quite misleading.

Consequently, one should apply the following rules to see if the full amount of brokered sales can be recognized as revenue:

  • Principal. The broker must act as the principal who is originating the transaction.
  • Risks. The broker must take on the risks of ownership, such as bearing the risk of loss on product delivery, returns, and bad debts from customers.
  • Title. The broker must obtain title to the product being sold at some point during the sale transaction.

 

Revenue Recognition for Accretion And Appreciation

Some company assets will grow in quantity over time, such as the timber stands owned by a lumber company. A case could be made that this accretion is a form of revenue, against which some company costs can be charged that are related to the accretion.

However, this accretion in value is not one that can be recognized in a company’s financial reports. The reason is that no sale transaction has occurred that shifts ownership in the asset to a buyer.
Some company assets, such as property or investments, will appreciate in value over time. Once again, a case could be made that the financial statements should reflect this increase in value. However, as was the case with accretion, accounting rules do not allow one to record revenue from appreciation in advance of a sale transaction that shifts the asset to a buyer.

For both accretion and appreciation, it is not allowable to record an unrealized gain in the financial statements; instead, the gain can only appear at the time of a sale transaction. The current accounting treatment tends to understate a company’s assets, since it restricts the recorded valuation to the original purchase price; however, the use of estimates to reflect increases in asset value could be so easily skewed by corporate officers striving to improve reported level of profitability or company valuation that there would not necessarily be any improvement in the accuracy of reported information if the accretion or appreciation methods were to be used.

 

Revenue Recognition For Initiation Fees

A company may charge an initiation fee as part of a service contract, such as the up-front fee that many health clubs charge to new members. This fee should only be recognized immediately as revenue if there is a discernible value associated with it that can be separated from the services provided from ongoing fees that may be charged at a later date.

For example: if a health club initiation fee allowed a new member access to the swimming pool area, which would not otherwise be available to another member who did not pay the fee, then this could be recognized as revenue. However, if the initiation fee does not yield any specific value to the purchaser, then revenue from it can only be recognized over the term of the agreement to which the fee is attached. For example, if a health club membership agreement were to last for two years, then the revenue associated with the initiation fee should be spread over two years.

 

Despite the large number of revenue recognition scenarios presented in this post, the accountant will probably only use the accrual method in most situations. The other revenue recognition methods noted here are designed to fit into niche situations in which the circumstances of an industry require other solutions to be found.