Methods for Recognizing Revenue
There are a lot of various ways to depict revenue on financial statements if you’re not acquainted with corporate accounting systems. Multiple methods of revenue recognition are permitted under generally accepted accounting principles (GAAP).
Even though the financial status of the firm is the same, the financial statements may seem quite different depending on which technique is used.
For revenue recognition, a corporation has five options.
Method 1: Earnings Completion and Payment Assurance
There should be no more obligations to the buyer for the vendor once they’ve finished using the earnings technique. There is no transaction if just 200 of the 500 football helmets ordered have been delivered. There should be no revenue if the seller is an appliance maker that offers broad warranty coverage and can properly estimate the cost of such service (i.e., warranty repair labor and components).
It’s also important to note that, in the case of a product with an unconditional return policy, a corporation cannot record the sale until the return window has closed. The selling firm must be able to adequately estimate the likelihood that it will be paid for the order in order to record revenue using this approach.
Method 2: Sales-based method
Investors may find this strategy to be the most logical. Cash or credit revenue is recorded as soon as a sale is made using the sales basis approach (such as accounts receivable). Even if cash is received before the transaction is complete, revenue is not recorded.
If a magazine buys an annual membership for $120, the publisher will only get $10 in income per month. Since the goods had not yet been delivered, if the firm went out of business, the consumer would be entitled to a pro-rated refund of the yearly membership fee.
Method 3: Completion Percentage
Bridge and plane-building companies often take years to deliver their goods to customers. Companies want to be able to demonstrate their shareholders that they are making money even when the project isn’t finished during this time period. If two requirements are satisfied, then corporations will employ the percentage of completion approach to recognize revenue.
A long-term, legally binding contract must first be established between all parties concerned. Additionally, it must be feasible to predict the proportion of the project that has been finished, as well as future income and expenses.. Both milestones and expenditures expended to estimate the overall cost are acceptable methods to recognize revenue under this approach.
A construction business might earn $2,000 per mile if it was given $100,000 to build 50 kilometers of motorway.
This strategy allows companies to record $2,000 in revenue for every mile they accomplish.
The technique based on actual expenditures is a little more difficult. Revenue recognition in this technique would be based on comparing the current cost of construction to the expected final cost. Take the building company’s estimate of $80,000 in components, materials, and labor, as an example. It had spent $5,000 in the first month, or 6.25 percent of the expected expenditure. The entire revenue ($100,000) would be multiplied by the cost percentage (6.25 percent) to arrive at a revenue of $6,250.
Watch out for early expenditure bookings, such as the acquisition of raw materials, when a corporation uses the percentage of completion technique. Cost should not be considered until the commodities have been employed in the manufacturing process, such as pouring concrete on a project site rather than buying it, for example. Overstatement of sales, gross profit, and net income may result if a company fails to recognize this difference.
Method 4: Cost Recoverability .
This is the most cautious way of recognizing income that has ever been devised. When a firm is unable to predict the whole cost of a project, the cost recovery strategy is applied. This means that until all of the project’s costs have been recouped, there is no profit to be made. Internal software development and the acquisition of certain sorts of land are two examples that come to mind.
Assume a legal firm spent $1 million developing its own software. After a few years, the partners decide to start selling the software under license to other companies. They made $250,000 in sales over the first three months of the year. All of this would be used to offset the $1 million in development costs that were originally incurred under the cost recoverability method of revenue recognition. The company’s income statement will show no revenue until the initial $1 million sum is zeroed out.
Method 5: Installing
The installment method of revenue recognition should be used when the actual collection of cash is questionable. Many real estate deals are plagued by this situation, in which a sale has been agreed upon but payment has yet to be received because the buyer’s financing has failed. Consequently, just the amount of money received is used to determine gross profit.
Suppose a developer invested $500,000 on an apartment renovation. On January 1, the buyer will pay $750,000 for the property, and on July 31, the buyer will pay the rest of the money in two payments. The developer gets a cheque for $375,000 on the first due date for the first installment payment. Since they have received 50% of the cash, their income statement will now represent 50% of the revenue and gross profit they have generated.
Keep an eye out for anyone trying to manipulate you.
Management may significantly modify the look of the income statement by changing the method of revenue recognition. When revenue recognition is done using the percentage of completion technique rather than the completed contract approach, the assets, shareholder equity, liabilities, and debt-to-equity ratio are all raised. Even if the business’s economic content and health remain same, the income statement will display more smoother revenues across numerous years.
In the first few years of a contract, if a firm follows the completed contract technique, it will report no revenue, which means it will not owe taxes. Shareholders in this company will be informed that they are making less money, but that they are accumulating more value because to the tax-deferred use of capital.
In order to determine whether company is doing better, investors should investigate and compare the revenue recognition of two firms in the same sector. It is considerably simpler to understand financial accounts properly if you know what kind of revenue recognition method a company is utilizing.