In business accounting there is a lot going on. You’ve got payroll accounting, operations account, inventory accounting and cost accounting (amongst others). So what does it all mean? Well, some of these branches are pretty straightforward and others are, well, less understandable. In this article we’ll focus on accounts receivable because that is where we uncover the details of revenue recognition. Check out Accounting Basics for a comprehensive tutorial on financial accounting.
What is revenue recognition?
Revenue recognition is an accounting principle that identifies circumstances when income becomes actual revenue. Each company will have their own policies of revenue recognition that are standard procedure for their operations. Sometimes companies can manipulate their recognition method to make their sales revenue go up or down depending on the needs and desires of the company. Sales and revenue are technically different things, but often times they are used interchangeably. Sales is actually a subset of revenue. For bigger companies revenue typically includes all sales and all other sources of income like debt interests and investments. This would mean the total amount of money being received by the company. The term sales usually refers to the actual income made from selling off inventory. For smaller companies that do not have debt interests or investments, the terms sales and revenue may be used to define total income. If this is old news to you, you may be interested in an advanced financial accounting course tailored to intermediate financiers such as yourself.
What types of revenue recognition are there?
There are four widely acknowledge types of revenue recognition: percentage of completion, completed contract, installment and cost recovery.
- Cost recovery
This is certainly the most conservative option for recognizing income. Business usually employ this method when there is no way to determine if the payment will actually be received or, the value of the sale cannot be determined yet. This means that even though the product is no longer in inventory, or the service was completed, the income is not recorded on the income statement as gross profit until the cost of goods (COGS or purchase price) is met. The purpose here is to ensure the cost of goods are recovered before recording the transaction as a profit. Once the payment is received the cost of goods is subtracted from the payment and the remaining amount is considered profit.
For example: Bob Inc. is selling a greenhouse to a customer for $5,000. The cost of goods (how much it costs to make or purchase the greenhouse for resale) is $2,000. This means the gross profit is $3,000 for Bob Inc. The customer makes a down payment on the greenhouse in the amount of $1,000. This leaves a balance of $4,000 that the customer owes. Even though there was a payment made of $1,000 to Bob Inc. the company will not recognize the sale until the cost of goods is met, which in this case is $2,000. This means when the customer pays another $1,000 for a total of $2,000 Bob Inc. will then consider the payment and it can be taxed.
It’s obvious that this method of revenue recognition directly affects financial reporting and thus directly affects how a business is taxed. Businesses choose the cost recovery method to avoid being taxed on items they may not recover the cost of, or as a way to manipulate their gross profit in an effort to pay lesser taxes for a period (defer taxes). That being said, it’s good to note that cost recovery is not in compliance with generally accepted accounting principles (GAAP). If there is a way to avoid using cost recovery, like by using the installment method – do so. It’s less of a headache now and later. For hours of quality business financing videos check out the CFA institute approved corporate finance course online.
- Installment Method
The installment method of revenue recognition is another form of recovery accounting. In other words, businesses don’t receive the entire payment of a good all at once. Instead, they receive a portion as a down-payment and then collect installment payments over the course of a long period of time. This is typically used for large purchases such as real estate, appliances or motor vehicles. It makes it easier on the customer to be a consumer when they don’t have to pay exorbitant amounts of money in one lump sum. Companies utilize the installment method when they feel relatively certain that there the transaction is risky, as in the customer may not ever pay the amount in full. This valuation method is more conservative than those taken in accrual based accounting. Much like the cost recovery method, this type of revenue recognition defers recording the gross profit until all payments are received. Learn more about accounting basics like the GAAP, revenue recognition and accrual account in the financial commandments.
Recording this installments can be tricky for a bookkeeper as they must keep track of each accounts receivable for multiple customers in multiple different stages of payment while reporting accurate information on the income statement. The best way to keep the paper work is straight is to 1) keep track of all installment sales layered by year of receivable while keeping them separated from other types of payment, 2) transition cost of sales and installment revenues to a deferred gross profit account at the end of every fiscal year, 3) and carry any deferred gross profit from one year to the next so it can be recognized when the account it paid in full.
- Percentage of Completion
Unlike the above two methods, percentage to completion recognizes revenue that applies to long-term projects with a high level of certainty that the project will be completed and an estimate on the remaining costs. If a contractor can accurately estimate the total duration and cost of a project the percentage of completion is a good way to approach accounts receivable. It there are circumstance that may interfere with the project deadline or maximum budget refer to a recovery based type of revenue recognition for safety. Businesses who use percentage of completion can report a percent of revenues equal to the percent of project completion. There are three ways in which the percentage completion can be measured: cost-to-cost method, efforts-expended method and the units-of-delivery method.
Cost-to-cost method: Basically, compare the cost of products used for the project up to the current date to the total project cost. Don’t include materials that have been purchased for the job but not yet used.
Efforts-expended method: Use the same principle of the cost-to-cost method except replace the materials with manual or machine labor. Compare the current effort put into the project with the expected total of project labor effort.
Units-of-delivery method: Again, this method compares the number of units delivered to the buyer and the amount of units to be delivered for total project completion.
- Completed Contract
When a company utilizes the completed contract revenue recognition method they do not record or acknowledge any amount of income until the project has been completely completed. This allows the business to defer gross profit and thus delay the payment of income taxes. This method should be used, again, when there is high risk associated with the project being completed, or there are hazards involved that could interfere with completion. Once the project is complete, the client pays the business the total amount due and the company can now record income and revenue on their income statement.
There is no “best method” but there is a worst, and its cost recovery mainly because the GAAP does not recognize it as a legitimate practice. It’s best to stick with the installment method if you must defer your gross profit until cost of goods is realized. For start-up companies, here’s a great starter course on finance and accounting to get you headed in the right direction.
Each company will adhere to different revenue recognition techniques depending on their circumstances, and the methods can even vary from project to project depending on the associated risk factors.