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5 Revenue Recognition Methods

5 Revenue Recognition Methods

Revenue recognition policy impacts the representation of your financial statements as well as the tax liability to be computed thereon. There are various revenue recognition methods which have to be adopted as per the peculiarity of the business. Buzzle furnishes information about the different types of revenue recognition methods.
Neha B Deshpande
Did You Know?
Revenue recognition policies are guided by the accepted accounting standards followed by the nation, in which your entity is registered. A new converged standard 'Revenue from contracts with customers' has been released by the FASB1 (Financial Accounting Standards Board) and IASB2 (International Accounting Standards Board) on May 28,2014, along with its implementation dates.
* 1 FASB - Financial Accounting Standards Board (an organization which looks after the generally accepted accounting principles (GAAP) by non-governmental organizations.

2 IASB - International Accounting Standards Board is responsible for IFRS development (International Financial Reporting Standards).
Revenue recognition policy means the timing at which the income of any organization is recorded in the books of accounts. The revenue recognition policy of any entity may differ as per their business, their accepted accounting policies, nature of complexity of business, nature of transaction, etc. It is not easy to zero in on any fixed revenue recognition policy, and it must adhere to the accounting standards prescribed by the nation, not to mention some practical difficulties which might crop up, and pose a difficulty, for its implementation. Management must consider the peculiarities of the business before deciding on any recognition policy, and of course, seek expert help if required. With the growth of the service industry, revenue recognition has become more of a complex affair. However, revenue recognition has significance not only for appropriate representation of income, but also to compute the tax liabilities to be accounted and paid for. Of course, applying an inappropriate method will indicate misleading profits.

Typically, books of accounts have two methods of accounting―cash system and accrual system of accounting. Cash system of accounting does not record transactions until and unless cash is actually paid or received. On the other hand, accrual system of accounting records transactions regardless of whether cash is received or spent. It implies that even receivables and payable are recorded. It gives a better picture of the financial position of any organization. Here are the five types of revenue recognition methods in brief.
Sales basis method
The most commonly used method of revenue recognition, it prescribes revenue to be recognized at the time when the ownership rights of the goods or services have been transferred to the buyer. It implies that the entity follows the accrual system of accounting.
Cost Recovery Method
As the name suggests, cost recovery method implies that profit should not be recognized until and unless all the expenses incurred for the transaction have been recovered. Thus, initially, no profits are recorded, and its accounting is deferred until payments from the customer exceed your costs incurred for the project. This results in initial understating of profits and overstating of profits in the future.

When is it implemented?
This method is adopted when there is an uncertainty regarding the recoverability of revenue from the customer.
Installment sales method
Similar to the cost recoverability method, the installment method is implemented in those circumstances where the recovery from the customer is to be spread over in installments. Typically used by the real estate industry, where returns from the customer are expected over a series of payments.

Company LMN sells to its customer an asset of USD 100,000. Cost of Asset is USD 90,000. The customer is required to make a down payment of USD 10,000 and pay in 4 installments, an amount equal to USD 22,500.
Gross profit to the company = Sale value - Cost = USD 10,000
Gross profit percentage = Gross profit / Sale value = 10%

Gross profit to be recognized = Gross profit received × Amount received in the respective year

Thus, the gross profit to be recognized every year as per the installment method of accounting is:

Year 1 Year 2 Year 3 Year 4
(32,500 × 10%)
(22,500 × 10%)
(22,500 × 10%)
(22,500 × 10%)
Percentage-of-Completion Method
Peculiar to the real estate and construction industry, this method prescribes accounting of revenue and expenses of any particular contract on the basis of percentage of completion of the contract.

Company RST has a construction contract worth USD 400 million. The contract has completed 1 year, and at its end, actual cost incurred is USD 50 million. The estimated costs to complete the contract, at the end of year 1 is USD 200 millions. For calculating revenue to be recognized, following steps should be considered -

Step 1: Calculate the percentage completed.

Percentage completed = Total cost incurred up to that period / Total Estimated Cost of the Contract

Step 2: Calculate revenue to be recognized

Revenue to be recognized = Total Contract Revenue × Percentage Completed

Gross Profit recognized by Company RST at the end of Year 1 is as follows :

Percentage of Completion = 50/250 = 20%
Revenue to be recognized = 400 × 20% = USD 80
Gross Profit recorded for Year 1 = 80 - 50 = USD 30
This is another method prescribed along with percentage-completion method especially for construction contracts. However, as the name suggests, in this method, accounting is done after the contract is completed. Obviously, an advantage is that the tax liabilities are deferred for the corresponding period. However, the tax liability gets increased in the year in which it gets recognized. This method can be adopted by small contractors, or if it is not possible to reliably estimate the result of the project.
Revenue recognition techniques will differ from every organization to organization, yet the policy of maintaining of books and accounts has to adhere to statutory requirements as advised by US GAAP guidelines (or the accounting practices followed by your nation), regarding the method to be adopted and the financial disclosures required to be made in your financial statements. However, with the emerging advent of IFRS and converged standards, it is necessary that you keep yourselves abreast with the latest developments. Revenue recognition will impact your financial statements as well as tax liability, thus, a very careful and deep understanding of the policy that is best suited for your organization is required.