Methods for Recognizing Revenue
Five methods management can use to smooth earnings on the income statement
Generally Accepted Accounting Principles (GAAP) allows for multiple ways a company can recognize its revenue. Depending on which method is chosen, the financial statements may look drastically different, even though the financial condition of the company is the same. There are five primary methods a company can use for revenue recognition.
Method 1: Completion of Earnings and Assurance of Payment
To recognize revenue, two key conditions must be met: completion of the earnings process and assurance of payment. With the completion of earnings method, the seller must not have a remaining obligation to the customer. For example, if an order for 500 football helmets has been placed and only 200 have been delivered, the transaction is not complete. If the seller is the manufacturer of appliances and promises extensive warranty coverage, it should not book the sale as revenue unless the cost of providing that service (i.e., warranty repair labor and parts) can be reasonably estimated. Additionally, a company that sells a product with an unconditional return policy cannot book the sale until the window has expired. To book revenue with assurance of payment method, the selling company must be able to reasonably estimate the probability that it will be paid for the order.
Method 2: Sales Basis
This method probably makes the most sense to investors. Under the sales basis method, revenue is recognized at the time of sale and can be for cash or credit (like accounts receivable). Revenue is not recognized even if cash is received before the transaction is complete. A magazine publisher, for example, that sells a $120 annual subscription will only recognize $10 of revenue every month. This is because if a company went out of business, it would have to return a pro-rated portion of the annual subscription price to the customer since it had not yet delivered the product.
Method 3: Percentage of Completion
Companies that build bridges or airplanes take years to deliver their products to the customer. During that time, companies want to be able to show its shareholders that it is generating revenue and profits, even though the project is not complete. As a result, companies will use the percentage of completion method for revenue recognition if two conditions are met. First, there needs to be a long-term legally enforceable contract between involved parties. It must also be possible to estimate the percentage of the project completed—as well as future revenues and costs. Under this method, the two ways to recognize revenue are by using milestones or costs incurred to estimate the total cost.
Imagine if a construction company is paid $100,000 to build 50 miles of highway, equaling $2,000 per mile. For every mile the company completes, it is going to recognize $2,000 in revenue on its income statement. Using the cost incurred method, the construction company would approach revenue recognition by comparing the cost incurred to-date by the estimated total cost. For example, let's assume the construction company expects the highway to cost it $80,000 in parts, material, and labor, and at the end of the first month, it had spent $5,000, or 6.25% of the estimated cost. They would then multiply the total revenue ($100,000) by the percentage of the cost incurred (6.25%), and recognize $6,250 as revenue on its income statement.
One caveat: If you find yourself reading through the 10K of a company that is using the percentage of completion method, you may want to watch out for premature booking of expenses, such as the purchase of raw goods. Until the goods have been used in the production cycle—like pouring the concrete on the job site and not just purchasing it at Home Depot—the cost should not be counted. A business that does not make this distinction is prone to overstate revenue, gross profit, and net income for the period.
Method 4: Cost Recoverability Method
This is the most conservative revenue recognition method of all. The cost recoverability approach is used when a company cannot reasonably estimate the total expense required to complete a project. The result is that no profit is recognized at all until all of the expenses incurred to complete the project have been recouped. Examples would include the development of internal software and certain types of land.
Assume a law firm developed its own software at a total cost of $1 million. Several years later, the partners decide to start licensing the software to other firms. In the first quarter, they have total sales of $250,000. Under the cost recoverability method of revenue recognition, all of this would serve as an offset to the original $1 million in development expenses. Nothing would appear in the income statement as revenue until the original balance of $1 million is gone.
Method 5: Installment
When the actual collection of cash is suspect, a company should use the installment method of revenue recognition. It is common in real estate transactions, where the sale may be agreed upon, but the cash collection is subject to the risk of the buyer's financing falling through. As a result, gross profit is only calculated in proportion to cash received.
For example, assume a developer spent $500,000 improving an apartment. They sold the property for $750,000, but the buyer is going to pay in two installments—one on January 1 and one on July 31. On the first payment due date, the developer receives a check for $375,000. Their income statement is now going to reflect 50% of the revenue and gross profit earned since they have collected 50% of the cash.
Be Wary of Manipulation
With only a change of revenue recognition accounting, management can drastically alter the appearance of the income statement by over or understating revenue and profit. The exact same contract using the percentage of completion method for revenue recognition instead of the completed contract method will result in higher assets, higher stockholder equity, lower liabilities, and a lower debt-to-equity ratio. The income statement will show much smoother earnings over several years, even though the economic substance and health of the business would be exactly the same.
Investors must research and compare the revenue recognition of two companies in the same industry to get an idea of which is performing better. With certain exceptions, a business that uses the completed contract method is going to report no income in the first years of the contract, meaning no taxes will be paid. Shareholders of this business are going to be told they are earning less, but their wealth is going to be greater because there is capital being used in the business tax-deferred.