- CFA Exams
- 2019 Level I > Study Session 7. Financial Reporting and Analysis > Reading 21. Understanding Income Statements
- 3. Revenue Recognition in Special Cases
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Subject 3. Revenue Recognition in Special Cases
A long-term contract is one that spans multiple accounting periods. How should a company apportion the revenue earned under a long-term contract to each accounting period?
- If the outcome of a long-term contract can be reliably measured, both IFRS and U.S. GAAP require the use of the percentage-of-completion method.
- If the outcome of a long-term contract can NOT be reliably measured:
- Under IFRS, revenue is only reported to the extent of contract costs incurred. Costs are expensed in the period incurred.
- Under U.S. GAAP, no revenue is reported until the contract is finished. This is called the completed contract method.
- If a loss is expected on a contract, the loss is reported immediately, regardless of the method used.
Revenues and expenses are recognized each period in proportion to the work completed. This is used for a long-term project if all of the following conditions are met:
- There is a contract.
- There are reliable estimates of revenues, costs, and progress towards completion.
- The buyer can be expected to pay the full contract price on schedule.
It recognizes profit corresponding to the percentage of cost incurred to total estimated costs associated with long-term construction contracts. It is the preferred method because it provides a better measure of operating activities and a more informative disclosure of the status of incomplete contracts. It also facilitates the forecast of future performance and cash flows. This method highlights the relationship among the income statement (revenues), the balance sheet (resulting receivables), and the cash flow statement (current collections).
The percentage-of-completion is equal to actual cost/estimated total cost, or it can be determined by an engineering estimate. Using the first approach:
- Percent completed = Costs incurred to date / Most recent estimate of total costs.
- Revenue to be recognized to-date = Percent complete x Estimated total revenue.
- Current period revenue = Revenue to be recognized to date - revenue recognized in prior periods.
To date, the most recent estimate of the total cost is used in computing the progress toward completion. It means that if cost estimates are revised as the project progresses, that effect is recognized in the period in which the change is made. Costs and revenues of prior periods are not restated.
This method does not recognize revenue and expense until the contract is completed and the title is transferred. All profits are recognized when the contract is completed. The completed contract method is used when:
- There is no contract; or
- Estimates of revenues, costs, or progress towards completion are unreliable; or
- The ability to collect revenues from the buyer is uncertain.
This method is more conservative than the percentage-of-completion method. Analysts may need to rely on the statement of cash flows to assess the contribution of long-term contracts to a company's profitability.
This method is used if the costs to provide goods or services are known but the collectability of sales proceeds cannot be reasonably determined. It recognizes both revenue and the associated cost of goods sold only when cash is received. Gross profit (sales - costs of goods sold) reflects the proportion of cash received. This method is sometimes used to report income from sales of noncurrent assets and real estate transactions.
This method is similar to the installment sales method but is more conservative. It is used if the costs to provide goods or services cannot be reasonably determined. Sometimes there is also substantial uncertainty about the collectivity of sales proceeds. Under this method, sales are recognized when cash is received but no gross profit is recognized until all of the costs of goods sold are collected. That is, it recognizes profit only when cash collections exceed the total cost of the product sold.
For both installment and cost recovery methods, analysts may need to rely on the cash flow statement to fully reveal the company's current and future profitability.
Internet companies often exchange rights to place advertisements on each other's websites (that is, barter). Should the company record the revenue based on the fair market value of the space and a related expense of the same amount? Or should both be ignored since they offset each other? The net result has no impact on earnings, but early-stage companies are often valued based on revenues rather than earnings or cash flow (often because they have no earnings or cash flow). Companies could inflate their values by recording barter transactions as "revenue" even if these arrangements did not produce earnings or cash flow for the respective entities.
In 1999, the FASB declared that revenue from such barter transactions should be reported only if the fair value of the advertising surrendered in the transaction is determinable based on the company's own historical practice of receiving cash for similar advertising from buyers unrelated to the counterparty to the barter transaction.
Gross versus Net Reporting
U.S. GAAP (EITF 99-19) addresses an issue that frequently arises for resellers and other companies: the question of whether to report the entire amount received from the end-user as revenue and the amount paid to the supplier as cost of sales, or to report just the net amount as revenue, as if that amount were a commission paid by the supplier for generating a sale from the supplier to the end-user. Essentially, the process for making this determination boils down to evaluating the relationships between the supplier, the company, and the end customer. Gross reporting treats the transaction as the company purchasing a product or service from the supplier and then selling that product or service to the end-user, while net reporting treats the transaction as the end-user making a purchase from the supplier, with the company acting as a sales agent.
Some indicators of gross revenue reporting are: The company is the primary obligor in the arrangement, has general inventory risk, can determine the product price, can change its supplier, and bears credit risk.
Financial Analysis Implications
An analyst should identify differences in companies' revenue recognition methods and adjust reported revenue where possible to facilitate comparability. Where the available information does not permit adjustment, an analyst can characterize the revenue recognition as more or less conservative and thus qualitatively assess how differences in policies might affect financial ratios and judgments about profitability.
Practice Question 1Under the completed contract method, revenue is recognized ______
A. when construction begins on the project.
B. when the project is complete.
C. throughout the project, based upon the amount of work completed each year.Correct Answer: B
Revenue is recognized only when the contract is completed.
Practice Question 2Under the installment method, revenue is recognized when the customer ______
A. orders the merchandise.
B. receives the merchandise.
C. receives the bill.
D. makes a cash payment.Correct Answer: D
If there is uncertainty about the probability of the collection of the revenues, then the installment method is used, which recognizes revenue as the cash is received, using the gross profit percentage.
Practice Question 3Freeda's Furniture Store records revenue under the installment sales method. The following information is available for the first year of business: Sales, $100,000; Cost of goods sold, $75,000; Cash collections, $50,000. How much realized gross profit on installment sales will Freeda recognize in Year 1?
C. $25,000Correct Answer: A
The gross profit rate = (sales- COGS)/sales = ($100,000 - $75,000)/$100,000 = 25%. Realized gross profit = cash collections * gross profit rate = $50,000 * 25% = $12,500
Practice Question 4Cruise Builders Inc., begins building a new ship for Happiness Cruise Lines in 2015. The project price is $12,000,000. The estimated total cost is $9,000,000 over three years. Here is the information for 2015 only: costs incurred, $3,000,000; estimated completion costs, $6,000,000; billings, $2,500,000; cash collected, $1,500,000. Which one of the following is the correct cost ratio to use in computing the profit for 2015 under the percentage-of-completion method?
C. 50%Correct Answer: A
The correct cost ratio is $3,000,000 current year costs/$9,000,000 estimated total costs = 33%.
Practice Question 5The percentage-of-completion method violates what general guideline on revenue recognition?
A. The earnings process is completed.
B. Collections are reasonably assured/have been received.
C. Costs are known or can be reasonably estimated.Correct Answer: A
The percentage-of-completion method violates this guideline since revenues are recognized prior to the completion of the long-term project. The rationale is that it provides a better measure of periodic performance than the completed contract method.
Practice Question 6Estimated losses on long-term construction contracts are recognized immediately under the percentage-of-completion method. True or False?Correct Answer: True
Although profits are recognized proportionately under the percentage-of-completion method, estimated losses on a contract are recorded in the period in which the loss is projected. This is an application of conservatism.
Practice Question 7The percentage used in the percentage-of-completion method of accounting for long-term construction contracts is generally based on the proportion of time elapsed relative to the overall length of the contract. True or False?Correct Answer: False
Basing the percentage ratio on the amount of time elapsed may not necessarily provide an accurate estimate of performance (or actual work). The ratio should be based on the actual costs incurred relative to the estimated total cost of the project.
Practice Question 8Under the percentage-of-completion method, revenue is recognized ______
A. when a project is complete.
B. throughout a project, based upon the amount of work completed each year.
C. throughout a project, based upon the amount of cash received from the customer.Correct Answer: B
The revenue will be recognized over the period of the contract, based upon the percentage of work completed.
Practice Question 9Which of the following is true regarding the completed-contract method?
A. It does not use a construction in progress account.
B. Billings on a construction contract represents the income of the project.
C. During the production on the project, the construction in progress account includes the profit.
D. Income is only recognized at the end of the project.Correct Answer: D
Because of uncertainty regarding costs or collection of the contract price, income cannot be recognized until the project is completed and collections have been made. The method does use a construction in progress account, but it does not include income during the project. Billings represents the actual amount that has been billed to the purchaser and is liability which is a measure of the contractor's obligation to perform.
Practice Question 10The following information applies to Smith Construction's Job 713 which was completed in 2001.
Assuming Smith Construction uses the percentage-of-completion method of revenue recognition in accounting for Job 713, the gross profit recognized in 2000 would be ______.
C. $36,000Correct Answer: B
The correct computation is as follows:
1) Percentage of completion as of at 12/31/00: 180,000/400,000 [180,000+220,000 estimate)=45% complete
2) Gross profit recognized in 2000: 45% x 100,000 est. GP [500,000-180,000-220,000] = 45,000
Practice Question 11The following information applies to Smith Construction's Job 713, which was completed in 2001.
If Smith Construction had used the completed contract method to recognize revenue, what amount of gross profit would have been recognized each year? (2000; 2001)
A. $0; $100,000
B. $45,000; $55,000
C. $100,000; $0Correct Answer: A
The entire $100,000 in gross profit [500,000 - 180,000 - 220,000] would be recognized in 2001 (the year of completion).
Practice Question 12Which of the following would appear more favorable under the percentage-of-completion contract in the earlier stages of a contract?
A. Return on assets
B. Cash flows from operations
C. Construction costs
D. Billings on construction contractCorrect Answer: A
Cash flows, construction costs, and billings on construction contract are all the same under either method. Income would be higher, making the return on assets larger, under the percentage-of-completion method.
Practice Question 13Under the percentage-of-completion method, as opposed to the completed-contract method, which of the following is true?
A. Current assets are probably smaller under the percentage-of-completion method in the earlier stages of the contract.
B. The current ratio is probably larger under the percentage-of-completion method in the later stages of the contract.
C. Current liabilities are probably smaller under the percentage-of-completion method in the earlier stages of the contract.Correct Answer: C
In the earlier years of the project, the percentage-of-completion method will usually report a construction in progress account that is larger than billings on construction contract. When the two accounts are offset, the result is a net debit (current asset). The opposite is probably true of the completed-contract method, where a net credit (current liability) will exist.
Practice Question 14Which of the following is true regarding the percentage-of-completion method, as opposed to the completed-contract method?
I. Construction costs incurred are greater for the percentage-of-completion method.
II. The percentage-of-completion method will recognize more income in the later stages of the construction project.
III. The construction-in-progress account is smaller during construction under the percentage-of-completion method.
IV. Income is recognized during the construction period under the percentage-of-completion method.Correct Answer: IV only
Construction costs incurred are the same for both methods. The completed-contract method will recognize all of the income in the last year of the project and it will be larger than income under the percentage-of-completion method. Under the percentage-of completion method, profit each period is recognized and debited to the construction-in-progress account, making it larger than it would be using the completed-contract method.
Practice Question 15In the installment sales method, revenue is recognized ______
A. as production takes place.
B. at or after the time of the sale.
C. after the cash is collected.Correct Answer: C
Installment sales are recognized as the associated cash is collected. The delay occurs because the sale fails to meet the measurability criterion; at the sale date, cash collection is uncertain, or the seller is required to perform future services at uncertain costs.
Practice Question 16The installment sales method of accounting may be used for financial statement purposes only if the ______
A. total amount to be collected is indeterminate.
B. collection period extends beyond 24 months.
C. installment payments are due in more than one fiscal year.Correct Answer: A
Per APB No. 10, the installment sales method is a cash basis of accounting which violates GAAP. However, its use is justifiable in situations where the ultimate amount to be collected cannot be determined due to uncertainties with regard to default or estimating uncollectibles.
Practice Question 17Under the percentage of completion method, the amount of work completed in a particular year is typically determined by comparing ______.
A. the costs incurred that year divided by the estimated total costs of the project
B. the cost incurred that year divided by the contract price
C. the total costs incurred to date divided by the contract priceCorrect Answer: A
The percentage complete is usually determined by looking at the costs that are incurred. For a particular year, the percent would be the costs incurred that year divided by the estimated total costs of the contract.
Practice Question 18Under the completed-contract method, the billings on construction contract represents a measure of the ______.
A. contractor's obligation to perform on the contract
B. contractor's performance to date
C. revenue recognized to dateCorrect Answer: A
The billings on construction contract account is the amount that has been billed to the purchaser and represents a measure of the contractor's obligation to perform on the contract.
Practice Question 19Which of the following statements would be an indication that the firm may use the percentage-of-completion method?
I. A reliable estimate of the costs of the project cannot be estimated; however, the contractor does have cost data from other projects.
II. There exists some uncertainty about the current credit-worthiness of the purchaser of the contract, but he has paid billings in the past.
III. There is no formal contract; however, there exists a verbal contract between the two parties.
IV. A reliable estimate of the portion of the contract that has been completed can be made.
A. I and IV
B. II and III
C. IV onlyCorrect Answer: C
The first three statements are actually indications that the completed-contract method should be used. The contractor has to be able to make reliable estimates on this project, not others. Any indication of uncertainty about collection would rule out the percentage-of-completion method. A formal contract should be in place before the percentage-of-completion method is used.
Practice Question 20Under the percentage-of-completion method, ______
A. billings on construction contract are used in determining the percentage of the project completed to date.
B. accumulated construction costs can be used in determining the percentage of the project completed to date.
C. accumulated construction costs can be used in determining the percentage of the project completed in the current year.Correct Answer: B
To use the percentage-of completion method, the firm must be able to estimate the portion of the contract that has been completed. One way to do this is to use the actual costs that have been incurred to date.
Practice Question 21Use of the percentage-of-completion method, versus the completed contract method results in higher ______.
A. debt equity ratios and cash flows
B. profitability ratios in the early years of the contract
C. total income over the life of the contractCorrect Answer: B
Percentage of completion results in the same cash flows and income over the life of the contract. In the early years of the contract, the profit margins will be higher.
Practice Question 22A company signs a long-term construction contract for $10 million. In the first year of the contract, costs to date totaled $4 million, of an estimated $8 million in costs. The company received cash payments of $7 million. The gross profit recognized in year one under the percentage of completion method would be ______.
B. $1 million
C. $3 millionCorrect Answer: B
Percentage-of-completion recognizes gross profit on a percentage basis. Since half the contract is completed ($4 million/$8 million), half the gross profit can be recognized. Gross profit is $10 million less estimated costs of $8 million = $2 million/2 = $1 million.
Practice Question 23Clay's Construction Company does work on large construction contracts that take many years to complete. Before they become a public company, they are trying to decide which method of recognizing revenue they should use for financial reporting only. If they decide to use percentage of completion rather than completed contract, the effect will be ______.
A. higher net income and lower cash flow
B. lower net income and higher cash flow
C. smoother net income and the same cash flowCorrect Answer: C
Choice of accounting method does not affect cash flow.
Practice Question 24Merry Lucnhco Corporation uses the percentage-of-completion method to recognize revenue. In 2000, Merry Lucnhco Co. agreed to construct a facility at a total contract price of $28.0 million and a total expected cost of $24.0 million. Actual costs and cash inflow information are presented below (in $ millions):
How much income did Merry Lucnhco Co. earn from the contract for years 1998, 1999, 2000 respectively?
1998 | 1999 | 2000
A. 0.2350 | 0.4700 | 0.4950
B. 0.4700 | 0.9400 | 0.9900
C. 0.7833 | 1.5667 | 1.6500Correct Answer: C
Cumulative Cost 1998 = (4.7/24.0)*100 19.5833%
Cumulative Revenue 1998= (4.7/24.0)*28.0 = 5.483333
Profit= Current Revenue - Expense = 0.783333
Practice Question 25Trading Co. uses the percentage-of-completion method to recognize revenue. In 2000, Trading Co. agreed to construct a facility at a total contract price of $27.0 million and a total expected cost of $24.0 million. At the end of 1999 estimated costs have been changed to $25.0. Actual costs and cash inflow information are presented below (in $ millions):
What will Trading Co. report as net income in 1998, 1999, and 2000 respectively?
1998 | 1999 | 2000
A. 0.5875 | 0.5885 | 0.8240
B. 1.1163 | 1.6473 | 1.9364
C. 0.0587 | 0.5885 | 0.8240Correct Answer: A
Cumulative Cost 1998 = (4.7/24.0)*100 = 19.5833%
Cumulative Revenue 1998= (4.7/24.0)*27.0 = 5.2875
Current Revenue 1998=(4.7/24.0)*27.0
Profit= Current Revenue - Cost = 0.5875
Cumulative Cost 1999 = (14.7/25.0)*100 = 58.8%
Cumulative Revenue 1999= (4.7/25.0)*27.0 = 15.876
Profit= Current Revenue - Cumulative Realized Profit - Cumulative Cost
= 15.876 - 0.5875 - 14.7 = 0.5885
Practice Question 26A company has undertaken a construction contract for $6,700,000, spread over three years with a projected gross profit of 40%. In the first quarter of the first year, the firm will book the following revenue and cost on the basis of the percentage-of-completion method:
A. revenues of $558,333 and production costs of $223,333
B. revenues of $558,333 and production costs of $335,000
C. revenues of $2,233,333 and production costs of $893,333Correct Answer: B
According to the percentage-of-completion method, a firm books revenue in proportion to work completed. On a three-year contract, 1/12th of the work would be completed in the first quarter of the first year, assuming uniform production. On this basis, the company will book a revenue of $558,333 (= $6,700,000/12) and a cost of 60% of this amount or $335,000 ( = $558,333 x 0.6). The cost of 60% is arrived at on the basis of the 40% gross profit margin, by subtracting the latter from 100%.
Practice Question 27Which of the following statements concerning the percentage-of-completion and completed-contract methods is CORRECT?
A. The completed-contract and percentage-of-completion methods produce the same cash flow statements prior to completion of the contract.
B. The completed-contract method produces greater net income during the period of construction than the percentage-of-completion method.
C. The percentage-of-completion method produces lower liabilities and greater assets than the completed-contract method.Correct Answer: C
Under the percentage-of-completion method, liabilities are lower, due to greater offset provided by construction in progress, and assets are higher, due to faster accrual of profit.
Practice Question 28A company entered into a three-year construction project with a total contract price of $5.3 million and an expected total cost of $4.4 million. The following table provides cash flow information relating to the contract (all figures in $):
Item | Year 1 | Year 2 | Year 3
Costs incurred and paid | 600,000 | 3,000,000 | 800,000
Amounts billed and payments received | 1,200,000 | 2,800,000 | 1,300,000
If the company uses the percentage-of-completion method, the amount of revenue (in $) recognized in Year 2 will be closest to ______.
C. 3,616,636Correct Answer: C
The revenue reported is equal to the percentage of the contract that is completed in that period, where percentage completion is based on costs. In Year 2, the percent completed is 3,000,000/4,400,000 = 68.2%, resulting in 68.2% x 5,300,000 = 3,616,636 revenue being recognized.
Practice Question 29A company has just completed the sale of a tract of land for $3.5 million; it was originally acquired at a cost of $2.0 million. The purchaser made a down payment of $200,000 with the remainder to be paid in equal installments over the next 10 years. A short time after the sale, significant doubt arose about the purchaser's ability to meet the future obligations for the land purchase. When compared to the cost recovery method of revenue recognition, the profit (in $) that the company will recognize in the year of the sale under the installment method is most likely to be higher by ______.
C. $104,328Correct Answer: B
Under the installment method, the portion of the total profit of the sale (3.5 - 2.0 = 1.5) that is recognized in each period is determined by the percentage of the total sales price for which the seller has received cash, which is 1.5/3.5 x 200,000 = $85,714; under the cost recovery method, no profit is recognized until the cash amounts received have exceed the seller's cost of the property.
Study notes from a previous year's CFA exam:
3. Revenue Recognition in Special Cases