Financial Reporting and Analysis II
Reading 21. Understanding Income Statements
Learning Outcome Statements
b. describe general principles of revenue recognition and accrual accounting, specific revenue recognition applications (including accounting for long-term contracts, installment sales, barter transactions, gross and net reporting of revenue), and implications of revenue recognition principles for financial analysis;
c. calculate revenue given information that might influence the choice of revenue recognition method;
CFA Curriculum, 2020, Volume 3
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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.
User Contributed Comments 4You need to log in first to add your comment.
In cfa schewser notes, it's written % completion to be more aggressive than completed contract as we are writting down revenue before completion
1. Liabilities lower under POC
2. Assets more under POC
3. Equity greater under POC
4. Leverage lower under POC
POC = percentage of complete method
Go by Asset = Liabilities + Equity
Under POC at evry stage, when revenue is recognised:
1. It increases asset when there is an income. The effect to the other side of the equation would yield two possibilities :
(a) Increase Equity OR
(b) Decrease Liability
2. Since the Revenue is recognised (Reported) in stages, it does not reflect the 100% leverage until the last phase is recognised. Until then the levearage remains low.
completed contract conditions are free of error ?