Tuesday, September 18, 2007

Revenue Recognition Methods

Depending on the business undertaking, the revenue of a firm varies according to the time and the deal with the customer. For example, a car maker gets its payment when a customer buys its car and pays for it. On the other hand, a prepaid mobile service provider gets the payment before it has provided its services - use of its network for the limited number of minutes provided. And a very visible category in the infrastructure development scenario in India is that of part payment based on the partial completion of a project, for example construction of flyovers.

The GAAP (Generally Accepted Accounting Practice) accounting standards allow for various methods for such revenue recognition. Companies are free to choose the method that best suits their business. And thereby it becomes very essential during an income statement analysis to determine that the method followed actually reflects the correct business scenario.

Sales basis method
Under this the earnings process is complete from the company, and the revenue is reasonably assured. This is the case where an individual buys a car and pays through cash or credit. Even when the customer pays through the credit card, the revenue from sale and the corresponding cost for manufacturing is recognized in the period when the sale was made. The actual cash may be delivered at any time later.

Percentage of completion method
This is the case of the airport, bridges and other long term project constructions. In these the whole work is not delivered within one accounting period. Here the revenue is reasonably assured. So at the end of every accounting period the firm recognizes revenue based on estimates of work completion. The estimate of completed work may be based on two parameters
  • Actual engineering work completed as estimated by the management/ engineering team.
  • Cost incurred to date, if the total cost has been reasonably estimated earlier. In case the cost estimate is revised in the future, the revised cost estimate is used to do the calculations for the next year.
For example, if it is estimated that a company A is building a flyover for Rs. 5,00,00,000 and it estimates that it would cost it Rs. 4,00,00,000. Here we assume that the payer is genuine and will pay up. Now if in the first year A incurs a cost of Rs. 1,00,00,000, going by percentage complete method, it would recognize a revenue of Rs. 1,25,00,000, thus making a profit of Rs. 25,00,000 for the first year.

If in the second year, A's project management goes on an overdrive and it incurs a cost of Rs. 1,50,00,000 for the second year for the amount of work it has done. So the total cost is now Rs. 2,50,00,000 based on which it recognizes a revenue of Rs. 3,12,50,000 [ (25/40) * Rs. 5,00,00,000 ]. The total profit for the 2 years comes to Rs. 62,50,000 out of which Rs. 25,00,000 was recognized in the first year itself. So the profit for the second year comes to Rs. 37,50,000.

Completed contract method
Under this method, the revenue is recognized only when the whole project is completed and delivery of the goods has been given to the customer. So if the project lasts for five years, there would be no profit for the first four years and would recognize it only at the end of the fifth year.

This is used when the costs can be estimated but the work is incomplete and the payment is not assured as well. Or it can be used where the costs can't be estimated by the supplier firm before delivery of the product.
Installment sales method
For example, if the cost of product is Rs. 100 and it is sold for Rs. 150. The gross profit is 50%. So when the seller receives Rs. 50 in the first installment of payment, the firm recognizes 1/3 (Rs. 50/Rs. 150) of the profit also which amounts to Rs. 50/3. This method is used when the earnings process is complete from the supplier/seller side but the payment is not assured or rests on the credibility of the buyer. For example in the current subprime housing issue.

Cost recovery method
Continuing from the above example, if the cost is Rs. 100 and it is sold for Rs. 150. When the first installment of Rs. 50 is received, no profit is recognized. With another Rs. 60 of revenue a profit of Rs. 10 is recognized. And with the remaining Rs. 40, the rest of Rs. 40 of profit is recognized in the period of the third year.
This is used when the earnings process is complete but there are contingencies built in there.
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