Lesson Objectives:- What the critical point is
- Comparing revenue recognition for public vs. private companies
- Use of the completed contract, percentage of completion and cost recovery methods
- When each method is used for long term contracts
In the last lesson, we reviewed an example of a long-term contract when talking about a government contract for a laboratory building.
When talking about most examples, the point in time when a company can recognize revenues is known as the critical point. This point is normally at the point of delivery but there are sometimes exceptions to this such as when there is a buyers check.
The process of revenue recognition can be a bit more complicated than just following the criteria and waiting until the critical point. Long term contracts can be completed over the course of 1 year, 3 years, 5 years, 10 years or even longer. Instead of waiting until the last year, companies should be gradually recognizing revenue as the contracted job is slowly being completed.
Revenue recognition for long term contracts can fall into either the completed contract method which is based off of the critical point or one of the gradual recognition methods: percentage of completion or cost recovery method.
Whether it is a public or a private company will determine which methods can be used to guide revenue recognition. Public companies must follow IFRS standards while private companies must follow GAAP guidelines.
Let's start with the percentage of completion which is the most common that falls in line with the IFRS standards.
The percentage of completion method uses gradual recognition to slowly recognize revenue as the work is being completed. The cost-by-cost basis is used to recognize the revenue slowly instead of waiting until the project is completed. The best way to understand how the cost-by-cost basis is by looking at example.
Let's say we have $10,000 worth of costs incurred and we have estimated that $20,000 total, which means we have incurred 50 percent of the costs. If the full contract is for $400,000, we will be able to recognize $200,000 worth of revenue at this point.
We are only able to use the percentage of completion method when the contract is fixed, meaning specific price is defined in the contract. The cost estimates and collectibility of the contract amount must be reasonably certain.
If the collectibility is not reasonably certain, we would use the cost recovery method which is much more conservative.
The cost recovery method, also known as the zero profit method, will defer the gross profit while the cash received is less than the costs. This method also adheres to IFRS standards and is used for public companies. The company will still be reporting the expenses and revenues with this method but again the gross profit will be deferred.
For example, if our revenues are $6,000,000, our costs are $4,000,000 and we've received $0 in cash, the gross profit of $2,000,000 will be deferred. Any amount less than $4,000,000 in cash would mean that the profit is deferred using the cost recovery method.
If for the following year, the cash received is $4,400,000 then $400,000 of the deferred gross profit would be recognized because it exceeds the amount of costs.
Again, the cost recovery method is used for gradual recognition when there is significant uncertainty when it comes to the contract price, cost and collectability.
Finally, let's talk about the methods that can be used for private companies under ASPE.
The percentage of completion method is the standard for private companies as it is used to gradually recognize the revenue amounts based on the progress of the job. This method is very fair for determining when revenue is recognized, but does require a certain level of certainty when it comes to contract cost and collectibility.
The alternative and more conservative method for private companies is the completed contract method which is based off of the critical point. This basically means that absolutely no revenues, no expenses and no gross profit is recognized until the contract is completed.
This method is only used when there is great uncertainty associated with the contract collectability as it can cause distortion of the expenses, revenues and gross profit figures. Public companies are not able to use the completed contract method as it does not align with IFRS standards.
The table above describes which method should be used based on the company type and the level of reliability and collectibility.
In the next lesson, we will be diving deeper into the concept of the percentage of completion method and taking a look at a real life example.