Lesson 49: Revenue Recognition and Long Term Contracts
In this lesson, we will learn what the critical point is and compare revenue
recognition for public vs. private companies. We will learn about the completed
contract, percentage of completion, and cost recovery methods, and 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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.