Describe income recognition after the sale when substantial performance remains

Answer 1

INCOME RECOGNITION AFTER THE SALE

Some businesses provide substantial services after the time of sale, while other businesses involve considerable uncertainty about cash collections. Both of these conditions introduce uncertainty. Under some circumstances this uncertainty is sufficient to preclude the firm's recognizing revenue at the time of sale; instead, it recognizes revenue sometime after the sale.

The two criteria for revenue recognition are:

1 . The seller must have substantially performed its obligations to the customer (for example, by transferring ownership of goods to the customer).

2 . The seller must have obtained an asset from the customer that it can reliably measure and, if the asset is not cash, the seller must be reasonably certain of converting the asset into cash.

SUBSTANTIAL PERFORMANCE REMAINS

When the seller has received cash, but has not earned all of the revenues represented by the cash by providing goods and services, the seller has incurred an obligation to provide goods or services. The generic term for these liabilities is deferred performance obligations, and a common account title is Advances from Customers; other names include Deferred Revenues and Unearned Revenues. Unlike other liabilities, such as accounts payable, which the firm typically settles by paying cash, it settles these performance obligations by delivering the promised goods or services. The firm recognizes revenue when it settles its obligation to the customer by performing as promised.

Cost Recovery Method

The cost recovery method matches the costs of generating revenue with cash receipts until the seller recovers all its costs. That is, the seller sets expenses equal to revenue in each period until it recovers all its costs. The seller does not recognize gross margin in income until it has recovered all of the costs of the sale. After cumulative cash receipts equal total costs, the seller reports revenue without any matching expenses in its income statement. The seller makes the same journal entry at the time of sale under the cost recovery method as under the installment method. The difference between the two methods arises later when the customer makes installment payments. Instead of applying the gross margin percentage to each cash collection from the customer, the seller sets cost of goods sold equal to revenue until it recovers the entire cost.

U.S. GAAP permits firms to use the installment method or the cost recovery method only when receivables are both collectible over an extended period and the seller has no reasonable basis for estimating the amount of cash that it will collect. IFRS does not contain this level of detail; however, its general guidance implies a qualitatively similar criterion. For most sales of goods and services, past experience and an assessment of customers' credit standings provide a sufficient basis for estimating the amount of cash the seller will receive. If the seller can reasonably estimate the amount of cash it will receive, the seller will recognize revenue no later than at the time of sale.

INCOME RECOGNITION BEFORE DELIVERY

A firm sometimes recognizes revenue and expenses before it delivers a product. To satisfy the two criteria for revenue recognition, the transaction must meet the following tests: (1) The seller has a firm arrangement with a particular customer and (2) The parties have agreed on a selling price. The seller can reliably estimate the costs to complete the contract. The seller has performed substantial work to create the product.

An example of such an arrangement is a long-term contract. Long-term contracts (for example, producing or constructing airplanes, trains, ships, or buildings) typically have three characteristics:

1 . The period of construction (production) spans several accounting periods.

2 . The seller identifies a customer, agrees on a contract price in advance (or at least in the early stages of construction), and has little doubt about the ability of the customer to make the agreed-on payments.

3 . The buyer makes periodic payments of the contract price as work progresses, sometimes called progress payments.

Certain long-term contracts with these characteristics may meet the criteria for recognizing revenue during the period of construction or production. These criteria include: the existence of an arrangement (as required by the SEC) that specifies a buyer, a product to be delivered, and an agreed-on price. The seller reasonably expects the customer will pay the contract price in cash as construction or production progresses or when the seller completes the work. The seller can reliably estimate the costs it will incur in providing these future services.

When the arrangement meets these criteria, U.S. GAAP and IFRS require firms to recognize income using the percentage-of-completion method. When the arrangement does not meet the criteria, U.S. GAAP requires firms to recognize income using the completed contract method; IFRS does not permit the completed contract method and instead specifies a variant of the cost recovery method.

PERCENTAGE-OF-COMPLETION METHOD

The percentage-of-completion method recognizes a portion of the contract price as revenue during each accounting period of construction or production, based on the proportion of total work performed during the accounting period. One commonly used measure of the proportion of total work performed during the accounting period is the ratio of costs incurred to date to the total estimated contract costs. Usually, the firm keeps track of these costs in an inventory account, Construction in Progress, or Construction in Process. As the firm recognizes revenue for portions of the contract price, it also recognizes equal portions of the total estimated contract cost as expenses. The firm recognizes the expenses by debiting Cost of Goods Sold and crediting Construction in Progress. The percentage-of-completion method follows the accrual basis of accounting and matches expenses with related revenue. The actual schedule of cash collections (that is, progress payments) from the customer does not affect revenue recognition. Even if the contract specifies that the customer will pay the entire contract price when the seller delivers the product, the seller may use the percentage-of-completion method so long as it can reliably estimate the amount of cash it will receive and the costs it expects to incur in completing the job.

COMPLETED CONTRACT METHOD

The completed contract method postpones revenue recognition until the seller completes all construction or production and transfers the finished item to the customer. U.S. GAAP specifies the completed contract method when the outcome of the contract is in doubt because of a lack of reliable estimates (of costs or cash to be collected).

PERCENTAGE-OF-COMPLETION METHOD COMPARED TO COMPLETED CONTRACT METHOD

The percentage-of-completion method provides information about the seller's performance during the contract period; in contrast, the completed contract method reports all profit only when seller completes the contract. The percentage-of-completion method reflects current performance on a timely basis, relative to the completed contract method. The shorter the contract length, however, the smaller are the accounting differences between the two approaches, so firms might use the completed contract method for short contracts because they find it generally easier to implement and there are no substantial differences in income relative to the percentage-of-completion method. Because persuasive evidence of an arrangement must exist as a condition for recognizing revenue, firms use the completed contract method if there is no contract with a specific customer, as for example, in the construction of residential housing on speculation. These situations require future marketing effort; moreover, substantial uncertainty may exist regarding the selling price and therefore the amount of cash the seller will collect. In addition, if there is sufficient uncertainty about the total contract costs, the seller may not use the percentage-of-completion method—even when it has a contract with a specified price.

IFRS REQUIREMENTS FOR RECOGNIZING CONTRACT REVENUE WHEN THE SELLER CANNOT RELIABLY ESTIMATE THE OUTCOME

As previously noted, IFRS specifies the percentage-of-completion method when the seller can reliably estimate the outcome of the contract, in terms of revenues and costs. If the seller cannot, then IFRS does not permit the use of the completed contract method. Instead, IFRS requires that the seller recognize revenue to the extent of recoverable contract costs and recognize expenses as incurred. That is, IFRS specifies that the seller recognize revenues equal to recoverable costs incurred and expensed. Therefore, we can think of this approach as a variant of the cost recovery method, which the seller applies when it cannot reliably estimate either the revenues or the costs, or both.