Applying the Revenue Principle in Special Circumstances

The revenue principle was introduced in Chapter 3. As noted earlier, application of this principle in the case of Timberland and similar companies was fairly straightforward. Such companies record revenue when goods or services are shipped or delivered. We now expand our discussion of the revenue principle and see how it is applied in business practice by companies other than typical manufacturers, wholesalers, and retailers.

DELAYED REVENUE RECOGNITION: INSTALLMENT METHOD

Recall that to record revenue (1) an exchange must take place, (2) the earnings process must be nearly complete, and (3) collection must be probable. Failure to meet the third revenue recognition criterion (collection must be probable) requires that revenue recognition be delayed until after an initial exchange. When a great deal of uncertainty concerning the collectibility of the sales price exists, revenue recognition is postponed until cash is collected from the customer. This revenue recognition method, called the installment method, is considered to be a very conservative method since it postpones revenue recognition, sometimes until long after goods have been delivered. The most common applications are in certain types of retail and real estate transactions in which payment is made over a multiyear period and a large proportion of customers stop making payments long before the final payment is due. Certain types of expensive equipment, such as supercomputers, are sometimes sold under contracts calling for payment to be made over a multiyear period and giving the customers the right to return the equipment and cease making payments if they are dissatisfied. The installment method also is required here. Application of this specialized revenue recognition method is discussed in intermediate accounting courses.

REVENUE RECOGNITION BEFORE THE EARNINGS PROCESS IS COMPLETE: LONG-TERM CONSTRUCTION CONTRACTS

An important exception to the usual criteria exists for companies involved in long-term construction projects such as building an office complex for a large corporation. These projects may take a number of years to complete. As a result, if the company recorded no revenue or expenses directly related to the project during the years that it worked on the project and then recorded a massive amount of revenue in the year that it delivered the product to the customer, the financial statements would not accurately represent the company's economic activities. This method of accounting is often referred to as the completed contract method.
      To deal with this unique problem for long-term construction projects, many companies use the percentage of completion method, which records revenue based on the percentage of work completed during the accounting period, instead of the completed contract method, which records revenue when the completed product is delivered to the customer.
      Under the percentage of completion method, revenues are based on the amount of work done each year. Typically, the amount of work accomplished each year is measured by the percentage of total cost that was incurred during the year. For example, assume that the total contract price was $50 million and the total cost for construction was $40 million. In 20A, the construction company spent $10 million, which was 25 percent of the contract cost ($10 million ÷ $40 million).¹ This percentage of completion is then multiplied by the total contract revenue to determine the amount of revenue to be reported in 20A (25% x $50,000,000 = $12,500,000).
      The amount of expense reported each year is the actual cost incurred ($10,000,000 in 20A), and the amount of income is simply the difference between revenue and expense ($12,500,000 - $10,000,000 = $2,500,000 in 20A). It is important to note that the total revenue, expenses, and income for the two methods over the life of the contract are exactly the same. The methods differ only in terms of the accounting periods in which the various revenues and expenses are reported (their timing). Percentage of completion recognizes income throughout the contract period; completed contract recognizes income only in the year of completion.
      Notice that the percentage of completion method does not completely satisfy the second revenue recognition criterion because revenue is reported before the earnings process is complete. It is the preferred method, however, in cases such as this because the completed contract method makes it appear that the contractor was not able to generate any profits for the initial years of the contract but then became very profitable in the final year. In reality, the company was active in all years. Thus, the percentage of completion method better represents this type of underlying economic activity.
      Companies may use the percentage of completion method when progress toward completion and costs to complete the contract can be reasonably estimated and they have a firm contract that guarantees payment to satisfy the cash collectibility revenue recognition criterion. In a recent survey of 600 companies,2 85 of them were involved in long-term construction contracts. Only 6 did not use the percentage of completion or a closely related method.

REVENUE RECOGNITION FOR SERVICE CONTRACTS

Companies that provide services over more than one accounting period often follow revenue recognition policies similar to those followed for long-term construction contracts. They may record revenue after all services have been provided (after the contract is completed) or may recognize revenue from the completed portion of the services. Since the individual size of the contracts involved often is small (compared to construction contracts) and companies often are engaged in many service contracts with different beginning and ending dates, the distortion caused by the completed contract method is usually smaller than that of long-term construction contracts. Yet many service companies, such as Federal Express, which provides air delivery service, employ the percentage of completion revenue recognition policy as indicated in the following note:

FEDERAL EXPRESS CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements
NOTE 1. SUMMARY OF SPECIFIC ACCOUNTING POLICIES
      Revenue recognition. Revenue is generally recognized upon delivery of shipments. For shipments in transit, revenue is recorded based on the percentage of service completed.

      For the services in progress at the end of the accounting period, Federal Express uses the percentage of completion method for revenue recognition, recognizing only a percentage of the revenues and related costs of providing the services based on the degree of completion of the service. This method is also called the proportional performance method. This form of revenue recognition is very similar to Time Warner's accounting for its TV cable contracts and McDermott's accounting for its construction contracts. Each company recognizes revenues and expenses related to the completed portion of its contract with the customer. The major difference is that Time Warner is paid for the cable subscriptions in advance, McDermott receives progress payments throughout the contract period, and Federal Express receives payment from its business customers after it provides the service.

FINANCIAL ANALYSIS

REVENUE RECOGNITION AND FINANCIAL STATEMENT ANALYSIS

Financial analysts cannot evaluate the income earned by a company if they do not understand how it applied the revenue recognition criteria. As a result, all companies disclose any special revenue recognition issues in the notes to their financial statements. For example, General Motors' annual report states the following:

Certain sales under long-term contracts, primarily in the defense business, are recorded using the percentage-of completion (cost-to-cost) method of accounting. Under this method, sales are recorded equivalent to costs incurred plus a portion of the profit expected to be realized, determined based on the ratio of costs incurred to estimated total costs at completion.

This succinct explanation of the percentage of completion method is an adequate explanation for someone who has read this chapter, but it is doubtful that someone who has not studied accounting would understand its meaning. This is an excellent example of the importance of careful study of accounting even if you do not major in accounting.

¹Cost overruns (underruns), which did not occur in this simple example, create additional accounting problems.

²Accounting Trends & Techniques (New York: AICPA, 1998).

DEMONSTRATION CASE A

(Complete the requirements before proceeding to the suggested solution that follows.)
Assume that (1) Federal Express had shipments in transit involving fees totaling $20 million on December 31 of the current year, (2) none of the fees had been collected, and (3) on average, the shipments in transit were 60 percent completed.

Required:

1. Determine what amount related to the shipments in transit is recognized as revenue in the current year using the revenue recognition rule indicated in its footnote included in the prior section.
2. Indicate what asset(s) is (are) affected by recording revenue from the shipments in transit (accounts and amounts).

SUGGESTED SOLUTION

1. Delivery revenue is recorded for $12,000,000.
2. Accounts Receivable increases by $12,000,000.

DEMONSTRATION CASE B

(Complete the requirements before proceeding to the suggested solution that follows.)
Jackson Construction Company entered into a long-term construction contract with the federal government to build a special landing strip at an Air Force base in Rapid City, South Dakota. The project took three years and cost the government $12 million. Jackson spent the following amounts each year: 2004, $2 million; 2005, $5 million; 2006, $3 million. The company uses the percentage of completion method. Cost estimates equaled actual costs.

Required:
Determine the amount of net income that Jackson can report each year for this project.

SUGGESTED SOLUTION

	2004	2005	2006
Revenue.................	$2,400,000	$6,000,000	$3,600,000
Expenses.................	2,000,000	5,000,000	3,000,000
Net income.................	$ 400,000	$1,000,000	$ 600,000

Computations:

2004: ($2,000,000 ÷ $10,000,000) x $12,000,000 = $2,400,000
2005: ($5,000,000 ÷ $10,000,000) x $12,000,000 = $6,000,000
2006: ($3,000,000 ÷ $10,000,000) x $12,000,000 = $3,600,000