Level 1 CFA® Exam:
Specific Revenue Recognition
Long-term contracts are contracts that are carried out in more than one period. For this type of contracts, we apply specific methods of revenue recognition. These are:
- percentage-of-completion method, and
- completed contract method.
The latter is permitted under U.S. GAAP only.
Percentage-of-Completion Method
Percentage-of-completion method is used when the outcome of a contract can be measured reliably.
According to the percentage-of-completion method, in each period:
- revenue equals percentage-of-completion multiplied by total contract revenue less revenue recognized in the previous periods,
- contract costs are expensed against the revenue,
- net income is reported.
Tango, Inc. has a 4-year construction contract for USD 144 million with the estimated total cost equal to USD 135 million. The company recognizes long-term contract revenue using the percentage-of-completion method. The table gives information about cash flows related to this construction contract:
| Year 1 | Year 2 | Year 3 | Year 4 | Sum | |
|---|---|---|---|---|---|
| cost incurred and paid | USD 37 million | USD 38 million | USD 30 million | USD 30 million | USD 135 million |
What is the amount of revenue and profit the company will recognize in all 4 years?
(...)
Under IFRS:
When the outcome of a contract cannot be measured reliably and when it is assumed that costs are probable to be recovered, the revenue in a given period can be recognized in the amount of costs incurred in this period. So, the profit is recognized after all costs are recovered.
Tango, Inc. has a 4-year construction contract for USD 144 million with the estimated total cost equal to USD 135 million.
The table gives information about cash flows related to this construction contract:
| Year 1 | Year 2 | Year 3 | Year 4 | Sum | |
|---|---|---|---|---|---|
| costs | USD 37 million | USD 38 million | USD 30 million | USD 30 million | USD 135 million |
The outcome of a contract cannot be measured reliably but it can be assumed that costs are probable to be recovered. The company operates under IFRS.
What is the amount of revenue and profit the company will recognize in all 4 years?
(...)
Under U.S. GAAP:
The completed contract method is used when a reliable estimate of the total costs cannot be determined until the contract is finished.
Under the completed contract method, profit is only reported upon completion of the contract.
Thus, in each period but last, no revenue and costs are reported.
Tango, Inc. has a 4-year construction contract for USD 144 million with the estimated total cost equal to USD 135 million.
The table gives information about cash flows related to this construction contract:
| Year 1 | Year 2 | Year 3 | Year 4 | Sum | |
|---|---|---|---|---|---|
| costs | USD 37 million | USD 38 million | USD 30 million | USD 30 million | USD 135 million |
The outcome of a contract cannot be measured reliably but it can be assumed that costs are probable to be recovered. The company operates under U.S. GAAP.
What is the amount of revenue and profit the company will recognize in all 4 years?
(...)
The completed contract method is used if:
- we cannot reliably measure the outcome of the contract, OR
- the company enters mainly into short-term contracts.
Remember that in both methods, a loss is reported immediately.
Tango Inc. has entered a three-year construction contract for USD 12 million. Costs will probably be recovered but given the uncertainty of future prices of materials, technology, and labor, the outcome cannot be measured reliably. The table gives information about expenditures related to this construction contract:
| Year 1 | Year 2 | Year 3 | |
|---|---|---|---|
| cash expenditure incurred | USD 3.5 million | USD 4.5 million | USD 2 million |
What is the revenue and profit that the company will recognize in Year 3 under IFRS and under U.S. GAAP?
(...)
When proceeds from a sale are to be paid in installments, we speak of installment sales.
According to IFRS, in the installment sales:
- revenue attributable to the sale price is recognized at the date of sale, and
- revenue attributable to the interest is recognized in future periods.
Under U.S.GAAP, when real estate is sold and cash collections are not assured, a company can use either:
- the installment method, or
- the cost recovery method.
According to the installment method:
Profit recognized in a given period equals the ratio of the amount of the sale price paid by the buyer to the sale price multiplied by the total profit.
According to the cost recovery method, profit is recognized after the amount paid by the buyer exceeds the seller’s costs.
The cost of property is equal to USD 12 million. The total sales price is USD 16 million. The buyer pays a down payment of USD 8 million. The rest of the sales amount is to be received in the next three years. There is a serious risk that the buyer will not be able to make all payments.
How much profit attributable to the down payment will be recognized if the installment method is used?
(...)
- Long-term contracts are contracts that are carried out in more than one period.
- For long-term contracts, we apply specific methods of revenue recognition: percentage-of-completion method and completed contract method (permitted under U.S. GAAP only).
- Percentage-of-completion method is used when the outcome of a contract can be measured reliably.
- Under IFRS when the outcome of a contract cannot be measured reliably and when it is assumed that costs are probable to be recovered, the revenue in a given period can be recognized in the amount of costs incurred in this period.
- Under U.S. GAAP the completed contract method is used when a reliable estimate of the total costs cannot be determined until the contract is finished.
- According to IFRS, in the installment sales: revenue attributable to the sale price is recognized at the date of sale, and revenue attributable to the interest is recognized in future periods.
- Under U.S.GAAP, when real estate is sold and cash collections are not assured, a company can use either the installment method or the cost recovery method.