9.5 Apply Revenue Recognition Principles to Long-Term Projects

Revenue Recognition for Long-Term Projects

Revenue recognition for construction projects

The percentage of completion method recognizes revenue and expenses based on how far along a project is. Progress is measured by comparing costs incurred to date against total estimated costs (though labor hours or machine hours can also serve as the measure).

The formula for recognized revenue in a given period:

$\frac{\text{Costs incurred to date}}{\text{Total estimated costs}} \times \text{Contract price}$

For example, if a contractor has spent $3 million on a project with $10 million in total estimated costs and a $15 million contract price, the recognized revenue so far would be:

$\frac{3{,}000{,}000}{10{,}000{,}000} \times 15{,}000{,}000 = 4{,}500{,}000$

This method gives a more accurate picture of financial performance over the life of a long-term contract. The downside is that it relies on estimates, which can be subjective and prone to errors from cost overruns or delays.

The completed contract method is the alternative. It recognizes all revenue and expenses only when the project is fully finished. No partial revenue or expenses appear during the project. This approach is simpler and more objective since it doesn't depend on estimates, but it can obscure a company's actual financial performance while work is in progress. A company building a bridge over three years, for instance, would show zero revenue from that project until the final year.

Installment method for real estate sales

The installment method recognizes revenue as cash is actually received from the buyer, rather than all at once at the point of sale. A portion of each payment is recognized as revenue based on the gross profit percentage.

The formula:

$\frac{\text{Gross profit}}{\text{Contract price}} \times \text{Cash received}$

Say a property sells for $500,000 with a gross profit of $150,000. The gross profit percentage is $\frac{150{,}000}{500{,}000} = 30\%$. If the buyer makes a $50,000 down payment, the seller recognizes $0.30 \times 50{,}000 = 15{,}000$ in revenue. Each subsequent installment payment gets the same 30% treatment.

This method is useful when there's uncertainty about the buyer's ability to make future payments, which is common with high-value real estate. By deferring revenue recognition until cash is in hand, it helps prevent overstating revenue and profits in case the buyer defaults.

Revenue recognition in multi-year contracts

Magazine subscriptions are a straightforward example. Revenue is recognized evenly over the subscription period. For a 12-month subscription sold for $120, you'd recognize $10 each month. When the subscription is first sold, the full amount is recorded as unearned revenue (a liability), which is gradually reduced as each month's revenue is recognized.

Combined equipment sales with service agreements are more complex. The total contract price must be allocated between the equipment and the service agreement based on their standalone selling prices.

• Revenue for the equipment portion is recognized when the equipment is delivered to the customer.
• Revenue for the service agreement portion is recognized over the term of the agreement (covering maintenance, warranties, etc.).

If standalone selling prices aren't directly available, use the residual method:

1. Allocate the contract price to the service agreement based on its estimated fair value.
2. Assign the remaining amount to the equipment.

For example, if a $10,000 bundled deal includes equipment and a 2-year service agreement, and the service agreement's estimated fair value is $3,000, then $3,000 is allocated to the service agreement (recognized over 24 months) and $7,000 to the equipment (recognized at delivery).

Additional methods for measuring project progress

Beyond the cost-based approach used in percentage of completion, there are other ways to measure how far along a project is.

• Input methods measure progress based on resources consumed or efforts expended, such as costs incurred, labor hours worked, or machine hours used.
• Output methods measure progress based on results achieved, such as units completed, milestones reached, or value delivered to the customer.

The milestone method recognizes revenue only when predetermined project milestones are reached. This works well for projects with clearly defined stages or deliverables where progress between milestones is hard to measure reliably.

Performance-based billing ties revenue recognition to specific performance metrics or outcomes rather than time elapsed or costs incurred.

Finally, contract modifications (changes in scope, price, or terms) may require adjustments to the revenue recognition method and the underlying estimates. When a contract is modified, you need to reassess whether the modification creates a separate performance obligation or changes the existing one.