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Principles of Accounting, Volume 1: Financial Accounting

9.5 Apply Revenue Recognition Principles to Long-Term Projects

Principles of Accounting, Volume 1: Financial Accounting9.5 Apply Revenue Recognition Principles to Long-Term Projects
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  1. Preface
  2. 1 Role of Accounting in Society
    1. Why It Matters
    2. 1.1 Explain the Importance of Accounting and Distinguish between Financial and Managerial Accounting
    3. 1.2 Identify Users of Accounting Information and How They Apply Information
    4. 1.3 Describe Typical Accounting Activities and the Role Accountants Play in Identifying, Recording, and Reporting Financial Activities
    5. 1.4 Explain Why Accounting Is Important to Business Stakeholders
    6. 1.5 Describe the Varied Career Paths Open to Individuals with an Accounting Education
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
  3. 2 Introduction to Financial Statements
    1. Why It Matters
    2. 2.1 Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate
    3. 2.2 Define, Explain, and Provide Examples of Current and Noncurrent Assets, Current and Noncurrent Liabilities, Equity, Revenues, and Expenses
    4. 2.3 Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet
    5. Key Terms
    6. Summary
    7. Multiple Choice
    8. Questions
    9. Exercise Set A
    10. Exercise Set B
    11. Problem Set A
    12. Problem Set B
    13. Thought Provokers
  4. 3 Analyzing and Recording Transactions
    1. Why It Matters
    2. 3.1 Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements
    3. 3.2 Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions
    4. 3.3 Define and Describe the Initial Steps in the Accounting Cycle
    5. 3.4 Analyze Business Transactions Using the Accounting Equation and Show the Impact of Business Transactions on Financial Statements
    6. 3.5 Use Journal Entries to Record Transactions and Post to T-Accounts
    7. 3.6 Prepare a Trial Balance
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  5. 4 The Adjustment Process
    1. Why It Matters
    2. 4.1 Explain the Concepts and Guidelines Affecting Adjusting Entries
    3. 4.2 Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries
    4. 4.3 Record and Post the Common Types of Adjusting Entries
    5. 4.4 Use the Ledger Balances to Prepare an Adjusted Trial Balance
    6. 4.5 Prepare Financial Statements Using the Adjusted Trial Balance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  6. 5 Completing the Accounting Cycle
    1. Why It Matters
    2. 5.1 Describe and Prepare Closing Entries for a Business
    3. 5.2 Prepare a Post-Closing Trial Balance
    4. 5.3 Apply the Results from the Adjusted Trial Balance to Compute Current Ratio and Working Capital Balance, and Explain How These Measures Represent Liquidity
    5. 5.4 Appendix: Complete a Comprehensive Accounting Cycle for a Business
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  7. 6 Merchandising Transactions
    1. Why It Matters
    2. 6.1 Compare and Contrast Merchandising versus Service Activities and Transactions
    3. 6.2 Compare and Contrast Perpetual versus Periodic Inventory Systems
    4. 6.3 Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System
    5. 6.4 Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System
    6. 6.5 Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods
    7. 6.6 Describe and Prepare Multi-Step and Simple Income Statements for Merchandising Companies
    8. 6.7 Appendix: Analyze and Record Transactions for Merchandise Purchases and Sales Using the Periodic Inventory System
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  8. 7 Accounting Information Systems
    1. Why It Matters
    2. 7.1 Define and Describe the Components of an Accounting Information System
    3. 7.2 Describe and Explain the Purpose of Special Journals and Their Importance to Stakeholders
    4. 7.3 Analyze and Journalize Transactions Using Special Journals
    5. 7.4 Prepare a Subsidiary Ledger
    6. 7.5 Describe Career Paths Open to Individuals with a Joint Education in Accounting and Information Systems
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  9. 8 Fraud, Internal Controls, and Cash
    1. Why It Matters
    2. 8.1 Analyze Fraud in the Accounting Workplace
    3. 8.2 Define and Explain Internal Controls and Their Purpose within an Organization
    4. 8.3 Describe Internal Controls within an Organization
    5. 8.4 Define the Purpose and Use of a Petty Cash Fund, and Prepare Petty Cash Journal Entries
    6. 8.5 Discuss Management Responsibilities for Maintaining Internal Controls within an Organization
    7. 8.6 Define the Purpose of a Bank Reconciliation, and Prepare a Bank Reconciliation and Its Associated Journal Entries
    8. 8.7 Describe Fraud in Financial Statements and Sarbanes-Oxley Act Requirements
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  10. 9 Accounting for Receivables
    1. Why It Matters
    2. 9.1 Explain the Revenue Recognition Principle and How It Relates to Current and Future Sales and Purchase Transactions
    3. 9.2 Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches
    4. 9.3 Determine the Efficiency of Receivables Management Using Financial Ratios
    5. 9.4 Discuss the Role of Accounting for Receivables in Earnings Management
    6. 9.5 Apply Revenue Recognition Principles to Long-Term Projects
    7. 9.6 Explain How Notes Receivable and Accounts Receivable Differ
    8. 9.7 Appendix: Comprehensive Example of Bad Debt Estimation
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  11. 10 Inventory
    1. Why It Matters
    2. 10.1 Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions
    3. 10.2 Calculate the Cost of Goods Sold and Ending Inventory Using the Periodic Method
    4. 10.3 Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method
    5. 10.4 Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet
    6. 10.5 Examine the Efficiency of Inventory Management Using Financial Ratios
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  12. 11 Long-Term Assets
    1. Why It Matters
    2. 11.1 Distinguish between Tangible and Intangible Assets
    3. 11.2 Analyze and Classify Capitalized Costs versus Expenses
    4. 11.3 Explain and Apply Depreciation Methods to Allocate Capitalized Costs
    5. 11.4 Describe Accounting for Intangible Assets and Record Related Transactions
    6. 11.5 Describe Some Special Issues in Accounting for Long-Term Assets
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  13. 12 Current Liabilities
    1. Why It Matters
    2. 12.1 Identify and Describe Current Liabilities
    3. 12.2 Analyze, Journalize, and Report Current Liabilities
    4. 12.3 Define and Apply Accounting Treatment for Contingent Liabilities
    5. 12.4 Prepare Journal Entries to Record Short-Term Notes Payable
    6. 12.5 Record Transactions Incurred in Preparing Payroll
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  14. 13 Long-Term Liabilities
    1. Why It Matters
    2. 13.1 Explain the Pricing of Long-Term Liabilities
    3. 13.2 Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method
    4. 13.3 Prepare Journal Entries to Reflect the Life Cycle of Bonds
    5. 13.4 Appendix: Special Topics Related to Long-Term Liabilities
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  15. 14 Corporation Accounting
    1. Why It Matters
    2. 14.1 Explain the Process of Securing Equity Financing through the Issuance of Stock
    3. 14.2 Analyze and Record Transactions for the Issuance and Repurchase of Stock
    4. 14.3 Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends, and Stock Splits
    5. 14.4 Compare and Contrast Owners’ Equity versus Retained Earnings
    6. 14.5 Discuss the Applicability of Earnings per Share as a Method to Measure Performance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  16. 15 Partnership Accounting
    1. Why It Matters
    2. 15.1 Describe the Advantages and Disadvantages of Organizing as a Partnership
    3. 15.2 Describe How a Partnership Is Created, Including the Associated Journal Entries
    4. 15.3 Compute and Allocate Partners’ Share of Income and Loss
    5. 15.4 Prepare Journal Entries to Record the Admission and Withdrawal of a Partner
    6. 15.5 Discuss and Record Entries for the Dissolution of a Partnership
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  17. 16 Statement of Cash Flows
    1. Why It Matters
    2. 16.1 Explain the Purpose of the Statement of Cash Flows
    3. 16.2 Differentiate between Operating, Investing, and Financing Activities
    4. 16.3 Prepare the Statement of Cash Flows Using the Indirect Method
    5. 16.4 Prepare the Completed Statement of Cash Flows Using the Indirect Method
    6. 16.5 Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency
    7. 16.6 Appendix: Prepare a Completed Statement of Cash Flows Using the Direct Method
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  18. Financial Statement Analysis
  19. Time Value of Money
  20. Suggested Resources
  21. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
    14. Chapter 14
    15. Chapter 15
    16. Chapter 16
  22. Index

While most receivable reporting is straightforward when recognizing revenue and matching expenses in the same period, a few unique situations require special revenue distribution for long-term projects. Long-term construction-company projects, real estate installment sales, multi-year magazine subscriptions, and a combined equipment sale with an accompanying service contract have special reporting requirements to meet revenue recognition and matching principles.

Long-term construction projects, such as construction of a major sports stadium, can take several years to complete. Typically, revenue is recognized when the earnings process is complete; however, if the construction project did not begin work immediately, this could delay recognition of revenue, and expenses accumulated during the period would be unmatched. These unmatched expenses can misstate financial statements (particularly the income statement) and mislead stakeholders. There are also tax implications, where a company may benefit from tax breaks with reduced earnings.

Two methods can be applied to long-term construction projects that are consistent with the revenue recognition criteria you’ve learned about. The methods commonly utilized by construction contractors are the percentage of completion and completed contract (see Figure 9.6). The percentage of completion method takes the percentage of work completed for the period and divides that by the total revenues from the contract. The percentage of work completed for the period distributes the estimated total project costs over the contract term based on the actual completion amount, up to that point. The percentage can be based on such factors as percentage of anticipated final costs incurred at a given point or an engineering report that estimates the percentage of completion of the project at a stage of production.

A photograph of a construction site.
Figure 9.6 Long-Term Construction Project. Revenue recognition requires use of the percentage of completion or completion contract method. (credit: modification of “Construction of Millennium Stadium, Cardiff” by Seth Whales/Wikimedia Commons, CC BY 2.0)

The completed contract method delays reporting of both revenues and expenses until the entire contract is complete. This can create reporting issues and is typically used only where cost and earnings cannot be reasonably estimated throughout the contract term.

Unlike most residential home loan transactions (usually labeled as mortgage loans), which tend to require monthly payments, commercial real estate sales are often structured as an installment sale (see Figure 9.7) and usually involve periodic installment payments from buyers. These payments can be structured with annual payments, interest-only payments, or any other payment format to which the parties agree.

A photograph of a house with a “For Sale” sign in the front yard.
Figure 9.7 Real Estate Installment Sales. Revenue recognition requires use of the installment method to account for long-term risk. (credit: modification of “Boost-the-Market-Value-of-Your-Home_L” by Dan Moyle/Flickr, CC BY 2.0)

However, a seller/lender has no guarantee that the buyer will pay the debt in its entirety. In this event, the property serves as security for the seller/lender if legal action is taken. The longer the debt remains outstanding, the higher the risk the buyer will not complete payment. With traditional accrual accounting, risk is not considered and revenue is reported immediately. The installment method accounts for risk and defers revenue using a gross profit percentage. As installment payments are made, this percentage is applied to the current period.

Multi-year magazine subscriptions are long-term service contracts with payment usually occurring in advance of any provided service. The company may not recognize this revenue until the subscription has been provided, but there is also no guarantee that the contract will be honored in its entirety at the conditions expected. Financial Accounting Standards Board, Topic 606, Revenue from Contracts with Customers, requires businesses to report revenue “in an amount that reflects the consideration to which the entity expects to be entitled in exchange for the goods or services.”6 Thus, once a change occurs to the expected revenue distribution, this new amount is recorded going forward.

A combined equipment purchase with an accompanying service contract requires separate reporting of the sale and service contract. An example of this is a cell phone purchase that has a service contract (warranty) for any damage to the unit. There is no guarantee that damage will occur or that service will be provided, but the customer has purchased this policy as insurance. Thus, the company must reasonably estimate this revenue each period and distribute this estimation over the life of the service contract. Or, the company may wait until the contract expires before reporting any revenue or expenses associated with the service contract.

Concepts In Practice

U.S. Bank Stadium Construction

HKS, Inc. received a construction contract from the Minnesota Sports Facilities Authority to build the new U.S. Bank Stadium. The construction contract services began in 2012, but the stadium was not complete until 2016. The total construction cost was approximately $1.129 billion.

The portion of construction revenues earned by HKS, Inc. could not be reported upon initial receipt of funds but were instead distributed using the percentage of completion method. Much of the costs and completion associated with building the stadium occurred in the later years of the project (specifically 2015); thus, the company experienced a sharp increase in percentage of completion in the 2015 period. This showed a substantial increase to revenues during this period.

IFRS Connection

Revenue and Receivables

When Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) began their joint work to create converged standards, a primary goal was to develop a single, comprehensive revenue recognition standard. At the time work began, International Financial Reporting Stands (IFRS) had one general standard that was applied to all companies with little guidance for various industries or different revenue scenarios. On the other hand, U.S. generally accepted accounting principles (GAAP) had more than 100 standards that applied to revenue recognition. Because of the global nature of business, including investing and borrowing, it was important to increase the comparability of revenue measurement and reporting. After years of work, a new standard was agreed upon; both FASB and IASB released a revenue recognition standard that is essentially the same, with only a few differences. In the United States, the new revenue recognition standards became effective for reporting in 2018 for publicly traded companies.

A few differences remain in the reporting of revenue. In accounting for long-term projects, IFRS does not allow the completed contract method. If estimating the percentage of completion of the project is not possible, IFRS allows revenues equal to costs to be recognized. This results in no profit recognized in the current period, but rather all profit being deferred until the completion of the project.

Receivables represent amounts owed to the business from sales or service activities that have been charged or loans that have been made to customers or others. Proper reporting of receivables is important because it affects ratios used in the analysis of a company’s solvency and liquidity, and also because reporting of receivables should reflect future cash receipts.

Under both U.S. GAAP and IFRS, receivables are reported as either current or noncurrent assets depending on when they are due. Also, receivables that do not have an interest component are carried at net realizable value or the amount the company expects to receive for the receivable. This requires estimation and reporting of an allowance for uncollectible accounts (sometimes referred to as “provisions” under IFRS). However, receivables that do have a significant financing component are reported at amortized cost adjusted for an estimate of uncollectible accounts.

GAAP and IFRS can differ in the financial statement presentation of receivables. GAAP requires a liquidity presentation on the balance sheet, meaning assets are listed in order of liquidity (those assets most easily converted into cash to those assets least easily converted to cash). Thus, receivables—particularly accounts receivable, which are highly liquid—are presented right after cash. However, IFRS allows reverse liquidity presentation. Therefore, receivables may appear as one of the last items in the asset section of the balance sheet under IFRS. This requires careful observance of the presentation being used when comparing a company reporting under U.S. GAAP to one using IFRS when assessing receivables.

In the case of notes receivable, the method for estimating uncollectible accounts differs between U.S. GAAP and IFRS. IFRS estimates uncollectible accounts on notes receivable in a three-level process, depending upon whether the note receivable has maintained its original credit risk, increased slightly in credit risk, or increased significantly in riskiness. For companies using U.S. GAAP, estimated uncollectible accounts are based on the overall lifetime riskiness.

Footnotes

  • 6 Financial Accounting Standards Board (FASB). “Revenue from Contracts with Customers (Topic 606).” FASB Accounting Standards Update, Financial Accounting Series. April 2016. https://asc.fasb.org/imageRoot/32/79982032.pdf
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