Accounting: The Language of Business - Vol. 2 (Intermediate: Part 135)

Bookkeeping migrated to America with European colonization. Although it was sometimes referred to as accounting, bookkeepers were still doing basic data entry and calculations for business owners. However, the businesses in question were small enough that the owners were personally involved and aware of the financial health of their companies. Business owners did not need professional accountants to create complex financial statements or cost-benefit analyses (Investopedia).

 

Revenue Recognition (Part V)

by

Charles Lamson

Significant Judgment in Revenue Recognition 

Companies disclose the judgment and changes in judgments made in applying the revenue recognition guidance. Companies provide a description of the timing of satisfaction of performance obligations, including the methods used to recognize revenue and an explanation of why the methods provide a faithful depiction of the transfer of goods or service. Companies also disclose information about the transaction price and the amounts allocated to performance obligation based on:

• Determining the transaction price, estimating variable consideration, adjustments for time value of money, and measuring noncash consideration.

• Assessing whether an estimate of variable consideration is considered.

• Allocating the transaction price, including standalone selling prices and variable consideration.

• Measuring obligations for returns, refunds, or other similar obligations.

Financial

Statement

Analysis

Comparison of the Percentage-of-Completion and Completed-Contract Methods 

This section highlights the financial statement effects of the percentage-of-completion versus the completed-contract methods. The primary criticism of the completed-contract method is that it does not properly measure economic activity. This criticism is avoided under the percentage-of-completion method.

The total revenues and costs for a long-term contract are the same under the completed-contract and percentage-of-completion methods. However, the timing of revenue and gross profit recognition on the contract differs with the methods. The percentage-of-completion method recognizes gross profit over the production. Whereas the completed contract method recognizes gross profit only at the end of the contract. The following tables based on the Bronco Builders illustrations from Examples 8.22 (from Part 128) and 8.23 (Part 129) compare the gross profit recognized and the net asset or net liability reported each year under the two revenue recognition methods.

Total gross profit recognized, $300,000 is the same; only the timing of recognition differs. The percentage-of-completion method best measures economic activity as it reports gross profit as production takes place each year.

The percentage-of-completion method also best measures the net asset (liability) position of the contractor. The difference in the valuation of the net asset (liability) is due to the recognizable recognition of gross profit under the percentage-of-completion method. Failure to recognize gross profit under the completed-contract method overstates the net liability or understates the net asset. Therefore, using amounts such as revenue, net income, total assets, liabilities, and equity differ in the two methods. 

Because the percentage-of-completion method recognizes gross profit over the production process, revenues and net income will typically be higher in early years than under the completed-contract method. Therefore, the profit margin ratio will be higher under the percentage-of-completion method. Under the percentage of completion method, assets are generally higher (and liabilities are lower) because the asset construction and progress includes a portion of the estimated profits. Equity is also higher under the percentage-of-completion method because profit is recognized. Therefore, the debt-to-equity ratio will generally be lower under the percentage of completion method. Exhibit 8.8 summarizes these effects on common ratios.

Exhibit 8.8 Select Financial Statement Ratios: Percentage-of-Completion Method versus Completed-Contract Method

Example 8.28 illustrates and compares these financial statement analysis ratios under the percentage-of-completion and completed-contract methods.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED. PP. 418-420*

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