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Summary of Revenue Recognition

Core Principle

The fundamental principle is that the difference between revenue and cost equals profit. However, applying this principle requires careful consideration of various factors, particularly the nature of the business.

Guiding Principles

  • Conservatism: While a guiding principle, conservatism isn't a simple rule to apply. It necessitates careful judgment based on the specific circumstances.
  • Matching Concept: Expenses associated with generating revenue should be recognized in the same period as the revenue itself. This is achieved through provisions like provisions for doubtful debts, warranty provisions, and sales return allowances.

General Revenue Recognition

In most situations, revenue is recognized upon delivery of the product or provision of the service.

Revenue Recognition for Long-Term Contracts

Long-term contracts present a unique challenge in revenue recognition. Several methods are used:

  1. Completed Contract Method:

    • Revenue is recognized only when the contract is fully completed and delivered to the customer.
    • This method is highly conservative, delaying revenue recognition until completion. It is similar to the delivery method.

  2. Percentage of Completion Method (POCM):

    • Revenue is recognized based on the progress of the project, often tied to milestones.
    • For example, if 20% of the work is completed in the first year, 20% of the total contract revenue is recognized.
    • Profit is recognized each year based on the estimated total profit.
    • Key Consideration: Actual profit may differ from the estimated profit, requiring adjustments in subsequent periods. This can lead to situations where a project initially projected to be profitable ends up incurring a loss, or vice versa. Accountants must diligently track and adjust for these changes in estimated profit.
    • POCM is considered more aggressive in recognizing revenue compared to the completed contract method.

  3. Cost Recovery Method:

    • Profit is recognized only after all project costs have been recovered.
    • This method is more conservative than POCM but less conservative than the completed contract method. It sits between the two in terms of revenue recognition timing.

Other Revenue Recognition Methods

  1. Installment Method:

    • Used when goods are sold on an installment basis.
    • Profit is recognized over time as cash is collected.
    • This method aligns profit recognition with the pattern of cash receipts.

  2. Production Method:

    • Revenue is recognized upon completion of production, even before delivery or sale.
    • This is the most aggressive method.
    • Suitable for industries like agriculture (grains) and mining where there is an assured market and readily determinable market price.

  3. Consignment Sales:

    • Revenue is recognized only when the goods are sold to the final customer by the consignee (the party holding the goods).
    • No revenue is recognized when goods are simply transferred to the consignee.

Matching Concept and Provisions

The matching concept is crucial in revenue recognition. Provisions are created to match expenses with the related revenue:

  • Provision for Doubtful Debts: Accounts for the possibility that some customers may not pay their dues.
  • Provision for Warranty: Accounts for expected future costs related to product warranties.
  • Allowance for Sales Returns: Accounts for expected returns of goods by customers.
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