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Conservatism in Revenue Recognition and Loss Recognition

Conservatism is a key accounting principle that requires recognizing losses as soon as they are probable, but delaying the recognition of gains until they are realized. This principle is particularly relevant in long-term projects and installment sales.

Impact of Conservatism on Different Revenue Recognition Methods

This document explores how conservatism affects various revenue recognition methods, especially when a project is projected to incur a loss. The methods discussed are:

  • Percentage of Completion Method: Revenue is recognized based on the percentage of work completed.
  • Completed Contract Method: Revenue is recognized only when the contract is completed.
  • Cost First Recovery Method: Revenue is recognized only after all costs have been recovered.
  • Installment Method: Profit is recognized proportionally to cash collections.

Loss Recognition During Project Execution

Let's consider a scenario where a project initially estimated to generate a profit ultimately incurs a loss.

Example:

  • Contract Value: ₹120 crore
  • Initial Estimated Cost: ₹100 crore
  • Revised Estimated Cost (after 2 years): ₹130 crore

This means a projected loss of ₹10 crore (₹130 crore - ₹120 crore).

Conservatism mandates recognizing this loss immediately when it becomes evident, not waiting until project completion.

1. Completed Contract Method and Cost First Recovery Method

Under these methods, no profit is recognized until the project is complete. However, when a loss becomes apparent, it must be recognized immediately.

  • Entry in Year 2:
    • Debit: Provision for Estimated Loss ₹10 crore
    • Credit: Expenses ₹10 crore

This creates a liability (Provision for Estimated Loss) and recognizes the loss in the income statement of Year 2. In Year 3, the provision account is adjusted against the actual loss.

2. Percentage of Completion Method

This method recognizes profit based on the percentage of completion. If a loss is projected, any previously recognized profit must be reversed, and the remaining loss recognized.

Example (Continuing from above):

  • Year 1 Profit (recognized): ₹4 crore
  • Year 2 Expenses: ₹40 crore

  • Year 2 Revenue (based on completion): ₹26 crore (assumed)

  • Year 2 Calculation:

    • Loss = Expenses - Revenue = ₹40 crore - ₹26 crore = ₹14 crore
    • Total Loss to be recognized in Year 2 = Previous Profit + Current Loss = ₹4 crore+₹10 crore = ₹14 crore
  • Year 3 expenses are 70 crore and revenue is 70 crore, resulting in zero profit.
  • Total loss is 10 crore (4 crore profit in year 1 - 14 crore loss in year 2 + 0 profit in year 3)

3. Installment Method

This method recognizes profit proportionally to cash collections. When a loss is projected, previously recognized profit must be reversed, and the remaining loss recognized.

Example (Continuing from above):

  • Year 1 Profit (recognized): ₹1.67 crore
  • Total projected Loss: ₹10 crore
  • Total Loss to recognize in Year 2: ₹1.67 crore + ₹10 crore = ₹11.67 crore
  • Year 2 Revenue (based on collections): ₹20 crore
  • Year 2 Expenses: ₹31.67 crore (to reflect the ₹11.67 crore loss)
  • The difference between the actual cash spent (40 crore) and the expenses recognized (31.67 crore) is added to the Work in Progress (WIP) account (8.33 crore).
  • In year three, expenses of 30 crore are recognized against revenue of 30 crore, resulting in zero profit. The remaining 40 crore spent is added to WIP.
  • In the following years (year 4 and 5), WIP is reduced as revenue is recognized to ensure no further profit or loss is recognized.

Important Note on Installment Method Example: The original example used a construction contract for illustrating the installment method, which isn't ideal. The installment method is more appropriate for sales where payments are received over time, even after the product is delivered.

Proper Example of Installment Sale

Scenario:

  • Sale Price of Air Conditioner: ₹60,000
  • Cost of Goods Sold: ₹48,000
  • Gross Profit: ₹12,000 (20% of sales price)
  • Payment Terms: 4 quarterly installments of ₹15,000

Accounting Entries:

  • January 1 (Sale):
    • Debit: Installment Account Receivable ₹60,000
    • Credit: Inventory ₹48,000
    • Credit: Deferred Gross Profit ₹12,000
  • March 31 (First Installment):
    • Debit: Cash ₹15,000
    • Credit: Installment Account Receivable ₹15,000
    • Debit: Deferred Gross Profit ₹3,000 (20% of ₹15,000)
    • Credit: Cost of Sales ₹12,000
    • Credit: Revenue ₹15,000
  • This process is repeated for the remaining three quarters, recognizing ₹3,000 profit each quarter.

This example illustrates the proper application of the installment method, where profit is recognized proportionally to cash collections.

Conclusion

Conservatism plays a crucial role in revenue recognition, especially in long-term projects and installment sales. It mandates the immediate recognition of losses when they become probable, ensuring that financial statements present a realistic view of the company's financial position. The specific application of conservatism varies depending on the revenue recognition method used.