“Cash Methods” LT Contract Revenue Recognition

Installment Sales
Use if you have no clue WHEN you will get money. You will only record revenue only if CASH is actually collected.

- Cannot establish reasonable bad debt %

Calculation:

1. Gross Profit = Sales – (Cost)
2. Gross Profit % = GP / Sales Earned
3. Revenue (per year) = Cash Collections*GP %
4. Installment Receivable = Sales – (Collections) – (Written Off Sales)
5. Deferred Revenue = Installment Receivable*GP %

Cost Recovery Method (most conservative)
Use if you have no clue that you will actually GET money. You don’t recognize profit until all COST has been recovered.

After you received the money that will fully cover your cost, then the money that comes in after can be recognized as profit.

Calculation:

1. Keep applying collected cash to cost.
2. The remaining collected will be gross profit.

Journal Entry for Both Method
Debit: Deferred Gross Profit
Credit: Realized Gross Profit

Long-Term Construction Contracts

Under GAAP, there are 2 methods to recognize the income of a long-term construction contract: (1) Completed-Contract method & (2) Percentage of Completion Method.

Completed-Contract Method

- Recognize income only on completion of the contract

- Expected loss recognized immediately in the year they are discovered

Calculation: 

Gross Profit = Contract Price - (Total Actual Costs)

Gross Profit = contract price - (costs incurred during the year) - (estimated costs to complete)

Percentage of Completion Method

- Income recognized is the percentage of estimated total income

- Loss must be recognized in full immediately in the year discovered

Calculation:

1. Gross Profit = Contract Price - (Estimated Total Cost [determined each year])
2. % of Completion = (Total Cost to Date)/(Total Estimated Cost of Contract)
3. Gross Profit Earned (Profit to Date) = (GP)*(% of Completion)
4. Gross Profit Earned for Current Year = PTD at Current Year - (PTD at Beginning of Period)

When to Use Each Method
In order to use the Percentage of Completion Method, all 3 of the following criteria must be met:

1. Estimations are reasonable
2. Company has the ability to complete the project
3. Buyer (other party) is able to pay the contracted payments

GAAP

If there is significant uncertainty exists for any of these, then the Completed Contract Method is required. If the collection of money from the customer in an installement sales contract is significantly uncertain, then the cost recovery method is required.
 

IFRS

The Completed Contract Method is not allowed under IFRS.

If there is any significant uncertainties in the 3 criteria, then the Cost Recovery Method must be used.