Recognition of Revenue Prior to Delivery

Accrual accounting allows some revenue recognition methods that recognize revenue prior to delivery or sale of goods.

Learning Objective

Distinguish between the percentage of completion method and the completion of production method of revenue recognition

Key Points

For most goods that have been sold and are undelivered, the sales transaction is not complete and revenue on the sale has not been earned. In this case, an accrual entry for revenue on the sale is not made.
The cash method of accounting recognizes revenue and expenses when cash is exchanged. For a seller using the cash method, if cash is received prior to the delivery of goods, the cash is recorded as earnings.
Under the percentage-of-completion method, if a long-term contract specifies the price and payment options with transfer of ownership and details the buyer's and seller's expectations, then revenues, costs, and gross profit can be recognized each period based upon the progress of construction.
The completion of production method allows recognizing revenues even if no sale was made. This applies to natural resources where there is a ready market for these products with reasonably assured prices, units are interchangeable, and selling and distributing costs are not significant.

Terms

accrual
A charge incurred in one accounting period that has not been paid by the end of it.
conservatism
A risk-averse attitude or approach; for accounting purposes, it relates to disclosing expenses and losses incurred immediately and delaying the recognition of revenues and gains until realized.

Full Text

Definition of Revenue Recognition

The accounting principle regarding revenue recognition states that revenues are recognized when they are earned (transfer of value between buyer and seller has occurred) and realized or realizable (collection is reasonably assured). A transfer of value takes place between a buyer and seller when the buyer receives goods in accordance to a sales order approved by the buyer and seller and the seller receives payment or a promise to pay from the buyer for the goods purchased. Revenue must be realizable. In order words, for sales where cash was not received, the seller should be confident that the buyer will pay according to the terms of the sale .

Goods in Inventory

Depending on the shipping terms of the sale, a seller may not recognize revenue on goods sold that are pending delivery.

Methods that Recognize Revenue Prior to Delivery or Sale

Percentage-of-completion method: if a long-term contract clearly specifies the price and payment options with transfer of ownership -- the buyer is expected to pay the whole amount and the seller is expected to complete the project -- then revenues, expenses, and gross profit can be recognized each period based upon the progress of construction (that is, percentage of completion). For example, if during the year, 25% of the building was completed, the builder can recognize 25% of the expected total profit on the contract. Percentage of completion is preferred over the completed contract method. However, expected loss should be recognized fully and immediately due to the conservatism constraint. All revenues, expenses, losses, and gains resulting from the percentage completed will be reported on the income statement.
Completion of production method: This method allows recognizing revenues even if no sale was made. This applies to agricultural products and minerals because there is a ready market for these products with reasonably assured prices, the units are interchangeable, and selling and distributing does not involve significant costs. All expected revenues and costs of production related to the units produced will be reported on the income statement.

[ edit ]

Prev Concept

Recognition of Revenue at Point of Sale or Delivery

Recognition of Revenue After Delivery

Next Concept