CFA Level 1 - Revenue Recognition and Accounting Entries

REVENUE RECOGNITION AND ACCOUNTING ENTRIES

Accounting Entries
The best way to identify the appropriate accounting entries is to consider an example:
Construction Company ABC, has just obtained a $50 million contract to build a five-building resort in the Bahamas for
Meridian Vacations. Company ABC estimates that each building will take a full year to build. Meridian Vacations has
agreed to pay Company ABC according to the following schedule: $5m in year 1, $10m in year 2, $10m in year 3,
$10m in year 4 and $15m in year 5. Company ABC has estimated that the total cost of this contact will be $35m, and
will occur over the five years in this way; $5m in year 1, $4m in year 2, $10m in year 3, $10m in year 4 and $6m in
year 5. Equal monthly payments will be made to ABC, and Meridian will have a 30-day grace period except for the
last payment in year 5.
Figure 6.6: Illustration of Construction Company ABCs expected figures

Total
Revenue: $50M
Total
Cost:
$35M
Year 1

Year 2

Year 3

Year 4

Year 5

Total

Cost

5,000,00
10,000,00 10,000,00
35,000,00
4,000,000
6,000,000
0
0
0
0

Payment 5,000,00 10,000,00 15,000,00

12,000,00 50,000,00
8,000,000
Terms
0
0
0
0
0
Cash
4,583,33
14,583,33
12,666,66 50,000,00
9,583,333
8,583,333
Received 3
3
7
0
Accounts
Receivabl 416,667 833,333
e

1,250,000 666,667

Percentage-of-Completed-Contract Method
We first need to estimate the revenues Company ABC will declare each year. Remember we are using the
percentage-of-completion method based on estimated cost.
Figure 6.7: Construction Company ABCs Estimated Revenues

Year 1

Year 2

Year 3

Year 4

Year 5

Total

Cost

5,000,00 4,000,00 10,000,00 10,000,00 6,000,00 35,000,00

0
0
0
0
0
0

% of
Completio 14.29% 11.43% 28.57%
n

28.57%

17.14% 100%

Cumulativ 14.29% 25.71% 54.29%

82.86%

100%

e
Revenue

7,142,85 5,714,28 14,285,71 14,285,71 8,571,42 50,000,00

7
6
4
4
9
0

Step 1:
Revenues to be declared
We first need to extrapolate how much each annual cost represents as a percentage of the total cost. Armed with this
information we multiply the percentage of completion with the total expected revenue for the project for each period.
Recall that one of the basic accounting principles is assurance of payment, and here is the formula used to determine
amount of revenues to be recognized at any given point in time:
Formula 6.4

(Services Provided to Date/Total Expected Services) x Total

Expected Inflow
This is basically the same formula used in the percentage-of-completion method.
Step 2:
Cost to be declared
Since this is the basic assumption of this accounting methodology, the expenses remain the same as the ones that
were estimated.
Results:
1. Annual Income Statement Entries
In each year, the revenues, expenses would be entered as seen on the following table.
Note: For simplicity, taxes were not considered.
Figure 6.8: Construction Company ABCs Income Statement (% of Completion
Method)

2. Balance Sheet Statement Entries

Figure 6.9: Construction Company ABCs Balance Sheet (% of Completion Method)

Explanation of Balance Sheet Entries:

Cash:It is the total cash Company ABC has on hand at the end of the year, and is defined as the total cash

inflow minus the total cash outflow. If the result of this equation were negative, the company would have to
borrow from its line of credit additional funds to cover its total expenses.
Accounts Receivable:The total amount billed less the cash received by Meridian.
Net construction in progress (asset) and net advance billing (liability):
These accounts offset each other and are composed of construction in progress less total billings.
o
If the result of this equation were negative, the company would have billed its client for more than

what has delivered. This would have constituted a liability for the construction company, and would
have been reported as net advance billings.
If this equation were positive, then the company would have built more than the client has paid for

it, and the result of the equation would have constituted an asset and would be recorded as net
construction in progress.
In most cases, companies only report net construction in progress or net advance billing on their

balance sheet.
Retained earnings The cumulative shares of the total profit to date. This item is not shown on the
balance sheet above. It normally appears after shareholders equity.
Formula 6.5

Construction in progress = the cumulative cost incurred

since inception + (cumulative percentage of completion x total
estimated net profit of the project)
Less
Total billings = cumulative amount billed to the client since
inception

Look Out!
Remember, if the result of the above equation is:
Positive (asset) = net construction in progress
Negative (liability) = net advance billings
Figure 6.10: Other Items on Company ABCs Balance Sheet (% of
Completion Method)

Completed-Contract Method
Under this accounting methodology, revenues and expenses are not recognized until the contract is completed and
the title is transferred to the client.
Annual Income Statements
In this case, nothing would be reported on the annual income statements until Year 5.
Figure 6.11: Company ABCs Income Statement (Completed Contract
Method)

Balance Sheet Statements

Under this method, the balance sheet entries are the same as the percentage-of completion method, except for the
Net Advance Billing account.
Figure 6.12: Company ABCs Balance Sheet (Completed Contract Method)

Balance Sheet Entries

Cash and accounts receivables stay the same under both the percentage of completion and completed
contract methods.
o This is normal because, no matter which method you use, you always know how mush cash you

have in the bank, and you how much credit you have extended to your client.
Net construction in progress (asset) / net advance billing The basic concepts are the same,
except that under this methodology, construction in progress does not include the cumulative effect
of gross profits in the formula (i.e. excludes cumulative percentage of completion x total estimated
net profit of the project).