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Revenue Recognition Method 4: Cost Recoverability Method

The most conservative revenue recognition method of all, the cost recoverability approach is used when a company cannot reasonably estimate the total expense required to complete a project. The result is that no profit is recognized at all until all of the expenses incurred to complete the project have been recouped. Examples would include the development of internal software and certain types of land.

Assume a law firm developed its own software at a total cost of one million dollars. Several years later, the partners decide to start licensing the software to other firms. In the first quarter, they have total sales of $250,000. Under the cost recoverability method of revenue recognition, however, all of this would serve as an offset to the original $1 million in development expense. Nothing would appear in the income statement as revenue until the entire original balance of $1 million had been wiped out.

Revenue Recognition Method 5: Installment

When the actual collection of cash is suspect, a company should use the installment method of revenue recognition. This is primarily used in some real estate transactions where the sale may be agreed upon but the cash collection is subject to the risk of the buyer's financing falling through. As a result, gross profit is only calculated in proportion to cash received.

For example, assume a developer spent $500,000 improving an apartment. He sold the property for $750,000 but the buyer is going to pay in two installments – one on January 1st and one on July 31st. On the first payment due date, the developer receives a check for half of what he is owed, or $375,000. His income statement is now going to reflect fifty-percent of the revenue and gross profit earned since he has collected fifty-percent of the cash (i.e., $375,000 revenue, $125,000 gross profit ($250,000 total gross profit [$750K selling price - $500K cost = $250K] x 50% = $125,000.) (Realize the actual rules governing accounting for real estate sales are more complex; this example is for simplicity sake only to illustrate the concept of the installment method.)

Ways Management Can Manipulate the Income Statement Using Revenue Recognition

As you can see, management can, with only a change of revenue recognition accounting, drastically alter the appearance of the income statement, over or understating revenue and profit. The exact same contract using the percentage-of-completion method for revenue recognition instead of the completed contract method will result in higher assets, higher stockholder equity, lower liabilities, and a lower debt-to-equity ratio. The income statement will show much smoother earnings over a several year period despite the fact that the economic substance and health of the business would be exactly the same. This is where the investor must dig in and compare the revenue recognition of two companies in the same industry to truly get an idea of who is performing better. The irony is that, with certain exceptions, a business that uses the completed contract method is going to report no income in the first years of the contract, meaning no taxes will be paid. The result is that the shareholders of this business are going to be told they are earning less but their wealth is going to be greater because there is capital being used in the business tax-deferred; a phenomenon very similar to the use of LIFO for inventory valuation.

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