Revenue Recognition

Firms earn revenue by selling goods and services, and incur expenses to earn that revenue. Because revenue recognition drives reported profit directly, getting the timing right, and matching the associated costs to it, is one of the most consequential judgements in accounting. This module works through eight recognition methods and the provisions that sit alongside them.

4.1 The Basic Premise

Generally, firms recognise revenue when goods are delivered and the invoice is generated. More precisely, revenue is recognised when the goods or services are delivered and the risk and reward associated with the product are transferred to the buyer.

The three questions and the three tests

Two questions have to be answered on every contract:

• When should revenue be recognised?
• How much should be recognised as revenue?

Formula: the three conditions for recognition. Revenue is recognised when the performance obligations are fulfilled, the consideration is measurable, and it is reasonably certain the amount will be realised.

All three must hold. Failing any one of them defers recognition.

The stage-by-stage test

Walking a sale from order to cash, only one stage passes the test.

Memory hook: order no, advance no, delivery yes, doubtful collection no again. The accrual method says recognise revenue when earned, whether or not cash is received; conservatism then pulls it back if collection is doubtful.

4.2 Delivery Method or Sales Method

The most common method: recognise revenue when goods are delivered and ownership transfers to the buyer.

Examples of exceptions:

• High-tech equipment requiring installation and testing: recognise on a successful trial run and issue of the performance certificate, not on physical delivery.
• Consignment sales: ownership does not pass on despatch, so recognition is handled differently (see section 4.11).

4.3 Percentage of Completion Method

Used for long-term contracts. For projects spanning multiple years such as construction or metro rail, recognise revenue based on the percentage of work completed. Without it, income would be badly understated during the project's life and then spike at the end.

Profit recognition: POCM is really about profit recognition. The revenue recognised is tied directly to the estimated profit for that portion of the project.

The township example

Given: a 3-year township project, total contract value Rs. 120 crore, total estimated cost Rs. 100 crore, therefore total profit Rs. 20 crore. Costs are 20, 40 and 40 crore in the three years, that is 20%, 40% and 40% of the total.

Answer: profits of Rs. 4, 8 and 8 crore in years 1, 2 and 3.

Recording POC in the accounting equation

Under POCM:

• Expenses are recorded when incurred. There is no work in progress account, because cost goes straight to the profit and loss account.
• Revenue is recognised as cost incurred plus the profit for the year.
• The debit side of the revenue entry goes to Receivables, not cash.
• Cash receipts are recorded separately and reduce receivables as they arrive.

POC year by year

Assume the customer pays 10, 20, 30, 40 and 20 crore over five years, a total of 120.

Revenue is $120 \times 20\% = 24$ in year 1 and $120 \times 40\% = 48$ in each of years 2 and 3.

POC receivables run-off

The receivables line is the tell-tale of POCM. It builds to 60 by the end of year 3, when all the revenue has been booked but only half the cash has arrived, then unwinds to zero. Recognising revenue three years before the cash is collected is exactly why POCM is described as the aggressive method.

4.4 Completed Contract Method

A conservative alternative to POCM. Used when there is uncertainty about final project costs and profit. It delays revenue and profit recognition until the contract is completed, which makes it a close relative of the delivery method.

Entries during the contract

During the project:

• Costs incurred are debited to Work in Progress (WIP), an asset on the balance sheet. Nothing goes to the profit and loss account.
• Cash received from the customer is credited to Advances from Customers, a liability.

Entries on completion

On completion in year 3:

• WIP of 100 is transferred to Cost of Sales, reducing the WIP asset to zero.
• Revenue of 120 is recognised.
• Receivables are debited, and the Advances from Customers balance of 60 is transferred against them.
• Profit of 20 is realised entirely in the year of completion.

Remaining collections of 40 in year 4 and 20 in year 5 reduce receivables to zero.

4.5 Cost-First Recovery Method

A hybrid. Revenue recognition for long-term contracts that falls between the percentage of completion and completed contract methods. It is based on the timing of cost recovery: profit is recognised only after the total contract costs are recovered through cash collections.

Accounting during the project

Identical to the completed contract method while the costs are unrecovered:

• Cash receipts are credited to Advances from Customers (a liability).
• Expenses are debited to Work in Progress, increasing the WIP asset.

The recovery point

Given: project cost Rs. 100 crore, contract value Rs. 120 crore, collections of 10, 20, 30 and 40 crore in years 1 to 4.

Answer: the full profit of Rs. 20 crore is recognised in year 4, the year in which cumulative collections reach the total cost of 100.

Entries on recovery

At the recovery point:

• Revenue is credited.
• Receivables are debited.
• Advances from Customers is debited and transferred to Receivables.
• WIP is transferred to Cost of Sales.

Cost-first recovery year by year

Effect of collection timing

The timing of cash collections determines when profit is recognised. Earlier cost recovery leads to earlier profit recognition. Change nothing about the work done and simply front-load the payment schedule, and the profit moves years earlier. That sensitivity to a purely financial term of the contract is the method's defining feature.

On conservatism: recognising the full profit before the contract is complete and before costs are recovered would be aggressive. Where that is the concern, the POCM or the completed contract method is used instead.

4.6 Instalment Method

Use case: appropriate when there is a high risk of customers not paying the full amount or delaying payments.

Focus on cash received. Profit recognition is tied to the cash received in each instalment, not to the completion percentage of the project.

Given: contract value Rs. 120 crore, total estimated profit Rs. 20 crore.

Instalment method year by year

Instalments received are 10, 20, 30, 40 and 20 crore over five years.

WIP under the instalment method

The WIP account tracks costs incurred but not yet matched with recognised revenue. Over the project's life it rises as costs are incurred and falls as those costs are transferred to cost of sales with each instalment received. By the end of the project the WIP balance is zero.

The Deferred Gross Profit presentation

The WIP treatment above suits a long construction contract. For an ordinary instalment sale, where the product is delivered up front and cash comes in later, the lectures use a cleaner presentation built on two accounts: Instalment Accounts Receivable and Deferred Gross Profit.

Given: an air conditioner is sold for Rs. 60,000 on 1 January, collected in four quarterly instalments of Rs. 15,000 on 31 March, 30 June, 30 September and 31 December. Cost of goods sold is Rs. 48,000.

Entry on 1 January (the sale itself), with no revenue or profit recognised:

Entries on each instalment date, repeated four times:

Answer: Rs. 3,000 of profit is recognised each quarter, and both the receivable and the deferred gross profit run to zero on 31 December.

Memory hook: Deferred Gross Profit is a liability, not income. It is profit the business has earned commercially but is not yet allowed to report, and it is released to the profit and loss account only as cash arrives.

4.7 The four methods compared

A compressed mental model of the four long-contract methods, which is the fastest way to hold them in memory:

POCM: consider profit based on work completion every year, use a receivables account, receivables less expense equals profit, deduct the receivables as the customer pays back.

Completed Contract: transfer expenses to a WIP account till work is completed, and recognise the receipts each year in an advances account. Close the WIP account once the contract period is over and the work is completed, and at the same time recognise the revenue in a receivables account and close the advances account. Close the receivables account as the customer gradually pays back the receivable in further years.

4.8 Revenue Recognition and Conservatism: the anticipated loss

Conservatism is the guiding principle. POCM is aggressive because revenue is recognised even where nothing has been collected. The completed contract and cost-first recovery methods follow conservatism.

The real test comes when a project turns loss-making mid-execution. Continue the township example with one change: after spending 20 and 40 crore in the first two years, the company learns that another 70 crore is needed in year 3.

There is no provision in the contract to claim compensation from the customer. At the end of year 2 the 130 is only an estimate.

Can the accountant ignore it and wait for year 3? No. The conservatism concept requires recognising the loss the moment it becomes known. So the entire 10 crore loss must land in year 2, and any profit already booked must be reversed at the same time.

The anchor insight: POCM and Installment method are similar when it comes to adjusting for loss, and Completed contract and cost first recovery are similar.

That pairing is exactly right, and the arithmetic below shows why: the two methods that booked nothing in year 1 charge 10, and the two that booked something in year 1 charge 10 plus the reversal.

Completed contract and cost-first recovery

No profit was recognised in year 1 under either method, so there is nothing to reverse. A single entry recognises the whole loss.

Answer: the year 2 charge is exactly 10 under both methods.

The Provision for Estimated Loss sits on the liability side. In year 3, when the work in progress account is closed, the provision is adjusted against it and closed. The result is that year 3's income statement is unaffected by the loss, because the loss was already taken in year 2.

Percentage of completion

A profit of 4 was recognised in year 1, so it has to be reversed on top of the 10 loss.

Answer: the year 2 charge is 14 under the percentage of completion method. From year 3 onward revenue is set equal to expense so no further profit or loss arises.

Instalment method

A profit of 1.67 was recognised in year 1 on the collection of 10, so 1.67 must be reversed.

Revenue in year 2 is the collection of 20, so the expense entry must be $20 + 11.67 = 31.67$ to produce a loss of 11.67. Only 31.67 of the 40 spent in year 2 goes to the profit and loss account; the balance of 8.33 is added to WIP.

Answer: the year 2 charge is 11.67 under the instalment method. From year 3 the expense is set equal to the collection each year, so no further profit or loss arises, and WIP closes at zero.

The four year-2 charges side by side

Every method ends at a total loss of 10. Only the timing and the size of the year 2 hit differ.

Common trap: the note about this example being a poor illustration of instalment sales is worth remembering. A construction contract completed in year 3 should not still show WIP in years 4 and 5. The example is stretched only so that all four methods can be compared on one dataset.

4.9 Production Method and Input Method

Production method: recognises revenue when production is complete, even if the product is not yet sold. Rarely used because of price volatility, but justified when products are readily saleable at a known price, for example grains with a government-set support price or readily marketable metals. It creates an Accrued Revenue asset account. On the actual sale, cash increases and Accrued Revenue decreases.

Input method: used by some software companies on time-and-materials contracts. Revenue is recognised based on the input provided, that is engineer hours worked, not on project completion.

Given: a bank contracts with a software company for implementation at Rs. 1,000 per software engineer hour, total estimated hours 2,000, of which 800 hours are worked in year 1.

Answer: Rs. 8 lakhs of revenue in year 1.

4.10 Franchise Business

The model: a franchisor grants a franchisee the right to use its brand and products or services. The franchisor typically provides technology, equipment specifications, shop layout and design, and key ingredients.

The recognition challenge: when should the franchisor recognise the fee?

Given: the franchise agreement is signed and a fee of Rs. 20 lakhs collected on 20 March 2024. The franchisee opens for business on 1 July 2024. The franchisor's accounting period ends 31 March.

Answer: recognise the revenue on 1 July 2024, when the shop opens to the public. Neither signing the agreement nor collecting the fee completes the franchisor's obligation: the service of setting up the franchisee is not fully delivered until the shop opens. This follows conservatism and aligns the fee with the period in which the service was completed.

Ongoing revenue: royalties and ingredient sales are recognised as they occur, because that is when the franchisor earns the incremental revenue.

4.11 Consignment Sales

How it works: a consignor (producer or supplier) sends goods to a consignee (shop or agent) who sells them on the consignor's behalf. Unsold goods are returned. Ownership remains with the consignor until the goods are sold to the end customer. Publishing houses and milk producers are typical examples.

Profit is recognised only when the actual sales happen, not when goods are shipped to the consignee. Note also that all consignment entries are recorded at cost, never at the invoice value raised on the consignee, because the transfer is only a movement of the consignor's own inventory.

4.12 Provision for Doubtful Debts

Conservatism and matching. When some customers are expected to default, conservatism requires recognising the potential loss immediately. The matching concept requires aligning this expense with the revenue it relates to, that is the credit sales made in the same period.

Estimating bad debts. Provisions are based on estimates guided by industry norms, past experience, or a review of individual customer accounts where overdue payments are few.

Creating the provision. If receivables are Rs. 200 lakhs and the estimated bad debt rate is 5%:

Provision for Doubtful Debts is a contra-asset account. It reduces the net value of receivables on the balance sheet without touching the receivables ledger.

Writing off a bad debt when a specific customer is known to be insolvent, say one owing Rs. 2 lakhs:

Crediting receivables reduces the balance of receivables. Debiting the Provision for Doubtful Debts reduces the balance of that account, and because the provision is a contra asset, reducing it increases net assets by the same 2 lakhs. The two effects cancel exactly, which is why a write-off has no profit impact: the expense was taken when the provision was created.

Recovery of a written-off debt:

Any excess recovered beyond the amount originally written off increases cash and is recognised as Other Income. Bad Debt Expense is not credited when a bad debt is recovered.

Updating the provision. At each period end, reassess the provision needed against current receivables. Increase it by debiting Bad Debt Expense and crediting the provision. If it needs to fall, debit the provision and credit Bad Debt Expense (or revenue). Where the surplus is small, the course's advice is to leave it undisturbed; where it is large, release it.

4.13 Provision for Warranty

Purpose: to account for the estimated cost of future warranty claims on products sold, recognising the expense in the same period as the related revenue.

Estimation: based on past experience, industry standards and the specific warranty terms, expressed as a percentage of sales revenue.

Given: sales of Rs. 1,000 lakhs and an estimated warranty cost of 3%.

When actual warranty work is performed, say Rs. 3,000 of parts drawn from inventory:

No profit and loss impact in subsequent years. Reducing the provision reduces liabilities, which on its own would increase owners' equity; crediting inventory or cash reduces assets, which reduces owners' equity by the same amount. The two cancel. The expense was already recognised when the provision was created.

Updating the provision: reviewed and adjusted each year based on the estimated remaining warranty obligations. Crediting the provision increases the liability; debiting it reduces the liability.

4.14 Allowance for Sales Returns

Purpose: to account for potential sales returns, particularly for items sold near the period end that may be returned in the next period. It applies the matching concept by recognising a probable reduction in sales revenue in the period the sale was made.

Materiality: if estimated returns are small relative to total sales, no adjustment is needed. If the value is significant, a provision is created.

When returned goods are scrapped they are no longer an asset and must be removed from the balance sheet. Since scrapped inventory has no value, an expense is recorded, reducing profit, unless company policy charges such losses to the provision (see exercise 8 below, where it does).

4.15 Exercise 1: Mars Electronics, sales method against instalment method

Mars Electronics sells televisions, air conditioners and other electronics on six or twelve month instalment terms, at a 30% profit margin, so cost of sales is 70% of sales value. It currently uses the sales method and is considering the instalment method.

Under the sales method, revenue is 40,00,000, cost of sales is $40{,}00{,}000 \times 70\% = 28{,}00{,}000$ and profit is 12,00,000.

Under the instalment method, revenue is the collection of 35,20,000, cost of sales is $35{,}20{,}000 \times 70\% = 24{,}64{,}000$ and profit is 10,56,000.

Answer: switching to the instalment method reduces reported profit by Rs. 1,44,000. This is the more conservative treatment. It is warranted where collection is delayed or uncertain, because a default forces the company to repossess and resell the asset, usually at a loss. Where collection experience is strong, the sales method remains acceptable even for instalment sales.

4.16 Exercise 2: Space Construction, completed contract against percentage of completion

Space Construction follows the completed contract method. Amounts spent on incomplete projects are held as work in progress and expensed on completion. Incomplete work is normally about 10% of the amount spent in a year. The company has now won a Rs. 1,440 crore airport contract running three years, and spent Rs. 300 crore on it in the current year, pushing incomplete work up to 60% of the amount spent.

The company bids at a 20% profit margin on the contract value, which is the same as a 25% mark-up on cost:

Each row obeys the work in progress roll-forward.

(a) Completed contract method. Revenue follows the cost incurred on completed contracts, marked up 25%.

(b) Percentage of completion method. Revenue follows the amount spent in the year, marked up 25%.

Answer: total profit is almost identical (645 against 635.75, a difference of only 9.25, being 25% of the closing WIP of 37), but the profile is completely different. Under CCM, profit jumps from 75 to 387.5 in 2026, distorting the picture of how the business actually performs. Under POCM the profile rises smoothly from 50 to 212.5 as the company scales up. Because the business model has changed from small one-year projects to a mix including large multi-year projects, the recommendation is to switch to the percentage of completion method.

4.17 Exercise 3: Sigma Steels, flat provision against age analysis

Sigma Steels sells through several hundred wholesalers on 30 day credit and provides for doubtful debts at a flat 5% of year-end receivables. An audit committee member proposes an age analysis instead: 5% for receivables within 30 days, 8% for 31 to 45 days, 10% for 46 to 60 days and 100% beyond 60 days. At 31 March 2024 receivables are Rs. 200 crore and the provision balance is Rs. 8 crore.

(b) Age analysis.

Answer: Rs. 2 crore under the flat method, Rs. 4.56 crore under the age analysis.

The accounting entry in case (a) is Bad Debt Expense debit 2, Provision for Doubtful Debts credit 2, with the provision appearing as a minus 2 on the asset side as a contra asset.

The age analysis is more scientific and more conservative. A flat 5% would provide only 0.1 against the 2 crore that is already more than 60 days overdue, whereas the matching concept requires taking the full hit on receivables that are that far past due. Some of it may still be collected, but recovery is dealt with separately when it happens.

4.18 Exercise 4: Ashoka Travels, write-off and recovery

Ashoka Travels provides travel desk services on 30 day credit and provides at 2% of outstanding receivables. At 31 March 2023 receivables were Rs. 600 lakhs and the provision was Rs. 12 lakhs. In August 2023 a customer owing Rs. 8 lakhs shut down and the dues were written off on 31 August 2023. At 31 March 2024 receivables were Rs. 800 lakhs.

(a) Incremental provision for the year ended 31 March 2024.

(b) Recovery on 10 June 2024 of Rs. 6 lakhs out of the Rs. 8 lakhs written off.

Answer: the provision runs 12, less 8 written off, plus 12 created, plus 6 recovered, giving a balance of Rs. 22 lakhs. Note that only the incremental amount is ever charged to expense: if receivables next year were Rs. 1,500 lakhs, the required provision of 30 against a balance of 22 would need only 8 more. If receivables fell so far that the required provision were much lower than the balance, the surplus could be released back to income, but a small excess is normally left undisturbed.

4.19 Exercise 5: ATR Ltd, consignment sales with expired goods

ATR Ltd supplies ready-to-eat food to retailers through distributors on consignment basis at a 50% margin. Shelf life ranges from 5 to 60 days, and ATR bears the cost of expired stock. For the year ended 31 March 2024:

Answer: profit for the year ended 31 March 2024 is Rs. 260 lakhs.

(b) The accounting equation entries. Everything is recorded at cost, never at the invoice value, because the transfer is only a movement of ATR's own inventory.

Closing inventory with the consignee $= 400 - 300 - 40 = 60$, which is the cost of the 120 of invoice-value goods still within their expiry date.

4.20 Exercise 6: Digisoft, percentage of completion against cost-first recovery

Digisoft received a Rs. 600 crore order to develop and implement customer data analytics software over three years. Estimated expenses are 80, 150 and 150 crore, a total of 380, so the estimated profit is 220 crore. The customer pays 200 crore at the end of each of the three years.

Work in progress is zero throughout, because every rupee spent is expensed as incurred.

Common trap: the receivables balance here is negative, which means it is an advance from the customer, a liability. Digisoft is collecting faster than it is recognising revenue. Do not force a negative into an asset line.

(b) Cost-first recovery method.

In year 1 no profit is recognised, so the 80 spent stays in WIP and the 200 received sits as an advance.

In year 2 cumulative collections of 400 exceed the total contract cost of 380, so recognition switches on. The full 220 cannot be taken, because the project is not finished. The company therefore reverts to the percentage of completion basis for the work done so far:

which is exactly the sum of the POCM profits for years 1 and 2 ($46.32 + 86.84$). Revenue is $230 + 133.16 = 363.16$ and WIP falls to zero.

In year 3 the balance is recognised: $220 - 133.16 = 86.84$.

Answer: POCM gives profits of 46.32, 86.84 and 86.84; cost-first recovery gives 0, 133.16 and 86.84. Cost-first recovery sits between the aggressive POCM, which books profit before any cash arrives, and the conservative completed contract method, which would book nothing until year 3 despite the full amount having been collected.

4.21 Exercise 7: XCool, provision for warranty

XCool sells refrigerators, air coolers and air conditioners with a five-year warranty and provides at 10% of sales value. At 1 April 2023 the provision stood at Rs. 400 lakhs. Sales for 2023-24 were Rs. 6,000 lakhs. During the year Rs. 80 lakhs was spent on warranty work: Rs. 60 lakhs on components and Rs. 20 lakhs on service engineers' salary and travel.

Provision for Warranty Expenses Account

Answer: the closing provision is Rs. 920 lakhs.

Because the warranty runs five years, the company does not net the new provision against the old balance. The 400 brought forward covers items sold in earlier years that are still under warranty, and the 600 created this year covers the current year's sales for the next five years. A periodic reconciliation, taking 10% of all sales still under warranty and comparing it with the balance, can be done every few years rather than annually.

4.22 Exercise 8: Sigma Traders, allowance for sales returns

Sigma Traders sells through online portals, pricing at cost plus 10% to 20%. Customers may return defective or non-conforming goods within seven days, and the company provides at 5% of sales. At 1 April 2023 the provision stood at Rs. 10 lakhs. For 2023-24, cash sales were Rs. 2,000 lakhs with cost of sales of Rs. 1,700 lakhs. Customers returned goods sold for Rs. 120 lakhs (cost Rs. 100 lakhs) and were refunded. Of the returned goods, Rs. 50 lakhs of cost was resold for Rs. 52 lakhs, Rs. 40 lakhs of cost was resold for Rs. 35 lakhs, and Rs. 10 lakhs of cost was scrapped. These resales were not part of the Rs. 2,000 lakhs. Losses on returned sales are charged to the Provision for Sales Returns.

Answer: profit for 2023-24 is Rs. 182 lakhs and the closing Provision for Sales Returns is Rs. 95 lakhs.

Memory hook: the gain of 2 lakhs on resale 1 is left in the profit and loss account of the year it arose; only losses are charged to the provision. That asymmetry is deliberate, and it is the reason the expense line for resale 2 shows 35 rather than 40: the 5 loss went to the provision, not to profit. The scrap of 10 likewise never touches the profit and loss account.

The purpose of the 95 carried forward is precisely to absorb losses on next year's returns, so that the cost of returning this year's sales does not fall on next year's profit.

4.23 Module Summary

• Revenue is recognised when performance obligations are fulfilled, consideration is measurable and realisation is reasonably certain. An order is not enough, an advance is not enough, and doubtful collection defers recognition even after delivery.
• The four long-contract methods differ only in the trigger: work completed (POCM), contract completed (CCM), cost recovered (cost-first recovery), cash collected (instalment). Total profit is always the same; only the profile changes.
• Ranked by aggressiveness: POCM, cost-first recovery, completed contract. The instalment method is conservative on collection risk specifically.
• On an anticipated loss, conservatism requires the whole loss to be taken the moment it is known. Methods that booked nothing in year 1 charge the loss alone; methods that booked profit charge the loss plus the reversal.
• Provisions for doubtful debts, warranty and sales returns all follow the same shape: create the expense in the period of the sale, then consume the provision in later periods without touching profit again.