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The Revenue Principle of GAAP requires Revenue to be recorded in the period it is Earned regardless of when it is billed or when cash is received.
In some cases, it is simple to determine the timing for Revenues Earned, once ownership of a product is transferred or a service is complete, revenue is considered to have been earned. But if revenue recognition were delayed until the end of a long term contract, the Matching Principle of tying revenues and their direct costs to each other would be violated. The solution to this problem is the Percentage of Completion method of Revenue Recognition.
Contract Revenues are tied to Costs, but Billings on Contracts are not always tied to Costs. Sometimes elements of a contract are billed in advance or sometimes they are delayed by mutual agreement (or disagreement). This mismatch between actual billed revenue and earned revenue will require an adjusting entry but since the Percentage of Completion method adjusts billed revenue to reflect earned revenue, billings are posted to revenues and adjusted later to reflect the correct earned revenue amount. (Debit Accounts Receivable, Credit Sales).
Long Term Contracts will have estimates for both sides of a contract, Costs and Revenues. Calculating Percentage of Completion requires both total actual and total estimated numbers to calculate a percentage so it uses the side where both the actual and estimated numbers can be known, Costs.
- Percent Complete = Actual Costs to Date / Total Estimated Costs
The Percent Complete is then applied to the Total Estimated Revenue to determine Earned Revenue to Date.
- Earned Revenue to Date = Percent Complete * Total Estimated Revenue
Finally, the Earned Revenue to Date is compared to the Billings on Contract to Date. The difference is either added to or subtracted from the Revenue.
- Earned Revenue to Date – Total Billings on Contract = Over/Under Billed Revenue
The Over/Under Billed Revenue accounts are Balance Sheet Accounts and they are often called either Billings in Excess of Costs (liability account that reflects over-billings) or Costs in Excess of Billings (asset account that reflects under-billings).
Work In Progress Statement:
**disclaimer: All information posted on this blog is from my own experience and training. The guidelines I present are general and in my experience, standard practice. I do not write with authority from any Accounting Standards Boards.