Definition
The term revenue recognition during production refers to the process of recording revenue as various milestones in a project are reached. The revenue recognition principle states a company can record revenue when they are realized or realizable and earned. Under certain conditions, a company may be able to record revenue before the product is delivered to a customer.
Generally, the accepted methods for recognizing revenue during production include the percentage-of-completion and completed-contract approach.
Explanation
The FASB Concept Statement No. 5 states that companies cannot recognize revenues as being earned until two conditions are met. They must be realized or realizable, which means the goods or services have been exchanged for cash or claims of cash (credit), or realizable if the transaction involves an asset that can be converted to a known amount of cash. They must also be earned, which means the company has substantially completed what it needs to do in order to be entitled to payment.
Revenue can be recognized at the point of sale, before, and after delivery, or as part of a special sales transaction. Long-term projects oftentimes require the buyer to make payments as certain milestones are reached. This is a common arrangement in the construction and other heavy equipment industries that might involve customized projects or products that can take years to complete or build.
Two common approaches to recognizing revenue during production include:
Percentage-of-Completion Method: this approach recognizes revenues and costs each accounting period as the project progresses. Calculations used in this method are usually based on the ratio of incurred costs to total costs.
Completed-Contract Method: in this approach revenue is only recognized when the project is completed. Costs and billings are accumulated on the balance sheet over the course of the project, but there is no transfer to the income statement until the project has been delivered to the buyer.
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