Revenue Recognition: Produce to order under production or construction contracts

Companies that produce to order under production or construction contracts often attempt to spread prospective revenues, related costs, and resulting net income over the life of the contract in proportion to the work accomplished. The method used to accomplish this spreading of revenues, costs, and income is called the percentage of- completion or production method. •Sales Basis. The sales (or accrual) basis is the most widely used method for recognizing revenues. Revenues are assumed to be earned at the time the sale is made, even though the cash may not have been collected from customers.

For companies that produce to open stock, the sale is the critical event for revenue recognition. Even though value is added to goods through the production process, these companies face considerable uncertainty about who the customer will be and about the amount and timing of the sale. It is necessary to have an arm’s length transaction, in which the customer is legally obligated to pay for the merchandise or service. Such factors as the signing of a sales contract and the delivery of the product provide evidence that the sale has been made.

At the time of the sale, revenue is recognized and the amount due from the customer is reflected as an asset such as accounts receivable. •Cash Receipts Basis. In some cases, the receipt of cash is considered to be the critical event for revenue recognition. There are three reasons for using the cash receipts basis. First, for some taxpayers, the use of the cash receipt basis is allowable for computing taxable income and may result in some postponement of tax payments. Second, when collection from customers is regarded as very uncertain, the cash receipts basis may be the best indication of actual revenues.

Finally, the cash receipts basis is more conservative than the sales basis. It is important to realize that when the cash receipts basis of revenue recognition is used, the product must also have been delivered to customers before revenue is recognized. Thus, if cash is received in advance (such as with magazine subscriptions), the receipt of cash would not be considered sufficient evidence for recognizing revenue. Reference link: http://classof1. com/homework-help/finance-homework-help