Adjusted cost revenue

What Is Adjusted Cost Revenue?

Adjusted cost revenue refers to the portion of a total contract or project revenue that is recognized by a business based on the costs incurred relative to the total estimated costs. This concept is central to specific methods within financial reporting and accounting principles, particularly for long-term contracts where revenue is earned over time rather than at a single point of sale. Rather than simply reflecting the total income from a sale, adjusted cost revenue links the recognition of revenue directly to the progress of a project, which is often measured by the expenditures made.

This approach ensures that revenue recognition aligns with the matching principle, where expenses are recognized in the same period as the revenues they help generate. Adjusted cost revenue helps companies accurately portray their financial performance, especially when dealing with complex projects that span multiple accounting periods and involve significant, ongoing costs.

History and Origin

The evolution of accounting standards, particularly those governing revenue recognition, has significantly shaped the concept of adjusted cost revenue. Historically, companies often recognized revenue only upon the completion of a contract or project, which could misrepresent financial performance for long-term endeavors. As businesses engaged in more complex and extended contracts, a need arose for methods that would allow for more timely and accurate reporting of financial progress.

This led to the development and widespread adoption of methods like the percentage-of-completion method, where revenue and associated costs are recognized proportionally as work progresses. The Financial Accounting Standards Board (FASB) in the U.S. and the International Accounting Standards Board (IASB) globally, converged their revenue recognition guidance in 2014, issuing Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (ASC 606), and International Financial Reporting Standard (IFRS) 15, respectively⁷, ⁸. These standards emphasize a five-step model for revenue recognition, moving away from prescriptive rules to a principles-based approach that focuses on the transfer of control of goods or services to the customer⁵, ⁶. IFRS 15, for instance, specifically includes requirements for accounting for costs related to a contract with a customer, which are recognized as an asset if certain criteria are met, directly influencing the adjusted cost revenue calculation⁴. The Securities and Exchange Commission (SEC) has also provided extensive guidance on revenue recognition, including how costs relate to performance obligations³.

Key Takeaways

• Adjusted cost revenue is the portion of total contract revenue recognized based on costs incurred, often in long-term projects.
• It aligns revenue recognition with the progress of a project, usually measured by expenditures.
• This method is crucial for proper accrual accounting and matching revenues with expenses.
• It is particularly relevant under modern revenue recognition standards like ASC 606 and IFRS 15 for contracts satisfied over time.
• Calculating adjusted cost revenue helps provide a more accurate picture of a company's financial health in interim financial statements.

Formula and Calculation

Adjusted cost revenue is most commonly calculated using the percentage-of-completion method, especially when costs are the chosen measure of progress. The formula for recognizing adjusted cost revenue in a period is:

Where:

• Costs Incurred to Date represents the actual expenditures on the project up to a specific reporting period. These include direct costs like labor and materials, and allocated indirect costs.
• Total Estimated Costs is the projected total cost to complete the entire contract or project.
• Total Contract Revenue is the agreed-upon total revenue for the entire contract with the customer, also known as the transaction price.

This calculation effectively determines the "percentage complete" of a project based on its cost input, and then applies that percentage to the overall contract revenue to arrive at the adjusted cost revenue to be recognized for the period.

Interpreting the Adjusted Cost Revenue

Interpreting adjusted cost revenue involves understanding the relationship between a project's expenditures and its recognized income. When a company uses this method, an increasing adjusted cost revenue figure typically indicates that the project is progressing and a proportional amount of the total gross profit is being earned. This approach provides a more realistic representation of a company’s financial activity for long-term projects, as opposed to recognizing all revenue and profit only upon project completion.

For example, if a project is 30% complete based on costs incurred, 30% of the total contract revenue would be recognized as adjusted cost revenue. This allows stakeholders to see the ongoing financial performance, rather than waiting until the end of a multi-year project to assess its profitability. It is essential for managing contract assets and contract liabilities that arise from these long-term arrangements.

Hypothetical Example

Consider "Bridge Builders Inc." which secured a contract to construct a municipal bridge for a total contract revenue of $10,000,000. The estimated total cost for the project is $8,000,000. The project is expected to take three years.

In the first year, Bridge Builders Inc. incurs costs of $2,400,000.

1. Calculate Percentage Complete:

   $$\text{Percentage Complete} = \frac{\text{Costs Incurred to Date}}{\text{Total Estimated Costs}} = \frac{\$2,400,000}{\$8,000,000} = 0.30 \text{ or } 30\%$$

2. Calculate Adjusted Cost Revenue for Year 1:

   $$\text{Adjusted Cost Revenue} = \text{Percentage Complete} \times \text{Total Contract Revenue} = 0.30 \times \$10,000,000 = \$3,000,000$$

For the first year, Bridge Builders Inc. would recognize $3,000,000 as adjusted cost revenue on its income statement. The corresponding cost of goods sold for the period would be the $2,400,000 incurred costs, resulting in a gross profit of $600,000 for that year. This method allows for a steady recognition of income and expenses over the project's life, providing a clearer picture of the company's annual net income.

Practical Applications

Adjusted cost revenue is particularly relevant in industries characterized by long-term projects or service contracts, such as construction, aerospace and defense, and certain software development firms. In these sectors, projects often span multiple reporting periods, making it impractical and misleading to wait for full completion to recognize revenue.

• Project-Based Businesses: Construction companies, for instance, use this approach to recognize revenue as they complete stages of building, tying the recognized revenue to the progress achieved, often measured by variable costs and fixed costs incurred.
• Government Contracts: Entities undertaking large government projects, which can last for years, often rely on adjusted cost revenue calculations to provide regular financial updates.
• Service Industries: Professional services firms with large, multi-year engagements may also apply this concept to accurately reflect earned revenue over the service period.
• Financial Reporting and Disclosure: Companies must disclose their revenue recognition policies, including how they account for costs to obtain or fulfill a contract under current accounting standards. ²This provides transparency to investors regarding how adjusted cost revenue figures are derived.

Limitations and Criticisms

While beneficial for long-term projects, the adjusted cost revenue approach, particularly through the percentage-of-completion method, has its limitations. A significant challenge lies in the estimation of total costs and project completion. If the initial estimates for total project costs are inaccurate, the recognized adjusted cost revenue and profit could be overstated or understated in early periods, requiring material adjustments in later periods. Such revisions can impact the reliability of a company's balance sheet and income statement.

Another criticism relates to the subjectivity inherent in estimating completion. While costs incurred offer an objective measure, external factors, unforeseen challenges, or changes in project scope can alter total estimated costs, making the "adjustment" dynamic and potentially prone to manipulation or significant error. The Securities and Exchange Commission (SEC) emphasizes that revenue should not be recognized until it is "realized or realizable and earned," which requires substantial accomplishment of performance obligations. ¹This highlights the need for robust internal controls and careful judgment when applying methods that rely on estimates to determine adjusted cost revenue. Furthermore, under the new revenue recognition standards (ASC 606 and IFRS 15), the focus is on the transfer of control, which might sometimes differ from a pure cost-based percentage of completion, especially for distinct performance obligations within a larger contract.

Adjusted Cost Revenue vs. Revenue Recognition

Adjusted cost revenue is not a standalone concept but rather a specific mechanism within the broader framework of revenue recognition.

While adjusted cost revenue specifically deals with how costs drive the recognition of a portion of total revenue, the general principle of revenue recognition dictates the fundamental criteria (like identifying a contract, defining performance obligations, and determining the transaction price) that must be met before any revenue, including adjusted cost revenue, can be recorded.

FAQs

What types of businesses commonly use adjusted cost revenue?

Businesses involved in long-term contracts, such as construction companies, aerospace and defense contractors, and certain software development firms, commonly use methods that result in adjusted cost revenue. This is because their projects often span multiple reporting periods, making it necessary to recognize revenue as work progresses.

How does adjusted cost revenue relate to the matching principle?

Adjusted cost revenue strongly aligns with the matching principle of accrual accounting. It ensures that the costs incurred to generate revenue are recognized in the same period as the portion of revenue earned, providing a more accurate measure of profitability for ongoing projects.

Is adjusted cost revenue the same as gross profit?

No, adjusted cost revenue is not the same as gross profit. Adjusted cost revenue is the portion of the total contract revenue recognized in a period. Gross profit, on the other hand, is calculated by subtracting the cost of goods sold (or costs incurred for a service) from the recognized adjusted cost revenue in that period.

What happens if the estimated total costs change during a project?

If the estimated total costs change during a project, the percentage of completion will need to be re-evaluated, leading to an adjustment in the recognized adjusted cost revenue in the current and future periods. These changes are typically accounted for prospectively, meaning the cumulative impact is spread over the remaining life of the contract, rather than restating prior periods. Such revisions can impact deferred revenue and other balance sheet accounts.

Are there alternatives to recognizing adjusted cost revenue based on costs?

Yes, other methods exist within revenue recognition for contracts satisfied over time. The "efforts-expended" method might measure progress based on labor hours or machine hours rather than costs. Another approach, common for certain services, recognizes revenue ratably over the contract term if performance obligations are satisfied evenly over time. The "completed contract method" recognizes all revenue and costs only upon project completion, but this is typically used for shorter-duration projects or when outcomes cannot be reliably estimated.