Navigating Revenue Recognition under U.S. GAAP for the FAR CPA Exam
Kyle Ashcraft, CPA · 2019 CPA Exam Scores · 95 FAR · 98 BEC · 91 REG · 90 AUD
Revenue recognition determines when and how a company records revenue — a critical piece of understanding financial performance, and a well-tested topic on the FAR section of the CPA exam.
What is the five-step revenue recognition model?
Under U.S. GAAP, revenue is generally recognized when:
- A contract with a customer exists
- Performance obligations are identified
- The transaction price is determined
- The transaction price is allocated to performance obligations
- Revenue is recognized when (or as) the performance obligation is satisfied
Example: sale of goods. Company A sells 100 units of a product at $20 each.
- Debit Accounts Receivable $2,000
- Credit Revenue $2,000
How does the percentage-of-completion method work?
Construction contracts often span multiple reporting periods, which is why long-term contracts commonly use the percentage-of-completion method to recognize revenue as work progresses, rather than waiting until the project is finished.
Worked example: a construction contract
Company B secures a construction contract worth $500,000, with total estimated costs of $400,000. By the end of Year 1, it has incurred $200,000 in costs — 50% complete ($200,000 ÷ $400,000).
Entry 1 — recording construction costs:
- Debit Construction in Progress $200,000
- Credit Cash or Accounts Payable $200,000
Entry 2 — recognizing revenue and gross profit: the gross profit is $250,000 revenue − $200,000 cost = $50,000. This entry never touches Accounts Receivable — that's what the billing entry is for.
- Debit Cost of Construction $200,000
- Debit Construction in Progress $50,000 (the gross profit)
- Credit Revenue from Long-Term Contracts $250,000
Entry 3 — recording billings (say $230,000 was billed):
- Debit Accounts Receivable $230,000
- Credit Billings on Construction in Progress $230,000
How do you tell over-billing from under-billing?
The amount billed to a customer doesn't always match the revenue recognized. Comparing the two tells you whether a contract is over-billed or under-billed:
- Over-billing — Billings on Construction in Progress exceed the full Construction in Progress balance (a liability)
- Under-billing — Billings on Construction in Progress are less than the full Construction in Progress balance (an asset)
The key is that Construction in Progress accumulates both costs incurred and gross profit recognized to date — not costs alone.
Example, continued: Construction in Progress = $200,000 costs + $50,000 gross profit = $250,000. Billings were $230,000.
- Construction in Progress balance: $250,000
- Billings on Construction in Progress: $230,000
- Net: under-billed by $20,000 (presented as a current asset — "costs and recognized profit in excess of billings")
Comparing billings only to raw costs ($230,000 vs. $200,000) would wrongly suggest a $30,000 over-billing — that comparison leaves out the $50,000 of gross profit already recognized.
What must be disclosed?
U.S. GAAP requires various revenue recognition disclosures, including revenue disaggregation, contract balances, and the transaction price allocated to remaining performance obligations.
Revenue recognition and billing are two separate events with two separate journal entries. Recognizing revenue moves Construction in Progress and Revenue; billing moves Accounts Receivable and Billings on Construction in Progress. Comparing the two tells you whether a contract is over- or under-billed — but only if you compare against the full CIP balance, profit included.
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Kyle Ashcraft, CPA scored 90 or above on every section of the CPA exam in 2019, including a 95 on FAR. He is the founder and sole instructor of Maxwell CPA Review, a complete CPA review course covering all six sections, where he creates every lecture, textbook and study outline himself.
