ACCT2511
Financial Accounting
Fundamentals
Topic 6
Revenue and Expense
Recognition
Mia Han
UNSW Business School
School of Accounting, Auditing & Taxation
Lecture Learning objectives
1. Explain the criteria used to decide when income should be recognised
2. Explain the criteria used to decide when expenses should be
recognised
3. Calculate the amount of income and revenue that should be recognized
in a particular period
4. Calculate the impact on profit of different revenue recognition methods
5. Understand the contents of an income statement
6. Understand the contents of a statement of changes in equity
7. Understand the concept of what-if analysis
Key Components of a Company Annual Reports
•Management Discussion & Analysis
•Structure of Board of directors
•Remuneration of directors, corporate governance
Financial Statements
Income
Statement
• revenues
• expenses
Balance Sheet
• assets
• liabilities
• shareholders’
equity
Notes to the Financial Statements
Statement of
changes in
equity
Statement of
Cash Flows
Auditor’s Report
LO 1.2
Lecture outline
1.
2.
3.
4.
5.
Definition and recognition of Income
Definition and recognition of Expenses
Content of Income Statement
Content of Statement of changes in equity
What-if analysis
Determining Profit
 The only way to accurately determine profit is to wait
until at the end of the enterprise’s life
• Reliable
• Not timely
• Not decision relevant
 Periodic profit
• Divide the lifetime profit into periodic profit
• Timely & decision relevant
• But greater uncertainty & requires more judgment
 Trade-off between reliability and relevance
Profit-making activities
– Think of an idea.
– Build/buy the warehouse
– Buy or make the inventory
– Advertise the product
– Deliver the product.
– Bill the customer.
– Collect the cash.
– Provide warranty service.
– Sell the product.
At what point is revenue recognised?
o The most common critical point is the point of delivery of
the goods or services to the customer.
1) Commence
a business
9) Receive
cash
8) Deliver
goods/services to
customers
7) Receive orders
after production
6) Completion
of production
2) Make
purchases
3) Receive
orders before
production
4) Start
production
5) Progressively
throughout
production
When have goods/services been delivered?
•
•
•
McDonald’s?
Qantas?
Myer?
Income: Definition
LO1
“increases in economic benefits during the accounting period… that results in
increases in equity, other than those relating to contributions from owners (AASB
Framework, paragraph 70)… and encompasses both revenue and gains (AASB
Framework, paragraph 74)”
Essential characteristics:
• Increases in economic benefits
• results in increases in equity
• other than contributions from owners
Income = Revenue (ordinary course of business)
+ Gain (not ordinary course of business)
LO1
Example (1)
A store sells a can of drink for $1.50.
• Inflow of economic benefits.
• Increase in assets (cash).
• Increase in equity (E = A – L).
Revenue or not?
LO1
Example (2)
The company borrows $1 million from the bank.
• Inflow of future economic benefit.
• Increase in assets (cash).
• Increase in liabilities (loan).
• No change in equity.
Revenue or not?
LO1
Example (3)
The company issues shares and receives $1 million from
shareholders
• Increase in assets (cash)
• Increase in equity (share capital)
Revenue or not?
Revenue recognition: 5-step model
1.
2.
3.
4.
LO1
Identify the contract with customers
Identify the separate performance obligations of the contract
Determine the transaction price of the contract
Allocate the transaction price to the performance obligations in the
contract
5. Recognise revenue when performance obligations are satisfied
Revenue recognition methods
• Point of delivery
• At some point after delivery
• When cash is received
LO1
LO2
Revenue recognition methods
• Point of delivery
• At some point after delivery
• When cash is received
• Over time: during production (% of completion
method)
• On completion of production
LO1
Over time (% of completion)
LO1
LO3
•
Point of delivery for construction work can be years in the future
•
There can be years with no profit and then all of sudden a year with high
profit.
•
We can consider recognising revenue during production.
Over time (% of completion)
LO1
LO3
• Determine what proportion of the project has been completed
• Recognise that proportion of expected revenue, expenses and profit
• Proportion completed is often measured using incurred costs
total costs needs to be reasonably determinable,
the contract price must be reasonably certain,
and there must be reasonable assurance of payment.
Revenue recognition methods
• Point of delivery
• At some point after delivery
• When cash is received
• Over time: during production (% of completion
method)
• On completion of production
LO1
Revenue for Construction projects:
LO1
LO3
Eiffel Ltd has a three-year project to complete a tower for UNSW.
• total revenue is estimated as $8 million and
• costs estimated as $6 million.
• the project was estimated to be completed as follows:
2019
20%
2020
70%
2021
100%
2019
2020
2021
Percentage of completion
method
On completion method
Revenue recognised:
20%*8 mil=1.6 mil
Expenses recognised:
20%*6 mil=1.2 mil
Profit 0.4 mil
Revenue recognised: 0
Revenue recognised:
(70%-20%)*8 mil =4 mil
Expenses recognised:
(70%-20%)*6 mil=3 mil
Profit 1 mil
Revenue recognised: 0
Revenue recognised:
(100%-70%)*8 mil=2.4 mil
Expenses recognised:
(100%-70%)*6 mil=1.8 mil
Profit 0.6 mil
Revenue recognised: 8 mil
Expenses recognised: 0
Profit 0
Expenses recognised: 0
Profit 0
Expenses recognised: 6 mil
Profit 2 mil
A construction company is building an apartment building. Based on previous
experience, the project will take 3 years to complete: 20% completed in year
1, 70% completed in year 2, and 100% completed in year 3.
The stage of completion and the costs of the project can be measured
reliably at the end of each financial period.
When should revenues be recognized?
A. During production
B. On completion
Airbus is building an aircraft for the government for a new military project.
As this is the first time they implement a new design and specifications,
there are significant uncertainties with the outcome of the project.
The stage of completion and the costs of the project cannot be measured
reliably at the end of each financial period.
When should revenues be recognized?
A. During production
B. On completion
Revenue for services
• Same 5-step revenue recognition process
1.
2.
3.
4.
Identify the contract with customers
Identify the separate performance obligations of the contract
Determine the transaction price of the contract
Allocate the transaction price to the performance obligations in the
contract
5. Recognise revenue when performance obligations are satisfied
On 1 March 2022, a customer paid Akira Advisory Ltd. $12,000 in cash
for consulting services ($1,000 for each month) to be provided in the next
12 months.
How much revenues should be recognized on 1 March 2022?
A. No revenues
B. $12,000 revenues
On 1 March 2022, a customer paid Akira Advisory Ltd. $12,000 in cash for
consulting services to be provided in the next 12 months. ($1,000 for each
month)
How much revenues should be recognized for the year ended 30 June 2022?
A. $4,000 revenues
B. $12,000 revenues
Subscription service example - Netflix
Netflix charges monthly fees for their streaming services. Customers are billed in
advance at the start of the month. For example, a customer signed up for a
standard Netflix subscription on 1 July. $16.99 will be charged to the customer’s
bank account on the 1st of every month. When should Netflix recognise revenue?
A. On the 1st of every month when $16.99 is received
B. At the end of every month
C. Only during the months that the customer watches at least one movie
When do you think Netflix has satisfied their performance obligations?
Lecture outline
1. Definition and recognition of Income
2. Definition and recognition of Expenses
3. Content of Income Statement
4. Content of Statement of changes in equity
5. What-if analysis
Expenses: Definition
“… decreases in economic benefits during the
accounting period … other than the owners’
distributions” (AASB Framework, para 70)
Essential characteristics:
• Decreases in economic benefits
• Other than the owners’ distributions
LO2
LO4
Expenses: Recognition
LO2
LO4
Recognition (AASB Framework, para 94):
• Decrease in future economic benefits, whether decrease in asset or
increase in liability
• Can be measured with reliability
LO2
LO4
Example (1)
Wages paid to a shop assistant.
• Economic benefits consumed.
• Decrease in an asset (cash).
• Decrease in equity (E = A – L).
Expense or not?
LO2
LO4
Example (2)
Purchase of a machine.
• Consumption of economic benefits.
• Decrease in assets (cash).
• Increase in assets (machine).
• No change in equity.
Expense or not?
LO2
LO4
Example (3)
Depreciation of $200 000
• Economic benefits consumed
• Decrease in assets (via accumulated depreciation)
• Decrease in equity (E = A – L)
Expense or not?
LO2
LO4
Example (4)
Dividends paid.
• Distribution to owners.
• Equity decreases, Asset of cash decreases.
Expense or not?
Capitalise v. expense (from COMM1140)!nexample
It is an asset if...
AASB Framework: characteristics:
• Future economic benefit
• Control
• Past event or transaction
AASB Framework: recognition criteria
• Probable
• Reliable measurement
…otherwise its an expense
LO2
LO4
Matching Principle
The matching principle states that a company must
“match” expenses with the revenues produced during the
current period.
1. Sales of Product – e.g. mobile phones
DR Cash/Accounts Receivable XX
CR Sales Revenue XX
DR COGS
CR Inventory
3. Later on when customers return the
phones under the warranty:
DR Provision for Warranty XX
CR Cash or Inventory XX
XX
XX
2. The company offers a warranty:
DR Warranty Expense XX
CR Provision for Warranty XX
We match Sales Revenue to
Expenses
Some more examples of matching principle
LO2
LO4
• Match warranty expense into the same period for when
revenue is recognised.
• Match COGS into the same period as revenue is recognised
for selling those goods.
• Match depreciation expenses of non-current assets into
periods where those non-current assets assist in earning
revenues.
Lecture outline
1. Definition and recognition of Income
2. Definition and recognition of Expenses
3. Content of Income Statement
4. Content of Statement of changes in equity
5. What-if analysis
Income statement
LO5
Major line items:
•
•
•
•
revenues
expenses
financing costs expense
shares of net profits or losses of associates and joint ventures
Income statement, cont.
•
•
•
•
LO6
income tax expense
net profit or loss
net profit or loss attributable to outside equity interest
net profit or loss attributable to members of the parent entity
XYZ Limited
Income Statement
for the year ended 30 June 2022
Revenues
Cost of sales
LO5
X
(X)
Gross profit
X
Other income
X
Other expenses (excluding financing expenses)
(X)
Financing expenses
(X)
Share of net profits/losses of associates and joint ventures
X
Profit/Loss before tax
X
Income tax expense
(X)
Net profit/loss
X
Net profit/loss attributable to outside equity interests (non-controlling interests)
X
Net profit/loss attributable to members of parent entity
X
Significant items
LO5
•
When a revenue or an expense from ordinary activities is of such size,
nature or incidence that its disclosure is relevant in explaining the
financial performance of a company
•
its nature and amount must be disclosed separately in the notes in the
financial report. These are normally referred to as individually
significant items.
Significant items (cont.)
LO5
Some circumstances that may give rise to the separate disclosure of significant
items:
the write-down of inventories or noncurrent assets
litigation settlements
restructuring of operations
disposal of items of PPE.
Expenses classified by:
LO5
A. Nature of expense method
• Expenses are aggregated in the income statement according to
their nature (for example, depreciation, purchases of materials,
transport costs, employee benefits and advertising costs),
• and are not reallocated among various functions within the entity.
• simple to apply because no allocations of expenses to functional
classifications are necessary.
LO5
Nature of expense method
An example of a classification using the nature of expense method is
as follows:
Revenue
Changes in inventories
Materials
Rent expenses
Salary expenses
X
X
X
X
Depreciation and amortisation expenses
Utilities expenses
Other expenses
X
X
X
Total expenses
Profit before income tax
X
(X)
X
Expenses classified by (Cont):
LO5
B. Function of expense or ‘cost of sales’ method
• classifies expenses according to their function as part of cost of sales or,
for example, the costs of distribution or administrative activities.
• At a minimum, an entity discloses its cost of sales under this method
separately from other expenses.
• This method can provide more relevant information to users than the
classification of expenses by nature
• allocating costs to functions may require arbitrary allocations and involve
considerable judgement.
LO5
Function of expense or ‘cost of sales’ method
An example of a classification using the function of
expense method is as follows:
Revenue
Cost of sales
X
(X)
Gross profit
X
Selling and Distribution expenses
Administrative expenses
Other expenses
Profit before income tax
(X)
(X)
(X)
X
Woolworths Ltd 2020 Income Statement
LO5
Lecture outline
1. Definition and recognition of Income
2. Definition and recognition of Expenses
3. Content of Income Statement
4. Content of Statement of changes in equity
5. What-if analysis
Statement of Changes in Equity
affecting
shareholders’
LO6
•
summarises transactions
accounting period.
equity
during
an
•
“bridge the gap” between Income Statement and the amount of
equity/capital on the Balance Sheet.
•
helps to complete the picture of the company’s financial activities for an
accounting period.
•
Equity is usually affected by
 Shareholders’ contributions
 Net profit/loss
 Distributions to shareholders
Statement of changes in equity – a ‘matrix’ format
statement
Opening balance
Share
capital
X
Retained
profits
X
Other
reserves
X
Total equity
X
Changes in equity for the
year
Issue of share capital
Dividends
Profit/Loss for the year
Revaluation
X
Closing balance
X
X
X
X
X
X
X
X
X
X
X
LO6
Lecture outline
1. Definition and recognition of Income
2. Definition and recognition of Expenses
3. Content of Income Statement
4. Content of Statement of changes in equity
5. What-if analysis
‘What-if’ analysis
LO7
• The ability to analyse accounting information to tell managers, bankers,
analysts and others what difference accounting policy choices or
business decisions make to the financial statements.
• Used by analysts and bankers to compare with other entities who use
different accounting policies.
• Used by managers in deciding upon accounting policies and particular
business decisions.
What-if analysis
LO7
•



What would happen to:
net profit
balance sheet numbers
financial ratios
•



If we change the accounting policy choices such as:
Inventory cost flow assumption (FIFO versus weighted average?)
Depreciation assumption (10 yrs versus 20 yrs?)
Revenue recognition method (completed contract method versus
percentage of completion method)
What-if: completed contract method versus percentage of
completion method
Eiffel Ltd has a three year project to complete a tower for UNSW.
• total revenue is estimated as $8 million and
• costs estimated as $6 million.
• the project was estimated to be completed as follows:
2019
20%
2020
70%
2021
100%
2019
2020
2021
Percentage of completion
method
On completion method
Revenue recognised:
20%*8 mil=1.6 mil
Expenses recognised:
20%*6 mil=1.2 mil
Profit 0.4 mil
Revenue recognised: 0
Revenue recognised:
(70%-20%)*8 mil =4 mil
Expenses recognised:
(70%-20%)*6 mil=3 mil
Profit 1 mil
Revenue recognised: 0
Revenue recognised:
(100%-70%)*8 mil=2.4 mil
Expenses recognised:
(100%-70%)*6 mil=1.8 mil
Profit 0.6 mil
Revenue recognised: 8 mil
Expenses recognised: 0
Profit 0
Expenses recognised: 0
Profit 0
Expenses recognised: 6 mil
Profit 2 mil
REVISION QUIZ
What would happen if ABC Ltd. decides to expense all their
development costs instead of capitalising?
A. Profit increases
B. Profit decreases
C. No change
REVISION QUIZ
What would happen if ABC Ltd. decides to depreciate their machinery
over 15 years rather than 10 years? (Let’s assume this is year 1)
A. Profit increases
B. Profit decreases
C. No change
Lecture outline
1. Definition and recognition of Income
2. Definition and recognition of Expenses
3. Content of Income Statement
4. Content of Statement of changes in equity
5. What-if analysis
Don’t forget!
• Assessment 1 Part 1 due next Week
End of Lecture
Week 8 Lecture
Cash flow statement Part 1