Com 4FK3
Financial Statement Analysis
Week 3, 2009
Income Recognition
Revenue Recognition
• Under accrual accounting, revenue may
arrive in a different accounting period than
when it is received in cash
• When to recognize;
 during production
 completion of production
 time of sale
 while receivables outstanding
 when cash collected
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Recognition Criteria
• The following criteria must both be met
 Has
provided all, or a substantial portion, of the
goods or services to be performed
 Has received either cash or a receivable or other
asset whose cash equivalent amount the firm
can measure with reasonable precision
• TOS may be too early if large and volatile:
bad debts, product returns, warrantee costs
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Microsoft: Unearned Revenue
• Office suite comes with a 5-year pledge of
support
• Support costs unknown at time of sale
• Microsoft decided to not recognize the
entire amount of revenue immediately
• Set up reserve account – unearned revenue
Is this income smoothing?
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Balance Sheet Effect
• When the revenue is recognized
 The
cash or receivable is added as an asset
 Expenses are recognized regardless of when the
cash is spent
• When the revenue is not recognized
 Money
spent is recorded as an asset
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Time Value of Money
• A central element of finance, grudgingly
accepted by GAAP
• Distant cash flows recorded at present value
using the discount rate at the time that they
are incurred
A
firm with 2 notes payable to a single source,
both due on the same day for the same amount
can have different values
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Expense Recognition
• Accrual basis expense recognition requires
 Costs
directly related to revenues become
expenses in the same period that the revenues
are recognized
 Costs that can’t be directly related to revenues
become expenses in the period when the firm
consumes the product or service
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Early Expense Recognition
• Warrantee expense recognize at time of sale
but actual cash spent later
 Expensed
on Income statement
 Liability established on balance sheet
• When performed
 No
expense reported
 Warrantee liability reduced
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Delayed Expense Recognition
• If expenses are incurred before revenue is
earned or recognized, the cost is added to
the balance sheet as an asset
 Work
in process inventory
 Capitalized development expenses
• When the revenue is recognized the expense
is declared and the value of the asset
account is reduced accordingly
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Recognition Example
• Xerox delivers a copier to a customer.
 The
contract is considered a capital lease for
financial accounting purposes
 Monthly payments cover; implied purchase
price, maintenance, paper, other supplies, and
implied interest payments
• When should revenue be recognized?
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Recognition Example
• Microstrategy provides
 Software
(5 year license)
 Customization of the software
 Training of staff on the use of the software
 Consulting services to maximize the value
added by using the software
• When should revenue be recognized?
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Long Term Contracts
• Income recognition is often complicated
when the manufacture of a product takes a
relatively long time
 Period
of construction spans many accounting
periods
 Contract price agreed in advance
 Customer makes periodic payments on the
contract price during production
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Percentage of Completion
• Period costs are calculated as a percentage
of total contract costs
• Percentage of gross profit is recognized as
income, and costs as expenses
• If estimated costs increase, any losses are
recognized when identified
Meets both revenue recognition requirements
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Completed Contract Method
• Similar to time of sale, no revenue or
expense is recognized until the contract is
complete and delivered to the customer
• Often used in short (3 month) contracts or
when the final purchaser is unknown
• May be considered too conservative
• % complete often required for tax purposes
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Revenue Recognition With
Uncertain Collectibility
• The second revenue recognition criteria
requires that the value of the future cash
flows must be predictable
• If bad debts can’t be reasonably estimated
or the contract is cancellable, that could
delay recognition
• Methods to handle these problems include;
instalment method and cost recovery first
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Uncertain Cash Methods
• Instalment method
 as
each payment is received, a fraction of the
total revenue and expenses are recognized in
relation to the % of total cash
• Cost recovery first
 as
each payment is received, an equivalent
dollar amount of expenses are recognized
 after all expenses are covered additional
payments are recorded as revenue
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