1. Revenue & Expenditure Recognition
Dr Vlieland-Boddy 1

2. Revenue Recognition

3. Introduction
Revenue recognition is probably the most single difficult issue in accounting.
A company’s reported results will vary considerably depending on when it chooses to recognize revenue.
Policies for recognising revenue are critical, and contentious.
The timing of revenue recognition is especially complex because the business activities that generate revenue are also complex.

4. Introduction (cont.) Some examples demonstrate the issues.
A gold mining company management elects not to sell gold which has an immediate market, butto wait for future price increases
Fuel companies, delay docking of tankers when prices are increasing so as to get more for their cargo.
Management may decide to bill early to increase expected results.

5. Revenues Vs Expenditures
Revenues as increases in economic resources, either through increases to assets or reductions to liabilities
Expenses are decreases in economic resources, either through outflows or the using-up of assets or incurrence of liabilities from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s normal business.

6. Earnings Process
A firm earns revenue as it engages in activities that increase the value of an item or service.
The earnings process involves incurring costs to increase the value of in-process products.
Conceptually, revenue is earned as activities are completed that bring a product closer to salable form.

7. When is Economic Value Added?
Revenue is created at each stage along the way in the production and sale process.
The issue in accounting is when during that earnings process should revenue be recognized by recording the increase in value in the books?

8. Financial Reporting Objective
Revenue recognition requires consideration of what is ethical and appropriate for the circumstances.
Companies do not always pick their accounting policies with “good accounting” as their first objective.
Companies bring a variety of motives to the decision, and may wish to maximize or minimize reported net income and net assets, or affect other key financial statement data in support of their specific financial reporting objectives.

9. Revenue Recognition
Revenue recognition refers to the recording of revenue by a company
GAAP & IFRS have three revenue recognition criteria that must be met :
Realized or realizable
Earned
Risk has passed

10. IFRS 15 There are 5 key factors:
There is a contract either written or oral.
Both parties have agreed the contract
Can identify each parties responsibilities
Payment terms clear
Has commercial substance
Confident that the buyer will pay.

11. Revenue Usually results in an increase to assets
Results from the sale of merchandise, performance of service, rental of property, or lending of money
Appears on income statement
Normal balance is a credit

12. Sales Account Value of Sale Made Asset Account Accounts Receivable
Debit
Credit
Value of Sale Made
Asset Account
Debit
Credit
Accounts Receivable

13. Recognition of Revenues Sale of a computer
Shipment of
the goods
5 May
Sales order
3 May
THE COMPANY
Receipt of the
computer
6 May
Receipt of the
bill
7 May
Payment of the bill
20 May
CUSTOMER
When should each recognise the sale date?

14. One Key Problem?
Revenue recognition has been the largest source of public company restatements over the past decade.
It represents a real area of subjective judgement and an area for profit manipulation. 14

15. Recognition of Expenses
Expenses are recognized when they are incurred
When they assist in producing revenue, regardless of the cash payment date
Here the matching principle is key.

16. Channel Stuffing Trade Loading and Channel Stuffing
“Trade loading is a crazy, uneconomic, insidious practice through which manufacturers—trying to increase sales, profits, and market share they don’t actually have—induce their wholesale customers, known as the trade, to buy more product than they can promptly resell”. 16

17. Long Term Contracts
In some instances the earnings process extends over several accounting periods. Delivery of the final product may occur years after the initiation of the project.
Examples are construction of large ships, office buildings, development of space-exploration equipment, and development of large-scale custom software. Contracts for these projects often provide for progress billings at various points in the earnings process.

18. Long Term Contracts
If the seller waits until the project or contract is completed to recognize revenue, the financial statements will be reliable, but it may not be relevant for decision making because the information is not timely

19. Recognition before completion
Long-Term Construction
Accounting Methods
Percentage-of-Completion
Method
Completed Contract
Method
1) Terms of contract must
be certain, enforceable.
2) Certainty of performance
by both parties
3) Estimates of completion
can be made reliably
No Longer to be used 19

20. Percentage-of-Completion Method
Must use Percentage-of-Completion method when estimates of progress toward completion, revenues, and costs are reasonably dependable and all of the following conditions exist:
1. The contract clearly specifies the enforceable rights regarding goods or services by the parties, the consideration to be exchanged, and the manner and terms of settlement.
2. The buyer can be expected to satisfy all obligations.
3. The contractor is expected to meet the contract. 20

21. Percentage-of-Completion Method
Measuring the Progress toward Completion
Most popular measure is the cost-to-cost basis.
The percentage that costs incurred bear to total estimated costs, can be applied to the total revenue or the estimated total gross profit on the contract. 21

22. Percentage-of-Completion Method
Measuring the Progress toward Completion
Cost-to-cost basis
Costs incurred to date =
Percent complete
Most recent estimate of total costs
Revenue to be recognized to date
Percent complete x Estimated total revenue =
Revenue to be recognized to date
Revenue recognized in prior periods
Current-period Revenue = - 22

23. Choosing a revenue recognition policy
Measurability and probability are essential requirements for revenue recognition, but those are relative terms.
There is a trade-off between those two qualitative characteristics and those of relevance and timeliness.
The earlier revenue is recognized, the more difficult it is to measure and the less certain it is of eventual realisation.
But the later revenue is recognized, the less useful it is for predicting cash flows and for evaluating management’s performance.

24. Recognition of gains and losses
Gains and losses are distinguished from revenues and expenses in that they usually result from an incidental events.
Whether an item is a gain or loss or an ordinary revenue or expense depends in part on the reporting company’s primary activities or businesses.
Most gains and losses are recognized when the transaction is completed.
Gains and losses from disposal of operational assets, sale of investments, and early extinguishment of debt are recognized only when the final transaction is recorded.

25. Recognition of gains and losses
Estimated losses are recognized before their ultimate realisation if they both
are probable and
can reasonably be estimated.
Examples are losses
on disposal of a segment of the business
pending litigation
expropriation of assets

26. Coffee Break
9.2.1 26

27. Study Pack 2 Have a look at this overnight.
There is also the answers there so test yourself. 27

28. Expenditure Recognition28

29. Capital Vs Revenue Expenditure
Capital Expenditure
Any material expenditure that will benefit several accounting periods.
Expenditure for ordinary repairs and maintenance.
To capitalize an expenditure means to charge it to an asset account.
It must meet the Asset Test
To expense an expenditure means to charge it to an expense account. 29

30. Capital Exp Revenue Exp
Balance Sheet Not Consumed
Income Statement Consumed
Must pass Asset Test….. 30

31. Returning to the Matching principal
We now need to match expenditure with the income.
We need a policy to release expenditure to match against the revenue generated. 31

32. Lets look at that long term contract through the eyes of the Company Contracting32

33. Example: Long Term Contract
Income
Income
Income
Income
Income
Expenditure
Expenditure
Expenditure
Expenditure
Expenditure 33

34. Their profile might look like this…
They have to invest for many years with no income to match the expenditure.
Their profile might look like this… 34

35. Example: Long Term Contract
Nil
nil
Nil
Nil
$500m
$100m
$200m
$200m
$200m
Nil
Capitalise In Balance Sheet
Capitalise In Balance Sheet
Capitalise In Balance Sheet
Capitalise In Balance Sheet 35

36. Example: Long Term Contract
Nil
Nil
Nil
$200m
$400
$100m
$100m
$100m
$50m
Nil
Capitalise In Balance Sheet
Capitalise In Balance Sheet
Capitalise In Balance Sheet
Capitalise In Balance Sheet 36

37. Government Grants
In some countries there is government financial support.
Such grants must be accounted for either as income or as a deduction from the item supported.
If it might be repayable the consideration of a provision needs to be considered.

38. Summary of key points
Revenue recognition policies must be chosen carefully because of their profound effect on key financial results.
Before the results of the earnings process are recognized in the accounting records, revenue must meet the recognition criteria of
probability
measurability.
Revenue must also be earned, and realized or realizable and should be at the time risk has passed between the two parties.

39. Summary of key points
Revenue recognition policies are chosen in accordance with the financial reporting objectives of the enterprise, constrained by the general recognition criteria of probability and measurability.
The choice of a revenue recognition policy involves a trade-off between qualitative criteria, such as between verifiability and timeliness.

40. Summary of Key Points
A sale transaction is usually measured at the sales invoice price.
When there are long-term, interest-free payment terms, discounting may be appropriate.
Barter transactions are typically recognized at the value of the asset or service given up.

41. Summary of Key Points
Long-term contracts can be accounted for using the percentage-of-completion method, or the completed-contract method.
If a long-term, fixed-price contract with a credit-worthy customer is accompanied by reasonably reliable estimates of
(a) cost to complete and
(b) percentage of completion, based either on output or input,
percentage-of-completion is appropriate.

42. Summary of key points
Revenue should be recognized at a critical event or on the basis of effort expended.
Critical events can be delivery, prior to delivery (e.g., on production, if there are no uncertainties regarding the sale transaction), or after delivery (if there are significant uncertainties about measurement, collection, or remaining costs).
Delivery is the normal critical event that triggers revenue recognition. As risk definitely passes.
The recognition of revenue results in an increase in net assets, which is recognized at the critical event.

43. Key Issue
Revenue and Expenditure recognition is a careful balance between the four basic accounting concepts.
Going Concern we usually accept. Matching, Consistency and Prudence need to be in balance.
We MUST be consistent!

44. What Number Do You Want?
Accounting is a political process, not an exact science.
There is a great deal of discretion available to managers.
Revenue recognition is one of those grey areas.
It needs to be fully explained in the notes.

45. In reality, so long as we are consistent then over time distortions will be removed.

46. I’m ready for some leisure time.
Bye for now!
I’m ready for some leisure time.
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