UNDERSTANDING THE INCOME STATEMENT
LOS 32.b: Explain the general principles of revenue recognition and accrual accounti!~g, demonstrate specific revenue recognition applications
Under the accrual method of accounting, revenue is recognized when earned and expenses are recognized when incurred. The important point to remember is that accrual accounting does not necessarily coincide with the receipt or payment of cash.
Consequently, firms can manipulate net income by recognizing revenue earlier or later or by delaying or accelerating the recognition of expenses.
Accordingtothe International Accounting Standards Board (IASB), the term "income"
includes revenue and gains. Specifically, income is defined as increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that resulr in increases in equity, other than those relating to contributions from equity participants.1
According to the Financial Accounting Standards Board (FASB), revenue is recognized in the income statement when (a) realized or realizable and (b) earned.2The Securities and Exchange Commission (SEC) provides additional guidance by listing four criteria
todetermine whether revenue should be recognized:3
1. There is evidence of an arrangement between the buyer and seller.
2. The product has been del ivered or the service has been rendered.
I. IASB, Framework for the Preparation and Presentation of Financial Statements, paragraph69.
2. Statement of Financial Accounting Concepts No.5, paragraph 83(h).
3. SEC Sraf( Accounting Bullerin J01.
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Study Sessio/l K Cross-ReferencetoCFA Institute Assigned Reading #32 - Understanding the Income Statement 3. The priceis determined or determinable.
4. The seller is reasonably sure of collecting money.
If a firm receives cash before revenue recognition is complete, [he firm reports i[ as unearned revenue. Unearned revenue is reported on the balance sheet as a liability. The liability is reduced in the future as [he revenue is earned. For example, a magazine publisher typically receives subscription payments in advance of delivery. When paymems are received, both assets (cash) and liabilities (unearned revenue) increase. As the magazines are delivered, the publisher recognizes revenue on the income statement and [he liability is reduced.
Specific Revenue Recognition Applications
Revenue is usually recognized at delivery using the revenue recognition criteria previously discussed. However, in some cases, revenue may be recognized before delivery occurs or even after delivery takes place.
Long-term Contracts
The percemage-of-completion method and the completed-comract method are used for comracts that extend beyond one accouming period, often contracts related to
construction projects.
In certain cases involving service contracts or licensing agreements, the firm may simply recognize revenue equally over the term of the contract or agreement.
The percentage-of-completion method is appropriate when the project's cost and revenue can be reliably estimated. Accordingly, revenue, expense, and therefore profit, are recognized as the work is performed. The percemage of completion i~; measured by the total COSt incurred to date divided by [he tOtal expected COSt of the project.
The completed-contract method is used when the outcome of a project cannot be reliablv measured or the project is shon-term. Accordingly, revenue. expense, and profit are recognized only when the contract is complete. Under either method, if a loss is expected, the loss must be recognized immedi~ltelv.
Under International Financial Reponing Standards (lFRS), if the firm cannot reliablv measure [he outcome of the project, revenue is recognized to the extent of contract
<;:OSts. costs are expensed when incurred. 3.nd profit is recognized only a[ completion.
The effect of using these differem revenue recognition methods for long-[erm contracts on the income st3.temem is illustrated in [he following example.
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SIlJ(I>ã Sc~~ion S
Cross-RcFerence to CFA Institute Assigned Reading #32 - Understanding the Income Statement
Example: Revenue recognition for long-term contracts
Assume thar AAA Construction Corp. has a con traertobuild a ship for $1,000 and a reliable estimate of rhe contracr's toral cost is $800. Project cosrs incurred byAAA . are as follows:
AAA Project Costs }-ear
Costs incurred
20X5
$400
20X6
$300
20X7
$100
Total
$800
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Determine AAA's net income from this project for each year using the percentage-of- completion and completed contract methods.
Answer:
Since one-half of the total contract cost [$400 / $800] was incurred during 20X5, the project was 50% complete at year-end. Under thepercentage-ofcompLetion .' method, 20X5 revenue is $500 [$1,000 x 50%J. Expenses (cost incurred) were $400;
thus, netincc mefor 20X5 'was $100 [$500 revenue -$400 expense]. "
At the end of 20X6, the project is 87.5% complete [($400 + $300) / $800]. Revenue to date should total $875 [$1,000 x 87.5%]. Since A..,AA already recognized $ 500 of revenue in 20X5, 20X6 revenue is $375 [$875 - $500]. 20X6expenses were $300 so 20X6 net income was $75 [$375 revenue - $300 expenseJ.
iAttheend of 20X7, the project is 100% complete [($400 + $300 +$100) / $800].
'Revenue to date should total $1,000 [$1,000 x 100%]. Since AAA already :tecognized$875 of revenue in 20X5 and 20X6, 20X7 revenue is $125
'[$1,000 - $875]. 20X7 expenses were $100 so 20X7 net incomewas$25
[$~25 revenue -$100 expense].
The table below summarizes the AAA's revenue, expense, and net income over the term of project unqer the percentage-of-completion method.
AAA Income Statements
20X5 20X6 20X7 Total
Revenue $500 $375 $125 $1,000
Expense A.llil. .J.illl -Lilil. --.8..Q.Q.
Net income $100 $75 $25 $200
Under the compLeted contract method, revenue, expenses, and profit are not recognized until the contract is complete. Therefore, at the end of 20X7, AAA reports revenue of $1 ,000, expense of $800, and net income of $200.
As compared to rhe complered contracr merhod, rhe percentage-of-completion method is more aggressive since revenue is reponed sooner. Also, rhe percentage-of-complerion
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StllJy Session H Cross-Reference to CFA Institute Assigned Reading #32 - Understanding the Income Statement method is more subjective because it involves cost estimates. However, the percentage-
of-completion method provides smoother earnings and results in better matching of revenues and expenses over time. Cash flow is the same under both methods.
Installment Sales
An installment sale occurs when a firm finances a sale and payments are expected to be received over an extended period. If collectibility is certain, revenue is recognized at the time of sale using the normal revenue recognition criteria. If collectibility cannot be reasonably estimated, the installment method is used. If collectibility is highly uncertain, the cost recovery method'is used.
Under the installment method, profit is recognized as cash is collected. Profit is equal to the cash collected during the period multiplied by the total expected profit as a percentage of sales. The installment method is used in limited circumstances, usually involving the sale of real estate or other firm assets.
Under the cost recovery method, profit is recognized only when cash collected exceeds cOSts incurred.
The effects of using the installment and the COSt recovery methods are illustrated in the following example.
EXample: Revenue recognition for installment sales
ASsume mat BBB Property Corp. sells a piece of land for $1,000. The originaI'cost of .the rand was $800; Collections received by BBB for the sale are as follows:
20X7 Total
CoHecrions $400 $400 $200 $1,000
Determine BBB's profit under the installment and cost recovery methods.
Answer:
Total expected profit as a percentage of sales is 20% [($1,000 - $800) / $1,000].
Under the installment method, BBB will report profit in 20X5 and 20X6 of $80 [$400 x 20%] each year. In 20X? BBB will report profit of $40 [$200 x 20%}.
Under the cost recovery method, the collections teceived duringlOX5 andlOX6 are applied to the recovery of costs. InlOX?, BBB will report $200 of profit.
IFRS 'lddresses when installment sale treatment is appropriate for certain real estate transactions. SpeciFically, the date when title to the properrv is rransFerr~d and the dare when the buyer acquires a vested imerest mal' differ. Also. insLlilment sale rre~ltmem
may be required when the risks and rewards of ownership are not tLll1sferred because the seller remains involved in the properr\'. Finally. significant uncertainrl' that rhe buyer can complete the rrJnsaction may require insrallmem sale rre;ltmenr.
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Slud)" Session 8
Cross-Referenceto CFA institute Assigned Reading #32 - Understanding the incomc Statemcnt Bartel' Transactiolls
. In ~l barter transaction, two parries exchange goods Ot services without cash pa~'ment.
A round-trip transaction involves the sale of goods toone parry with the simultaneous purchase of almost identical goods from the same party. The lInderl~ãingissue with these transactions is whether revenue should be tecognized. In the late 1990s several internet companies incteased their revenue significantly by "bu~'ing" equal values of advertising space on each others' websites.
According to U,S. GAAP, revenue from a barter transaction can be recognized at fair value only if the firm has historically received cash payments for such goods and services and can use this historical experience to determine fair value.4
Under IFRS, revenue from barter transactions must be based on the fair value of revenue from similar non barter transactions with unrelated parties.)
Gross and Net Reporting ofRevenue
Under gross revenue reporting, the selling firm reports sales revenue and COSt of goods soldseparatel~'"Under net revenue reporting, only the difference in sales and COSt is reponed. \X"Thiie profit is the same, sales are higher using gross revenue reporting.
For example, consider a travel agent who arranges a first-class ticket for a customer flyingto Singapore. The ticket price is $10,000 and the travel agent receives a $1,000 commission. Using gross reponing, the travel agent would report $10,000 of revenue,
$9,000 of expense, and $1,000 of profit. Using net reponing, the travel agent would simply report $1,000 of revenue and no expense.
The following criteria must be met in order to use gross revenue reporting under U.S.
GAAP. The firm must:
Be the primary obligor under the contract.
Bear the inventory risk and credit risk.
Be able to choose its supplier.
Have reasonable latitude to establish the price.
Implications for Financial Analysis
As noted previously, firms can recognize revenue before delivery, at the time of delivery, or after delivery takes place, as appropriate. Different revenue recognition methods can be used within the firm. Firms disclose their revenue recognition policies in the financial statement footnotes.
Users of financial information must consider two points when analyzing a firm's revenue: (J) how conservative are the firm's revenue recognition policies (recognizing revenue sooner rather than later is more aggressive), and (2) the extent to which the firm's policies rely on judgment and estimates.
4. Emerging Issues Task Force EITF99-17, "Accounting for Advertising Barter Transactions. "
5. IASB, SIC Interpretation 31, Revenue - Barter Transactions Involving Advertising Serv ices, paragraph 5.
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Study Session 8 Cross-Reference to CFA Institute Assigned Reading #32 - Understanding the Income Statement