Business F768 - McMaster University
Download
Report
Transcript Business F768 - McMaster University
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
2
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
3
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?
4
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
5
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
6
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
7
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
8
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
9
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?
10
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?
11
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
12
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
13
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
14
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
15
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
16