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Understanding Income Statement

explain the general principles of revenue recognition and accrual accounting, demonstrate specific revenue recognition applications and discuss the implications of revenue recognition principles for financial analysis
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Revenue Recognition

Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liability that result in increase in equity IFRS Framework The term income includes revenue and gains. Gains arise from peripheral or secondary activities.

Under the accrual method of accounting, revenue is recognized when earned and expenses are recognized when incurred.
Since 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.
Shoaib A. Qureshi | NUST Business School | Understanding Income Statement

Understanding Income Statement

explain the general principles of revenue recognition and accrual accounting, demonstrate specific revenue recognition applications and discuss the implications of revenue recognition principles for financial analysis
10

IASB
Revenue Recognition

1.

the entity has transferred to the buyer the significant risks and rewards of ownership of the goods; the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold; the amount of revenue can be measured reliably; it is probable that the economic benefits associated with the transaction will flow to the entity; and

2.

3. 4.

5.

the costs incurred or to be incurred in respect of the transaction can be measured reliably.

Shoaib A. Qureshi | NUST Business School | Understanding Income Statement

Understanding Income Statement

explain the general principles of revenue recognition and accrual accounting, demonstrate specific revenue recognition applications and discuss the implications of revenue recognition principles for financial analysis
11

FASB
Revenue Recognition

According to the Financial Accounting Standards Board (FASB), revenue is recognized in the income statement when:

(a) realized or realizable; and (b) earned.

Shoaib A. Qureshi | NUST Business School | Understanding Income Statement

Understanding Income Statement

explain the general principles of revenue recognition and accrual accounting, demonstrate specific revenue recognition applications and discuss the implications of revenue recognition principles for financial analysis
12

SEC
Revenue Recognition

There is evidence of an arrangement between the buyer and seller. The product has been delivered or the service has been rendered. The price is determined or determinable. The seller is reasonably sure of collecting money.

Shoaib A. Qureshi | NUST Business School | Understanding Income Statement

Understanding Income Statement

explain the general principles of revenue recognition and accrual accounting, demonstrate specific revenue recognition applications and discuss the implications of revenue recognition principles for financial analysis
13

Special Cases
Long Term Contracts
Revenue Recognition

The percentage-of-completion method and the completed-contract method are used for contracts that extend beyond one accounting period, often contracts related to construction projects. Percentage-of-completion method is appropriate when the projects cost and revenue can be reliably estimated. Accordingly, revenue, expense, and therefore profit, are recognized as the work is performed. The percentage of completion is measured by the total cost incurred to date divided by the total expected cost of the project.
Shoaib A. Qureshi | NUST Business School | Understanding Income Statement

Understanding Income Statement

explain the general principles of revenue recognition and accrual accounting, demonstrate specific revenue recognition applications and discuss the implications of revenue recognition principles for financial analysis
14

Special Cases
Long Term Contracts

The Completed-Contract method is used when the outcome of a project cannot be reliably measured or the project is short-term. Accordingly, revenue, expense, and profit are recognized only when the contract is complete.

Revenue Recognition

Under either method, if a loss is expected, the loss must be recognized immediately.
Under IFRS, if the firm cannot reliably measure the outcome of the project, revenue is recognized to the extent of contract costs, costs are expensed when incurred, and profit is recognized only at completion.
Shoaib A. Qureshi | NUST Business School | Understanding Income Statement

Understanding Income Statement

explain the general principles of revenue recognition and accrual accounting, demonstrate specific revenue recognition applications and discuss the implications of revenue recognition principles for financial analysis
15

Example: Revenue Recognition For Long-term Contracts

Shoaib A. Qureshi | NUST Business School | Understanding Income Statement

Understanding Income Statement

explain the general principles of revenue recognition and accrual accounting, demonstrate specific revenue recognition applications and discuss the implications of revenue recognition principles for financial analysis
16

Example: Revenue Recognition For Long-term Contracts

Shoaib A. Qureshi | NUST Business School | Understanding Income Statement

Understanding Income Statement

explain the general principles of revenue recognition and accrual accounting, demonstrate specific revenue recognition applications and discuss the implications of revenue recognition principles for financial analysis
17

Example: Revenue Recognition For Long-term Contracts

Shoaib A. Qureshi | NUST Business School | Understanding Income Statement

Understanding Income Statement

explain the general principles of revenue recognition and accrual accounting, demonstrate specific revenue recognition applications and discuss the implications of revenue recognition principles for financial analysis
18

Special Cases
Long Term Contracts
Revenue Recognition

As compared to the completed contract method, the percentage-of-completion method is more aggressive since revenue is reported sooner. The percentage-of-completion 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.
Shoaib A. Qureshi | NUST Business School | Understanding Income Statement

Understanding Income Statement

explain the general principles of revenue recognition and accrual accounting, demonstrate specific revenue recognition applications and discuss the implications of revenue recognition principles for financial analysis
19

Special Cases
Installment Sales
Revenue Recognition

An installment sale occurs when a firm finances a sale and payments are expected to be received over an extended period. If collectability is certain, revenue is recognized at the time of sale using the normal revenue recognition criteria. If collectability cannot be reasonably estimated, the installment method is used. If collectability is highly uncertain, the cost recovery method is used.

Shoaib A. Qureshi | NUST Business School | Understanding Income Statement

Understanding Income Statement

explain the general principles of revenue recognition and accrual accounting, demonstrate specific revenue recognition applications and discuss the implications of revenue recognition principles for financial analysis
20

Special Cases
Installment Sales
Revenue Recognition

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.
Shoaib A. Qureshi | NUST Business School | Understanding Income Statement

Understanding Income Statement

explain the general principles of revenue recognition and accrual accounting, demonstrate specific revenue recognition applications and discuss the implications of revenue recognition principles for financial analysis
21

Example: Revenue Recognition For Installment Sales

Shoaib A. Qureshi | NUST Business School | Understanding Income Statement

Understanding Income Statement

explain the general principles of revenue recognition and accrual accounting, demonstrate specific revenue recognition applications and discuss the implications of revenue recognition principles for financial analysis
22

Special Cases
Installment Sales
Revenue Recognition

IFRS addresses when installment sale treatment is appropriate for certain real estate transactions. Specifically, the date when title to the property is transferred and the date when the buyer acquires a vested interest may differ.

Also, installment sale treatment may be required when the risks and rewards of ownership are not transferred because the seller remains involved in the property. Finally, significant uncertainty that the buyer can complete the transaction may require installment sale treatment.
Shoaib A. Qureshi | NUST Business School | Understanding Income Statement