REVENUE RECOGNITION, RECEIVABLES, AND THE INCOME STATEMENT

• External financial statements attempt to convey three broad, overlapping

types of accounting information:1. information concerning a company's
current and cumulative financial condition;
• 2. information concerning the change in the company's overall financial
condition, as reflected by the major components of its cash flows;
• 3. and information concerning the company's recent operating
performance.
• Financial statement users frequently place the greatest emphasis on recent
performance data for decision­making purposes. Indeed, how well a
company
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regards to the company's overall investment value and creditworthiness than
how well it performed in the past.
• Publicly held corporations and companies issuing audited financial reports
are required to provide three basic financial statements: the balance
sheet, a statement of cash flows, and an income statement. Each
statement is intended to convey a different set of information. In the case of
the income statement, this statement reports the company's current
operating performance for its most recent accounting period

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 REVENUE RECOGNITION, RECENABLES, AND THE INCOME STATEMENT
• In its simplest form, the income statement contains two broad categories of items:
revenues and expenses) The "revenues" may be thought of as the level of
accomplishment attained by the company,
• while the "expenses" represent the effort expended to attain that level of
accomplishment.
• More specifically, revenues represent the actual or expected inflow of assets, the
settlement of liabilities, or both, from a company's primary business activity, while
expenses represent the utilization or consumption of assets, or incurring of liabilities,
or both, to produce the revenue inflow.
• There are three broad categories of income (or loss) producing activities: operations,
other, and unusual or extraordinary .
• Gross earnings, gross profits, or gross margin refers to the amount of earnings
remaining after the cost of sales and services have been deducted from
revenues and, hence, that is available to cover the other costs of operations .
• The earnings (or loss) from operations, is a summary performance measure
indicating, overall, how successful the primary business activities of the company
have been.
• Revenues and expenses may also result from activities unrelated to the com­pany's
primary business activity .
• Another integral part of the income statement is the disclosure of the net income
(loss) on a per share of common stock basis.
• As a final point, some companies present both an income statement and a state­ment
of retained earnings in an integrated format. This approach is frequently adopted
when the primary factors affecting retained earnings are limited to earnings (or
losses) and dividends.

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 Revenue Realization and Recognition
• Performance measurement can best be conceptualized as a comparison
of effort and accomplishment. In accounting, effort is measured in
terms of a company's current expenses and accomplishment in terms
of its current revenues. Broadly speaking, operating revenues represent
the inflow of assets from the company's primary business activity .
• Revenues are frequently associated with cash inflows; but under the accrual
basis of accounting, revenues may be used to represent a much broader
inflow of assets.
• Operating revenue can only be generated by the sale or provision of goods
or services. Critical to the measurement of operating revenue is a
determination of exactly when revenue has been earned, or "realized."
Once realized, it can then be "recognized," or recorded, in the
company's financial statements
• Criteria for Recognition:
• It is widely accepted that two criteria must first be met before a
company can recognize revenue:
• 1. the revenue must have been earned (Le., realized), and
• 2. the level of revenue must be measurable.
• These two criteria will generally be satisfied when
• (1) the earnings process is complete and (2) an exchange has
occurred.

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 Revenue Realization and Recognition
• Measurability - One of the fundamental principles of accounting is to
present objective, verifiable information.
• With respect to revenues, this principle implies that a company must
be able to determine with a high degree of certainty exactly how much
revenue has been earned.
• Thus, lacking a specific sales or contract price, it is generally considered
unacceptable to estimate what revenues might be.This philosophy is
intended to prevent the overstatement of current revenues.
• A corollary to the criterion of measurability is the notion that not only
should revenues be highly certain but so also should the costs (or
expenses) incurred to generate those revenue. This corollary evolves
from the matching principle.
• Namely, that if revenues are recognized, then the associated costs incurred
to generate those revenues should also be recognized. Thus, it is essential
to determine with a reasonable degree of accuracy not only the revenues to
be recognized but also the costs to be matched with the revenues earned.

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 REVENUE REALIZATION CRITERION
• Realization: The Critical Event. A second criterion for the recognition
of revenues is the realization principle: revenues must be earned
before they can be recognized.
• But when does realization occur? Realization is typically linked to the
critical event in a company's operating cycle. The critical event refers
to that point in the operating cycle at which there is substantial
evidence that the revenue-generating transaction will be completed
(i.e., that goods or services will be transferred and compensation
paid). Once this point is attained, there is a high degree of certainty
that the earnings process is or will be completed.

• RECOGNITION METHODS:
• For merchandising or manufacturing concerns, revenue recognition tends
to most commonly occur at the point of sale. Once a sale is
consummated via an exchange transaction, both the measurability and the
realization criteria have been satisfied. Regardless of whether the customer
pays by cash or by credit, revenue can then be recognized.
• In some instances, a customer may pay a deposit on an item before
taking delivery. This is frequently the case if goods must be ordered
specifically for a customer. Even though the deposit may be nonrefundable,
it is common practice not to recog­nize the customer advance as revenue
until the goods are shipped or delivered to the buyer.

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 RECOGNITION METHODS:
• Delivery Basis of Revenue Recognition
• Shipment Basis of Revenue Recognition
• Point of Sale versus Installment Method
• Special Industry Method:
• CONSTRUCTION INDUSTRY— i) Completed Contract Method
• ii) Percentage of completion method

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 Revenues Adjustments
• In recognition of revenues there is another pertinent question regarding how
much revenues be recognized.
• There might have several factors which may lead to adjustment of revenues: 1.
Implicit Interest.
• 2. Uncollectible Accounts ----Most companies extend credit to their
customers as an inducement to patronize their products. And, while the initial
decision to extend credit may have been based upon an assumption of a high
degree of collectibility, subsequent information may contradict this initial decision
and suggest the need to provide for potential credit losses. In effect, subsequent
information may suggest that it was inappropriate to recognize revenue at the point
of sale; however, rather than treat this information as an adjustment to revenues
and it is most commonly accounted for as an expense of conducting business.
• The methods might be a) percentage of credit Sales
• b) percentage of receivables
• c) The aging of receivables
• Regardless of which approach is adopted, it should be remembered that these are just
estimation approaches. To ensure that all expenses, including the cost of extending credit to
customers, are matched with revenues at the end of each accounting period, it is necessary
to utilize one of these estimation approaches .
• 3. Sales Discount
• 4. Sales Return and Allowances

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 Financial Analysis

• A primary use of the information contained in financial statements is ratio

analysis. It is often difficult to assess the relative performance of a firm
merely by looking at the reported level of earnings, just as it is difficult to
assess the relative borrowing capacity by looking only at the level of
outstanding debt. Instead, it is often more informative to examine the
relationship between various items in the financial state­ments. These
relationships, or ratios, are frequently more revealing than the absolute
numbers used to create them.
• Profitability Analysis: The profitability of a company may be analyzed in
two ways. First, the absolute level of revenues, gross margin, or net
earnings, for example, can be analyzed over time; this is called trend
ana!ysis. And second, a series of profitability ratios can be calculated.

• Ratios mostly used : 1. Return on Assets (ROA), sometimes called ROI

• Net Income
Average total assets
2. Return on Current Assets : Net Income
Average current Assets

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 Financial Analysis
• 3. The rate of return on common equity (ROE)
• Net Income – Pref. stock dividend
• Average Common Equity
• 4. Gross Margin Ratio
• 5. Net Profit Ratio
• 6. Return on Assets = Asset Turnover X Net Profit Margin
• 7. Accounts Receivable Turnover = Net Credit Sales
• Average Accounts Receivables

• Analysis of Risk The concept of risk has many meanings; however, in the context of accounting,
risk refers to the probability that unforeseen or unexpected factors will occur and, thereby, reduce
the revenue or earnings stream (and implictly the cash flow stream) of a company. These factors
may be economy wide (e.g., inflation, recession, and high interest rates), industry wide (e.g.,
increased competition, changes in technology, raw materials constraints), or firm-specific (e.g.,
employee discontent, equipment failure, etc.). Regardless of its source, any thorough financial
analysis must consider the risk exposure of a company.
• In some cases, risk exposure may be revealed by ratios, such as liquidity and solvency ratios.
Liquidity measures attempt to portray the ability of a company to meet its short-term cash
obligations, whereas solvency (or leverage) measures portray the firm's ability to meet its long-
term debt obligations.

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