REVENUE RECOGNITION

AS-9 as per the standard formulated by Institute of Chartered Accountants of India

WHY REVENUE RECOGNITION?

Problems arising due to accrual concept. Supplier might agree to sell at a point of time and deliver goods at a different point of time Supplier might bill the buyer at a different time from the time of delivery of goods Buyer may pay at a later date than the date of billing.

REVENUES ARE
Inflows/ other enhancements/ settlements of liabilities or all of these during a period Delivering/producing of Goods or rendering of services that constitute the organizations main operations. Financial Accounting Standards Boards (FASB)

GOLDEN RULE
Before revenue is recognized, it must be realized or realizable and earned. Realized means that payment has been received for the transaction, while realizable means that the company has a right to payment. Revenue is earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by revenues.

What is acceptable in meeting the realized and earned conditions?

Generally revenue can be recognized at the time of sale, with the producer delivering the produced product, and the buyer paying the producer. CASH SALES If the sale and or the receipt of cash from the buyer is done before the product is produced and delivered, recognition will not occur until after the product is produced and delivered. RECEIVED CASH ON 25th MARCH 2009 PRODUCT TO BE DELIVERED ON 31st JULY 2010.

Contd.
Only after costs are recognized the profit can be recognized. DEVELOPMENT OF RAW LAND Costs huge and time period is long; Down payments are small; Recognize only after costs are recovered. Land acquired for development in 2004. received part payments from customers in 2005,2006. All the costs recovered in the year 2009.

Contd
If the product is contracted for before production/Construction, a business may use a percentage of completion method. In 2001 Justin Corp entered into a production contract for a contract price of $6 million and expected cost of $4.8 million with a profit of $ 1.2million. Actual production cost and cash inflows over the duration of the contract is as follows:

Contd..
2001(Amt$) Cost incurred (CY) Cost incurred-Cumulative Estimated remaining costs to complete as on 31st Dec Amounts billed and cash received in Current year Amounts billed and cash received in Cumulative 800 800 4800 1300 1300 2002(Amt$) 2800 3600 1200 2500 3800 2003(Amt$) 1200 4800 0 2200 6000

Contd
What would be the income using percentage completion method and completed contract method. On dec 31st 2002, the company determines that the total cost of the project will be $5400 making remaining costs to complete $1800. What would be the impact on Income of the firm as per percentage completion method?

Contd.
workings mac 1.xls

Contd..
If a company provides a service or the right to use an asset over a period of time, and if there is a contract in place as to how the buyer will pay for these services or use of assets, the company may recognize revenue as time passes. A common example of this would be a lease. if collectability of payment is uncertain, revenues cannot be recognized until payment is received

 In case of consignment shipping, Goods shipped on 25th July 2011 sold all the goods by the consignee on 31st August 2011.When will revenue be recognized? 31st Aug 2011 A XYZ Franchisee enters into an agreement with Del on 23rd June 2011. The franchise fee is paid on Dec 23rd 2011. The franchisor provides services to XYZ from 3rd May 2012 to July 3rd 2012. When will Dells revenue be recognized? After July 3rd 2012

Contd.
When Prices are certain If grains are harvested in July 2011 and sold on Aug 2011. When will the farmer recognize revenues? July 2011 When the customer pays on installment basis .Revenue is recognized when Installments are received.

Difference between Delivery Method and Installment method.

A jeweller sells a watch in 2005 for $400 and the customer agrees to pay $200 in 2005 and $200 in 2006. what would be the income if revenue is recognised on delivery method and installment method? workings mac 1.xls

Some accounting issues that affect revenue recognition

Barter of goods or services between firms will be recorded at listed price rather than lower price of the two. Recording of license /membership fees at the time of signing agreement rather than over the term of the agreement. Companies that act as agents (eg: advt agency) record the gross amount billed as revenue rather than their commission income.

EXPENSE RECOGNITION
Accounting issues :Deferral of marketing expenses or sales commission when deferred the reported income Increases Sears Company defers direct marketing expenses to the tune of $131 million in 1990 and $180 million in 1991.If all are expenses then its pretax income will be $49 less 1. Delaying expense recognition until it is actually incurred. This will increase reported incomes.

Contd..
an aircraft company changed its accounting method for major overhauling costs from accrual(accrued in advanced of next scheduled overhaul on the basis of engine usage and estimates of overhaul) method to direct expense method(when incurred).

Contd.
If the aircraft company has overhauling estimates to the extent of 152 million while the actual expense incurred every year is 67 million and its revenues are 252 million. How is the income impacted due to the change?252-152 or 252-67

ANALYSIS OF DEP
Dep is an allocation process and not a valuation process Income is that amount that can be distributed without affecting the firms productive capacity. Then cash flows generated by an asset cannot be considered as cashflow until there is provision for replacement.

Importance of Depreciation
Asian Paints Bharti Telecom Indraprastha Medical Corp Reliance Energy Shoppers Stop Infosys JK Cement ITC 21 crores 1412 13 414 12 409 42 320 19% of PBTD 38% 37% 35% 23% 13% 45% 9%

Determinants of Dep
Historical Cost or Revalued Amount Revaluation by appraisal by competent valuers and changes made in the relevant year for changes made. If the revaluation results in a higher amount for the assets then it is shown as reserve on revaluation which is not available for distribution.

Contd.
Expected Useful life of the asset Period/units Average age(%)= accumulated dep/end gross invt.( explains relative age of depreciable assets to gross invt.) These calculations are influenced by salvage value and life of the assets =34000/340000=10% Newer assets will be more efficient

Cont
Estimated Salvage value/residual value/scrap value This allocation for (dep)re investment bypreserves the fund from being distributed as dividends or paid as taxes (tax shield) Methods of depreciation Sinking Fund, Straight line, Accelerated dep (sum of digits and units of production(service hours) Group and Composite dep methods

Contd..
workings mac 1.xls

Dep
When asset is revalued or sold workings mac 1.xls

Impairment of assets
Applicable fro April 2004-AS28; Decrease in the fair value of a long lived asset due to unfavorable economic conditions, technological developments, declines in market demand (firms are temporarily idle and find it difficult to continue operations at previous levels) is called impairment workings mac 1.xls

INVENTORY VALUATION-AS 2
Meaning For sale in the ordinary course of business In the process of production for sale In form of materials and supplies to be consumed during production.

Identify inventory classified acc to previous slide?

Titan Industries Watches Jewellery* Finished goods Gold, Brass, Steel, components, precious and semi precious stones* Raw Materials and Bought out components Unfinished Watches and Jewellery* WIP

Problem of inventory valuation

What is the value of inventory that will be shown in the financial statements until the related revenues are recognised AS-2: FG and WIP are valued at cost or net realizable value which ever is lower RM are valued at cost except in situations where write down to net realizable value is required. AS 2 for manufacturing concerns; other standards for eg:AS 7 for construction contracts.

Interpretation inventory comparing financial reports of Cos.

Workings mac1 Ratio of inventory to Total assets will depend upon nature of industry Inventory holding period- ITC and Ranbaxy hold close to 3 months of their sales in inventory. Heavy dependence on inventory

Methods of Valuation
Inventory account is affected by two Purchase of goods (P) Subsequent sale (COGS) Relationship can be written as EI=BI+P-COGS or BI+P=COGS+EI For any year left side is known BI+P This should be shown as COGS and EI during the period.

Process Illustrated under 2 scenarios

Workings mac1 Inventory in Balance Sheet The ending inventory Current replacement cost is 14 Rs. Which is 14*300 units=4200 Acc to FIFO its 3950 LIFO 3100 W.Ave 3536 (closest is ?) Value is recorded at Replacement cost i.e.market value or Cost which ever is lower on the conservatism principle

Debate on what is profit

Consider a situation purchased Rs6 is sold for Rs 10. Cost to replace is Rs 7. Prior to replacement Rs4 If it is to be available to Shareholder the its Rs 3 only. The diff of $1 (original Cost-cost of replacement) is holding gain or inventory profit Restatement of financial statements is pemitted as LIFO method os not accepted as per GAAP

Analysing Income Statementinventories

During periods of growing prices and stable or growing inventory LIFO depicts better measurement of current income and future profit FIFO is a Balance Sheet safe. During periods of growing prices and stable or growing inventory LIFO Vs FIFO a comparison

LIFO Vs FIFO
LIFO COGS Higher EBIT Lower IT Lower Net Income Lower Cash flow Higher Invent Bal Lower Working Lower Cap FIFO Lower Higher Higher Higher Lower Higher Higher

Impact on Income and taxes

Workings Mac 1

RATIO ANALYSIS
Discussion of every ratio is under the following head Function Computation Analytical value nad aid to decision making Assessment/ bench marking Strategic key drivers

ROI
Return on Networth F: measures net profit earned on eq shareholders funds. It is a measure of overall profitability of a company after paying cost of borrowed capital and IT to govt. Also known as ROE RONW(%)=(PAT-Preferred dividend) ----------------------------------x100 Eq.shareholders funds or net worth(Eq. Capital+Reserves& Surplus-Miscellaneous expenditure not written off)

ROI
Adjust for extraordinary items for calculation of PAT A high ratio usually means High dividend More internal accruals Better growth prospects More lenders high valuation in capital market attract good personnel retention of employees greater

ROI
Assessment Comparison of Growth in previous year to a longer term past With industry leader With industry average With weighted average cost of capital With cost of borrowings and cost of equity

ROI
Strategic key drivers Growth in sales Efficient asset utilisation Cost economies Tax planning Lower cost of borrowings Optimum capital structure

ROI-EPS
Earning per share Measures overall profitability in terms of per equity share capital EPS= PAT-Preferred dividend ______________________ Weighted average No Of Equity Shares outstanding This is the basis for valuation of shares for IPO, for strategic decision making like take overs, aquistions, mergers etc

ROI-EPS
Bench marking like ROE Strategic key drivers Same as ROE RONW also contributes

Solvency ratios
1) Net Asset Value:also known as networth per share or book value per share It seeks to assess to what extent the value of equity share of a company contributed at par or premium has grown /wealth created. NAV= Eq shareholders funds __________________________ No of equity shares outstanding Only closing values need to be considered

Contd
Indicates efficiency of management in building reserves and surplus Bench marking same as ROE Strategic key drivers are the dividend policies and share premium RONW and EPS

Contd.
Debt Equity (times) Measures the proportion of debt and equity in the capital structure/assets financed through long term funds =LTF _________ Total Net worth(Eq shareholder funds +preference capital) Higher the debt higher is the financial risk of default in interest and debt service Affects sources of raising additional finance

Contd.
Bench marking 1.5:1; higher ratio for capital intensive and infrastructure projects. Strategic key drivers Borrowing policy Dividend policy EPS and RONW

Contd.
Interest Coverage (Times)/Times Interest Covered Measures capacity of the company to pay interest liabilities on its LTF out of its cash profits = PAT+Interest on long term debt+non cash charges __________________________________ Interest on LTF Higher the ratio the company is in a better position to service its debt and has less default risk.

Contd
Bench mark 2:1 Main strategic driver is the proportion of non cash charges in the expense structure of the company.

Contd
Debt Service Coverage Ratio(DSCR)times Measures the capacity of the company to pay installments of principal due and interest liability incurred on its long term borrowings out of its cash profits. =PAT+interest on LTF+non cash charges __________________________________ Interest on LTF+Instalments of principal due

Contd..
Higher the ratio greater the ability of the company to service debt. Main drivers tenure of loans, cost of borrowings, proportion of non cash borrowings.