ncome Statement - Revenue

Recognition Principle

PowerPoint Presentation by Dr. Muhammad Nabeel Ashraf

Ref: Financial Statement Analysis and Corporate Issuers (CFA Level 1

book 3

REVENUE RECOGNITION

• Revenue is the top line in an income statement, so we begin the

discussion of line items in the income statement with revenue

recognition.

• Accounting standards for revenue recognition (which we discuss later

in this section) became effective at the beginning of 2018 and are

nearly identical under IFRS and US GAAP.

• The revenue recognition standards for IFRS and US GAAP (IFRS 15 and

ASC Topic 606, respectively) were issued in 2014 and resulted from an

effort to achieve convergence, consistency, and transparency in

revenue recognition globally.

General Principles

• A fundamental principle of accrual accounting is that revenue is

recognized (reported on the income statement) when it is earned,

this is often when the company delivers the goods or services.

• Similarly, there are situations when a company receives cash in

advance and actually delivers the product or service later. In this case,

the company would record a liability.

Five steps in recognizing revenue:

1. Identify the contract(s) with a customer

2. Identify the separate or distinct performance obligations in the

contract

3. Determine the transaction price

4. Allocate the transaction price to the performance obligations in the

contract

5. Recognize revenue when (or as) the entity satisfies a performance

obligation.

Example: Revenue Recognition

Part 1: Performance obligation.

• Builder Co. enters into a contract with Customer Co. to construct a

commercial building.

• Builder Co. identifies various goods and services to be provided, such as

pre-construction engineering, construction of the building’s individual

components, plumbing, electrical wiring, and interior finishes. With

respect to “Identifying the Performance Obligation,” should Builder Co.

treat each specific item as a separate performance obligation to which

revenue should be allocated?

• In this example, the second criterion is not met because it is the building for

which the customer has contracted, not the separate goods and services.

Part 2: Progress towards completion

• Builder Co.’s contract with Customer Co. to construct the commercial

building specifies consideration of $1 million. Builder Co.’s expected

total costs are $700,000. The Builder incurs $420,000 in costs in the

first year.

• How much revenue should Builder Co. recognize for the first year?

• The standard states that for performance obligations satisfied over

time, revenue is recognized over time by measuring progress toward

satisfying the obligation.

• In this case, the Builder has incurred 60% of the total expected costs

($420,000/$700,000) and will thus recognize $600,000 (60% ×

$1 million) in revenue for the first year.

Part 3: Variable consideration

• Assume that Builder Co.’s contract with Customer Co. to construct the

commercial building specifies consideration of $1 million plus a bonus of

$200,000 if the building is completed within 2 years.

• Builder Co. has only limited experience with similar types of contracts and

knows that many factors outside its control (e.g., weather, regulatory

requirements) could cause delay.

• The Builder incurs $420,000 in costs in the first year. how much revenue

should Builder Co. recognize for the first year?

• The standard addresses so-called “variable consideration” as part of

determining the transaction price. A company is only allowed to recognize

variable consideration if it can conclude that it will not have to reverse the

cumulative revenue in the future. In this case, Builder Co. does not

recognize any of the bonus in year one because it cannot reach the nonreversible conclusion given its limited experience with similar contracts and

potential delays from factors outside its control.

Part 4: Contract revisions - performance bonus

• Assume in the beginning of year two, Builder Co. and Customer Co. agree to

modify the contract.

• As a result the consideration will increase by $150,000, and the allowable

time for achieving the bonus is extended by 6 months. Builder expects its

costs will increase by $120,000.

• Also, given the additional 6 months to earn the completion bonus, Builder

concludes that it now meets the criteria for including the $200,000 bonus

in revenue. How should Builder account for this change in the contract?

• Therefore, the company must update its transaction price and measure of

progress.

• Builder’s total revenue on the transaction (transaction price) is now

$1.35 million ($1 million original plus the $150,000 new consideration plus

$200,000 for the completion bonus).

Part 4: Contract revisions - performance bonus (Continue)

• Builder Co.’s progress toward completion is now 51.2% ($420,000 costs

incurred divided by total expected costs of $820,000).

• Based on the changes in the contract, the amount of additional revenue to

be recognized as (51.2% × $1.35 million) - $600,000 already recognized.

The additional $91,200 of revenue would be recognized as a “cumulative

catch-up adjustment” on the date of the contract modification.

Part 5: Acting as an agent

• Assume a Company operates a website that enables customers to purchase

goods from various suppliers.

• The customers pay the Company in advance. The suppliers deliver the

goods directly to the customer, and the Company receives a 10%

commission.

• Should the Company report Total Revenues equal to 100% of the sales

amount (gross) or Total Revenues equal to 10% of the sales amount (net)?

• Revenues are reported gross if the Company is acting as a Principal and net

if the Company is acting as an Agent.

• In this example, the Company is an Agent because it isn’t primarily

responsible for fulfilling the contract, it should report only the amount of

commission as its revenue. explain everything im a begginner studying finance so please use easy wordings and teach my the notes

ChatGPT

ChatGPT

Certainly! Let's break down the key points about revenue recognition in a simple manner:

1. What is Revenue Recognition?

• Revenue is the money a company earns from selling goods or providing services. Recognizing revenue means recording it in the company's financial statements, typically on the income statement.

1. Why is it Important?

• Revenue is crucial because it's the top line of the income statement. Understanding when to recognize revenue accurately reflects a company's performance and financial health.

1. Principle of Revenue Recognition:

• Revenue is recognized when it is earned, usually when goods are delivered or services are performed.

1. General Principles:

• Revenue should be recorded when the company fulfills its obligations to customers, even if cash hasn't been received yet.
• Sometimes, companies receive cash in advance for goods or services they will provide later. In such cases, they record a liability until the obligation is fulfilled.

1. Five Steps in Recognizing Revenue:

• Identify the contract(s) with customers.
• Identify the separate performance obligations in the contract.
• Determine the transaction price.
• Allocate the transaction price to the performance obligations.
• Recognize revenue when the company satisfies a performance obligation.

1. Example of Revenue Recognition:

• Imagine a construction company, Builder Co., building a commercial building for Customer Co.
• Builder Co. identifies various services to be provided, such as pre-construction engineering and building components.
• Revenue is recognized over time as progress is made towards completing the project.

1. Considerations in Revenue Recognition:

• Variable Consideration: If the total payment depends on certain conditions, like completing the project within a specific timeframe, revenue recognition might be affected.
• Contract Revisions: If the terms of the contract change, revenue recognition should be adjusted accordingly.
• Acting as an Agent: If a company facilitates transactions between buyers and sellers but isn't primarily responsible for delivering goods or services, it reports revenue as a commission rather than the total sales amount.

1. Summary:

• Revenue recognition is vital for understanding a company's financial performance.
• It follows principles ensuring revenue is recorded accurately and fairly.

Understanding revenue recognition helps investors and stakeholders assess a company's financial health and performance effectively.

You

BRO?? EXPLAIN THE SOLUTIONS VARIABLES OR WHATEVER

ChatGPT

ChatGPT

Of course, let's go through each part of the revenue recognition example and break down the solutions with simple explanations:

Part 1: Performance obligation

• The construction company, Builder Co., has a contract with Customer Co. to build a commercial building.
• Builder Co. needs to determine if each specific item, like pre-construction engineering and building components, should be treated as separate performance obligations.
• In this case, since the customer is contracting for the entire building, not individual services, Builder Co. doesn't treat each item separately.

Part 2: Progress towards completion

• Builder Co. has a $1 million contract with expected costs of $700,000. In the first year, it incurs $420,000 in costs.
• To determine revenue for the first year, Builder Co. looks at the progress made toward completing the project.
• Since 60% of the total expected costs have been incurred ($420,000/$700,000), Builder Co. recognizes 60% of the contract value as revenue for the first year, which is $600,000.

Part 3: Variable consideration

• Builder Co.'s contract includes a $1 million base payment plus a $200,000 bonus if the project is completed within 2 years.
• However, due to uncertainties like weather or regulations, Builder Co. cannot be sure if it will receive the bonus.
• Therefore, in the first year, Builder Co. doesn't recognize any bonus revenue because it can't guarantee it will earn it.

Part 4: Contract revisions - performance bonus

• In the second year, the contract is modified, increasing consideration by $150,000 and extending the bonus timeframe by 6 months.
• Builder Co. also expects additional costs of $120,000.
• Now, Builder Co. concludes it will meet the criteria for the $200,000 bonus.
• Builder Co. updates the transaction price to $1.35 million ($1 million original + $150,000 new consideration + $200,000 bonus).
• It then adjusts revenue based on the progress towards completion, recognizing additional revenue as a "cumulative catch-up adjustment."

Part 5: Acting as an agent

• Imagine a company operating a website where customers buy goods from various suppliers, and the company gets a 10% commission.
• The customers pay the company upfront, but the suppliers deliver the goods directly.
• Since the company is only facilitating the transactions, it reports revenue as the commission it earns (10% of sales), not the total sales amount.

These explanations help understand how revenue recognition principles are applied in different scenarios, considering variables like contract terms, progress, and changes.

You

Revenue should be recorded when the company fulfills its obligations to customers, even if cash hasn't been received yet.

? easy examples

ChatGPT

ChatGPT

Sure, here are some easy examples to illustrate the concept:

1. Subscription Services:

• Imagine you subscribe to a streaming service like Netflix. You pay for a month's subscription upfront, but you can enjoy the service throughout the month.
• Even though Netflix receives the cash at the beginning of the month, they fulfill their obligation to provide you with access to their content throughout the month.
• So, Netflix recognizes revenue evenly over the month, reflecting the service they provide to you.

1. Online Retail Purchases:

• Suppose you order a product online and choose to pay upon delivery.
• The online retailer ships the product to you immediately, fulfilling their obligation to deliver the item.
• Even though they haven't received payment yet, they recognize revenue at the time of shipment because they've completed their part of the transaction.

1. Construction Projects:

• Let's say you hire a contractor to renovate your kitchen. The contractor completes the work according to the contract terms, but you haven't paid them yet.
• Despite not receiving payment, the contractor has fulfilled their obligation by completing the renovation work.
• Therefore, the contractor recognizes revenue for the completed work, even if payment is pending.

In each of these examples, revenue is recognized when the company fulfills its obligation to provide goods or services to the customer, regardless of whether cash has been received at that time. This aligns with the principle of accrual accounting, where revenue is recorded when it is earned, not necessarily when cash changes hands.

You

So, Netflix recognizes revenue evenly over the month, reflecting the service they provide to you.

wdym

ChatGPT

ChatGPT

Certainly! Let's break down the process of revenue recognition for a subscription-based service like Netflix:

1. Subscription Revenue Recognition:

• When you subscribe to Netflix, you typically pay a fixed fee for a month of access to their streaming service.
• Netflix's obligation is to provide you with access to their content throughout the month.
• Instead of recognizing all the subscription revenue immediately when you pay, Netflix spreads it out evenly over the subscription period to reflect the service they provide continuously.

1. Example:

• Suppose you subscribe to Netflix for $15 per month.
• You pay $15 at the beginning of the month but have access to Netflix's content for the entire month.
• Instead of recognizing the full $15 as revenue immediately, Netflix recognizes $15/30 = $0.50 of revenue for each day of the month.
• So, on the first day of the subscription, Netflix records $0.50 as revenue, and the same amount is recorded each subsequent day until the end of the month.
• By the end of the month, Netflix has recognized the full $15 as revenue, reflecting the service provided throughout the subscription period.

This approach aligns with the principle of recognizing revenue when it is earned, in this case, reflecting the ongoing service provided by Netflix throughout the subscription period.

You

then whats the concept of accrual

ChatGPT

ChatGPT

The concept of accrual accounting is fundamental in understanding how revenue and expenses are recognized in financial statements. Here's a simple explanation:

1. Accrual Accounting:

• Accrual accounting is a method of accounting where transactions are recorded when they occur, regardless of when cash is exchanged.
• It focuses on matching revenues with expenses in the period in which they are incurred, rather than when cash is received or paid.

1. Key Principles:

• Revenue Recognition: Revenue is recognized when it is earned, regardless of when payment is received. This means that revenue is recorded when goods are delivered or services are performed, even if the customer hasn't paid yet.
• Expense Recognition: Expenses are recognized when they are incurred, meaning when goods or services are received, or when obligations are created, regardless of when payment is made. This ensures that expenses are matched with the revenues they help generate.

1. Example:

• Suppose a company provides services to a customer in January but doesn't receive payment until February.
• According to accrual accounting:The company recognizes revenue in January when the services are provided, even though payment is received in February.
• Similarly, if the company incurs expenses, such as salaries or utilities, in January but doesn't pay until February, the expenses are still recognized in January when they are incurred.

1. Advantages:

• Provides a more accurate picture of a company's financial performance by matching revenues with the expenses incurred to generate them.
• Helps in better decision-making by showing the financial position of a company at a specific point in time, rather than just based on cash flows.

1. Comparison with Cash Accounting:

• In contrast, cash accounting records transactions only when cash is received or paid. It doesn't consider when revenue is earned or expenses are incurred.
• Accrual accounting is generally preferred for its ability to provide a more comprehensive view of a company's financial performance over a specific period.

In summary, accrual accounting ensures that revenues and expenses are recorded when they are earned or incurred, providing a more accurate representation of a company's financial position and performance.

You

then is the concept of accrual and revenue recognition same

ChatGPT

ChatGPT

While accrual accounting and revenue recognition are closely related concepts, they are not exactly the same. Here's a breakdown of each concept:

1. Accrual Accounting:

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You

explain with example

ChatGPT

ChatGPT

Certainly! Let's clarify the difference between accrual accounting and revenue recognition with examples:

1. Accrual Accounting:

• Accrual accounting is a method of recording transactions when they occur, regardless of when cash is exchanged. It focuses on matching revenues with expenses in the period they are incurred.
• Example: Suppose a company provides services to a client in December but doesn't receive payment until January of the following year. In accrual accounting:The company would recognize the revenue from the services rendered in December, when they were performed, even though the payment is received in January.
• Similarly, if the company incurs expenses, such as salaries or utilities, in December but doesn't pay until January, the expenses are still recognized in December when they are incurred.

1. Revenue Recognition:

• Revenue recognition is a specific aspect of accrual accounting that focuses on when revenue should be recorded. It dictates when revenue earned from the sale of goods or services should be recognized in the financial statements.
• Example: Continuing with the previous example, let's say the company entered into a contract with a client to provide services over a three-month period, from October to December. The total contract price is $3,000, with $1,000 to be received each month.In October, the company provides services worth $1,000. Even though they haven't received payment yet, according to revenue recognition principles, they recognize $1,000 of revenue in October.
• In November and December, the company provides services worth $1,000 each month. They recognize $1,000 of revenue in November and December, respectively, as they fulfill their obligation to the client each month.

In summary, while accrual accounting encompasses the broader principle of recording transactions when they occur, revenue recognition is a specific application of accrual accounting that focuses on when revenue should be recognized based on the completion of obligations or delivery of goods and services.

You

bro explain in easy words how many times do i say

ChatGPT

ChatGPT

Sure, I'll simplify the explanation:

1. Accrual Accounting:

• Accrual accounting means recording transactions when they happen, not necessarily when cash changes hands. It's like keeping track of things as they occur.
• Example: Let's say you do some work for your neighbor in December but they don't pay you until January. With accrual accounting, you'd record the work you did in December, even though you got paid in January.

1. Revenue Recognition:

• Revenue recognition is a part of accrual accounting. It's about knowing when to count money as earned, even if you haven't received it yet. It's like acknowledging when you've done something to earn money.
• Example: If you have a job where you get paid at the end of each week, you'd recognize your weekly pay each week, even though you get the actual money later.

So, in short:

• Accrual accounting is about keeping track of transactions as they happen.
• Revenue recognition is about knowing when to count money as earned, even if you haven't received it yet.

You

use the netflix example im confused by this pther examples

ChatGPT

ChatGPT

Absolutely, let's focus on the Netflix example:

1. Accrual Accounting:

• With accrual accounting, transactions are recorded when they happen, not necessarily when cash is received or paid. It's like keeping track of things as they occur.
• For Netflix, when you subscribe for a month, they record the subscription revenue each day of the month, even though you paid upfront at the beginning of the month.

1. Revenue Recognition:

• Revenue recognition is a part of accrual accounting. It's about knowing when to count money as earned, even if you haven't received it yet. It's like acknowledging when you've done something to earn money.
• For Netflix, they recognize a portion of your subscription fee as revenue each day of the month, reflecting the service they provide you over that time, even though they received the full payment upfront.

So, in short:

• Accrual accounting is about keeping track of transactions as they happen.
• Revenue recognition for Netflix means recognizing a portion of your subscription fee each day, reflecting the service they provide you over that time, even though you paid upfront for the whole month.

You

For Netflix, when you subscribe for a month, they record the subscription revenue each day of the month, even though you paid upfront at the beginning of the month.

then isnt the same happening in Revenue Recognition:

?

ChatGPT

ChatGPT

Yes, you're correct. In the case of Netflix, both accrual accounting and revenue recognition are happening simultaneously and are closely intertwined. Allow me to clarify:

1. Accrual Accounting:

• Accrual accounting involves recording transactions when they occur, regardless of when cash is exchanged. It's like keeping track of events as they happen.
• In the case of Netflix, when you subscribe for a month, they spread out the recognition of your subscription revenue evenly over the subscription period (each day of the month), even though you paid upfront at the beginning of the month. This is a key aspect of accrual accounting.

1. Revenue Recognition:

• Revenue recognition is a specific aspect of accrual accounting that focuses on when revenue should be recognized based on the completion of obligations or delivery of goods and services. It's about knowing when to count money as earned, even if you haven't received it yet.
• For Netflix, revenue recognition dictates that they recognize a portion of your subscription fee as revenue each day of the month, reflecting the service they provide you over that time, even though you paid upfront for the whole month. This aligns with the broader principle of revenue recognition.

So, in summary:

• Accrual accounting involves recording transactions when they occur, and in the case of Netflix, it means spreading out the recognition of subscription revenue over the subscription period.
• Revenue recognition, as part of accrual accounting, dictates how Netflix recognizes revenue each day of the subscription period, reflecting the service they provide you, even though you paid upfront at the beginning of the month.

You

Sometimes, companies receive cash in advance for goods or services they will provide later. In such cases, they record a liability until the obligation is fulfilled.

then isnt subcriptions a type of lilbility??

ChatGPT

ChatGPT

In accounting, when a company receives cash in advance for goods or services it has yet to provide, it typically records a liability on its balance sheet. This liability represents the company's obligation to fulfill the goods or services in the future.

In the case of subscription-based services like Netflix, where customers pay upfront for access to content over a specific period, the company indeed records a liability. The liability represents the obligation to provide the service (content access) to the customer over the subscription period.

So, yes, in this context, subscriptions are indeed a type of liability for the company until the service is provided to the customer. Once the service is rendered (such as streaming access provided throughout the subscription period), the company can then recognize the revenue, and the liability decreases accordingly.