Financial Statement Analysis

Lecture 03

Wahid SherAni
Ph.D. Scholar
GAAP
 “In the Pakistan , generally accepted accounting
principles, commonly abbreviated as GAAP or
simply GAAP, are accounting rules used to prepare,
present, and report financial statements for
publicly-traded companies and many privately-held
companies.” (Wikipedia)
 Revenue Recognition
Recognition refers to the time when
transactions are recorded on the books. The
FASB’s two criteria for recognizing revenues
and gains are when:
1. They are realized or realizable.
2. They have been earned through substantial
completion of the activities involved in the
earnings process.
Both of these criteria generally are
met at the point of sale
Accrual vs Cash Accounting
 Generally accepted accounting principles (GAAP)
require that business use accrual accounting.
Time-Period Concept
 The time-period concept ensures that accounting
information is reported at regular intervals.
 Basic accounting period is 1 year
 A fiscal year ends on a date other than December 31.

 Interim financial statements are usually prepared for

periods such as a month, a quarter, or semiannual
period.
Revenue Recognition Principle...
6

 Indicates that revenue be recognized in

the accounting period in which it is
earned.
 is considered earned

when the service has been provided

or
 when the goods are delivered.
Revenue Principle
 When should revenue be recorded?
 Revenue should be recorded when it has been earned.
 Delivered Good or Service to a Customer
 What amount of revenue should be recorded?
 Theamount of revenue recorded is the cash value of
the goods transferred to the customer.
Matching Principle...
8

requires that expenses be recorded in

the same period in which the
revenues they helped produce are
recorded.
Matching Principle
 Expenses are costs of assets used up and/or liabilities
created in earning revenue.
 Matching involves two steps:
 Identify all expenses incurred during the period.
 Measure the expenses and match the expenses against
revenues earned.
 Expenses may
 be paid in cash.
 result from using up an asset such as supplies
 result from creating a liability (payable)
Accrual vs Cash Accounting
 Accrual Accounting
 Impact of business transactions are recorded when the
transaction occurs
 Revenues are recognized when earned.
 Expenses are recognized when incurred.

 Cash Accounting
 Transactions are recorded when cash is received or
paid.
 Revenues are recorded when cash is received.
 Expenses are recorded when cash is paid.
 Understanding financial statements are the starting
point for analysis
 therefore, the financial analyst should must
understand the concept of asset, liabilities , income ,
cash flow.
 How income and cash flow be defined and
measured.
 the relationship among income , cashflow and
assets is captured by concept of economic earning.

Economic Earning can be defined as

“ the net cashflow plus the change in the market value
of an assets.
The market value of the of an asset is equal to
present value of their cashflow discounted at rate
(risk-Free rate)
 Accrual concept is the most fundamental principle of
accounting which requires recording revenues when
they are earned and not when they are received in
cash, and recording expenses when they are
incurred and not when they are paid.
Cash and Accrual Bases of Accounting

 Cash basis: revenues are recognized when cash is

received and expenses are recognized when cash is
paid
 Accrual basis: revenues are recognized when
earned and expenses are recognized when incurred

LO 2
Example 4.1—Comparing the Cash
and Accrual Bases of Accounting
Exhibit 4.2—Comparing the Cash and
Accrual Bases of Accounting
 GAAP allows preparation of financial statements on
accrual basis only (and not on cash basis).
 This is because under accrual concept revenues and
expenses are recorded in the period to which they relate
and not when they are received or paid.
 Application of accrual concept results in accurate
reporting of net income, assets, liabilities and retained
earnings which improves analysis of the company’s
financial performance and financial position over
different periods.
Accrual vs Cash Accounting
 Under accrual accounting, cash transactions are
recorded as well as noncash transactions such as:
 Purchases of inventory on account
 Sales on account

 Depreciation expense

 Accrual of expenses incurred but not yet paid

 Usage of prepaid rent, insurance, and supplies

 Accrual vs. Cash-Basis Accounting
3-20

ACCRUAL CASH
 Records business  Records transactions only
when cash is received or
transactions when they
paid
occur  When customer pays for
 When sale is made product or service
 When bill is received  When bills are paid

 Complies with GAAP  Only used by very small

 Presents accurate businesses
financial picture  Omits important info
The Revenue Recognition Principle
 Recognized in the income statement when they are
realized, or realizable, and earned
 Revenues: Inflows of assets or settlements of
liabilities
 Deliveringor producing goods
 Rendering services

 Conducting other activities

LO 3
Expense Recognition and the
Matching Principle
 Association of revenue of a period with all of the
costs necessary to generate that revenue
 Direct matching: associate revenues of a period with
their costs
 Indirect matching: associate costs with a particular
period
• Example: depreciation on building
 Expenses incurred in two different ways:
 From the use of an asset
 From the recognition of a liability

LO 4
 Revenue Recognition Before
Delivery/completion
Revenue may be recognized before
delivery under certain circumstances.
• Long-term construction contracts are a
notable example
Two methods are available:
• The percentage-of-completion method, and
• The completed contract method
 Introduction

• If a Company waits until the production or

service period is complete to recognize
revenue, this approach is referred to as the
completed-contract method. All income
from the contract is related to the year of
completion.
• Percentage-of-completion accounting was
developed to relate recognition of revenue on
long-term construction-type contracts to the
activities of a firm in fulfilling these contracts.

8-24
 Revenue Recognition Before
Delivery
Long-Term Construction
Accounting Methods

Percentage-of-Completion Completed Contract

Method Method

1) Terms of contract must 1) To be used only when

be certain, enforceable. the percentage method is
2) Certainty of performance inapplicable [uncertain]
by both parties 2) For short-term contracts
3) Estimates of completion
can be made reliably
 Percentage-of-Completion:
Example
Data: Contract price: $4,500,000 Estimated cost: $4,000,000
Start date: July, 2015 Finish: June , 2018
Balance sheet date: Dec. 30 June
Given: 2016 2017 2018

Costs to date $1,000,000 $2,916,000 $4,050,000

Estimated costs to complete $3,000,000 $1,134,000 $ -0-
Progress Billings during year $900,000 $2,400,000 $1,200,000
Cash collected during year $750,000 $1,750,000 $2,000,000

What is the percent complete, revenue and gross

profit recognized each year?
Formula
 Percentage-of-Completion:
Example
2003 2004 2005

% complete 1,000,000 = 25% 2,916,000= 72% 100 %

to-date 4,000,000 4,050,000

Revenue 4,500,000 * 25% 4,500,000 * 72% 4,500,000

recognized = 1,125,000 less 1,125,000 less 3,240,000
= 2,115,000 = 1,260,000

Gross Profit 1,125,000 less 2,115,000 less 1,260,000

recognized 1,000,000 1,916,000 less 1,134,000
= 125,000 = 199,000 = 126,000
 Recognizing Current & Overall
Losses on Long-Term Contracts
A long-term contract may produce:
• either an interim loss and an overall profit,
• or an overall loss for the project
Under the percentage-of-completion
method, losses in any case are immediately
recognized.
Under the completed contract method,
losses are recognized immediately only when
overall losses are indicated.