Unit 1 External Financial Statements and Revenue

Recognition

1.1 Concepts of Financial Accounting

1. Objective of general-purpose Financial Reporting

Financial Accounting (External Reporting)
It is a set of financial statements that are historical focus (previous performance) and are
prepare by accounting principles (GAAP or IFRS). The objective is to provide useful to users
who are mainly external users (they make decisions outside the firm and determine if
business is profitable or not). The information reported is related to financial position
(information relates the entities economic resources and claims) of the business and is useful
to understand the economic resources, evaluate management and predict future returns.
Statements are also prepared in conformity (complying with rules) with accounting
principles.
Management Accounting (Internal Reporting)
It contains reports that are future oriented (future performance) used in decision making,
planning, and controlling. They are mainly used by internal users (management, BOD, and
employees) to make decisions regarding the operations and do not need to follow GAAP or
IFRS.

2. Users of Financial Statements

There are 2 types of users, including Direct and Indirect Interests. A person with direct
interest will be have an economic interest in the business (directly affected with the results of
the business).
Direct Interests include:
a. Investors and Potential Investors
b. Suppliers and Creditors
c. Employees
d. Management
Indirect Interests (represent direct users) include:
a. Financial Advisors and Analysts
b. Stock Market and Exchanges
c. Regulatory Authorities (Tax)
d. Labor Unions

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Users of financial statements are assumed to have reasonable knowledge of the business and
are willing to study the business with reasonable diligence. Financial Statements are prepared
with an assumption that users have that knowledge to ensure the understanding by all parties.
Annual Report- it is a report made on a yearly basis and is prepared by management to
shareholders and External Users with GAAP. Its designed to provide information that is
pertinent (relevant) to investors and external users. It is very useful to external users and least
useful to internal users.
Managers responsible for operating activities use internal reports to provide information
about internal functions for efficiency and effectiveness.

3. Features of Financial Statements

Financial Statements provide useful information for external parties. The Financial Statement
Notes and Disclosures (management analysis) are very essential in understanding the
Financial Statements and are considered an integral part but are not actual financial
statements. The Notes are very crucial aspect as they amplify or explain the statements. Notes
include the accounting policies, assumptions, revenue recognition and allocation of asset.
Financial Statements must not be used to correct errors in the past.

1) Relevance- accounting info must be capable of making a difference in a decision.

(the new information added to a financial statement is considered relevant info as it
clarifies how well the entity is operating)

2) Faithfully Presented- information must be complete, free of errors and unbiased and
must describe what really happened.

3) Timeliness- information must be available at the correct timing before losing its
capacity.

4) Verifiability- independent measures used, using same accounting methods and

provide similar results.

5) Comparability- information must be presented in the same date to be comparable.

(same accounting period must be used)

6) Consistency- the firm must use the same accounting methods. Ex- Inventory
Valuation (FIFO vs LIFO), Depreciation Methods (SLN vs DDB)

7) Historical Cost- assets and liabilities are recorded with the original cost, even if the
value changes over time. (changes in FV or MV must not be reflected in the Balance
Sheet)

8) Going Concern- the entity is assumed to continue operating in the foreseeable future.

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 4. Accrual Basis of Accounting
Financial Statements are prepared by accruals basis. Its means that revenues are recognized
when earned not when cash is received. Expenses are recognized when incurred and not
when cash is paid. GAAP operated with Accruals Basis. This is the best method for entities
ability to generate cash flows for past and future.
Under cash basis, revenue is recognized when cash is received, and expenses are recognized
when cash is paid.

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 1.2 Statement of Financial Position (Balance Sheet)

The Statement of Financial Position (Balance Sheet) reports the amounts of assets (value),
liabilities (debt) and equity (net worth) at a specific time. The Balance Sheet helps users
assess liquidity, financial flexibility, and risk. The balance sheet does not intent to show the
value of the business, however with other statements, estimation maybe done with the analyst
own judgement.
Assets = Liabilities + Equity
NOTE
✓ Resources of the entity include assets
✓ Capital Structure includes the amount contributed by creditors (liabilities) and
investors (equity)
✓ This equation is based on proprietary equation (relation to owner), equity is what
remains after removing resources and obligations.

1. Assets
Assets- resources owned and controlled by an entity as a result of past events, which
represent future economic benefits. They are generally reported in the order of liquidity.
An asset is considered current asset if it is expected to be realized in cash, sold, or consumed
within an entity’s operational cycle or 1 year whichever is longer (operating cycle is the
average time from acquisition of raw material and realization of cash after sale).
1) Cash and Cash Equivalents- cash on hand or in bank or checks
2) Short Term Investment- available for sale securities, trading securities and held for
maturity securities (maturity less than 3 months)
3) Receivables- accounts receivable or notes receivable
4) Inventory- raw material, work in process and finished goods
5) Prepaid Expenses- prepaid rent (valued at cost – used portion)

Non-current asset is not qualifying as current asset, expected to be realized in cash, sold, or
consumed during the normal operating cycle.
1) Investments and Funds- include non-operating items that intend to help beyond the
1 year or operating cycle.
a. Investments in securities made to control another entity
b. Specific kinds of available for sale securities or held to maturity debt securities
c. Restricted funds including retiring long-term debt or pension funds or
acquisition/construction of non-current asset

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 2) Property, Plant and Equipment- tangible, operating items recorded at cost and
reported with accumulated depreciation.
a. Land and Natural Resources (depletion)
b. Building, equipment, or furniture (depreciation)

3) Intangible Assets- non-financial assets without physical substance, they can be

purchased or developed. Ex- patent, goodwill, franchise, or copyright.

2. Liabilities
Liabilities- present obligations of an entity that arise from past events. Their settlement is
expected to result in an outflow of resources of the entity.
A liability is considered current liability if it is expected to be settled or liquidated in an
ordinary course of business of an operating cycle or 1 year, whichever is longer. (generally
current liabilities are expected to be settled or liquidated within 1 year from the balance sheet
date).
1) Trade Payables- items related to operating cycle (ex- AP / NP)
2) Other Payable- arise from operations (ex- salaries, taxes, rentals)
3) Unearned Revenues- occur from collection in advance of delivering goods or
performing service.
4) Other Obligations- expected to be liquidated in an ordinary course of business
a. Short Term Notes to purchase an asset
b. Payments for sinking funds (ex- amount to replace an asset)

Non-current Liabilities are those not qualifying as current liabilities and are expected not to
be settled within one year or operating cycle. Examples are as follows:
❖ Non-current Notes and Bonds
❖ Lessee liabilities with refinancing agreement
❖ Post-retirement benefits obligations
❖ Deferred Tax from inter-period tax allocation (temporary difference in tax liability)
❖ Obligations under warranty
❖ Deferred Revenue

NOTE
In order to classify a short-term debt to become reported under Non-current Liabilities, the
entity must intent to refinance it and enter into an agreement before the balance sheet is
issued.
Most long-term debts are subjected to covenants or restriction for a specific amount the entity
owns.

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 3. Equity
It is the residual interest in the assets of an entity. Equity is affected by operations as well as
the transactions by owners (dividends and contributions). Investment by owners increase the
equity in the business and increases the ownership interest (through assets or services).
Distribution to owners decrease the equity as they transfer assets to owners and decreases
ownership interest.
1) Capital Contributions by owners- (par value / face value of common stocks and
preferred stocks issued)

2) Additional Paid in Capital- it is the excess amount of contribution from owners, by

the sale of shares above the par / stated value

3) Retained Earnings- it is the accumulated net income that is not distributed to owners
(credit nature). Payment of excess in this balance is return on capital, not dividends.

4) Treasury Stock- it is the firm own stock that has been re-purchased. (it is an equity
contra account). Its reported either with cost or par value. Treasury stock has no
voting right and receives no cash dividends or distribution in case of liquidation.

5) Accumulated Other Comprehensive Income- items not recorded in the Income

Statement

6) Non-Controlling Interest- a portion of the equity of subsidiary that the reported

entity does not own entirely (minority interest)

4. Notes and Disclosure

The notes are considered an integral part of the statements. Notes include:
➢ Accounting Basis (accruals basis vs cash basis)
➢ Accounting Policies (LIFO vs FIFO)
➢ Details about Investments
➢ Maturity Dates of Securities
➢ Details of Capital Stock and Preferred Stock

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 5. Uses and Limitations of Balance Sheet
Uses
✓ Provide basis to compute rate of returns, capital structure (capital leverage) and
predict future inflows
✓ Helps users assess liquidity, solvency, financial flexibility, and risk. Liquidity- it is
the ability (time/speed) to convert assets into cash. The greater the liquidity the lower
chance for failure.
✓ Financial Flexibility- how much of the business funding relies on debt. It refers to
the timing and amount that the business can get to respond to unexpected needs or
take advantage of opportunities.
✓ Risk- the unpredictable future events that can affect the company’s cash flow and
financial results
✓ Solvency- it is the ability for the company to pay its obligations when due. The higher
level of long-term debts vs assets, the lower solvency it has. (Ex- 80% debt and 20%
equity)

Limitations
❖ The balance sheet numbers show the values at a specific date and values may change
dramatically in few days before or after publishing the Balance Sheet
❖ Several items are recorded with historical costs which may not be equal to the fair
value (fixed asset)
❖ Preparation of Balance Sheet requires estimation or judgment
❖ The balance sheet may omit values that cannot be recorded objectively to the
business (ex- human resources, competitive advantage)

6. Off-Balance Sheet Financing

It is the process by which companies borrow and not record the debt in the Balance Sheet, to
improve its Financial Position making securities more attractive for investment. Firms use it
when the business is close to the borrowing limit and wants to purchase something. It is also
a method to lower borrowing interest rate as a way to manage risks or improve debt-to-equity
(the ratio of assets financed by liabilities) and leverage ratio.
Examples:
1) Operating Leases- the lessor (owner) reports the asset in the Balance Sheet, but the
lessee (user) reports rental expenses for the use of the asset.
2) Factoring Receivables with recourse- (the process of selling receivables to a third
party for collection, the main firm is liable if the debtor did not pay)
3) Special Purpose Entities- a firm may create another firm for the purpose of keeping
liabilities in a project, off the parent firm.
4) Joint Venture- it is an agreement between 2 or more firms to pool their resources to
accomplish a specific task.

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1.3 Income Statement and Statement of Comprehensive
Income

The Income Statement reports the results of Profit or Loss of a company’s operation during a
given period of time (for year ended 31 Dec). The Income Statement helps users predict
amounts, timings, and uncertainty of future cash flows (revenues and expenses).

1. Elements of Income Statements

1) Revenues- inflows from major operation related to the entity’s main activity, related
to delivering goods or service.
2) Expenses- outflows from major operation related to the entity’s main activity, related
to delivering goods or service.
3) Gains- inflows other than the major operation of the business, that increase the equity
(ex- lawsuit gain, gain from sale of asset, interest income from bank deposit,
dividends/gain from investment in other entities.
4) Losses- outflows other than the major operation of the business, that decrease the
equity (ex- loss from sale of asset, lawsuit loss, loss in investment)

NOTE
All of the above transactions affect the net change in equity during the period and are
considered income, except:
a. Transactions with owners
b. Prior-period adjustments (ex- correction of error or changes in accounting
principle)
c. Items reported in the Other Comprehensive Income
d. Transfers to and from Retained Earnings

Revenues, Expenses, Gains and Losses are all temporary (nominal) accounts, as they
record transactions at a specific time and then closed (returned to zero). Income and Losses
are closed to Retained Earnings (real account) at the end of the period.
The expense recognition principle is associated with cause and effect, systematic, rational
allocation, and immediate recognition.
Matching Principle is essential to recognize current expenses with current revenues (cause
and effect)

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 Revenue XXX
(-) COGS XXX
Gross Profit XXX
(-) Expenses XXX
+ Gains XXX
(-) Losses XXX
Net Profit /Loss XXX

Share-Based Payment- it is an arrangement of certain payments between employer and

employee (Ex- used when a startup wants to expand relations with employees) it includes and
recognized with FV:
a. Call Option- gives the employees the right to purchase share for the service they
provide (no actual payment) if they continue their employment at a specific period.
b. Share Appreciation Rights- the right that entitles employees to cash payment in
regard to increase in market value of the firm’s share.
c. Share Ownership- the plan to distribute shares for the employees for the service they
provide if they continue their employment at a specific period of time.

Other Expenses include the following:

1) General and Administrative Expenses- are incurred for the benefit of the
organization as a whole not to a specific function. (ex- salaries, office, supplies)
2) Selling Expenses- incurred to sell or market the product (ex- commission,
advertising, shipping cost to the customer)
3) Interest Expense- recognized based on passage of time for a loan or bond (effective
interest method / book value is used)

2. Types of COGS
There are 2 types of COGS and is classified depending on the main activity of the business.
1) Retailer- COGS is mainly calculated by change of inventor as this kind of businesses
purchase goods to be resold.
Beginning Inventory
+ Net Purchases
+ Freight IN
COGAFS
(-) Ending Inventory
COGS

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 2) Manufacturer- COGS is calculated by considering the DM, DL, MOH, WIP and FG,
as these products are being produced under this business
Beginning Raw Materials
+ Net Purchases of Raw Materials
Materials Available for Usage
- (Ending of Raw Material)
Direct Material
+ Direct Labor
+ Manufacturing Overhead (fixed + variable)
Total Manufacturing Costs
+ Beginning of WIP
- (Ending of WIP)
COGM
+Beginning of FG
COGAFS
- (Ending of FG)
COGS

There are 2 ways to present the Income Statement:

1) Single Step Income Statement- this method groups revenues and gains together, and
expenses and losses together and get the final result. (the drawback is that there is no
Gross Profit)

2) Multi-Step Income Statement- under this

method it separates operating income and
expenses from non-operating items.

NOTE
Earnings per Share (EPS) must always be disclosed
under both methods.

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 3. Reporting Irregular Items
There are 2 types of Irregular Items that can be reported on the Income Statement.
1) Discontinued Operations- it is any component
that the entity has been or will be eliminated from
a company’s operations, it is reported net of tax
and after the section of Income from Continuing
Operations (Net Income).

It may have 2 components:

a. Gain or Loss from Operations held for sale
strategic shift has major effects on financial
statements, (ex- production line)

b. Gain or Loss from Disposal of that Operations

2) Extra-Ordinary Items- in certain events that occur infrequently and unusual in

nature, it is considered a one-time gain or loss. Reported on pre-tax basis (before tax).
(ex- earthquakes)

Allocation of tax from continuing operations, discontinued operations and accumulated OCI
is called intra-period tax allocation (allocation in one period).

Notes Disclosure and schedules is specifically related to the Income Statement and must
include:
❖ Earnings Per Share (EPS)
❖ Depreciation Schedules
❖ Income Tax Expenses and its components
❖ Pension Expense and its components

Benefits of Income Statement:

✓ Helps users evaluate past performance and compare it to its competitors
✓ It is a basis to predict future performance
✓ It helps users assess the risk or uncertainty of achieving future cash flows

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Limitations of Income Statement include:
➢ The statement does not show all changes in revenues and expenses, some are reported
in OCI statement and therefore are not realized
➢ The income statement reports result on accruals basis, the firm may recognize the
revenue before the cash is received
➢ This statement is not enough to assess the liquidity and it must be viewed with
Balance Sheet and Cash Flow Statement
➢ The preparation of this statement requires judgment and estimates

4. Other Comprehensive Income

The Comprehensive Income includes all changes in equity (net assets) of a business, except
investment by owners and dividends. The items presented in the OCI cannot be added to the
Net Income as the gain or loss is unrealized. Items are always reported net of tax.
Items included on the OCI:
1) Gain or Loss from translation of foreign operations (different branches)
2) Special amounts of post-retirement plans
3) Unrealized Gain or Loss due to changes in fair value of available for sale debt
securities
4) Gain or Loss from cash flow hedge (investing in something that might increase value
later)

There are 2 ways to present the Other Comprehensive Income:

a. One Continuous Financial Statement (Net Income and OCI)
b. Two Separate but Consecutive Statements

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 1.4 Statement of Changes in Equity and Equity
Transactions

The Statement of Changes in Equity is reported for the period ended of 31 Dec, and it
presents a reconciliation for the accounting period for the beginning and ending balances.
Equity presents the net worth or net asset of the business.
Format of Changes in Equity Statement
Beginning Balance
+ Net Income for the period
+ OCI for the period
- (Dividends Declared)
- (Treasury Stock re-purchased)
Ending Balance

1. Statement of Retained Earnings

The Retained Earnings Statement reports parts of the changes in equity. It is not considered
as a main statement, but it supports the changes in equity. The retained earnings sometimes
report appropriate (restricted finds) for a specific purpose and must be disclosed in notes. It
is reported as follows:
Beginning Balance of Retained Earnings
+/- Prior Year Adjustments
+/- Net Income/Loss
- (Dividends Distributed)
Ending Balance of Retained Earnings

Prior Year Adjustments includes the cumulative effect on the Income Statement. In any case,
changes are not considered gains. They include:
1) Changes in Accounting Principle (ex- LIFO vs FIFO)
2) Correction of Errors from previous years
The previous items are adjusted retrospectively, which adjusts the differences from previous
years. These adjustments are related to the previous years and must not be included in the
current year’s net income.
3) Changes in Accounting Estimates (useful life of an asset)
This change is only adjusted prospectively, where the future years will be taking effect and
no adjustments shall be done with the previous years.
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 2. Common and Preferred Stocks

✓ Stock Authorized- the max amount of stock legally allowed to issue.

✓ Stock Issued- the amount of authorized stock that has been actually issued.
✓ Stock Outstanding- the amount of stocks that has been purchased by shareholders.

Common Shareholders
They are the owners of the firm, who have the right to select the BOD and vote for the BOD
resolutions. They are not entitled to dividends, unless if declared by the BOD (the firm may
choose to declare or not). Common shareholders receive their liquidating distributions the
last, after all obligations have been satisfied. They also have preemptive rights, which gives
them the priority to purchase additional paid in capital with that specific proportion (this
helps to protect the common shareholder’s interest in the firm).

Preferred Stockholders
There are considered debt and equity, who do not have voting rights. They also have a fixed
charge (dividend), but payment of dividends is not obligatory. Dividend is paid at a specific
rate (ex- 10%) and is received before common shareholder, even when liquidating the
business.
Common feature of preferred stockholders is being cumulative preferred stock which
accumulates unpaid dividends from previous years and must be paid in full before common
shareholders. Another feature is convertible preferred stock, which can convert his
preferred stock into common shares.

3. Equity Transactions
The value of stock increases, comparing to the par value (face value on the share) to market
value.
Entry
Cash (shares*market price) XXX
Common Stock (shares*par value) XXX
Additional Paid-In Capital (difference) XXX

Direct Costs of issuing stocks (underwriting, legal, tax etc.) must be recognized as decrease
in proceeds and additional paid-in capital not as expense.

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There are 4 ways to divide dividends:
1) Cash Dividends
On the declaration date the BOD approves dividends and is recognized then at the Retained
Earnings.
Entry
Declaration date:
Retained Earnings XXX
Dividends Payable XXX

Payment date:
Dividends Payable XXX
Cash XXX

2) Property Dividends
The entity declares dividends which consist of tangible property. The firm must re-measure
the Fair Value of the asset on the declaration date and recognize any gain or loss, which
presented in the Income Statement. Then the retained earnings are decreased for the fair
value.
Entry
Declaration Date:
Land (80,000-50,000) 30000 market value – carrying
amount
Gain on Land Investment 30000

Retained Earnings 80000

Property Dividends Payable 80000

Payment Date:
Property Dividends Payable 80000
Land 80000

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A stock dividend involves no distribution of cash or property, the stock dividends are
classified under different equity accounts, not liabilities. The recipient (receiver) of the
dividends does not consider it as income as it is the same proportion in the equity and same
carrying amount.

3) Stock Dividends- recognized by fair value and considered stock dividends if issuance
of share less than 20% to 25% is considered

4) Stock Split- its issuance does not affect the total equity, its only reduces the par value
of each stock and increases the number of shares. No entry is required but must be
disclosed and more than 20% to 25% is recognized as stock split.

In order for an item to be recognized in the main body of the financial statements, it must
meet basic elements that are measurable, sufficient certainty, relevant and reliable. If an item
does not meet all of them but still considered an integral part of the statements, it must be
disclosed in the notes. Note Disclosures and schedules related to changes in equity statement
include:
✓ Share Based Payment
✓ Dividends
✓ Retained Earnings
✓ Stockholders’ Equity
✓ Class of Stock (rights and privileges)

Limitations of Statement of Changes of Equity

1) The financial statements report on accruals basis, the firm may recognize a revenue or
expense before cash was paid or received.
2) The statement reports items at a specific time and numbers may change after
publishing the statements.

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IFRS Difference
An entity must reconcile between the carrying amount for the beginning and end of periods
separately, disclosing changes in subsidiaries that do not result in loss of control.
The dividends distributed to owners, the amount per share and analysis of all OCI items must
be show either in Changes in Equity Statement or in Notes Disclosure.

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 1.5 Statement of Cash Flows

The main purpose of the Statement of Cash Flows is to provide relevant information
regarding the cash receipts and cash payments of the firm in a specific period. This statement
helps users assess the liquidity (ability to generate positive future cash flows), solvency
(ability to meet obligations) and financial flexibility (resources that the business finance
from activity, owners, or loans). The statement main reconciles the cash and cash equivalent
for beginning and ending of the period.
There are 2 ways to present the SCF, direct and indirect methods and the main difference in
both is presenting the operating income only.
There are 3 main items where the SCF including Operating, Investing and Financing
activities.

1. Operating Activities
It includes all transactions related to the main activity of the business (items on Income
Statement). They begin with the net income. It includes Current Assets, Current Liabilities
and some Income Statement items
Cash Inflows:
✓ Cash receipts from goods and service
✓ Cash receipts from other revenues
✓ Cash received from interest and dividends (invested in other entities)
Cash Outflows:
✓ Cash payment to supplier or employees
✓ Cash payment to government (ex- taxes, fines, duties)
✓ Payment on interest debt (ex- loan)

RULES
➢ Increase in Current Assets –
➢ Decrease in Current Assets +

➢ Increase in Current Liabilities +

➢ Decrease in Current Liabilities –

➢ Non-cash loss/expense included in Net Income +

➢ Non-cash gain/revenue included in Net Income –

➢ Loss/Expense whose cash effects are related to investing or financing +

➢ Gains/Revenue whose cash effects are related to investing or financing –

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Example (operating activities)

2. Investing Activities
It represents the extent to which expenditures have been used for resources intended to
generate future cash flows. Item involved is Non-Current Assets.
Cash Inflows:
✓ Cash receipts from sale of tangible and intangible assets
✓ Cash receipts from sale of investment (debt or equity)
Cash Outflows:
✓ Cash payments used to acquire tangible and intangible assets
✓ Cash payments used to purchase investments (debt or equity)

RULE
➢ Increase in Non-Current Assets –
➢ Decrease in Non-Current Assets +

Examples

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 3. Financing Activities
Involves cash effects of other transactions related to issuance, settlement or reacquisition of
entity’s debts or equity. Items involved are Non-Current Liabilities and Equity.
Cash Inflows:
✓ Proceeds from issuance of shares (obtaining resources from owners)
✓ Proceeds from loans, notes, bonds, and short/long term borrowings

Cash Outflow:
✓ Cash repayment of borrowed amounts
✓ Payment of cash dividends
✓ Treasury stock
✓ Payment by a lessee for a reduction in liability of the capital lease

RULE
➢ Increase in Non-Current Liabilities +
➢ Decrease in Non-Current Liabilities –
➢ Increase in Equity +
➢ Decrease in Equity –

Example

Notes Disclosure in Statement of Cash Flows includes all non-cash information and
financing activities must be stated. Ex- conversion from debt to equity (convertible stocks),
acquisition of assets by capital or operating lease and exchange of assets or liability.

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 Statement of Cash Flow (INDIRECT METHOD)

OPERATING ACTIVITIES
Net Income XXX
+ Depreciation XXX
+/- Loss/Gain on sale of Equipment XXX
+/- Increase/Decrease in AR XXX
+/- Increase/Decrease in Inventory XXX
+/- Increase/Decrease in AP XXX
+/- Increase/Decrease in Other Liability XXX

INVESTING ACTIVITIES
+/- Purchase/Sale of Non-Current Asset XXX

FINANCING ACTIVITIES
+/- Issuance/Sale of Bonds XXX
+/- Issuance/Sale of Common Stock XXX
+/- Issuance/Sale of Preferred Stock XXX
(-) Dividends Paid (XXX)

RECONCILATION
Net Increase/Decrease in Cash and Cash Equivalent XXX
Beg. Balance of Cash and Cash Equivalent XXX
End Balance of Cash and Cash Equivalent XXX

Under the direct method, the entity calculates the Gross Profit using the cash receipts and
cash payments. If this method was used, then the reconciliation must be presented in a
separate schedule.

Limitations of Statement of Cash Flow

❖ This statement is not sufficient for forecasting the profitability of a firm, as non-cash
items are disregarded.
❖ It may not present the true liquid position
❖ Information can be manipulated (ex- management can schedule payment after cash
flow statement preparation)
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 1.6 Revenue from Contracts with Customers

Any contract must have the following:

✓ Client,
✓ Consultant
✓ Background and Purpose (scope of work)
✓ Timetable (deadlines)
✓ Rights and Responsibilities of Client and Purpose,
✓ Declaration of Ability (provide service and pay amount)
✓ Professional Fees or Price
✓ Payment Terms
✓ Expected days for the service
✓ Acceptance of Terms by signing

1. Recognition of Revenue
There are 5 steps in this model (for both goods and services):
1) Identify Contract with the customer
2) Identify the performance obligations in the contract
3) Determine the transaction price
4) Allocate/Link the transaction price to the performance obligations in the contract
5) Recognize revenue as a performance obligation is satisfied

1) Identify Contract with the customer

1.1 Contract is an agreement between 2 or more parties that create enforceable rights and
obligations

1.2 The contract was approved by both parties

1.3 The contract has commercial substance (gain), providing a service for revenue

1.4 Each party’s rights regarding goods/services can be transferred or provided and
payment terms are identified

1.5 It is probable (90%) that the entity (consultant) will collect substantially all the
considerations ($) which is entitled in the contract (Collectability)

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 2) Identify the performance obligations in the contract

2.1 A performance obligation is a promise in a contract with a customer to transfer to the

customer goods/services that are distinct (clear) OR series of similar specific
goods/services

Promised goods/services are distinct (both):

1) Capable of being distinct
2) Separately identifiable from other promises in the contract

2.2 A contract may include an option for the customer to acquire additional goods/services
for free or at discount. If the option provides a material right to the customer, it must be
considered as a separate performance obligation in the contract.

3) Determine the Transaction Price

3.1 A transaction price is the amount of consideration to which the entity expects to be
entitled in exchange of transferring the promised goods/services to the customer.

3.2 A transaction price excludes the amounts to be collected on behalf of third parties

3.3 The transaction price should not be adjusted for the time value of money if:

1) The delivery of the promised goods/services is less than 1 year

2) The customer paid in advance and the delivery of goods/services is
provided by the customer.

4) Allocate/Link the transaction price to the performance obligations in the

contract

4.1 After the performance obligations are identified and the total transaction price is
determined, the transaction price is allocated to performance obligations on the basis of
relative standalone price (the price at which the entity sells its goods/service)
(Divide the project into phases to allocate the $ to be received from the customer)

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 5) Recognize Revenue as performance obligation is satisfied

5.1 An entity recognizes revenue when it satisfies a performance obligation by

transferring the promised goods/services to a customer

1) The performance obligation is satisfied over-time

OR
2) The performance obligation is satisfied at a point in time

5.2 The asset/service is transferred when the customer has control over the asset/service

1) Goods- the customer has the ability to use the asset and obtains its benefits
freely/directly
2) Services- the customer has received substantially the benefits

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 2. Exceptions to Revenue Recognition

1) Identify the Contract with the customer

If the 5 criteria are not met, then:
❖ No revenue is recognized
❖ The consideration received is recognized as a liability, however,
if the entity would recognize revenue in the amount of non-
refundable consideration, any,
a. If the contract has been terminated
b. The entity transferred the goods/services and there are no
further obligations
c. No obligations against the client

❖ Contract Modification exists when the parties agree (in writing) to change the scope
of work and the change is immaterial.
❖ A separate contract would be agreed if:
a. The scope of work increased as additional goods/services are provided and are
distinct.
b. Increase in the price of consideration due to additional goods/services would
be provided and are distinct.

2) Identify the performance obligations in the contract

NO EXCEPTIONS

3) Determine the Transaction Price

❖ The transaction price is adjusted for the effect of time value of money,
when the contract includes a significant financing component, exists
when:
a. There is a difference between cash selling price (today) and
the amount of consideration to be received (future)

❖ There is a time gap between the expected date of delivery of

goods/services and date of receiving considerations

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Example (fianancing component)

Example (fianancing component- Advance Payment)

The contract may include variable consideration because:

➢ Refund due to right of return
➢ Sales incentive
➢ Prompt pay discount
➢ Volume discount

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If a contract includes a variable consideration (amount), the entity must estimate the
consideration that is entitled in the exchange for transferring the goods/services to the
customer. The methods to estimate include:
1) Expected Value (weighted average of variable consideration amounts)
2) Most Likely Amount (range of possible consideration amounts)
3) Volume Discount (prospective or retrospective)

Example (retrospective volume discount)

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 4) Allocate/Link the transaction price to the performance obligations in the
contract
If the standalone price is not directly observable, it must be estimate using the following:
1) Adjusted Market Assessment
2) Expected Cost + Profit Margin
3) Residual (Total Consideration – observable standalone selling price for other
goods/services)

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 1.7 Recognition of Revenue Over-Time

The entity must recognize revenue over time when the performance obligation is satisfied
over time. So, the entity can measure the progress towards complete satisfaction, it must be
reasonably measured using:
1) Input Method
2) Output Method
In order to determine which method to use, it depends on the nature of the good/service
promised to transfer to the customer and how does the entity transfer control of the
good/service.

1) Input Method- recognizes the revenue from the entity’s perspective on the basis of
entity’s input to the satisfaction of the performance obligation and the total expected
inputs to the performance obligation.
Examples- Costs incurred, labor hours spent, resources used, time spent, or machine hours
used. All of the previous do not recognize all revenue but recognize revenue as a percentage.
Cost Incurred (cost to cost method)
This method recognizes revenue/profit when:
1) Extent of progress towards completion, contract revenue and contract costs are
reasonably estimated.
2) Enforceable rights regarding goods/service to be provided, the consideration to be
exchanged and the terms if settlement are clearly specified
3) Obligations of the parties are expected to be fulfilled

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 2) Output Method- recognizes revenue from the customer perspective, on the basis of,
the value of goods/services transferred to the customer and the remaining
goods/services promised under the contract.
Examples- Appraisal of results achieved, milestone reached, units produced, units
delivered, practical expedient, extent of cost (zero profit).
Practical Expedient- revenue is recognized at the amount of revenue which the entity
has the right to invoice to the customer

Extend of Costs (Zero Profit) - revenue is recognized to the extent of costs incurred if
the progress towards complete satisfaction is not reasonably measured. (Revenue = Costs
Incurred)

As soon as an estimated loss on any project becomes distinct, it must be recognized in full
despite the method used.

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