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Chapter 2

Revenue and Expense Recognition; Income


Measurement and Reporting
INTRODUCTION
Most businessmen and other users of accounting information consider
Accounting as a means of knowing the profits and losses of
organization. Yes, the measurement of periodic income of a business
enterprise is perhaps the foremost objective of the accounting process.
Accounting measure income for an accounting period by matching
expired cost with realized revenue under a system of accrual
accounting. This process requires workable standards for the
recognition of revenue, expenses, gains and losses applicable to each
period.
In this Unit, you will learn how and when income is recognized and the
factors you must consider before recognition and you will also learn
about the conditions for expense recognition.
The final part of this Unit will focus on the measurement of profits or
losses and the manner of reporting them.
Objectives:
Upon successful completion this Unit, you will be able to:

Identify the conditions required to realize revenues and


expenses:

Differentiate between revenue realization and revenue


recognition;

Describe various possible revenue recognizing conditions;


and

Specify the problems related to income reporting.

Section l: Recognition of Revenues

Overview
The ultimate objective of business enterprises is one and the
same, i.e. generating a maximum profit without violating the law of
the country they are operating a maximum in. In doing this they
involve in the production and sell of goods or services. Now a day
business enterprises sell goods or services are mostly on credit.
Sometime companies enter into agreement with their customers to
produce good services for them alone. There are many types of
dealings in the business world Companies can even collect cash in
advance from their customers to produce goods of provide services.
Thus, in this section I am going to discuss the issues related to the
timing of revenue recognition.

FINANCIAL ACCOUNTING I, CHAPTER II, By Abdi .D

Specific Objectives
After successfully studying this Section, you will be able to:

Define the term revenue.

Describe the condition required to recognize revenue


and

Identify other revenue realization practices of


organizations.

1.1 Revenue
Revenue is cash collected or promised for collection from the provision
of goods or services. Examples of revenue include sales fees, interest
income, dividends, rents and royalties.
Revenue is said to have been realized (Obtained or gained) when a
measurable transaction (such as a sale) or an event (such as the
rendering of services) is completed or is sufficiently finalized to warrant
the recording of earned revenue in the accounting records. The
identification of critical times for learning revenue is the foundation of
the revenue realization principle.

Revenue is cash received or to be received as a


result of selling of goods or services.

Revenue is realized at the time when goods or


services are sold or rendered.

Recognition of revenue implies the recording of revenue realized in the


books of accountings. Revenue is recognized when it is realized with
sufficient reliability. Hence, only realized and measurable revenue
appears in a business enterprises income statement.
Some times, business enterprises enter into an agreement with their
customers to service the products they have sold to them. There may
also exist an arrangement, which requires sellers to deliver the goods
at the place of the buyers. In whatever cases, however, revenue is
recognized only when the earning process is completed
The earning process involves the completion activates such as:

Purchasing raw materials for production ;

Purchasing raw materials for manufacturing and selling:

Rendering services;

Delivering and servicing products sold, etc,

Revenue recognition means putting the revenue


realized in the books of the accounts of the enterprise.

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1.2 Revenue Realization Conditions


Business enterprises add various to products at different stages of
activities. A manufacturer adds values to products at various stages of
the production activity. At some stage enterprises and raw materials
are added. At others, they move materials from machine to machine
for further processing using human labor. More costs and hence more
value is attached to the products. But revenue is not at each stage.
However, somewhere on the line, evidence arise that the value of the
output is greater than the costs incurred in producing the output. When
such evidence becomes conclusive, the value of the output is
measured and revenue is indicated. Thus, revenue is recognized in
financial accounting at specific stage of the earning process, generally
when the following three or four revenue realization conditions are met:
i.

Sufficiently reliable evidence exists to measure the market


value of the output such evidence is generally provided by an
exchange transaction between involved.

ii.

Sale transaction is executed without the buyer paying the


selling price of the goods or services at the date of the
transaction, has to be economic capacity on the part of the
buyer to do so in future. A simple legal form of exchange does
not support revenue realization.

iii.

The earning process, which is the production of goods or


services and the delivery of them, is complete.

iv.

Collection of the claims from customer and clients who have


purchased goods and services reasonably assured.

The movement of goods among relate department within the


organizations and transaction with parties without economic substance,
are not a source of realized revenue. Besides, recognition of revenue is
not appropriate when a relatively high probability exists that the claim
from customers and clients will not be collected.

1.3 Revenue Recognized at Time of Sale and Delivery


It is impossible, under accrual accounting to recognize revenue
before sale.
At any point prior to sale; the expected selling of a product and the
ability to sell it at a profit may be so uncertain they do not constitute
sufficient evidence to justify an upward valuation of the product; and
This may be because of the following two reasons;
i.

Unit a sale is made and the product delivered to and


accepted by the customer, the future stream of revenue is
both uncertain and unearned.

However delivery of goods on consignment basis can not be considered


as a sale. Consignment is an arrangement between a consignor

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(seller) of goods and a consignee (agent). In this type of delivery,


whereby the consignee will store the goods and sell them on behalf of
the consignor to get commissions from the consignor.
Title to such good on consignment remains with the owner until the
agent sells the goods to ultimate consumers. At such times which sales
transaction takes place revenue is recognized by the consignor.
Consignor is one, which sends goods to agents to help it sell products
on its behalf.
Consignee is an agent, which accepts goods to sell them to customers
on behalf of the consignor order to get commissions for doing this.

1.4 Revenue Recognition when Right of Return Exists


It is not unusual to sell some product with the right to return them
back to the selling company In the music and book publishing
industries it is common practice to give retail stores the right to
return product sold and delivered to them if they cannot resell
these products.
When such a right of return exists, the seller continues to be
exposed to the usual risks of ownership. In this type of transaction
revenue is recognized, on the date of sale only if all of the
following conditions are met.
i.

The sellers price to the buyer is substantially fixed or


determinable on the date of sale. The buyer knows the
amount to be paid to the selling company.

ii.

The buyer has paid the seller, or is obligated to pay the


seller and the obligation is not contingent on resale of the
product. Reselling of the product is the sole responsibility of
the receiver-buyer.

iii.

The buyers obligation to the seller would not change in the


event of theft or physical destruction or damage of the
product. If the product is destroyed or stolen while in the
possession of the buyer, the buyer cannot refuse to pay to
the seller the price agreed upon.

iv.

The buyer acquiring the product for resale has economic


substance apart from that provided by the seller. The buyer
taking the product and promising to pay cash in the future
to the seller, has to have other assets in its possession
which will enable it to pay the debt.

v.

The seller does not have significant obligation for future


performance to Br. ing about resale of the product by the
buyer. The sale made should not be conditioned on reselling
the products by the buyer.

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vi.

1.5

The amount of future returns can be reasonably estimated.


Form past experience, the seller can reasonably estimate
how many of the products sold would be returned in the
future.

Sale on the Installment plan

Sale on the installment arrangement implies that the buyer will be


required to make partially a down payment at the date of purchase.
The rest of the money will be paid in some regular interval of time
period in the future. The buyer makes payments monthly in a series.
When the time period required to pay and finish the debt is long, the
seller is likely to charge the buyer interest. The revenue from
installment sales in the same manner as from regular sales, unless the
collection of the installment receivables is not assured and there is no
reasonable basis for estimating the probability of collection.

1.6 Revenue Recognition Before Delivery


Generally, realization does not occur unless a sale has taken place.
However, in some cases we consider that revue is realize before even
the product is delivered. This is because the seller performs certain
activities, which Br-ing about a sale and a significant potion of the
earning process. Although performance by the seller is not completed,
the amounts of the partial performance may be both economically
relevant and measurable.
Under such circumstances, the postponement of revenue recognition
until delivery of the product would be overly conservative and assign
the entire profit on the sale to the accounting period in which delivery
is made. The may result in a shifting of income among periods and
product misleading. At what stage in the productive (earning) process.
Might revenue be recognized when a sale occurs but is not considered
to result in revenue realization? Possible answers to this question are
1.6.1 prior to production,
1.6.2 during production,
1.6.3 On completion of production and
1.6.4 At some other stage based, for example, on production,
accretion, discovery, receipt of orders of orders from
customers or billing of customers.
1.6.1

prior to production

It is common to enter into agreement to sell products or survives


before they are produced. For example, motion pictures, agricultural
products, recorded music, and computer products may be pre-sold for
future delivery, perhaps months in advice of actual production. Usually
such transaction should be entered in the accounting records in a
memorandum form, or not at all recoded, unless a cash deposit is
received by the seller. When a deposit is received it is carried in a
liability ledger account until the sale is completed and the goods are
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delivered to the purchaser. Then and only then, is a sale recorded and
revenue is realized.
Newspapers and magazines subscriptions, insurance premiums, rents,
and fees for most services may be received in advance of production or
performance of the goods or service. Amount received by the sellers of
such goods or services represent deferred revenue (a liability) until
delivery or performance takes place.
1.6.2.

During production

During production Revenue recognition during production applies for long-term


contracts such as:

Construction type contracts,

Development of air craft,

development of weapons deliver system

Development of space exploration hardware, etc.

In this Type of contracts the seller/ buyer may bill the purchaser at various
intervals of the project.
Reverence is recognized portion by portion depending

on the proportion of

exerted or may be different to the time when the project is completed and
handed over to the client.
The accounting profession recognizes two distinctly different methods of
accounting for long term construction. These Method:
i.

Percentage of completion Method, and

ii.

Completed contract method

Percentage of completion Method:

revenue and gross profit are

recognized each period based upon the progress of the construction process.
Costs incurred each year are deducted from realized contract revenue to
measure the gross profit earned in the year. The period contract completed
generally is measured by comparing the costs incurred to date with the total
estimated costs of completing the contract.
Thus, use of the percentage of completion method for revenue recognition is
appropriate only when the actual costs incurred may be measured with

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reasonable precision and the estimate of the additional costs required to


complete the contract is reasonably reliable.
The other alternative is to wait until the project is completion and handed over
to the client when it becomes cleat to both parties that a noticeable part of the
job is completed,
Let me take an example to illustrate the percentage of completion method of
revenue recognition for construction type contracts.
Early at the beginning of 1999 ABC Co agreed to construct a te-story building
at a total counteract price of Br..120 million At the end of 1999, the total cost
incurred on the building has become Br.20M the rest of the work is estimated
to be completed with an additional cost of Br..80 m What is the revenue to be
realized for 1999? What is the related general profit figure?= revenue of 1999[20 100X120M] Br. 24M
=Costs incurred..
G. profit

20M
K.4M

Construction continued in year 2000 and total cost at the end of the year has
reached ( including last years )Br 60 M the rest of the work is estimated to
estimated (after a new revision is made )an additional cost of Br 30 m what is
the revenue of year 2000? and what about the related G. profit?
=Revenue of 2000[120) -24]
=cost incurred (60-20)
=G. profit

Br.56M
40M
16M

Let us assume further that the project was completed and handed over to the
client close to the end of year 2001 Total cost incurred has become Br. 95m
what is the revenue and the related G. profit of 2001?
= Revenue 120m- 24-56)
= cost incurred (95-600
=G. profit

Br.40 M
3
5m

Hence the contractor would realize br. 24m of revenue in 1999br.. 56m in 2000
and Br. 5 m in 2001 The illustration shows that the revenue year is proportional to
the work preformed under the percentage of contract completion method revenue

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on long term construction work is realized based on the proportion of work


completed in each year.

1.6.3.

on Completion of production

under the completed-contract method revenue and gross profit are recognized
only at point of sale, that is when the contract is completed Costs of long term
contracts in process and current billings are accumulated but there are no interim
charges or credits to income statement accounts for revenues, costs and gross
profit.
The principal advantage of the completed contract method is that reported
revenue is based on final results rather than on estimates of unperformed work
its major disadvantage is that s\it does not reflect current performance what the
period of a contract extends into more than accounting period. Although
operations may be fairly uniform during the period of the contract, is not until the
year of completion creating a distortion of earning.
1.6.4 Others
There are other methods of revenue recognition which are not in line with the
rules of accounting. These are:
i.

Accretion ; certain products such as agricultural commodities increase


in value through the various stages from planting to harvesting this
method has also been proposed for livestock and products like fish and
mushroom Under accrual accounting accreting in value does not fit the
definition of revenue Hence revenue is not recognized when value is
added to assets

ii.

discovery: Discovery of valuable deposits of ore or crude oil by


business enterprises engaged in extraction

business suggest that

revenue be recognized the moment these assets are found As in the


case of accretion discovery does not result in realized revenue because
there is no sale transaction to provide reliable evidence for the
measurement of revenue.
iii.

Receipt of order:

computer

some business like those in the publishing and

hardware industries record sale at the time they receive orders from

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customers This method of revenues recognition may be appropriate in rare case


when firm orders are accompanied by substantial and non returnable cash
deposits or when legal title to the product ordered passes to purchasers hence
orders are received. However this too is not considered appropriate in financial
accounting practices.
Recognition of revenue through accretion receipt of order or discovery
is not acceptable methods of revenue recognition in accrual
accounting.

1.7 Revenue Recognition after Delivery


Acceptable method of accounting states that revenue has to be recognized at the
time of sale and delivery of good/ services. However in the case 0f product sales,
revenue recognition may be delayed until some stage in the earning process
subsequent to sale and delivery. Because the sale and delivery may not provide
of revenue realization.
In such instances you may record revenue under the installment method, the cost
recovery, other method or some other method based on cash collections.
Installment sale plan: There are instances where businesses sell their products
under the installment plan That is, accept the promise of customers to pay cash in
series rather than at once hence business enterprises that sell goods on the
installment plan may use the installment method of accounting only when accrual
accounting is not considered appropriate.
The installment method is widely used for it payment of income taxes until
installment receivables are collected. However the installment method is not
acceptable for financial accounting unless considerable doubt exists as to the
collectibles of the receivables and a reasonable estimate of doubtful accounts
expense cannot be made:
Every time cash is collected, the seller recognizes gross profit in proportion. If the
gross profit rate on sale is say 30 percent, every time 30 percent of the amount
collected will be treated as gross profit To illustrate this let us take the following
example On June 30,1999ABC company sold merchandise on installment plan for
Br. 500,000. the costs of merchandise sold totals Br. 400,000 This implies the
gross profit rate is 20 percent of sale [100,000/500,000x100=20%]. The term of

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the transaction says tat Br. 20,000 of the selling price will be paid down on June
30- at the time of sell and the rest at the rate of Br. 24,000 month for 20 months
to come ABC Companys fiscal period ends on December 31 each year.
The cash collected, recovery of cost and realized gross profit on these sales for
ABC Company are summarized below:
Year

cash collected
(I)

1999

Recovery of cost
80%

Br.164,000

Realized G. profit
20%

(II)

[I-II]

Br. 131,200

Br. 32,800

2000

288,000

230,400

57,600

2001

48,000

38,400

9,600

Br. 400,000

Br. 100,00000

Totals

Br. 400,000

installment method of accounting becomes appropriate for income tax purpose not
for financial reporting purposes
Next to this you can see the journal entries recorded in the books of the seller to
recognize the sale and cash collections at different time periods. Let us assume
ABC Company uses the perpetual inventory system.
During Year 1999
To recognize the installment sale:
Installment Receivables
Cost of installment sale
Installment sale
Inventories

500,000
400, 000
500,000
400,000

Installment Receivable debited is the total amount of selling price of the


merchandise. Cost of installment sales is 80% of the price of the merchandise.
Under perpetual inventory system the cost of sales will be credited to the
inventory account to show the decrease in the inventories.

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To Record deferred gross profit:


Installment sale

500,000

Cost of installment sale

400,000

Deferred gross profit

100,000

Deferred Gross profit represents the amount of gross profit will be realized each
time cash is collected
To recognize cash collection:
Cash

164,000
Installment Receivables

164,000

The cash collected has become 164,000 because it includes the down payment
and the monthly installments [Br. 20,000+ (6x24, 000) = 164,000]. There were six
collections made in 1999 from July to December.
To recognize the realized profit:
Deferred

32, 8000

Gross Profit

32,800

During Year 2000


To recognize cash collections:
Cash

288,000
Installment sale

288,000

Cash collected in year 2000 represents twelve installments. Each installment


carries Br. 24,000 Hence, the total becomes Br... 288,000
To record the realized profit:
Deffered gross profit

57,600

Realized gross profit

57,600

The amount of realized gross profit 57,600 because it is 20 percent of the


collected in that year [20 ] x 288,000].
100
During Year 2001
To record cash collections:
Cash
Installment receivables

48,000
48,000

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The amount collected in year 2001 is the last one In the previous years 18
months installment(six for 1999 and twelve for 2000) are already collected. Thus
the remaining are two months collection [2x24, 000= 48,000A].
To record realized gross profit:
Deferred gross profit

9,600

Realized gross profit

9,600

Here again the amount written as recognized, Br. 9,600 is 20 percent of the cash
collected in that year (.2x48,000).
While preparing financial statement at the end of each accounting year,
installment receivables from revenue transaction are included among current
assets in the balance sheet. The balance in the deferred gross profit account is
deducted from installment receivables as a valuation account.
Under the installment method, revenue will be recognized in proportion to the cash
collected.
Installment sales receivable account is current asset account and thus to be
reported in the balance sheet at its appropriate place.
Deferred gross profit that is unrealized gross profit balance at the end of the year
has to be deducted from the installment receivable account as a valuation
account.
Realized gross profit will be included in the income statement like other revenues.

1.8 Revenue Recognition from Service Transactions

Enterprise operating in service industries sell perform acts agree to


perform certain acts on a later date or permit their resources to be
used by others. Unlike goods services cannot be produced and stored.
Collectively these revenue-generating activities are called service
transaction these include advertising, entertaining, and banking public
accounting and activities of law firms, and hospitals.
Generally, revenue is recognized as a service transaction when the
service are performed or rendered. Performance consists of the
completion of rendering service or a specified act or act, or its
realization occurs with the passage of time.
The following methods are acceptable approaches to revenue
recognition for service giving businesses.
Services unlike goods cannot be produced and stored await
sale.

8.4.1

Specific Performance Method

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Under this method revenue is recognized at the time the service or the
act is preformed It is similar to the sales method of revenue recognition
from product sales. When the provision of service is over, revenue is
realized. it constitutes no parts. A single act of entrainment or a single
provision of service to be preformed; and when it is finished revenue is
realized
The following examples can illustrate the basic assumptions of specific
performance method:

i.

Services provided to affect a purchase of a house to some one


(Brokerage service)

ii.Service give to some one to transfer his cash from one destiny to
another (banking service)

iii.

Entertaining an audience in a gathering by a musical show


(entertaining service)

1.8.2 Completed performance Method


This method is similar to the completed contract method of revenue
recognition for constriction type contracts Revenue under this method
will be recognized when the services are given completely.
In a theatrical show it may be meaningless to an audience without the
last part of the act even if 90% of it is performed.
1.8.3 Proportional performance method
There are case when proportional performance method is appropriate
particularly when the services to be performed are distinct and
separable Let me say, a company performance a mechanical fitness
checking to a number of vehicles of vehicles of another company but
did not finish doing so that entire fleet as agreed on the contract.
Given that the contract will be completed in the following period for the
current year revenue can be recognized proportionately to the service
performed.
Finally in this Section, you have to underline that when firms get cost
savings it should not be treated as revenues That is to say for example,
if a company builds its store on its own by incurring Br. 90,000 on
material and lab our by rejecting a lowest bid price of Br. 120,000 the
decision of management becomes beneficial. There you see a cost
saving of Br. 30,000 This Br. 30,000 however by any means should not
be reported as revenue earned.
Another item that possibly could be confused with revenue is cost
offsets like purchase discounts. This one again is never treated as
revenue. Discounts firms get by buying under favorable arrangements
with sellers are not revenues. Rather they have to be accounted as
simply as reduction of the purchase price.
Discounts from purchase prices are to be treated as deduction (cost
offsets) from purchases. As I said earlier revenues are collection
resulting from selling of goods or services.
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Section 2 Recognition of Expenses


Overview
Recognition of expenses is equally important as recognition of
revenues. This is be causes if one fails to recognize expenses as
appropriately as it should be, it will give wrong meaning to the financial
statements that would be prepared letter.
Hence it is important to discuss of expenses following the rule and
procedures in accounting.
Objective
Upon successful completion of this section you will be able to;

Distinguish between expenses and losses;

Identify the differences between product costs and period cost;

Explain the principles of expense recognition and

Describe the classification of costs of service transaction.

The term expense is defined as an outflow of cash made or is to be


made in the future for the purpose of generating revenue. As I
discussed in the earlier unit revenues can be earned as a result of
selling services or goods.
It is obvious to an organization to sacrifice some of its resources while
making effort to generate revenue. That is, it becomes impossible to
produce goods/ services without using some assets in the process of
production.
On the other hand losses are different from expenses. Losses are
reduction on the businesss net assets or capital resulting from rare
transactions. When assets of business Enterprise are used up or
expired or when a liability is assumed without any future benefits to
the organization you can say there is a loss.
If a company sells its assets for an amount less than its carrying value
in the books, it will sustain losses. An expiry or usage of an asset which
is not related to the effort of revenue generation is a loss.
The difference between expense and loss can also be seen from their
timing of recognition precognition perspectives too. Expenses are
recognized usually at time when related revenue is realized However
losses are recognized when incurred irrespective revenue realization.
2.1 Costs and timing of their Recognition
In producing goods and delivering them to buyers, the cost firms incur
are of many type. They incur a variety of cost while producing different
items for sale, there are variety of costs incurred. Some of the costs
expenses can be traced to the final output. Others are not visible to be
specifically traced to one product costs like material cost can be traced
in the final output the expenses incurred to advertise the sale these
output cannot be traced to the specific product.

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Most selling and administrative expenses cannot be traced to specific


products hence it becomes important to know the acceptable
accounting practices that are applied while recognizing expenses and
costs.
2.2

Product and Period Costs

There are costs that can be directly from the output. In a


manufacturing business enterprise, some can be traced to physical out
and are accumulated in inventories evidence of revenue realization is
available for example, the cost of direct material and labor used to
manufacture a product can be identified directly with a unit of
inventory Such cost are known as product costs. For a merchandising
business, product costs relate solely to the of goods acquired for resale.
For a service enterprise on the other hand the direct or the initial direct
costs are traceable and are called Product costs.
Period costs are costs usually referred to as expenses. They are
recognized in the accounting period in which they occur. Period costs
such as advertising and sales, salaries, generally are not related to
production and are expensed (deducted form revenue immediately),
because the benefits are received in the some period the cost are
incurred.
Hence, when a firm incurs product, it debits it to the asset account to
which the cost is related While incurring period cost, business debit any
expense account it is related to
Buying identical items at different prices is another problem you face
allocating costs to products. When you sell some of those identical
items, it becomes
Difficult to assign the cheaper/more expensive/cost to those sold or
remaining in the inventory form. There is an accounting convention to
solve such problems, however.
Some costs are incurred as a result of using some long-term assets like
building and equipment; they provide services to the company for a
long time. However they do not remain in the same condition forever It
is difficult or determine how much of the assets service has been used
been used during the current period and what the cost of the services
is.
In the case of material or merchandise, their at least a physical flow of
goods to indicate the changes that are taking place. In contrast
productive assets such as machinery show little change in their
physical condition as they provide services despite these, though
subjective, the expiration of costs of such assets will be measured and
accounted for using accepted accounting methods. It cannot be
ignored altogether.
2.3

Principles of Expense Recognition

Enterprises incur costs or expenses as long as they are in operation


regardless of the type of activity they are in (producing good/services
or merchandising or dosing a combination of theses). This is normal

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15

and they cannot avoid it. The expenses business enterprises incur
during an accounting period may be classified under one the following
three groups:
2.3.1

costs directly associated with revenue recognized in the period

2.3.2
Costs associated with the period on a basis other than a
directrelationship with revenue.
2.3.3
Costs that cannot reasonably be associated with any other
period.
2.1

Some costs and Expenses Cause certain Revenues to be

Generated: Unless you:

give up or sacrifice resources in some forms, it is impossible to


get revenue

Buy goods from bulk sellers, you cannot sell goods;

Sell goods, you cannot get revenue from sales.

Cost may be recognized as expenses based on a presumed direct


association with specific revenue. Costs that appear to be related to
specific revenue are recognized as example together and at the same
time with the recognition of the related revenue. For example a
business earns its revenue while selling goods to its customers. At the
same time the cost of goods sold is recognized as an expense at that
specific time the sale is made.
2.2 Systematic and rational Allocation: when a direct association
of costs with revenues cannot be reasonably mad, like in the case
above, a systematic and rational allocation basis will be used. Costs
can be allocated to periods when it is reasonable to conclude that
they have been incurred.
This method involves assumption. When certain costs appear to have
given benefit to the business in the current period, costs can be
recognized in that same period for example, premium paid to insure
the companys assets for the twelve months period just ending, will
have to be recognized as an expired cost.
2.3 Depreciation on plant assets and amortization on
intangible asset are Expenses recognized at different periods
distribute systematically. Property taxes are plaid on property held
in each accounting period property taxes are also allocated on the
same, the systematic allocation basis;
Immediate recognition of cost and expenses: Costs and expense are
recognized in the current accounting period when.

Cost incurred in the current period are not expected to provide any
future benefits,

Costs deferred as assets in earlier periods no longer provides is


benefits,

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16

Allocation of cost to revenues or to accounting periods is


impractical or is considered to serve no useful purpose.

Application of the last method of expense recognition principles is a


final alterative. As much as possible costs should be associated, if
possible, with revenue on the of cause and effect. It such an
association is not practical, a systematic and rational allocation of the
costs is attempted. If neither of these procedures is feasible, costs are
expensed as incurred or as soon as expiration of the service potential
of the costs becomes evident.
For example, researched development costs general and administrative
costs and amounts paid to settle litigation (court cases) are to be
recognized as expenses in period they are incurred.
Application of the third method (immediate recognition of expenses)
of expense recognition is the last alternative. It is taken only when the
other two cannot be taken.
Besides, costs deferred in earlier period that have lost their service
potential such as obsolete plant assets or worthless intangible assets)
are written off as soon as the loss becomes evident and measurable.
2.4

Expense Recognition for Service Transactions

Unlike goods or tangible outputs, services once produced cannot be


stored. Once produced, it is true to assume that they are disposed.
Generally, costs are recognized as expenses in the accounting period in
which the associated revenue is recognized, and costs not expected to
be recovered are not deferred.
In applying this general principle for service for giving enterprises we
classify costs into three:
a. Initial direct costs: These are costs directly associated with
negotiating and ending service transaction. For example,
commission, legal fees costs of credit investigations, document
processing fees and a portion of any salespersons compensation
are classified as initial direct costs.
b. Direct costs These are costs that have a clearly beneficial or
causal relationship to the services performed for a specific
customer of a group of customers. For example, labor and assets
used in service contracts are direct costs.
ii. Indirect costs: These are all other costs not included in the first
two categories Such costs include selling expenses general and
administrative expenses (including doubtful accounts expense).
Indirect costs are recorded immediately as expense, regardless of
the method used to recognize revenue.
I have already discussed the methods of revenue recognitions for
service giving enterprises in Section 1 of this chapter.

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17

When revenues from service transaction is recognized under the


specific performance method or under the completed performance,
method initial direct cost are recognized as expenses in the accounting
period that the related revenue is recognized.
Such costs incurred before revenue is recognized are postponed are
recognized as expenses at the time the related revenue is recognized
in the accounting records.
When the proportional performance method of revenues recognition is
used for service transactions, initial direct costs are recognized as
expenses in the same manner as revenues is recognized.
However direct cost are expensed as incurred, because a close
correlation generally exists between the amount of performance and
the amount of direct of direct costs incurred.
Under the cash collection method of revenue recantation for service
giving enterprises, however, both initial direct costs and direct costs
are recorded immediately as expenses because of the substantial
uncertainty surrounding the collectibles of the claims from clients.
2.5

Recognition of losses

Losses can occur as a result of normal transactions or an extraordinary


event When losses occur, they be recognized in the accounting periods
in which they occur.
Losses can occur as a result of disposing of plant or retiring long-term
debt regardless of what .the amount will be entered in the income
statement prepared for that specific period.
The recognition of gain from the same transactions will not, however,
necessary recognized similar to losses.

Section: 3

Income Measurements and Reporting

Overview
Income measurement is one of the most important functions of
accounting. The Income statement is the vehicle used to depict income
data of the organization periodically. In reporting income, we use the
accrual basis of accounting is used. Accrual basis of accounting is
consistent with the Generally Accepted Accounting principles.
Thus, because both cash basis income and economic have serious
shortcomings and are fundamentally incompatible, accountants have
adopted the accrual basis of accounting as a reasonable approach to
income measurement.
Objectives:

Describe the objective of financial reporting;

Identify the problems associated with income reporting;

Specify the special problems in the measurement and reporting


of income; and

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18

Distinguish between; extra ordinary gain/loss/and gain/ loss on


cumulative effect of change in accounting. principles.

3.1 Income and the Objectives of Financial Reporting


The financial Accounting standards Board (FASB) has identified the
most important objectives of financial reporting are the following :

Provide financial information


components to the users.

Provide financial information to users about the organizations


present and continuing ability to generate favorable cash
flows.

Provide insight to the ability of management of the enterprise


in discharging its responsibility to owners.

Provide financial information to various users including


investors, creditors and assess the strength and weaknesses
of the enterprise.

about

earnings

and

its

The main objective of accounting is to supply relevant and timely


financial information to users. The report is prepared periodically and
as much as possible of informant which are useful.
Improvement in the measurement and reporting of income are needed
if income statement is to be of maximum value to users in predicting
comparing and evaluating the earning power of the business
enterprises.
3.2

The Complexity of Income Measurement

Is income recognized when the value of assets change in favor of its


owners, irrespective of existence of sale of not?
For e.g if asset held in the store now are costing more than what used
to be while buying them, do we recognize the difference as income
earned?
An asset bought for sale six or so month ago for Br.100 when the price
level was Br. 100 It is sold today for Br 125 when the price level is 125
can you recognize the difference Br. 25 (Br.125-100) as an income?
Next you will see the possible answers to this questions that the
accounting practices has to offer.
3.2.1 What is Income?
Income is the amount by which an interpose has become better off
today than it was in the past. Hence the objective in measuring income
is to determine by how much a business emprise has become betteroff during some period of time as a result of its operations.
Thus, in measuring income, provided there is objective evidence the
business is better-off today than it was in the past, the difference is
considered as income. Thus Questions raised earlier in subsection 32
above can be answered with this understandings Even if the value of
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19

asset have changed as long as there is no transaction ( objective


evidence) it is not possible to realize income.
As to rise in price, irrespective of price level the difference between
buying and selling price is gross income. Price level adjustment can be
made by through revealing the rise in price information separately.
Income is the amount by which an enterprise has become
better-off today than it was in the past.
Lifetime Income: to measure income, it is impractical to wait until the
business enterprise ceases operations First, I have the business going
concern principle (I have discussed in Modul1 of this Course) which
says that it is not possible to identify when an enterprise is going to
stop operation. Secondly, the firm has to report performances to its
owners, government, and pay part of profit dividend and taxes.
If however, you were asked to measure the lifetime income of a
business enterprise at the time it was being liquidated, you can do it as
follows: Let us take an example, which shows hoe lifetime income is
computed ABC Company, which operated for the last 20 years
exhibited the following facts:

Total investment made by owners----------Br. 20 million.

Total amount of cash collected by selling the business upon


liquidation (after paying liabilities--------------Br..41 million.

Total amount of assets withdrawn by owners so far Br..18 Million


Hence, lifetime income would be

Life time income =

Br. 41 million- [Br..20 m+Br..18 m]


= Br. 3 million.

If you ignore the time value of money and effects of inflation, income of
a business enterprise is easy to measure. The reason is that the
beginning and end of the life of any entries, the value of its net assets
may be measured with reasonable accuracy.
The investment by owners and the proceeds received on liquidation
usually are definite amounts of cash or other assets.
3.3

The Impact of Changing Prices

When price level rises the amount you will receive by selling a product
will be more than what could be collected under normal circumstances.
Besides, the cost inputs will be higher than it used to be.
Business will report more than the usual profit margin if they have
stocks of goods bought during non- inflationary situation but sold when
price level rise exists.
Let us take the following example to illustrate different income
recognition options.

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20

A company produced a fixed asset item for sell 1999 when price level
was 100 ,by expending a total of Br.10,000 on input. It did not sell the
product on the same year but was in the store for one year (until year,
2000) In 2000 the asset item was sold for Br. 18,000 By the time it was
sold Price has risen to 115 and the cost of producing the same type of
product gone up to Br..12,000.
3.3.1 The Nominal Gross Profit Method:
It reports the entire difference between revenue realized and
historical cost without regard to differences in the purchasing power of
the birr.
Nominal gross profit:
Revenue realized--------------- ---------------Br 18,000
Less actual cost of good sold --------------

10,000

Gross profit

8,000

3.3.2 The Nominal Gross Profit, With Price gain Isolated


Method:
Under this method, the effect of changes in specific prices is isolated,
and the fact part of the gross profit is attributed to rising replacements
cost and disclosed. The difference between the actual cost of a product
and its replacement cost at the time it is sold is known as Inventory
profit.
Revenue realized---------------Br..18,000
Less replacement of product----------------12,000
Operating margin-------------------------Br6,000
Add price gain or inventory profit:
(Br.12, 000Br.10.00)

Br2,000

Nominal gross profit


(Operating margin+ price gin)

Br8,000

3.3.3 Constant purchasing power Gross profit


Under this method the measuring unit will be changed to constant
purchasing power. Both costs and revenue are stated in year 2000
purchasing power.
Revenue realized -------------------------------------Br.18,000
Less actual cost in constant purchasing power;
(Br.10,0000x1.15)

11,500

Gross profit in constant purchasing power----------------6,5000


During a period of inflation, there is an understandable problem in the
first and the second nominal gross profit method approaches. Hence,
Supplementary information in the income statement will be required to
show price level variations. This is so because accrual accounting
adopts the first method.

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21

3.4 Special Problems in the Measurement and Reporting of


Income
There are other problems related to income measurement. These are
related to inclusion of gains and losses associated with less common
items. The problems are related to income tax allocations; inter period
tax allocations and intra period tax allocations.
Inter period tax allocations: It is a process of apportioning income
taxes among two or more accounting periods because of temporary
differences in the recognition of revenue and expenses.
Inter period tax allocations become an issue there is difference
between taxes on the income statement and taxes on income tax
reports.
On the other hand intra period tax allocation is the process of
apportioning income taxes of a single accounting period among the
different sources of income or loss that are presented separately in the
income statement.
Recognizing more depreciation this year than next year is an issue
related to inter period tax allocation. /this is so because recognizing
more depreciation this year is paying less income tax this period tax
allocation
Distributing the total income tax payable to different sources of income
of same year is intra period tax allocation.
To have very clear picture of these two activities, first I will discuss the
following
Business segment
Extraordinary event
Cumulative effect of change in accounting principle
Prior period adjustment
Business Segment: A business segment is a component of a business
enterprise whose activities represent a separate major line of business
or class of customers. In order to be classified as a business segment:
The arm of the company must either contribute a significant
share of profit
to the overall income of the business; or
It has to be engaged in uniquely different line of activity.
The income/gain/loss/ resulting from operation of the business
segment to be reported next to income from continuing
operation net of tax.
Even when the business segment is discontinued have sold, the gain or
loss on disposal of the segment has to be reported likewise.

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22

A Business segment is an arm of a bigger business which:


o contributes significant amount of sales/ income to the overall
business ;or
o

Is engaged in unique business activity.

Extraordinary Items: Extraordinary items are events and


transactions that are distinguished by their unusual nature and by the
infrequency of their occurrence. Thus, both of the following criteria
should be met to classify manor transaction as an extraordinary item.
This is to APB- Accounting Principles Board
i.
Unusual nature: - the underling event or transaction should
possess a high degree of abnormality and be of a type clearly
unrelated to, or only incidentally related to, the ordinary and typical
activities of the entity taking into account the environment in which
the entity operates.
ii.

Infrequency of occurrence: - the underlying event or


transaction should be of a type that would not reasonably be
expected to recur in the predictable future, taking into
account the environment in which the entity operates.
Examples of extraordinary items are the following:
Loss from major causalities (such as earthquakes or severe
hailstorms in localities where such events are infrequent):
Loss from prohibition of business under newly enacted law
or regulations;
Gain or loss on disposal of only holding of common stock or
land that had been owned for many years:
Gain or loss on extinguishments (retirement ) of debt; and
Gain on restricting of troubled debt

Cumulative effect of change in accounting: - it is true that in


previous chapter stressed accountants are not to change accounting
methods from one to the other. If they do so they will violate one of the
accounting principles called consistency
However, management of a business enterprise may justify a change in
accounting principles on grounds that it is preferable to the former.
There are three types of accounting changes:

i.

i.

changes in accounting principle,

ii.

changes in accounting Estimate, and

iii.

Changes in reporting entity.

Change in accounting principle:


It is change in the
method of accounting adopted by a business organization like,

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23

from straight- line depreciation to declining balance method,


from FIFO to LIFO inventory costing etc.
When there is a change in accounting principles like these, it
requires the inclusion of the cumulative effect of a change to a new
principle in net income of the accounting period in which the change
is made.
Such a change requires restatement of asset or liability as of the
beginning of the current to the amount that would have existed if
the newly adopted principle had been used in prior periods.
Hint. This is not the scope of this section.
ii.

Change in accounting estimate: that is like increasing or


decreasing the original estimate of the life of a fixed asset
items or its salvage values, etc.

When there are changes of this kind, it will affect this years and the
future years amount recognized in form of depreciation. No
commutative effect will be shown in the current years income
statement unlike changes in accounting estimate.
iii.

changes in Reporting Entity: changes in reporting entity


exist when the group of business enterprises comprising the
reporting entity join with such business combination of two or
more companies accounted for as a joining of interests or
assets;

Prior period adjustment: the is reinstating of accounts to rectify or


correct errors committed in prior. Since normally books of prior years
will be closed the adjustment will be made onto the retained earnings
or capital accounts of enterprises.

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