Tag: International Financial ReportingOsmania University b.com Notes

The revenue recognition principle is a cornerstone of accrual accounting together with the matching principle. They both determine the accounting period in which revenues and expenses are recognized. According to the principle, revenues are recognized when they are realized or realizable, and are earned (usually when goods are transferred or services rendered), no matter when cash is received. In cash accounting in contrast revenues are recognized when cash is received no matter when goods or services are sold.

The revenue recognition principle states that one should only record revenue when it has been earned, not when the related cash is collected.

Cash can be received in an earlier or later period than obligations are met (when goods or services are delivered) and related revenues are recognized that results in the following two types of accounts:

• Accrued revenue: Revenue is recognized before cash is received.
• Deferred revenue: Revenue is recognized when cash is received.

Revenue realized during an accounting period is included in the income.

Accounting for Revenue Recognition

If there is doubt in regard to whether payment will be received from a customer, then the seller should recognize an allowance for doubtful accounts in the amount by which it is expected that the customer will renege on its payment. If there is substantial doubt that any payment will be received, then the company should not recognize any revenue until a payment is received.

Also, under the accrual basis of accounting, if an entity receives payment in advance from a customer, then the entity records this payment as a liability, not as revenue. Only after it has completed all work under the arrangement with the customer can it recognize the payment as revenue.

Under the cash basis of accounting, you should record revenue when a cash payment has been received.

Conditions for Revenue Recognition

According to the IFRS criteria, for revenue to be recognized, the following conditions must be satisfied:

• Risks and rewards of ownership have been transferred from the seller to the buyer.
• The seller loses control over the goods sold.
• The collection of payment from goods or services is reasonably assured.
• The amount of revenue can be reasonably measured.
• Costs of revenue can be reasonably measured.

Steps in Revenue Recognition from Contracts

The five steps for revenue recognition in contracts are as follows:

1. Identifying the Contract

All conditions must be satisfied for a contract to form:

• Both parties must have approved the contract (whether it be written, verbal, or implied).
• The point of transfer of goods and services can be identified.
• Payment terms are identified.
• The contract has commercial substance.
• Collection of payment is probable.

2. Identifying the Performance Obligations

Some contracts may involve more than one performance obligation. For example, the sale of a car with a complementary driving lesson would be considered as two performance obligations the first being the car itself and the second being the driving lesson.

Performance obligations must be distinct from each other. The following conditions must be satisfied for a good or service to be distinct:

• The buyer (customer) can benefit from the goods or services on its own.
• The good or service is separately identified in the contract.

3. Determining the Transaction Price

The transaction price is usually readily determined; most contracts involve a fixed amount. For example, a price of Rs.20,000 for the sale of a car with a complementary driving lesson. The transaction price, in this case, would be Rs.20,000.

4. Allocating the Transaction Price to Performance Obligations

The allocation of the transaction price to more than one performance obligation should be based on the standalone selling prices of the performance obligations.

5. Recognizing Revenue in Accordance with Performance

Recall the conditions for revenue recognition. Conditions (1) and (2) state that revenue would be recognized when the seller has done what is expected to be entitled to payment. Therefore, revenue is recognized either:

• At a point in time;
• Over time

GAAP Revenue Recognition Principles

The Financial Accounting Standards Board (FASB) which sets the standards for U.S. GAAP has the following 5 principles for recognizing revenue:

• Identify the customer contract
• Identify the obligations in the customer contract
• Determine the transaction price
• Allocate the transaction price according to the performance obligations in the contract
• Recognize revenue when the performance obligations are met

The Indian Accounting Standards (Ind AS) shall be applicable to the companies as follows:

1. On voluntary basis for financial statements for accounting periods beginning on or after April 1, 2015, with the comparatives for the periods ending 31st March, 2015 or thereafter.
2. On mandatory basis for the accounting periods beginning on or after April 1, 2016, with comparatives for the periods ending 31st March, 2016, or thereafter, for the companies specified below:

• Companies whose equity and/or debt securities are listed or are in the process of listing on any stock exchange in India or outside India and having net worth of Rs. 500 Crore or more.
• Companies other than those covered in (2.) (a) above, having net worth of Rs. 500 Crore or more.
• Holding, subsidiary, joint venture or associate companies of companies covered under (2.) (a) and (2.) (b) above.

3. On mandatory basis for the accounting periods beginning on or after April 1, 2017, with comparatives for the periods ending 31st March, 2017, or thereafter, for the companies specified below:

• Companies whose equity and/or debt securities are listed or are in the process of being listed on any stock exchange in India or outside India and having net worth of less than rupees 500 Crore.
• Companies other than those covered in paragraph (2.) and paragraph (3.)(a) above that is unlisted companies having net worth of rupees 250 crore or more but less than rupees 500 Crore.
• Holding, subsidiary, joint venture or associate companies of companies covered under paragraph (3.) (a) and (3.) (b) above.
• However, Companies whose securities are listed or in the process of listing on SME exchanges shall not be required to apply Ind AS. Such companies shall continue to comply with the existing Accounting Standards unless they choose otherwise.

4. Once a company opts to follow the Indian Accounting Standards (Ind AS), it shall be required to follow the Ind AS for all the subsequent financial statements.
5. Companies not covered by the above roadmap shall continue to apply existing Accounting Standards prescribed in Annexure to the Companies (Accounting Standards) Rules, 2006.
6. Banks:

• Scheduled commercial banks (excluding regional rural banks) will be required to prepare Ind AS based financial statements for accounting periods beginning from 1 April 2019 onwards. Ind AS will be applicable to both consolidated and individual financial statements.
• Holdings, subsidiaries, joint ventures or associate companies of scheduled commercial banks (excluding regional rural banks) will be required to prepare Ind AS based financial statements for accounting periods beginning from 1 April 2019 onwards.
• Urban cooperative banks and regional rural banks are not required to apply Ind AS and will continue to comply with the current accounting standards applicable to them.

7. Non-banking financial companies:

• Phase I companies required to prepare Ind AS based financial statements for accounting periods beginning from 1 April 2019 onwards (consolidated and individual financial statements) are:
• Non-banking financial companies having net worth of Rs. 500 crores or more; and holdings, subsidiaries, joint ventures or associate companies of the companies above other than those companies already covered under the general corporate roadmap.
• Phase II companies required to prepare Ind AS based financial statements for accounting periods beginning from 1 April 2019 onwards (consolidated and individual financial statements) are:
• Non-banking financial companies whose equity and/or debt securities are listed or are in the process of listing on any stock exchange in India or outside India and having net worth less than Rs .500 crores; non-banking financial companies that are unlisted companies, having net worth of Rs. 250 crores or more but less than Rs. 500 crores; and holdings, subsidiaries, joint ventures or associate companies of the companies above other than those companies already covered under the general corporate roadmap.
• Non-banking financial companies having net worth below Rs. 250 crores and not covered under the above provisions shall continue to apply the current accounting standards applicable to them.

8. Insurers: Insurance companies will be required to prepare Ind AS based financial statements for accounting periods beginning from 1 April 2020 onwards. Ind AS will be applicable to both consolidated and individual financial statements.

A statement of changes in equity and similarly the statement of changes in owner’s equity for a sole trader, statement of changes in partners’ equity for a partnership, statement of changes in shareholders’ equity for a company or statement of changes in taxpayers’ equity for government financial statements is one of the four basic financial statements.

The statement explains the changes in a company’s share capital, accumulated reserves and retained earnings over the reporting period. It breaks down changes in the owners’ interest in the organization, and in the application of retained profit or surplus from one accounting period to the next. Line items typically include profits or losses from operations, dividends paid, issue or redemption of shares, revaluation reserve and any other items charged or credited to accumulated other comprehensive income. It also includes the non-controlling interest attributable to other individuals and organisations.

This primary purpose of Statement of Changes in Equity is to provide details about all the movements in the equity account during an accounting period, which is otherwise not available anywhere else in the financial statements. As such, it helps the shareholders

 and investors in making more informed decisions about their investments. Further, it also allows the analysts and other readers of the financial statements to understand what factors resulted in the change in the equity capital.

The statement is expected under the generally accepted accounting principles and explains the owners’ equity shown on the balance sheet, where:

Owners’ equity = Assets – Liabilities

Requirements of IFRS

IAS 1 requires a business entity to present a separate statement of changes in equity (SOCE) as one of the components of financial statements.

The statement shall show:

• Total comprehensive income for the period, showing separately amounts attributable to owners of the parent and to non-controlling interests
• The effects of retrospective application, when applicable, for each component
• Reconciliations between the carrying amounts at the beginning and the end of the period for each component of equity, separately disclosing:
• Profit or loss
• Each item of other comprehensive income
• Transactions with owners, showing separately contributions by and distributions to owners and changes in ownership interests in subsidiaries that do not result in a loss of control

Requirements of the GAAP

In the United States this is called a statement of retained earnings and it is required under the Generally Accepted Accounting Principles  whenever comparative balance sheets and income statements are presented. It may appear in the balance sheet, in a combined income statement and changes in retained earnings statement, or as a separate schedule.

Therefore, the statement of retained earnings uses information from the income statement and provides information to the balance sheet.

Retained earnings are part of the balance sheet (another basic financial statement) under “stockholders equity (shareholders’ equity)” and is mostly affected by net income earned during a period of time by the company less any dividends paid to the company’s owners / stockholders. The retained earnings account on the balance sheet is said to represent an “accumulation of earnings” since net profits and losses are added/subtracted from the account from period to period.

Retained Earnings are part of the “Statement of Changes in Equity”. The general equation can be expressed as following:

Ending Retained Earnings = Beginning Retained Earnings − Dividends Paid + Net Income

This equation is necessary to use to find the Profit Before Tax to use in the Cash Flow Statement under Operating Activities when using the indirect method. This is used whenever a comprehensive income statement is not given but only the balance sheet is given.

Closing Balance of Equity = Opening Balance of Equity + Net Income – Dividends +/- Other Changes

• Opening Balance: It represents the value of equity capital at the beginning of the reporting period, which is the same as the prior period’s closing balance of equity.
• Net Income: It represents the net profit or loss reported in the income statement during the period.
• Dividends: Dividends declared during the reporting period should be subtracted from the equity balance as it represents the distribution of wealth among shareholders.

Steps

Step 1. Firstly, determine the value of the equity at the beginning of the reporting period, which is the same as the value at the end of the last reporting period. It is the opening balance of equity.

Step 2. Next, determine the net income or loss booked by the firm.

Step 3. Next, determine the value of the dividend declared by the management for the reporting period.

Step 4. Next, determine all the adjustments for the reporting period, which may include effects of changes in accounting policies, correction of prior period errors, changes in reserve capital as well as share capital.

Step 5. Finally, the closing balance of equity can be derived by adding net income (step 2) to the opening balance of equity (step 1), deducting dividends (step 3), and other adjustments (step 4), as shown below.

The statement of comprehensive income is a financial statement that summarizes both standard net income and other comprehensive income (OCI). The net income is the result obtained by preparing an income statement. Whereas, other comprehensive income consists of all unrealized gains and losses on assets that are not reflected in the income statement.  It is a more robust document that often is used by large corporations with investments in multiple countries.

Comprehensive income is the variation in a company’s net assets from non-owner sources during a specific period. Comprehensive income includes net income and unrealized income, such as unrealized gains or losses on hedge/derivative financial instruments and foreign currency transaction gains or losses. Comprehensive income provides a holistic view of a company’s income not fully captured on the income statement.

Components Comprehensive Income

One of the most important components of the statement of comprehensive income is the income statement. It summarizes all the sources of revenue and expenses, including taxes and interest charges.

Unfortunately, net income only accounts for the earned income and incurred expenses. There are times when companies have accrued gains or losses resulting from the fluctuations in the value of their assets, that are not recognized in net income. Some examples of these unrealized gains or losses are:

• Adjustments made to foreign currency transactions
• Gains or losses from pension and other retirement programs
• Gains or losses from derivative instruments
• Unrealized gains or losses from available-for-sale securities
• Unrealized gains or losses from debt securities

One thing to note is that these items rarely occur in small and medium-sized businesses. OCI items occur more frequently in larger corporations that encounter such financial events.

That said, the statement of comprehensive income is computed by adding the net income which is found by summing up the recognized revenues minus the recognized expenses to other comprehensive income, which captures any unrealized balance sheet gains or losses that are excluded from the income statement.

Uses of a Statement of Comprehensive Income

As explained earlier, the statement of comprehensive income encompasses the income statement and other comprehensive income. Preparing the income statement sheds light on a company’s financial events. Here are some of the uses of an income statement:

Analysis tool for investors

The SCI, as well as the income statement, are financial reports that investors are interested in evaluating before they decide to invest in a company. The statements show the earnings per share or the net profit and how it’s distributed across the outstanding shares. The higher the earnings for each share, the more profitable it is to invest in that business.

Detailed revenue information

The primary purpose of an income statement is to provide information on how a company is raising its revenue and the costs incurred in doing so. The income statement is very thorough in highlighting these details. Not only does it explain the cost of goods sold, which relate to the operating activities, but it also includes other unrelated costs such as taxes. Similarly, the income statement captures other sources of revenue which are not associated with the main operations of a company. This entails items such as the accrued interest from business investments.

Limitations of a Statement of Comprehensive Income

Difficulties in making predictions

Another area where the income statement falls short is the fact that it cannot predict a firm’s future success. The income statement will show year over year operational trends, however, it will not indicate the potential or the timing of when large OCI items will be recognized in the income statement.

Misrepresentation

Although the income statement is a go-to document for assessing the financial health of a company, it falls short in a few aspects. The income statement encompasses both the current revenues resulting from sales and the accounts receivables, which the firm is yet to be paid.

Similarly, it highlights both the present and accrued expenses that the company is yet to pay. But if there’s a large unrealized gain or loss embedded in the assets or liabilities of a company, it could affect the future viability of the company drastically. Therefore, an income statement on its own can be misleading.