Objectives – Income measurement
Apply the revenue recognition principle
Apply the matching principle to recognize expenses
Describe the basic format and the contents of the income statements
Explain additional items on the income statement
Explain the effects of sales on the cash flow statement
Income Measurement aka Revenue Recognition
In a recent survey,
o top three concerns
42% great risk of errors
35% most complex to manage
57% errors in revenue – highest level of material impact to f/s
o 92% of public companies use manual processes/spreadsheets
o Difficult to internally control processes for revenue recognition
We care – why?
Method of recognition can affect:
o Revenue & Expenses
o Net Income/Loss
o Balance sheet accounts such as A/R, deferred revenue
Which affects financial ratios such as Gross Margin, Return on SE, other profitability ratios
May lead stakeholders such as investors, regulators, management, customers and others to
make an “incorrect” decision
Revenue Recognition Principle
Revenues are recognized when they are earned
How do we know when revenue has been earned?
o Performance has occurred
o Amount of revenue can be reasonably measured
o Collection of payment is reasonably assured
o Costs required to earn revenue can be reasonably measured
Critical Event Approach
Revenue & related expenses recognized when the critical event occurs
Critical event can occur when: o Goods & services delivered (walk out of store with groceries)
o Order received and terms of sale finalized
o Production is completed – even if the buyer has not taken delivery
o Cash is collected
What is the critical event at Enron?
Revenue Recognition at Enron (Selling gas 20 years forward)
1. Performance has occurred – delivery of gas would not take place for 20+ years. No cash
exchange prior to that date.
2. Amount of revenue can be reasonably measured – no active trading in the 20 year forward
market – therefore not possible to reasonably measure revenue (no one else was selling gas 20
years in advance)
3. Collection of payment is reasonably assured – Did anyone know?
4. Costs required to earn revenue can be reasonably measured – can you determine the costs to
earn revenue 20 years from now?
Revenue & related expenses recognized over some period of time
Appropriate for long term projects (like construction – to give you revenue to pay workers and