Jumat, 24 Oktober 2014

5 Revenue Recognition Methods

Did You Know?
Revenue recognition policies are guided by the accepted accounting standards followed by the nation, in which your entity is registered. A new converged standard 'Revenue from contracts with customers' has been released by the FASB1 (Financial Accounting Standards Board) and IASB 2 (International Accounting Standards Board) on May 28,2014, along with its implementation dates. 
* 1 FASB - Financial Accounting Standards Board (an organization which looks after the generally accepted accounting principles (GAAP) by non-governmental organizations. 
2 IASB - International Accounting Standards Board is responsible for IFRS development (International Financial Reporting Standards).

Revenue recognition policy means the timing at which the income of any organization is recorded in the books of accounts. The revenue recognition policy of any entity may differ as per their business, their accepted accounting policies, nature of complexity of business, nature of transaction, etc. It is not easy to zero in on any fixed revenue recognition policy, and it must adhere to the accounting standards prescribed by the nation, not to mention some practical difficulties which might crop up, and pose a difficulty, for its implementation. Management must consider the peculiarities of the business before deciding on any recognition policy, and of course, seek expert help if required. With the growth of the service industry, revenue recognition has become more of a complex affair. However, revenue recognition has significance not only for appropriate representation of income, but also to compute the tax liabilities to be accounted and paid for. Of course, applying an inappropriate method will indicate misleading profits. 

Typically, books of accounts have two methods of accounting―cash system and accrual system of accounting. Cash system of accounting does not record transactions until and unless cash is actually paid or received. On the other hand, accrual system of accounting records transactions regardless of whether cash is received or spent. It implies that even receivables and payable are recorded. It gives a better picture of the financial position of any organization. Here are the five types of revenue recognition methods in brief.

Sales basis method
The most commonly used method of revenue recognition, it prescribes revenue to be recognized at the time when the ownership rights of the goods or services have been transferred to the buyer. It implies that the entity follows the accrual system of accounting.

Cost Recovery Method
As the name suggests, cost recovery method implies that profit should not be recognized until and unless all the expenses incurred for the transaction have been recovered. Thus, initially, no profits are recorded, and its accounting is deferred until payments from the customer exceed your costs incurred for the project. This results in initial understating of profits and overstating of profits in the future. 

When is it implemented?
This method is adopted when there is an uncertainty regarding the recoverability of revenue from the customer.

Installment sales method
Similar to the cost recoverability method, the installment method is implemented in those circumstances where the recovery from the customer is to be spread over in installments. Typically used by the real estate industry, where returns from the customer are expected over a series of payments. 

Company LMN sells to its customer an asset of USD 100,000. Cost of Asset is USD 90,000. The customer is required to make a down payment of USD 10,000 and pay in 4 installments, an amount equal to USD 22,500. 
Gross profit to the company = Sale value - Cost = USD 10,000
Gross profit percentage = Gross profit / Sale value = 10%

Gross profit to be recognized = Gross profit received × Amount received in the respective year

Thus, the gross profit to be recognized every year as per the installment method of accounting is:

Year 1 Year 2 Year 3 Year 4
(32,500 × 10%) 2,250
(22,500 × 10%) 2,250
(22,500 × 10%)
(22,500 × 10%)

Percentage-of-Completion Method
Peculiar to the real estate and construction industry, this method prescribes accounting of revenue and expenses of any particular contract on the basis of percentage of completion of the contract.

Company RST has a construction contract worth USD 400 million. The contract has completed 1 year, and at its end, actual cost incurred is USD 50 million. The estimated costs to complete the contract, at the end of year 1 is USD 200 millions. For calculating revenue to be recognized, following steps should be considered -

Step 1: Calculate the percentage completed. 

Percentage completed = Total cost incurred up to that period / Total Estimated Cost of the Contract

Step 2: Calculate revenue to be recognized 

Revenue to be recognized = Total Contract Revenue × Percentage Completed

Gross Profit recognized by Company RST at the end of Year 1 is as follows : 

Percentage of Completion = 50/250 = 20%
Revenue to be recognized = 400 × 20% = USD 80 
Gross Profit recorded for Year 1 = 80 - 50 = USD 30

This is another method prescribed along with percentage-completion method especially for construction contracts. However, as the name suggests, in this method, accounting is done after the contract is completed. Obviously, an advantage is that the tax liabilities are deferred for the corresponding period. However, the tax liability gets increased in the year in which it gets recognized. This method can be adopted by small contractors, or if it is not possible to reliably estimate the result of the project.

Revenue recognition techniques will differ from every organization to organization, yet the policy of maintaining of books and accounts has to adhere to statutory requirements as advised by US GAAP guidelines (or the accounting practices followed by your nation), regarding the method to be adopted and the financial disclosures required to be made in your financial statements. However, with the emerging advent of IFRS and converged standards, it is necessary that you keep yourselves abreast with the latest developments. Revenue recognition will impact your financial statements as well as tax liability, thus, a very careful and deep understanding of the policy that is best suited for your organization is required.
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Key Differences Between Capital Expenditures and Operating Expenditures

Important Statistics:
Capital expenditures for the conventional and non-conventional sector of the oil and gas extraction industry increased to USD 42.8 billion and USD 31.2 billion for the last year, respectively.
Operational expenditures for the conventional and non-conventional sector of the oil and gas extraction industry increased to USD 30.3 billion and USD 28.6 billion respectively.

Every business has expenditures; that is what it thrives on. On an everyday basis, money is spent in raw materials, wages, equipment, patents, transport, etc. For convenience and effective finance planning, expenses are divided into capital expenditures and operating expenditures, also called 'Capex' and 'Opex' respectively (alternatively, they are addressed as capital and operating expenses as well). The former involves future expenses, while the latter involves current expenses. Careful planning is necessary in order to manage both these type of expenditures. A Capex vs. Opex comparison is given below, which highlights the important differences between the two.

Capital Expenditure
As already mentioned, it is an expenditure for the future.
In a business, planning for future endeavors and projects is very important.
For this purpose, certain assets need to be purchased and retained.
This is undertaken by businesses in order to expand their operations and production.
In fact, even an expense that involves improvement of an already existing asset can be considered as a capital expense.
The asset has to be capitalized, i.e., it needs to have a life beyond the accounting period.
Even the money that is spent on starting a new business can be considered as a capital expense.
Operating Expenditure
It is an expenditure for the present day scenario.
Every business venture needs money on a daily basis for everyday expenses.
For this purpose, money needs to be spent on stuff like light and electricity, rent, heat, wages, etc.
A business needs operating expenses for its survival.
The reduction of these expenses during troubled times in order to keep up with the cut-throat competition is a crucial responsibility that the management team needs to undertake.
While doing so, care needs to be taken to see to it that the quality of products is not significantly altered.
Factors of Differentiation

Capital ExpenditureOperating Expenditure


◾ Throughput indicates the number of items that pass through a process. In case of accounting of throughput in Capex, it involves whatever money is spent on the inventory.◾ In case of accounting of throughput in Opex, it involves the money that is spent in order to convert inventory into throughput.

Accounting Period

◾ Whenever capital expenses are incurred, you cannot deduct them during that accounting period. Over some time, machinery, buildings, etc. (fixed assets) undergo depreciation, while patents, copyrights, etc. (non-physical assets), are amortized.◾ Whenever operating expenses are incurred, they are completely deducted during that accounting period.


◾ It leads to a tax saving. This is because the expenses are entered as assets for the future, which lead to a depreciation on the income statement. Consequently, the profit is lowered, and it creates a tax saving.◾ It leads to tax incurring. This is because the expenses are not registered as future assets, so they do not depreciate in value. Consequently, the expenses are charged against income for that accounting period, which leads to taxation.

Property Dealings

◾ In the property and real estate business, capital expenses include the money that is spent on buying the property.◾ Operating expenses in property deals include the money that is spent in maintaining the property.


◾ Capital assets, like factory equipment, production machinery, vehicles, buildings, furniture, computer systems, lab apparatus, patents, etc.◾ Rent, utilities, machinery repair, worker wages, pension plans, advertising costs, accounting fees, legal expenditures, etc.

Some Points to Remember
Understanding what expenses that come under each of the above is very important for any business.
Deciding which expense is preferable among the two is difficult, as they both are vital for organizational growth.
If at all any one needs to be preferred over the other, factors like taxation benefits and book value are considered.
The operating expenses include the cost of goods sold, which involves direct labor, direct materials, property taxes, benefits, etc.
Capitalized assets require plenty of maintenance.
Lowering operational expenses may involve laying off employees, reducing material, etc.
The country's tax laws play a vital role in deciding which asset comes under which expense.
Capital and operating expenditures are always planned and managed separately. They are crucial in determining how and how much an organization spends in the duration of the budgeting period. The expenses that are incurred under each of these methods vary with different companies, based on specific criteria. There might be crucial situations, wherein Opex becomes mandatory for a business owner and Capex becomes optional. Decisions taken in such situations must be carefully thought over and assessed, so that the business does not incur a loss.
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Differences Between Capital and Revenue Expenditure

 Any business entity has various expenses to bear―office furniture, machinery, stationery, salary of employees, Internet and telephone expenses, transportation of a machine, etc. However, for accounting these expenses, they have to be classified either as capital or revenue expenditure. This classification depends on various factors, such as the nature of business of the entity, the tenure of benefit from the expense, and other accounting policies, followed by the respective organization as per the accepted policies of their nation. 

This classification forms the basis of accounting and any mistake will have a direct impact on the financial statements of the entity. Wrong classification can also be deliberately done to dress up and manipulate accounts, to deceive potential investors. If you're planning to be an accountant, or you're a reader of financial statements, it is essential that you know the difference between the expenses. Let's see the key differences between capital and revenue expenditure with the help of few examples.

Capital ExpenditureRevenue Expenditure


◼ It is that expense which is spent for buying an asset, providing a long-term benefit, i.e., for a period which is more than the business operating cycle. Such assets are known as fixed assets in accounting language.◼ In layman's terms, revenue expenses are a business entity's everyday expenses to earn their operating revenue. Usually, in accounting, matching concept is followed, i.e., revenue expenses and operating income are recorded for the relevant accounting period.

Treatment in Financial Statements

◼ It is transferred to the balance sheet of the business entity, and entered under the 'Fixed Assets' column.◼ It is recognized immediately after it is incurred. However, there are two systems of accounting―cash and accrual system. In the accrual system, non-cash items are also recorded. Revenue Expenses are written off, thus forming part of the 'Profit and Loss' statement.

Examples of How to Classify? (With Journal Entries)

Classification is a crucial part, and there are various criteria on which you should classify the expenses. Consider the following parameters:

(a) Business of the Entity

Example#1: Company X has a business of buying and selling cars. Company Y has a bought a car to be used as transportation for the employees. 

◼ Company Y has purchased the car as a 'fixed asset' which is going to be used for long-term benefit, i.e., to facilitate commuting of its employees. Therefore, it will treat it as capital expenditure. 

Journal entry in this case will be:

Fixed Asset (debit)
Cash/Creditor (credit)

◼ Business of Company X is to buy and sell cars, thus these cars are 'current assets' for them. Thus, it will be treated as revenue expense, as these cars will form part of their inventory expense. 

Journal entry in this case will be:

Purchases (debit)
Cash/Creditor (credit)
(b) Purpose of Purchase

Example#2: Sam has a business of buying and selling computers. He buys 8 computers and uses 2 of them for his office. In this case, purpose of buying of computers in each case has to be analyzed. 
◼ Sam has bought the 2 computers for office use, and not for trading. Thus, they will be treated as assets in the books of his accounts.

Journal entry in this case will be:

Computers (debit)
Cash/Creditor (credit)
◼ On the other hand, Sam has bought the other six computers, for regular trading. Thus, for him, these computers are stock to be sold off.

Journal Entry in this case will be:

Purchases (debit)
Cash/Creditor (credit)

Costs Associated with Purchase of a New Asset
◼ Various costs are associated with the purchase of assets, and a very careful understanding of this matter is required, since you have to follow relevant accounting policies followed by that particular country. For example, some accounting principles prescribes that installation expenses, professional fees for technical experts, delivery handling expenses, etc., should be added to the cost of the asset.◼ After you purchase an asset, there are various costs which will be attracted in due course. For example, repairs and maintenance costs are required to be written off (i.e., treated as revenue expenditure). There is going to be reduction in the value of an asset, due to usage and passage of time, thus depreciation of an asset is provided for, to reduce its value. It implies that depreciation is treated as a revenue expenditure.

Benefit of capital expenditure lasts for more than one accounting period; however, revenue expenses form the backbone of any organization. It might happen that the organization does not have any capital expenses in any particular year, but it is impossible to not have any revenue expenditure. Of course, capital expenses symbolize growth and expansion of that organization, and impaired assets are required to be replaced over a period of time; whereas revenue expense are required to earn the operating income. If you mistakenly capitalize expenses instead of writing it off, your assets will increase and profits will be inflated for that amount. That is the reason, special care is taken by accountants and auditors while verifying their classification.
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How to Calculate Capital Expenditures

Important Statistics:
The total rental and non-rental gross capital expenditures for United Rentals Inc. for the first nine months of 2014 is USD 1.568 billion, as compared to the total rental and non-rental gross capital expenditures for the first nine months of 2013, which was USD 1.570 billion.
Every company uses two kinds of expenses to help easy accounting and feasibility in business operations. These expenses are broadly categorized as operational expenditures (Opex) and capital expenditures (Capex). The former includes all the money that is spent on the current operations of the business, i.e., whatever money is needed for running the company, for example, rent, worker's wages, utilities, raw materials, etc. Capex, on the other hand, includes all the money that is spent on buying assets that will be for the future of the company. This also includes the money that is spent on improving the quality of an already existing asset. There is no standard capital expenditures formula for calculation, as it varies from one business to another. However, a general outlook is presented in this article.

An Overview
As already mentioned, Capex involves expenses to buy assets for tomorrow.
It is classified into two types, the first one of which involves spending money in order to develop the shelf-life of the existing assets, and the second one involves actually buying assets for future use.
This former amount is always added in the income statement.
The company uses this amount in order to expand their operations.
Examples of long-term assets include property, equipment, machinery, apparatus, patents, etc.
Steps to Calculate

Step I

Obtain the financial statements of the company for the last two years.

Step II

List down the net amount of the fixed assets at the end of the preceding year and at the end of the current year. While doing so, you need to disqualify the intangible assets as well as those obtained from acquisitions, during that accounting period.

Step III

Subtract the net amount of the fixed assets at the end of the preceding year from the net amount of fixed assets at the end of the current year.

Step IV

List down the accumulated depreciation at the end of last year and current year. This value should not include any depreciation or amortization of the assets acquired.

Step V

Subtract the latter from the former.

Step VI

Add the total depreciation to the change in assets. There, you have the amount of capital expenditures for the accounting period.


Example I
Let's say, you own a computer company. You have sufficient systems, yet you do not have any backup in case any of the existing systems fail.
In that case, if you invest in 10 new computer systems, this amount you spend is listed as a capital expenditure.
Your company's book value is automatically increased by that amount and is recorded in the company's income statement.
Now, since this is an electronic item, it depreciates with time, and over how much ever time it depreciates (determined by the method the company uses), the value is entered as an annual depreciation value.

Example II
Assume that you buy some furniture for your workplace, for USD 30,000.
If you believe the useful life of the furniture to be around 5 years, you will need to assume USD 6,000 as a depreciation value.
The amount used for the purchase is expensed in the income statement over time.
The depreciation leads to reduced profit and taxation.

Things to Remember
Though already mentioned in the earlier paragraphs, it is vital to remember that there are 2 types of Capex - the expansion expenditures and the maintenance expenditures.
The maintenance expenditures are expensed in the balance sheet.
Capex cannot be deducted during the accounting period. Over time, the assets undergo depreciation and amortization.
Since the expenses are entered on the income statement, there is a depreciation in the asset value, which leads to a lowered profit and a tax saving.
While comparing companies with regards to Capex, always keep in mind that this amount is different for different companies, and the comparison should be made between industries having a common platform.
Capex must be capitalized during the accounting phase, in the balance sheet within the asset's shelf life.
Capex, when recorded on the balance sheet, is termed as a capital outlay.
Capex is used in the cash flow to capital expenditures ratio, which helps business analysts determine the company's capability to finance future projects.
Every company needs to set up a minimum capitalized value.
Sometimes, some assets are expensed irrespective of whether they come under Capex or not. This is done in order to avoid recording details of the depreciation of minimum value assets.
Capital expenditures are crucial for the financial stability of the company. They are always spent on the tangible assets, like buildings and machines. How much of an amount is set aside for Capex is dependent on the current situation of the company and the growth targets. Analysis of Capex is an important phase to be considered while increasing the efficiency of the company.

Source : http://www.buzzle.com