1-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides

1-1Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & WinesSlides prepared by Mary Low

Chapter 14Income


Chapter 14 Objectives• Describe the nature of income

• Identify the various points where income could be recognised

• Describe the criteria for the recognition of income


Chapter 14 Objectives• Explain the diversity of generally accepted practices

across different industries with respect to the recognition of income

• Identify the importance of the timing of income recognition in assessments of the performance and the financial position of entities


Chapter 14 Overview

14.1 The definition of income

14.2 Different points for income recognition

14.3 Determining when to recognise income

14.4 Tests for the resolution of uncertainty

14.5 Some applications


Introduction• Primary objective of accounting:

– To measure and report the economic activities of an entity

Entities engage in activities to generate income

• Activities that are measured by accounting functions


Looking back (previous chapters)

• Introduced the conceptual framework

• Explored the principles and rules applicable to accounting for assets and expenses


Looking forward:

This chapter:

• Explores:

– The nature of income

– Criteria for recognition of income

– Task of eliminating uncertainty as to the amount of income ultimately to be received by the entity

– Issues influencing the timing of income recognition


14.1 The definition of income

• AASB Framework

– Definition of income

Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants


14.1 The definition of income• Applying:

– The assumptions and principles of historical cost accounting and

– Drawing on the definitions of income

The following key points are made:

– Income increases owner’s equity

An income-producing transaction or another event must be one that increases net assets

– Contributions of capital are not income. Met assets increase by profit is the concern under income definitions

– The form of consideration ultimately received is immaterial – it might be cash, the reduction of a liability or an exchange of services. Any of these can lead to an increase in net assets



• Revenue should be recognised when it is earned but the earning cycle is continuous

• Continuous operations are broken down into time periods for accounting reports

• Profit results from an organisation’s range of activities including:

– Establishment of the business

– Buying inventory and other assets

– Advertising

– Selling goods and/or services

– Delivery to customers

– Invoicing customers

– Collecting cash, and

– Providing follow-up services including warranty service


14.2 Different points for income recognition• Stages of a typical earnings cycle



• Recognising income at different points1. Point of production

When income is recognised at the point of production, the expenses in producing the good are also recognised at that time

2. Point of sale Refers to the point at which income is recognised

ie. when products/services are sold

3. Point of cash receipt Refers to the point at which income is recognised

ie. cash is collected



• Tests

– To reconcile the desire to recognise income at the moment of its accomplishment with the need for reliability

– Include tests for:

External (sale) transaction

Realisation

Critical event and

Resolution of uncertainty



• External (sale) transaction test

– An income event is required to occur, in accordance with the historical cost principle of ‘primary transactions’

An income event is a primary event

• It increases the net assets• A transaction is necessary before income can be recognised

– However, a transaction alone

is not sufficient to justify the recognition of income



• External (sale) transaction test

– In an increasingly complex world

The transaction test is not easily applied

• There are difficulties in identifying an income-producing transaction

– For example:

An agreement to sell a product in three months’ time is a transaction, but few accountants would accept that a sale has occurred until the product has been delivered

The transaction must be of a certain type before income can be recognised


14.3 Determining when to recognise income• Recognition of income

– External transaction test

Table 14.1 Selection of events on which income is recognised or denied

Events Has an external transaction taken place?

1. Retail credit sales External transaction taken place

2. Sales under warranty External transaction taken place

3. Marketing board for wheat, selling price is known Dubious that external transaction taken place

4. Perform service and invoice customer External transaction taken place

5. Increase in market value of asset No external transaction taken place

6. Advance sales of magazine subscriptions External transaction taken place but immediate recognition of income denied. ‘Right’ type of transaction has not yet taken place

7. Sales order received, with deposit External transaction taken place but immediate recognition of income denied. ‘Right’ type of transaction has not yet taken place

8. Sales on approval External transaction taken place but immediate recognition of income denied. ‘Right’ type of transaction has not yet taken place


14.3 Determining when to recognise income• Test for realisation:

– Terms ‘realisation’ and ‘recognition’ used interchangeably in accounting literature

Result that it has become increasingly difficult to distinguish between them

– In our view:

Realisation

• Should refer to the conversion of an asset into cash or a claim to cash

Income recognition

• Will be at the point in the operating cycle at which it is deemed appropriate to recognise

The two issues are not always identical



• Test for realisation

– Income realisation normally arises in the final stages of the operating cycle and is only one possible point for income recognition

– Realisation test

Implies that income should be recognised only when there is an external transaction that results in the receipt of cash or a claim to cash

The adoption of a strict realisation test is effective in identifying cases in which income may be recognised

• but it is less successful in indicating when income may not be recognised



• Test for realisation

Table 14.2 Testing for realisation of income for selected events

Events Has income been realised?

1 Retail credit sales Produces a claim on the customer, an account receivable, and this satisfies the realisation test

2 Sales under warranty Produces valid claims on outsiders

3 Marketing board for wheat, selling price is known Dubious, since the claim on the marketing authority will not exist until the product is delivered

4 Perform service and invoice customer Performance of a service produces valid claims on outsiders

5 Increase in market value of asset No claim on a customer and no cash received

6 Advance sales of magazine subscriptions Advance magazine sales have resulted in the receipt of cash

7 Sales order received, with deposit The receipt of a cash deposit with a sales order amounts to a partial realisation of the sale

8 Sales on approval No cash received



• Accomplishment: the critical event criterion

– As a measure at the point at which income is ‘earned’

– Profit is earned at the moment of making the most critical decision, or of performing the most difficult task in the cycle of a complete transaction

– In most cases, the sale is the most critical event

Excellent ideas, huge time and energy contributions, and a sound production process are worthless unless the goods can be sold




– Critical event approach attempts to provide a more comprehensive test

Under the collections basis, the critical event notion:

• Suggests that collection is the critical event

– Sometimes ‘collecting the cash’ is the hardest step in the earning process, so this becomes the critical event




– Critical event approach

Seems to provide a sensible criterion for recognising income when it is earned, until this question is asked:

• ‘What is there about an event that makes it critical to the earning of income?’

– This question can be answered only by delving deeper still



• The resolution of uncertainty

– Sufficient uncertainty must be eliminated before income is recognised

This will require a change in net assets to be:

• Measurable and thus verifiable

• Permanent (unlikely to be reversed)



• The resolution of uncertainty

Table 14.3 Testing for resolution of uncertainty using selected events

Events Is income recognised because of resolution of uncertainty?

1 Retail credit sales Income recognised

2 Sales under warranty Income recognised

3 Marketing board for wheat, selling price is known Income recognised

4 Perform service and invoice customer Income recognised

5 Increase in market value of asset Income not recognised

6 Advance sales of magazine subscriptions Income not recognised

7 Sales order received, with deposit Income not recognised

8 Sales on approval Income not recognised


14.4 Tests for the resolution of uncertainty

• Martin and Coombes (adopted by SAC 4)

– ‘Income should be recognised at the earliest point at which all of the following tests have been satisfied:

1. An agreement has been entered into by the entity with one or more independent parties.

2. Cash has been received, or the entity has a claim on another party or parties that:

a)is for a specific consideration, either in cash, other assets, or a reduction in debt owing by the entity; and

b) may not be cancelled at will by either party.

3. All acts of performance necessary to establish a valid claim on the other party have been completed.

4. It is possible to estimate to a satisfactory extent the uncollectability of debts or the return of goods sold.’



• Increases in values of assets

– As a general rule, increases in the market values of assets will fail the tests for income recognition because:

No sale agreement exists with an independent party to verify the gain

No non-cancellable claim exists and

Not all acts of performance have been completed to secure the income or gain

– These tests will not be met until a sale has been made



• Long-term construction projects– Contracts that extend over a number of years

Such as a long-term construction contract• Construction projects could include buildings, ships, roads,

bridges, tunnels and dams

• To prevent the situation in which no income is recognised until the final year– Common to allocate income over the project life


14.5 Some applications• Long-term construction projects

– Activities are continuous Impossible to allocate the income on any natural basis

– In practice:

Two methods of income recognition

1.The completed contracts method of income recognition– Recognises no income until the contract has been completed

2.The percentage of completion method of income recognition– Attempts to take account of the progress during each period of the contract by allocating the

income in accordance with some measure of the proportion of the contract completed in each period



– Bridge-building contract example Capable Builders Ltd began business on 1 January 20X1 with contributed

capital, in cash, of $3 million. The company agreed to build a bridge over the Weary River for the sum of $8 million, payable in instalments as follows.

20X1 $600 000

20X2 7 400 000

Total $8 000 000

Costs over the two-year construction period were:

20X1 $750 000

20X2 250 000

Total $1 000 000



• Long-term construction projects– Bridge-building contract example

Income recognition using completed contract method• Under this method the entire income is recognised in the year

of completion• In accordance with the matching concept, the production costs

incurred in the first year are carried forward as assets and matched against income in the second year

• The asset, contracts in progress, is reduced by the amount billed to the client in the first year


14.5 Some applicationsCAPABLE BUILDERS LTD

Completed contracts method

Income Statement

20X1 20X2 Total

Income $Nil $8 000 000 $8 000 000

less Production costs Nil 1 000 000 1 000 000

Net profit $Nil $7 000 000 $7 000 000

Balance sheets

20X1 20X2

Assets

Cash at bank $2 850 000 $10 000 000

Contracts in progress $750 000

less Billings to date 600 000 150 000 ---

3 000 000 10 000 000

Shareholders’ equity

Capital 3 000 000 3 000 000

Retained profit _________ 7 000 000

$3 000 000 $10 000 000




Income recognition using percentage of completion method• This method uses the costs incurred as an indicator of the proportion of

the contract completed in each period

• The total income from the project is then allocated to each period in accordance with the costs incurred

– Since 75% of total costs ($750 000 of $1 000 000) were incurred in the first year, 75% of the income is recognised.

– The amount of income recognised in excess of the amount billed is included as a contract receivable on the Balance Sheet.


14.5 Some applicationsCAPABLE BUILDERS LTD

Percentage of completion method

Income Statement

20X1 20X2 Total

Income $6 000 000 $2 000 000 $8 000 000

less Production costs 750 000 250 000 1 000 000

Net profit $5 250 000 $1 750 000 $7 000 000

Balance sheets

20X1 20X2

Assets

Cash at bank $2 850 000 $10 000 000

Contracts in progress $6 000 000

less Billings to date 600 000 540 000 ---

8 250 000 10 000 000

Shareholders’ equity

Capital 3 000 000 3 000 000

Retained profit 5 250 000 7 000 000

$8 250 000 $10 000 000




Completed contract method• No profit is shown in 20X1• All the profit is shown in the second year of the project

– Result may convey misleading information, particularly in 20X1, suggesting that the business was idle during the first year

Percentage of completion method• Incomes are allocated across the two periods of time in

proportion to the work completed in each period



– Percentage of completion method

Provides more relevant information to decision makers

Method is based on a number of assumptions

• Includes the view that the long-term contract is readily divisible into reporting periods

– If assumptions are proved incorrect, then misleading results may be provided

Overall consensus is that percentage of completion method is more superior

• Relates income more directly to the effort

– Hence, the accomplishment in any period

• However circumstances like inflation or industrial disputes can bring in an uncertainty element

– With regards to determining the total costs of the project thereby making it difficult to recognise income


Summary• Recognition of income results in an increase in

owner’s equity and therefore an increase in the entity’s net assets

• Income will either increase assets or decrease liabilities and also result in an increase in owner’s equity

• Contributions of capital by owners is not income


Summary• Recognising income is very difficult because the

process of earning income is continuous but accounting reports only focus on a specific point in time

• Correctly determining when income is recognised is important to provide both relevant and reliable accounting information


Summary• Recognising income requires that the amount be

measurable and probable

• 4 tests are available to help determine when income may be recognised– External transaction test– Realisation test– Critical event test– Resolution of uncertainty test


Summary• Issues occur when assets controlled by an entity

increase in value (thus satisfying the definition of income) but do not meet the income recognition criteria until they are sold

• Long-term projects also create issues regarding when to recognise income

Documents

1-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides