Tuesday, September 18, 2007

Revenue Recognition Methods

Depending on the business undertaking, the revenue of a firm varies according to the time and the deal with the customer. For example, a car maker gets its payment when a customer buys its car and pays for it. On the other hand, a prepaid mobile service provider gets the payment before it has provided its services - use of its network for the limited number of minutes provided. And a very visible category in the infrastructure development scenario in India is that of part payment based on the partial completion of a project, for example construction of flyovers.

The GAAP (Generally Accepted Accounting Practice) accounting standards allow for various methods for such revenue recognition. Companies are free to choose the method that best suits their business. And thereby it becomes very essential during an income statement analysis to determine that the method followed actually reflects the correct business scenario.

Sales basis method
Under this the earnings process is complete from the company, and the revenue is reasonably assured. This is the case where an individual buys a car and pays through cash or credit. Even when the customer pays through the credit card, the revenue from sale and the corresponding cost for manufacturing is recognized in the period when the sale was made. The actual cash may be delivered at any time later.

Percentage of completion method
This is the case of the airport, bridges and other long term project constructions. In these the whole work is not delivered within one accounting period. Here the revenue is reasonably assured. So at the end of every accounting period the firm recognizes revenue based on estimates of work completion. The estimate of completed work may be based on two parameters
  • Actual engineering work completed as estimated by the management/ engineering team.
  • Cost incurred to date, if the total cost has been reasonably estimated earlier. In case the cost estimate is revised in the future, the revised cost estimate is used to do the calculations for the next year.
For example, if it is estimated that a company A is building a flyover for Rs. 5,00,00,000 and it estimates that it would cost it Rs. 4,00,00,000. Here we assume that the payer is genuine and will pay up. Now if in the first year A incurs a cost of Rs. 1,00,00,000, going by percentage complete method, it would recognize a revenue of Rs. 1,25,00,000, thus making a profit of Rs. 25,00,000 for the first year.

If in the second year, A's project management goes on an overdrive and it incurs a cost of Rs. 1,50,00,000 for the second year for the amount of work it has done. So the total cost is now Rs. 2,50,00,000 based on which it recognizes a revenue of Rs. 3,12,50,000 [ (25/40) * Rs. 5,00,00,000 ]. The total profit for the 2 years comes to Rs. 62,50,000 out of which Rs. 25,00,000 was recognized in the first year itself. So the profit for the second year comes to Rs. 37,50,000.

Completed contract method
Under this method, the revenue is recognized only when the whole project is completed and delivery of the goods has been given to the customer. So if the project lasts for five years, there would be no profit for the first four years and would recognize it only at the end of the fifth year.

This is used when the costs can be estimated but the work is incomplete and the payment is not assured as well. Or it can be used where the costs can't be estimated by the supplier firm before delivery of the product.
Installment sales method
For example, if the cost of product is Rs. 100 and it is sold for Rs. 150. The gross profit is 50%. So when the seller receives Rs. 50 in the first installment of payment, the firm recognizes 1/3 (Rs. 50/Rs. 150) of the profit also which amounts to Rs. 50/3. This method is used when the earnings process is complete from the supplier/seller side but the payment is not assured or rests on the credibility of the buyer. For example in the current subprime housing issue.

Cost recovery method
Continuing from the above example, if the cost is Rs. 100 and it is sold for Rs. 150. When the first installment of Rs. 50 is received, no profit is recognized. With another Rs. 60 of revenue a profit of Rs. 10 is recognized. And with the remaining Rs. 40, the rest of Rs. 40 of profit is recognized in the period of the third year.
This is used when the earnings process is complete but there are contingencies built in there.

Thursday, September 06, 2007

Other Comprehensive Income

Everybody knows the Accounting Equation: Assets = Liabilities + Equity.

Now the Equity portion of the equation is what the owners puts in into the business when they start a business. It also includes the money that comes into the company by issuing common stock. So if you and I were to buy shares into the company, we would also become the owners. With this overwhelming feeling also comes risk involved. The risk of losing all the money that you and I have put into our business. If our business were to fail it would take with it all our capital. So it becomes imperative to know what are the avenues where the equity increases or decreases. There are 4 such methods in which it could be affected.

Unrealized Gain/Loss on AFS Securities
AFS is available for sale securities. These are stocks of other companies that you have bought and can be readily sold in the market, but you decide not to sell them for the entire accounting period. The accounting period may be a full year, or a quarter or whatever. For example you have 100 shares of company A, valued at Rs. 100 each. So at the start of the year the value of the securities is Rs. 10,000. Although you have not done any work, yet by merely holding the securities the value of those would have increased or decreased. That essentially increases or decreases the owners' equity.

Translation Error
Suppose you were to buy 100 bottles of Château Cheval Blanc red at the start of the year for a total of 100,000 francs at the start of the year. And suppose at the end of the year it still costs the same in francs. But you would have paid in rupees or whatever currency is local to you. Now if the currency conversion rate of rupee vs. the franc at the start of the year were to be 1 franc = Rs. 35 and at the end of the year it were to change to 1 franc = Rs. 30, the change in the value of your asset would be Rs. 5,00,000. Again no transactions but you are affected by the currency rate fluctuations.

Minimum Pension Liability
Every month your company collects a percentage of your salary as your contribution towards EPF (Employees' Pension Fund) and contributes an equal amount on its own. It then invests that amount in hopes of being able to give you some interest on that money at some later date. Now depending upon its investment, there would be a deficit or gain in the amount in the fund and the promised amount it has to give out as pension to its employees. This needs to be reported in the company's balance sheet against owners' equity.

Cash Flow Hedges
Assume the case of a manufacturing company. It runs on raw materials to produce finished goods. In most cases the production planning supervisor would know the amount of raw materials the company would need, say, 6 months down the lane. Some of the materials are to be imported and paid in dollars. The company expects that the rupee-dollar exchange rate to change drastically in that time. So the company makes a deal with someone else, that for a fixed amount of rupees that person would give the company a fixed amount of dollars with which the company can pay for the raw materials. If the reporting were to happen between now and then, and supposing the exchange rate has changed, the change is to be reflected in the accounting books. Note, that the transaction has not happened as yet. But the company has committed the money at some level to the apparent profit/loss needs to be reported. In fact this is one of the ways in which TCS recently managed to give better results than expected.

Listening to: Creed - One Last Breath
via FoxyTunes