1. 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 prepared by Mary Low Chapter 14 Income

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

3. 1-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 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

4. 1-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low Chapter 14 Overview 14.1 The definition of income 14.2 Different points for income recognition 14.3 Determining when to recognise income 14.4Tests for the resolution of uncertainty 14.5Some applications

5. 1-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 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

6. 1-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low Looking back (previous chapters) Introduced the conceptual framework Explored the principles and rules applicable to accounting for assets and expenses

7. 1-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 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

8. 1-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 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

9. 1-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 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

10. 1-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.2 Different points for income recognition 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

11. 1-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.2 Different points for income recognition Stages of a typical earnings cycle

12. 1-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.2 Different points for income recognition Recognising income at different points 1.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

13. 1-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.3 Determining when to recognise income 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

14. 1-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.3 Determining when to recognise income 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

15. 1-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.3 Determining when to recognise 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

16. 1-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 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 EventsHas an external transaction taken place? 1.Retail credit salesExternal transaction taken place 2.Sales under warrantyExternal transaction taken place 3.Marketing board for wheat, selling price is knownDubious that external transaction taken place 4.Perform service and invoice customerExternal transaction taken place 5.Increase in market value of assetNo external transaction taken place 6.Advance sales of magazine subscriptionsExternal transaction taken place but immediate recognition of income denied. ‘Right’ type of transaction has not yet taken place 7.Sales order received, with depositExternal transaction taken place but immediate recognition of income denied. ‘Right’ type of transaction has not yet taken place 8.Sales on approvalExternal transaction taken place but immediate recognition of income denied. ‘Right’ type of transaction has not yet taken place

17. 1-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 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

18. 1-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.3 Determining when to recognise income 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

19. 1-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.3 Determining when to recognise income Test for realisation Table 14.2 Testing for realisation of income for selected events EventsHas income been realised? 1Retail credit salesProduces a claim on the customer, an account receivable, and this satisfies the realisation test 2Sales under warrantyProduces valid claims on outsiders 3Marketing board for wheat, selling price is knownDubious, since the claim on the marketing authority will not exist until the product is delivered 4Perform service and invoice customerPerformance of a service produces valid claims on outsiders 5Increase in market value of assetNo claim on a customer and no cash received 6Advance sales of magazine subscriptionsAdvance magazine sales have resulted in the receipt of cash 7Sales order received, with depositThe receipt of a cash deposit with a sales order amounts to a partial realisation of the sale 8Sales on approvalNo cash received

20. 1-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.3 Determining when to recognise income 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

21. 1-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.3 Determining when to recognise income Accomplishment: the critical event criterion –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

22. 1-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.3 Determining when to recognise income Accomplishment: the critical event criterion –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

23. 1-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.3 Determining when to recognise income 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)

24. 1-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.3 Determining when to recognise income The resolution of uncertainty Table 14.3 Testing for resolution of uncertainty using selected events EventsIs income recognised because of resolution of uncertainty? 1Retail credit salesIncome recognised 2Sales under warrantyIncome recognised 3Marketing board for wheat, selling price is knownIncome recognised 4Perform service and invoice customerIncome recognised 5Increase in market value of assetIncome not recognised 6Advance sales of magazine subscriptionsIncome not recognised 7Sales order received, with depositIncome not recognised 8Sales on approvalIncome not recognised

25. 1-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 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.’

26. 1-26 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.5 Some applications 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

27. 1-27 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.5 Some applications 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

28. 1-28 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 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

29. 1-29 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.5 Some applications Long-term construction projects –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

30. 1-30 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.5 Some applications 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

31. 1-31 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.5 Some applications CAPABLE BUILDERS LTD Completed contracts method Income Statement 20X120X2Total Income$Nil$8 000 000 less Production costs Nil 1 000 000 Net profit $Nil $7 000 000 Balance sheets 20X120X2 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 Capital3 000 000 Retained profit _________ 7 000 000 $3 000 000 $10 000 000

32. 1-32 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.5 Some applications Long-term construction projects –Bridge-building contract example  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.

33. 1-33 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.5 Some applications CAPABLE BUILDERS LTD Percentage of completion method Income Statement 20X120X2Total 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 20X120X2 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 Capital3 000 000 Retained profit5 250 000 7 000 000 $8 250 000 $10 000 000

34. 1-34 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.5 Some applications Long-term construction projects –Bridge-building contract example  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

35. 1-35 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 14.5 Some applications Long-term construction projects –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

36. 1-36 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 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

37. 1-37 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 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

38. 1-38 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 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

39. 1-39 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: A Framework for Decision Making 2e, by Jackling, Raar, Williams & Wines Slides prepared by Mary Low 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