Saturday, August 11, 2012


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The accounting literature distinguishes between two approaches to define revenues: an inflow concept and outflow concept.

The inflow concept of revenues defines revenues as an inflow or an increase in assets and reduction of liabilities arising from the operational activities of the firm. An inflow concept represents an asset liability approach.

The outflow concept of revenues defines revenues as an outflow of goods and services, or by the use of companys resources. The outflow concept follows the revenue-expense approach.

Asset liability approach measures income statement as a change in assets and liabilities. This approach is superior to revenue-expense approach, because assets and liabilities are real and income is determined by changes in net assets. Revenue-expense approach turns things other way around, and says that net assets are consequences of income measurement. Currently accounting system uses revenue expense approach to define income, where income is derived by matching costs to recognized revenues. The main disadvantage of this approach is the ambiguity of matching expenses to revenues. Kyle will explain in more detail the he matching principle.

The downside to asset-liability approach is that it expenses all of the expenses in current period rather than capitalizing them. For example, purchase of new equipment used for the production is expensed in the period it was purchased, rather than amortizing it for its useful life. This way we have losses showing in the current period, rather than deferring some expenses to other periods equipment is used. Even though, we currently use Revenue Expense approach, some accounting concept like R&D costs are expensed in current period, thus following asset liability approach. The reason behind this accounting treatment is because of uncertainty whether R&D costs created any value to the business.

In both inflow and outflow concept, definition of revenues does not include gains. Gains are nonrecurring income to be displayed separately in the financial statements. As the CICA Handbook states gains are increases in net assets or equity from incidental transactions and events affecting the entity, and all other events affecting the entity except those that result from revenues or equity contributions.

One of the current issues facing accounting is when to recognize revenues. Many of the companies report revenues earlier in order to show better performance for the current period, but than the revenue turns to be unrealizable. Accounting standards recognize revenues in the period during which the major economic activities necessary for creation and disposition of goods and services has been accomplished. Three criteria should be followed when recognizing the revenue:

· there is reasonable assurance regarding the measurability and collectability of consideration

· there is existence of a transaction

· and there is substantial completion of the earning process.

Currently the firm must be direct participant in the transaction before revenues are recognized. Thus the historical cost of asset is used for valuation basis. Some argue that the firm does not need to be a party to the transaction but that a market transaction in general is sufficient. For example, the asset should be revalued at the market price, and gain can be recorded prior to sale.

Generally revenues are recognized at the point of sale. But there are situations when revenues are permitted to be recorded other than the time of sale. These are

- During production

- End of production

- When cash is received

Recognizing revenues during production uses % of production method, which is acceptable for long term construction contracts. Some products have readily determinable price, and there is high demand for the product, such as gold, silver, wheat, that the revenues can be recognized at the end of production. Revenues that are recorded when the cash is received use the installment or cost recovery method. This is necessary, when we are not sure about measurability or collectability or substantial completion has not been met.

Two additional bases for recognizing revenues have been suggested, but not approved. These are accretion basis, where products market price is known, and the changes of the assets are recorded, such as growth of timber. Another alternative is recognizing revenues at discovery basis, for example when natural gas is discovered. The discovery is argued to be the significant to the earning process.

Last items of the income statement are expenses and losses.

There are three accounting techniques used to create an expense, matching allocation and expiration. The tree possible cases are

· costs that are directly related to the revenue of the period are matched against revenue

· costs that are associated to the period but not as a direct relation with revenue are allocated to the period

· cost that cannot be associated to any period and are expired are expensed immediately. 

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