Chapter 12

Revenue Recognition and

Reporting Results of
Operations
Prepared by Vivian Wang
Week 13
HKSYU

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Chapter 12

Revenue
Recognition
and Reporting
Results of
Operations

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Introduction: Example
 A company’s pattern of sales and profit are
important factors in evaluating its financial success.
Consider PetroChina whose principle business
activities principally engages in exploration and
sales of crude oil and natural gas, refining of crude
oil and petroleum products, as well as production
and sales of basic and derivative chemical products
and other chemical products.
 One of the attributes of financially successful
companies like PetroChina is their consistent
strength over time in terms of primary measures of
financial performance, such as revenue and profit.
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Introduction: Under Armour
 The following trends can be observed in PetroChina’s
income statements from 2017 to 2019:
◦ Revenues
 Increased 17 percent from 2017 to 2018
 Increased 6 percent from 2018 to 2018
 Revenues is the largest single figure in the company’s
financial statements in each year.
 Profit, which starts with revenues and is reduced by
various expenses required to generate those sales,
increased from (numbers in millions) RMB 39,395 in
2017 to RMB 73,980 in 2018 and to RMB 67,015 in
2019.

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Revenue Recognition
 When revenue is included in a company’s income
statement it is considered “recognized.”
 Revenue recognition is an important principle of
financial reporting that determines when revenue
should be recorded and included in a company’s
financial statements.
 The general principle is that revenue is recognized when
it has been earned.
◦ This means that the company receiving the revenue has done
everything required in its agreement with a customer and the
expenses related to the revenue have been incurred or can be
reasonably estimated.
◦ Application of the matching principle because revenue is
matched with expenses required to earn the revenue.
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Revenue as a Driver
 Revenue has a significant impact on a number of other
financial statement items such as cost of goods sold and
other expenses, such as wages, utilities, and taxes.
 In the statement of financial position (balance sheet),
cash and receivables are directly tied to the revenue
that is recognized in the income statement for the same
period.
 Cash received from revenue transactions that have been
recognized in the income statement is a direct
determinant of the amount of cash provided by
operations in the statement of cash flows.

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Revenue as a Contract
 A contract is an agreement between two or more parties
that creates enforceable rights and obligation for both
parties. The earning and subsequent recognition of revenue is
the direct result of a contract between a seller (e.g., a retail
establishment) and a buyer (e.g., a customer).
 Several aspects of sales transactions may complicate the
revenue recognition process including the right of return by
the customer, payment of amounts purchased on credit,
warranties promised by the seller, and so on.
◦ For routine transactions, across a large number of sales
transactions, the financial implications of these uncertainties can
be estimated and generally do not delay the recognition of
revenue.

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Performance Obligations
 In determining the correct amount and timing of revenue
recognition, performance obligations are particularly
important.
◦ A performance obligation is a promise a company makes to
transfer goods and/or services to a customer.
 The timing of revenue recognition is directly tied to the
completion of performance obligations in a contract with a
customer. As performance obligations are completed, the
seller recognizes revenue.
 Some transactions involve multiple performance obligations
in a single transaction. In this situation, the seller must
separate the revenue into two or more elements.

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Performance Obligations: Example
 For example, assume an automobile dealer sells a
vehicle and offers two additional services. One is an
extended warranty for two years beyond the
manufacturer’s three-year warranty. The second is an
optional agreement to service the vehicle for the first
three years.
 The automobile dealer has three performance
obligations: to deliver the vehicle, to complete any
warranty work required by the extended warranty
agreement, and to service the vehicle for the designated
period. The automobile dealer allocates the total
amount received among the three streams of revenue
and recognizes each as performance obligations are
complete.
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Performance Obligations: Example
(concluded)
 For example, assume the total transaction amount is
$35,000. The extended warranty is estimated at 5
percent of the total price, less the amount of the
service agreement, which is estimated to be $400 per
year. Revenue would be recognized as follows

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Developing Predictive Information
 Because of the importance of income reporting in making
assessments about the future, events and transactions other
than normal, recurring revenues, and expenses require
careful attention in the preparation and interpretation of an
income statement.
 The results of items that are not likely to repeat on a regular
basis are presented separately from the results of the
company’s normal, recurring activities. Two categories of
events and transactions that require special treatment are
◦ (1) nonrecurring items that are unusual in nature and/or occur
infrequently and
◦ (2) discontinued operations in which a portion of the business
has been eliminated.

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Irregular Items: An Illustration
 Farmer Corporation operates both a small
chain of retail stores and two motels.
◦ During the current year, the company sells
both motels to a national hotel chain.
◦ In addition, Farmer Corporation reports one
unusual and infrequent item, a loss on the
settlement of a lawsuit.

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Farmer Corporation: Income
Statement

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Unusual and/or Infrequent Gains and
Losses
 Unusual and/or infrequent gains and losses:
◦ Typically do not recur often.
◦ Do not occur in predictable patterns.
◦ Are sometimes referred to as nonrecurring items.
 Examples include:
◦ Losses due to labor strikes.
◦ Gains or losses on the sale of plant assets.
◦ Losses from storms and natural disasters.
◦ Losses due to lawsuits.

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Unusual and/or Infrequent Gains and
Losses: Tax Effects
 Unusual and/or infrequent items are not
presented on a net-of-tax basis.
 Any income tax effect of these items is
combined with the income tax on normal,
recurring revenue and expenses and included in
the item Income Tax Expense.

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Restructuring Charges
 Restructuring charges consist of items such as
losses on:
◦ Write-downs on plant assets.
◦ Sale of plant assets.
◦ Severance pay for terminated workers.
◦ Relocation of operations and/or employees.
 Such charges are presented on the company’s
income statement as a single item.
 If the restructuring involves discontinuing a
component, then such expenses should be
presented as part of discontinued operations.
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Discontinued Operations
 When management enters into a formal plan to
sell or discontinue a component of the entity,
the results of that component’s operations are
shown separately in the income statement.
 Excluding the part of the business that will no
longer affect the company’s operations in the
future enables users of the financial statements
to better evaluate the performance of the
company’s ongoing (continuing) operations.

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Discontinued Operations (concluded)
Two items are included in the discontinued
operations section of the income statement:
1. The profit or loss from operating the
component prior to its disposal.
2. The gain or loss on disposal of the component.

KEY POINT

The income taxes relating to the discontinued operations

are shown separately from the income tax expense
relating to continuing business operations.

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Your Turn: Investor
One of the most important determinants of a company’s share price is
expected future earnings. Assume that you are considering investing in
Worsham Corporation and are evaluating the company’s profitability in
the current year. The profit of the corporation, which amounted to
$4,000,000, includes the following items.

Loss on a discontinued component of the business (net of tax): $750,000

Gain on the sale of Land to the City of Phoenix: $300,000

Assume the gain on the sale of land is based on the total received and
does not include income taxes, which are expected to be 30 percent.
Adjust profit to develop a number that represents a starting point for
predicting the future profit of Worsham Corporation. Explain the reason
for each of the adjustments. Explain how this adjusted number may help
you predict future earnings for the company.

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Earnings per Share
 Computing earnings per share is easiest when the
corporation has issued only ordinary shares and the
number of outstanding shares has not changed
during the year.
 In this case, earnings per share is equal to profit
divided by the number of shares outstanding.
◦ The weighted-average number of shares for the year is
determined by multiplying the number of shares outstanding
by the fraction of the year that number of shares outstanding
remained unchanged.

KEY POINT
Earnings per share applies only to ordinary shares; preference
shareholders have no claim to earnings beyond the stipulated
preference shares dividends.
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Earnings per Share: Example
Assume a company had 80,000 shares of ordinary shares outstanding
during the first nine months of the current year. The company then
sold 60,000 additional shares so that 140,000 shares were outstanding
during the last three months of the year. The weighted-average
number of shares outstanding for the year is 95,000, determined as
follows.

If the company’s profit for the year was $250,000, earning per share is
calculated as follows: $250,000 ÷ 95,000 shares = $2.63.

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Preference Dividends and Earnings per
Share
 When a company has preference shares outstanding, the
preference shareholders participate in profit only to the
extent of the preference share’s stated dividend.
 To determine the earnings applicable to the ordinary shares,
we first deduct from profit the amount of current year
preference dividends.
 The annual dividend on cumulative preference shares is
always deducted, even if not declared by the board of
directors for the current year.
◦ If there are preference dividends in arrears, only the current year’s
preference shares dividend is deducted in the earnings per share
computation.
 Dividends on noncumulative preference shares are deducted
only if they have been declared by the board of directors.
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EPS Example with Preference Dividends
Assume that Perry Corporation has 200,000 shares of
ordinary shares and 12,000 shares of $6 cumulative
preference shares outstanding throughout the year. Profit
for the year totals $595,000. Earnings per share of
ordinary shares would be computed as follows.

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Presentation of EPS on the Income
Statement
 Publicly owned corporations are required to
present earnings per share figures in their
income statements.
 If an income statement includes discontinued
operations, per-share figures are shown for
both profit from continuing operations and
profit.
 The per-share calculation for profit from
continuing operations is computed by
substituting that amount for the profit figure in
the preceding calculation.
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Presentation of EPS on the Income
Statement (concluded)

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International Case in Point
Valuation multiples such as price-earnings ratios are often
used to estimate a firm’s value. The use of price multiples
to compare firms from different countries is challenging
for many reasons. One important reason is that national
differences in accounting principles are a source of cross-
country differences. For example, research has shown that
such differences in accounting principles cause p/e ratios
in Japan to be generally lower than in the United States
for comparable companies with similar financial results.

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Your Turn: Financial Analyst
You are working for a stock market research firm and your boss asks you
to present an analysis of Foster, Inc.’s performance, focusing primarily on
earnings per share. Her primary purpose for having you do this analysis is
to consider whether Foster, Inc., is a good investment in terms of the
company’s expectations for future profitability. In analyzing Foster, Inc.’s
income statement you determine the following.

On the basis of only the limited information presented above, what is

your recommendation to your boss regarding Foster, Inc.’s prospects for
future profitability? Justify your conclusion.

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Basic and Diluted Earnings per Share
 Basic earnings per share is based on the weighted-
average number of ordinary shares actually
outstanding during the year.
 Diluted earnings per share incorporates the impact
that convertible instruments would likely have on
basic earnings per share.
 Convertible instruments may include:
◦ Preference shares
◦ Convertible bonds
◦ Share options

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Reporting Other Comprehensive Income

 Traditionally, an income statement presented all

items of income and expense recognized in profit
or loss while the statement of changes in equity
presented all items not recognized in profit or loss.
 However, certain items not recognized in profit or
loss are not exactly related to changes in equity
arising from transactions with shareholders in their
capacity as shareholders.
 Such items as required or permitted by the IFRS
have been recognized and described as an item
of other comprehensive income.
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Statement of Profit or Loss and
Other Comprehensive Income
 Other comprehensive income and total
comprehensive income must be presented in the
financial statements now but cannot be presented in
the statement of changes in equity.
 They may be displayed to users of financial
statements in any of the following ways:
1. In a single statement of profit or loss and other
comprehensive income
2. In two separate statements shown, as follows:
1. The first statement - statement of profit or loss; and
2. The second statement – the statement of profit or
loss and other comprehensive income
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Statement of Profit or Loss and
Other Comprehensive Income (single one)

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Statement of Profit or Loss and
Other Comprehensive Income (2-statement)

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Cash Dividends
 Investors buy shares in a corporation with the
expectation of getting their original investment
back as well as earning a reasonable return on
that investment.
 The return on a stock investment is a
combination of the following:
1. The increase in value of the shares
(share appreciation).
2. Cash dividends.

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Requirements for Cash Dividends
1. Retained earnings.
o Theoretical maximum for dividends is the balance of
retained earnings.
o Many companies limit dividends to a small portion of
profit in order to retain monies to grow the business.
2. Adequate cash position.
o The company must have enough cash in order to pay
dividends.
3. Dividend action by the board of directors.
o Formal action by the board of directors is necessary
to declare a dividend.

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Dividend Dates
Four significant dates are involved in the distribution of a
dividend. These are as follows.
1. Date of declaration.
o On the day on which the dividend is declared by the
board of directors, a liability to make the payment
comes into existence.
2. Ex-dividend date.
o The ex-dividend date is significant for investors in
companies whose shares trade on stock exchanges.
o A person who buys the shares before the ex-dividend
date is entitled to receive the dividend that has already
been declared; conversely, a shareholder who sells
shares before the ex-dividend date does not receive the
dividend.
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Dividend Dates (concluded)
3. Date of record.
o The date of record follows the date of declaration,
usually by two or three weeks, and is stated in the
dividend declaration. To be eligible to receive the
dividend, a person must be listed in the
corporation’s records as the owner of the shares
on the date of record.
4. Date of payment.
o The declaration of a dividend includes an indication
of the date of payment as well as the date of record.
Usually the date of payment comes two to four
weeks after the date of record.
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Date of Declaration
Date of Declaration
• Board of directors declares the dividend.
• Record a liability.
On December 15, the board of directors declares a $1.00 per
share cash dividend on its 125,000 ordinary shares
outstanding. The dividend is payable to shareholders of record
on January 10 and paid on January 25.

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Ex-Dividend Date and Date of Record
Ex-Dividend Date
• Determines who receives the dividend
• No entry made

Date of Record
• Significant primarily for the shares transfer
agent and the shares registrar.
• No entry made

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Date of Payment

Date of Payment
• Record the payment of the dividend to
shareholders.

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Dividend Dates: Example
On June 1, 2022, a corporation’s board of directors
declared a dividend for the 2,500 shares of its $100
par value, 8 percent preference shares. The dividend
will be paid on July 15. Which of the following will be
included in the July 15 entry?
A. Debit Cash $20,000.
B. Debit Dividends Payable $20,000.
C. Credit Dividends Payable $20,000.
D. Credit preference shares $20,000.

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Dividend Dates: Example (concluded)

On June 1, 2022, a corporation’s board of directors

declared a dividend for the 2,500 shares of its $100
par value, 8 percent preference shares. The dividend
will be paid on July 15. Which of the following will be
included in the July 15 entry?
A. Debit Cash $20,000.
B. Debit Dividends Payable $20,000.
C. Credit Dividends$100Payable
× 8% = $20,000.
$8 dividend per share
$8 × 2,500 = $20,000 total dividend
D. Credit preference shares $20,000.

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Liquidating Dividends
 A liquidating dividend occurs when a corporation
pays a dividend that exceeds the balance in the
Retained Earnings account.
 Liquidating dividends usually are paid only when a
corporation is going out of existence or is making
a permanent reduction in the size of its
operations.
 Shareholders may assume that a dividend
represents a distribution of profits unless they are
notified by the corporation that the dividend is a
return of invested capital.

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Stock Dividends
 Stock dividend is a term used to describe a
distribution of additional shares to a company’s
shareholders in proportion to their present
holdings.
 The dividend that has been declared is satisfied
by issuing additional shares rather than being
paid in cash.
 Most stock dividends consist of additional
shares of ordinary shares distributed to holders
of ordinary shares.

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Cash Dividends vs. Stock Dividends
1. Cash Dividends
a. Distribution of cash by a corporation to its
shareholders.
b. Reduces both assets and shareholders’ equity.
2. Stock Dividends
a. No distribution of assets.
b. No change in assets, liabilities, or total shareholders’
equity.
KEY POINT

Each shareholder receives additional shares, but his or her

percentage ownership in the corporation is no larger than before.

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Stock Dividend: Illustration
Assume that a corporation with 2,000 shares of ordinary
shares outstanding is owned equally by James Davis and
Susan Miller, each owning 1,000 shares. The corporation
declares a stock dividend of 10 percent and distributes
200 additional shares (10 percent of 2,000 shares), with
100 shares going to each of the two shareholders.
o Davis and Miller now hold 1,100 shares apiece, but each
still owns one-half of the business.
o Furthermore, the corporation has not changed in size;
its assets and liabilities and its total shareholders’ equity
are exactly the same as before the dividend.

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Recording Stock Dividends
 In accounting for relatively small stock dividends,
the market value of the new shares is transferred
from the Retained Earnings account to the paid-in
capital accounts.
 This process sometimes is called capitalizing
retained earnings.
 The overall effect on shareholders’ equity is the
same as if the dividend had been paid in cash, and
the shareholders had immediately reinvested the
cash in the business in exchange for additional
shares.

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Stock Dividend: Example
Assume that on June 1, Aspen Corporation has outstanding 100,000
shares of $5 par value ordinary shares with a market value of $25 per
share. On this date, the company declares a 5 percent stock dividend,
distributable on July 15 to shareholders of record on June 20. The
entry at June 1 to record the declaration of this dividend is as follows:

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Reasons for Stock Dividends
 Management often finds stock dividends appealing
because they allow management to distribute
something of perceived value to shareholders while
conserving cash that may be needed for other
purposes like expanding facilities and introducing
new product lines.
 Shareholders favor stock dividends because they
receive more shares and for small stock dividends,
often the share price does not fall proportionately.
◦ Also, the dividend is not subject to income taxes (until the
shares received are sold).

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Case in Point
An investor who purchased 10,000 shares of MTR Corp.
(listed in HK) in 2000 would have paid about HK$124,000.
Ten years later, those 10,000 shares were worth about
HK$343,600! Does it mean that the share price of each
share increased over 177% over that period? No!
Since 2000, MTR has declared numerous stock dividends.
The investors may also help create more demand for
MTR’s share and services—and in many cases, they also
become loyal customers to the services provided by MTR
to the public, i.e. the mass transit railway. After MTR
declared numerous stock dividends, an investor who had
purchased 10,000 shares in 2000 would own over 12,847
shares 10 years later without ever having had to purchase
additional shares.
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Distinction between Share Splits and
Stock Dividends
• The difference between a stock dividend and a share split
lies in:
o The intent of management.
o The related issue of the size of the distribution.
• A stock dividend usually is intended to substitute for a cash
dividend and is small enough that the market price of the
share is relatively unaffected.
• Stock dividends do not result in a change in the par value of
the share.
• Share splits typically represent a much larger increase in the
number of outstanding shares.
• Share splits are designed to bring down the market price
per share.
• Share splits result in a pro rata reduction in the par value of
the share.
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Retrospective Application and
Retrospective Restatement
• A company may change its accounting policy when
(1) the change is required by an IFRS or
(2) the change results in the financial statements providing
reliable and more relevant financial information.
• Unless an IFRS allows an alternative treatment, a company
has to apply a new accounting policy as if that policy had
always been applied, called retrospective application.
• When a change in accounting policy is applied
retrospectively, the company adjusts the opening balance of
each affected component of equity for the earliest prior
period presented and the other comparative amounts
disclosed for each prior period presented as if the new
accounting policy had always been applied.
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Retrospective Application and
Retrospective Restatement
• On occasion, a company may discover that a material error
was made in the measurement of profit (or in other
elements) in a prior year.
• Because profit is closed into the Retained Earnings account,
an error in reported profit causes an error in the amount of
retained earnings shown in all subsequent statement of
financial position.
• When such errors are discovered, they must be corrected.
The correction, called a retrospective restatement, is shown
in the statement of changes in equity as an adjustment to
the balance of retained earnings at the beginning of the
current year.
• The amount of the adjustment is shown net of any related
income tax effects.
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Restrictions of Retained Earnings
 Some portion of retained earnings may be
restricted because of various contractual
agreements.
 A restriction of retained earnings prevents a
company from declaring a dividend that would
cause retained earnings to fall below a
designated level.
 Most companies disclose restrictions of
retained earnings in notes accompanying the
financial statements.

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Statement of Changes in Equity
A statement of changes in equity is required to show the changes
during the year in all of the shareholders’ equity accounts.

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Shareholders’ Equity Section of the
Balance Sheet

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12- 55
Learning Objective Summary LO12-1
LO12-1: Define the principle of revenue recognition,
including the conditions that must be met for revenue to
be recognized in the financial statements. Revenue
recognition refers to the timing of when revenue is recorded and
included in a company’s income statement. As a general principle,
revenue is recognized when it has been earned, which means that
the performance obligations of the seller have been satisfied.

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Learning Objective Summary LO12-2
LO12-2: Describe how irregular profit or loss items,
including unusual and/or infrequent items and discontinued
operations, are presented in the income statement. Items
that are unusual and/ or infrequent are presented in the income
statement with normal, recurring revenues and expenses, but with
separate line-item disclosure. When an identifiable component of
the business has been discontinued, a subtotal for Profit from
Continuing Operations is shown, followed by the discontinued
operation. Discontinued operations is further separated into the
results of operations and any gain or loss on the disposal, both on a
net-of-tax basis.

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Learning Objective Summary LO12-3
LO12-3: Compute earnings per share and distinguish
between basic and diluted earnings per share. The earnings
per share figure is computed by dividing the profit applicable to the
ordinary shares by the weighted-average number of ordinary shares
outstanding. Diluted earnings per share is computed for companies
that have outstanding securities convertible into shares and other
arrangements that could result in an increased number of
outstanding shares. The purpose of showing both basic and diluted
earnings is to alert investors to the extent to which an increased
number of shares could reduce basic earnings per share.

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Learning Objective Summary LO12-4
LO12-4: Define other comprehensive income and total
comprehensive income, and explain how they differ from profit.
Items of income and expense that are not recognized in profit or loss
as required or permitted by an IFRS are components of other
comprehensive income. An example of a component of other
comprehensive income is the change in market value of equity
investments. Total comprehensive income for a period is profit or loss
for the period plus or minus all components of other comprehensive
income or loss for the period.

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Learning Objective Summary LO12-5
LO12-5: Describe and prepare a statement of profit or loss
and other comprehensive income. Profit or loss for a period is
presented in the income statement. Other comprehensive income
may be presented in a combined statement with profit or loss for the
period, or in a separate statement of profit or loss and other
comprehensive income.

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Learning Objective Summary LO12-6
LO12-6: Account for cash dividends and stock dividends, and
explain the effects of these transactions on a company’s
financial statements. Cash dividends reduce retained earnings at
the time the company’s board of directors declares the dividends. At
that time, the dividends become a liability for the company. Stock
dividends generally are recorded by transferring the market value of
the additional shares to be issued from retained earnings to the
appropriate share capital accounts. Stock dividends increase the
number of shares outstanding but do not change total shareholders’
equity, nor do they change the relative amount of the company owned
by each individual shareholder.

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Learning Objective Summary LO12-7
LO12-7: Define retrospective application and retrospective
restatement, and explain how they are presented in financial
statements. Unless an IFRS allows an alternative treatment, a
company has to apply a new accounting policy as if that policy had
always been applied, called retrospective application. Retrospective
restatement corrects an error in the amount of profit reported in a
prior year. Because the profit of the prior year has already been
closed into retained earnings, the error is corrected by increasing or
decreasing the Retained Earnings account. Retrospective restatements
appear in the statement of changes in equity as adjustments to
beginning retained earnings. They are not reported in the income
statement for the current period.

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Learning Objective Summary LO12-8
LO12-8: Describe and prepare a statement of changes in
equity and the shareholders’ equity section of the
statement of financial position. The statement of changes in
equity explains the changes during the year in each shareholder’s
equity account. The statement lists the beginning balance in each
shareholder’s equity account, explains the nature and the amount of
each change, and computes the ending balance in each equity
account.

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Learning Objective Summary LO12-9
LO12-9: Illustrate steps management might take to
improve the appearance of the company’s profit. Companies
may take certain steps that are intended to improve the appearance
of the company’s financial performance in its financial statements.
This may result from recognizing revenue before it is earned or
delaying the recognition of expenses to a subsequent accounting
period.

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End of Chapter 12

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