Revenue Recognition

1. Revenue recognition is a five-step test for deciding how much sales revenue a company is allowed to record, and when it is allowed to record it.
2. Step 1: Find the contract. Did a real customer agreement exist? Example: Netflix sells a one-year subscription for USD 120.
3. Step 2: Find the promises. What exactly did the company promise to deliver? Example: Netflix promised streaming access for 12 months, not one giant service delivered on day one.
4. Step 3: Find the price. How much money does the company expect to collect after discounts, refunds, bonuses, or variable fees?
5. Step 4: Split the price across the promises. If the customer bought software plus support, do not dump the whole price into one bucket just because cash arrived today.
6. Step 5: Book revenue only as each promise is kept. Netflix should record USD 10 per month, not USD 120 on day one, because you are using the service month by month.
7. Remember: Contract, promises, price, split price, book revenue. Like a restaurant bill: first confirm the order, then list the dishes, total the bill, split it if needed, and only call it earned when the food is served.
8. Before you even think about revenue, ask whether IFRS or U.S. GAAP treats the customer agreement as a real contract. A contract exists only if collecting the money is probable.
9. What is probable: The company is confident enough that the customer will pay.
10. Under IFRS: probable means more likely than not. Think: just over the 50 percent line can be enough.
11. Under U.S. GAAP: probable means likely to occur. Think: stronger proof of collection is needed.
12. Example: Larsen & Toubro signs a USD 100 million highway contract with a government customer that often pays late. If collection is only slightly better than a coin toss, IFRS may treat the agreement as a contract, but U.S. GAAP may say, "Not enough proof yet."
13. Example: A phone company sells handsets plus two-year service plans to customers with weak credit. If payment looks clearly likely, both IFRS and U.S. GAAP can treat the agreement as a contract. If payment looks doubtful, neither should let the company rush into revenue.
14. Remember: IFRS is the lower collectability hurdle; U.S. GAAP is the higher hurdle. Same customer, same deal, different answer.
15. Why this matters: if it is not treated as a contract, do not book revenue just because a deal was signed. Revenue recognition starts only after the agreement passes this collectability gate.
16. Under the converged accounting standards, the incremental costs of obtaining a contract and certain costs incurred to fulfil a contract must be capitalized. If a company expensed these incremental costs in the years prior to adopting the converged standards, all else being equal, its profitability will appear higher under the converged standards.
17. Principal vs agent presentation is about whether the company is the real seller or just the middleman.
18. What is principal: The company controls the product before the customer gets it.
19. What is agent: The company only arranges the sale for another seller.
20. Amazon acting as the seller of its own inventory is closer to principal. If Amazon buys a speaker for USD 70 and sells it for USD 100, it reports USD 100 of revenue, USD 70 of cost of sales, and USD 30 of gross profit.
21. Amazon Marketplace acting as a platform for a third-party seller is closer to agent. If the customer pays USD 100 to the seller and Amazon earns a USD 30 commission, Amazon reports USD 30 of revenue, not USD 100.
22. Same economics, wild ratio difference: in both cases net profit can be USD 20 after USD 10 of selling, general, and administrative expense. But the principal shows a 20 percent net margin on USD 100 revenue, while the agent shows a 67 percent net margin on USD 30 revenue.
23. Remember: principal looks bigger because revenue is gross. Agent looks leaner because revenue is only commission. Do not compare margins without checking the mix.
24. Franchising and licensing split the business into different revenue buckets. Do not treat all store sales as the parent company’s revenue.
25. If McDonald's owns and operates a restaurant, McDonald's reports the full burger-and-fries sale as revenue.
26. If a franchisee owns the McDonald's restaurant, the franchisee records the customer sale. McDonald's records only its royalty or fee from the franchisee, not the full restaurant sales.
27. Upfront franchise fees: If a franchisee pays to open a new unit, the parent does not dump the whole fee into revenue on day one. It first records deferred revenue, then recognizes it over the franchise agreement.
28. Supply chain sales: If the parent sells food, equipment, or supplies to franchisees, it records revenue when those products are shipped or delivered, depending on shipping terms.
29. Remember: a company-owned restaurant is like running the shop yourself. A franchise is like renting out the brand and collecting a cut.
30. Software revenue depends on whether the customer gets a software license or an ongoing software service.
31. Software license: If the customer gets the software as it exists today and can install or use it, revenue is usually recognized when the software is made available.
32. Support and updates: Revenue is recognized over the support period because the company keeps serving the customer after the license is sold.
33. Software as a service: The customer does not take possession of the software. They access it through the cloud, so revenue is recognized over the subscription term.
34. Microsoft selling a traditional Office license is closer to upfront revenue because the customer receives the software right away. Microsoft 365 is closer to over-time revenue because the customer keeps receiving cloud access, updates, and service.
35. Netflix does not sell you a movie file forever. It gives you streaming access month by month, so the revenue pattern is over the subscription period.
36. Remember: if the customer gets the thing now, revenue may be upfront. If the customer keeps receiving access, updates, or service, revenue is spread over time.
37. Long-term construction and production contracts recognize revenue over time when control passes to the customer as work is performed.
38. This fits work where the customer receives benefits as the company performs, controls the asset while it is being built, or must pay for work completed to date.
39. Progress can be measured by output, such as units completed, or input, such as costs incurred as a percentage of total expected costs.
40. Boeing or Lockheed Martin may build a custom aircraft or defense system over several years. If the customer controls the work as it is built and must pay for work completed, revenue is recognized over time, not only when the final aircraft or system is delivered.
41. Numerical anchor: If the contract price is USD 10 million, expected cost is USD 7 million, and the company has completed 60 percent of the work based on costs incurred, it recognizes USD 6 million of revenue and USD 1.8 million of profit so far.
42. Remember: if the customer is effectively taking control as the work is done, do not wait until the final delivery to recognize everything.
43. Bill-and-hold means the customer has bought the product, but asks the seller to keep it for now.
44. Revenue can be recognized only when the reason for holding is real, the product is separately identified for that customer, the product is ready for delivery, and the seller cannot use it or redirect it to another customer.
45. Real-world-style example: A company orders a custom Tesla fleet vehicle, the exact vehicle identification number is assigned to that customer, the vehicle is ready, title and risk have passed, but the customer asks Tesla to hold it for a few weeks because its delivery lot is full. Revenue can be recognized because control has passed.
46. Bad version: the seller keeps a generic product in the warehouse and could still sell it to someone else. That is not enough.
47. Remember: bill-and-hold works only when the product is basically the customer’s property already.
48. Selling, general, and administrative expense means normal overhead that is not directly the product cost.
49. What is selling expense: Costs to sell the product, such as sales staff, advertising, and delivery support.
50. What is general and administrative expense: Head-office costs, such as management salaries, accounting, legal, and office rent.
51. Why it matters: in the principal-versus-agent example, the same USD 10 overhead makes the agent’s margin look much higher because the agent reports only USD 30 of commission revenue.

Expense Recognition

1. You look more profitable as long as you’re piling up assets faster than you’re wearing them out. Once growth slows or assets mature, the bill arrives via depreciation.

1. Expense recognition is about matching cost to the period that consumed the benefit.
2. What is expense recognition: The accounting decision about when spending becomes an expense on the income statement.
3. Why expense recognition is used: It stops companies from showing profit in one period while hiding the related cost in another period.

4. Example: If Tata Motors sells a car today, the cost of that specific car should hit cost of goods sold today, even if the inventory was bought last quarter.

5. The matching model is used when the expense directly helped create specific revenue.

6. What is matching: Put the cost in the same period as the revenue it helped generate.
7. Inventory is the cleanest exam case. Inventory first sits as an asset. When the product is sold, the inventory cost becomes cost of goods sold.
8. Problem: A retailer buys 7,600 units for USD 321,600, sells 5,600 units for USD 50 each, and identifies that the remaining 2,000 units cost USD 89,800.
9. Solution:

• Explanation: The unsold inventory is not an expense yet. It is still waiting on the balance sheet for the period in which it gets sold.

• Period costs are expensed as incurred because they do not connect neatly to one specific sale.

• What is a period cost: A cost that supports the period as a whole, not one identifiable product sale.
• Administrative salaries, management costs, information technology costs, research costs, ordinary repairs, and maintenance usually go here.
• Payroll is usually a period cost, but there are exceptions. Factory labor may become inventory first. Some sales commissions may be capitalized and expensed systematically or as the related sale happens.

• "It helped the business" is not enough to capitalize. Rent, advertising, and routine repairs help the business, but they usually do not create a separable future asset.

• Capitalization first, then depreciation or amortization later, is used when spending creates a long-term asset.

• What is capitalization: Recording spending as an asset instead of immediate expense.
• What is depreciation: Spreading the cost of a tangible long-lived asset, such as equipment, over its useful life.
• What is amortization: Spreading the cost of an intangible asset, such as capitalized software, over its useful life.
• Land is the classic exception. Land is capitalized but normally not depreciated because it does not have a predictable wasting life.

• Intangible assets with indefinite lives are also not amortized. They are tested for impairment instead.

• Capitalize versus expense changes timing, not the total pre-tax cost over the asset life.

• If a company spends EUR 900 on equipment with a three-year life and zero salvage value, capitalizing creates EUR 300 depreciation each year.
• If the company expenses the full EUR 900 immediately, Year 1 profit is lower, but Years 2 and 3 profit are higher because there is no depreciation left.
• Over the full three years, total expense is still EUR 900 under both methods. The fight is about when the expense appears.
• Capitalizing makes the current year look better; expensing makes future growth look better.

1. The capitalization benefit continues only while new capitalized spending exceeds depreciation or amortization.
2. Imagine Jio buys one USD 300 network device every year, and each device is depreciated over three years at USD 100 per year.
3. Year 1 depreciation is USD 100, so capitalization makes profit USD 200 higher than immediate expensing.
4. Year 2 depreciation is USD 200, so the benefit shrinks.
5. Year 3 depreciation is USD 300, exactly equal to the new USD 300 device bought that year. The profit boost disappears.

6. So do not memorize "capitalization always boosts profit." It boosts profit only while the company is adding assets faster than old assets are being expensed.

7. Depreciation method and useful-life estimates are not boring footnotes; they move profit.

8. Longer useful life means lower annual depreciation and higher current profit.
9. Higher salvage value means lower depreciable cost and higher current profit.
10. Accelerated depreciation means higher early depreciation, lower early net income, and, if tax reporting follows the same method, higher operating cash flow because taxes are paid later.
11. Impairment loss means the asset was written down because its carrying value was too high. It lowers current net income but does not reduce current operating cash flow because it is non-cash.

12. Exam point: An impairment often hints that past depreciation was too low and past profits were overstated.

13. Capitalized interest is debt cost hidden inside an asset.

14. What is capitalized interest: Interest cost added to the cost of a long-construction asset instead of being reported immediately as interest expense.
15. If Reliance builds a refinery for its own use, capitalized interest becomes part of property, plant, and equipment and later appears through depreciation.
16. If DLF builds apartments for sale, capitalized interest becomes part of inventory and later appears in cost of sales when apartments are sold.
17. Analyst adjustment: For interest coverage, use total interest cost, not only interest expense shown on the income statement.

• Notation in simple language:
  • Earnings before interest and taxes: Profit before interest cost and tax cost.
  • Current-period capitalized interest: Interest paid or incurred this year but added to an asset.
  • Amortization or depreciation of previously capitalized interest: Old capitalized interest that is flowing through the income statement this year.

• Why this matters: if you ignore capitalized interest, a heavily building company can look safer than it is. Credit analysts usually include capitalized interest when testing coverage.

• Capitalized interest also distorts cash flow classification.

• Under U.S. GAAP, expensed interest is in operating cash flow. Under IFRS, interest paid may appear in operating, investing, or financing cash flow depending on the company policy.
• Capitalized interest usually appears with the asset, so it can move out of operating cash flow and into investing cash flow.

• Watch this: operating cash flow may look stronger even though the company has not generated more cash. The interest cash still left the business; it just moved category.

• Software development costs are a common margin case because "technological feasibility" requires judgment.

  • What is technological feasibility: The point at which the software is far enough along that the company believes it can be completed and sold.
  • Before technological feasibility, software development is expensed as research and development.
  • After technological feasibility, software costs are capitalized until the product is available for general release.
  • Microsoft historically treated feasibility as being reached very late, near product release, so most development cost was effectively expensed.
  • A software company that capitalizes aggressively will show higher current earnings before interest, taxes, depreciation, and amortization, higher operating cash flow, and lower valuation multiples than a similar company that expenses development.

1. Expense estimates are where management can quietly shape earnings.
   • Watch uncollectible accounts as a percentage of sales. A sudden lower allowance can raise profit today.
   • Watch warranty expense as a percentage of sales. A company may say product quality improved, but the analyst should check whether claims actually fell.
   • Watch useful life and salvage value assumptions. Longer lives and higher salvage values reduce depreciation.
   • Compare companies in the same industry. If two similar retailers have very different bad-debt estimates, either their customers are truly different or one estimate deserves suspicion.
   • If the monetary effect can be estimated, adjust the reported expenses to a common basis. If it cannot be estimated, at least label which company is using the less conservative policy.

Nonrecurring Items

1. Nonrecurring items are material events that are unusual in nature or infrequent in occurrence. Examples: gains or losses from sale of assets or part of a business, impairments, write-offs, write-downs, and restructuring costs.
2. Do not blindly remove these items from analysis. Some firms have “unusual” losses every year or every few years. If it keeps happening, it is not helping you understand recurring earnings to pretend it does not exist.
3. A discontinued operation is different. Management has decided to dispose of a business that is physically and operationally distinct from the rest of the firm in assets, operations, and investing and financing activities.

1. Once a business qualifies as a discontinued operation, move its profit or loss out of normal operations and show it near the bottom of the income statement, net of tax.
2. What is net of tax: The tax effect is already included, so do not tax it again.
3. Example: Suppose Reliance sells a retail chain and will have no further involvement. The retail chain’s profit or loss should not be mixed with Reliance’s continuing telecom or energy operations. Put it after income from continuing operations, net of tax.
4. If prior income statements are shown, separate the discontinued business there too. Otherwise last year and this year are not comparable.

5. Remember: discontinued operation = separate bucket at the bottom. Do not bury it inside revenue, cost of goods sold, or operating profit.

6. Losses are recognized earlier than gains when a discontinued business is being disposed of.

7. Measurement date: The date management commits to the disposal plan and the operation qualifies for discontinued treatment.
8. Expected loss: If the company expects to lose money during the shutdown period or on the sale, recognize that expected loss at the measurement date.
9. Expected gain: If the company expects to make a gain on sale, wait until the sale is actually completed.
10. Example: Tata decides to sell a small division. If it expects a USD 20 million loss, book the loss when the disposal plan qualifies. If it expects a USD 20 million gain, do not celebrate early. Recognize the gain only when the sale closes.

11. Remember: accounting is faster to admit bad news than good news here.

12. For forecasting, remove discontinued operations from future earnings because that business will not be around to generate future profit or cash flow.

13. Example: If Disney sells a TV network, do not include that network’s future profit when forecasting Disney after the sale. It is no longer part of the machine.
14. But do not ignore the disposal completely. It may tell you strategy changed, cash is coming in from the sale, debt may be repaid, or management is cutting a weak business.

15. Remember: remove it from recurring earnings, but still ask what the sale says about the company.

16. Accounting policy changes and accounting estimate changes are treated differently.

17. Change in accounting policy: Usually retrospective. Restate old financial statements as if the new policy had always been used, unless doing so is impractical.
18. Example: Microsoft adopted a new revenue recognition policy and restated earlier years, so analysts could compare revenue and net income on the same basis.
19. Change in accounting estimate: Prospective. Do not rewrite old years. Apply the new estimate to the current and future periods.
20. Example: If a company changes a machine’s useful life from 10 years to 8 years, old depreciation stays old. Only current and future depreciation change.
21. Remember: policy change rewrites the movie from the beginning. Estimate change only changes the next scenes.

Basic Earnings Per Share

Cash comes in Cash buys back some shares @ market price Only the leftover shares increase the denominator >That leftover is the true dilution.

• What is Warrant: A warrant is essentially an equity call option issued by the company; a warrant holder has the right but not the obligation to purchase newly issued shares at the exercise price.
• What is Basic EPS: (Actual earnings - Preferred Dividend) / actual weighted ordinary shares.

1. What are Actual weighted shares: Weighted average number of shares outstanding during the period. Shares outstanding adjusted for how long they existed during the year. For example:

| ------------------------------------------------------ | --------- | | Shares outstanding on 1 January 2018 | 1,000,000 | | Shares issued on 1 April 2018 | 200,000 | | Shares repurchased (treasury shares) on 1 October 2018 | (100,000) | | Shares outstanding on 31 December 2018 | 1,100,000 | The actual weighted shares are calculated as:

1. What is Preferred Dividend? This is the dividend paid to the preferred shareholders. Preferred stock doesn't come under common stock and hence EPS removes it.
2. What is Diluted EPS: “What EPS would be” if all dilutive instruments became common stock. This would be (Actual Earnings - Preferred Dividends) / (Ordinary Shares + New common stock that would have been issued at conversion))
3. What is Dilution: The instruments convertible into ordinary equity can become shares ⟶ share count rises ⟶ EPS goes down. That's dilution.
4. What is stock split: Suppose a company with a market capitalization of $100 has 100 shares (each share is priced $1). The company declares 2:1 stock split, which means each share would be split into 2 shares. This means the number of shares will be now: (100 * (2/1)) = 200. Now each share would be priced $0.5.
5. Complex Capital Structure: Under IFRS, the type of equity for which EPS is presented is referred to as ordinary. Ordinary shares are those equity shares that are subordinate to all other types of equity. When a company has issued any financial instruments that are potentially convertible into common stock, it is said to have a complex capital structure.

DILUTED EPS

1. What-if, if everything that can be converted into common stock is converted into common stock. This increases the number of shares and reduces EPS. This is diluted EPS.
2. What-if bonds are converted, When company converts bonds into common stock, in the numerator, you add after-tax interest. In the denominator, you add the new shares issued on conversion.

1. What-if preferred stock is converted, In this case, you add preferred dividends to numerator and add new shares issued on conversion to denominator.

TREASURY STOCK METHOD

1. If exercise is uneconomic → no exercise → no new shares → not dilutive. If exercise is economic:
   • Shares are issued
   • Cash comes in
   • Cash buys back some shares @ market price
   • Only the leftover shares increase the denominator
   • That leftover is the true dilution.

Ratios and Common-Size Income Statements

1. Common-size income statement = divide every line item by Revenue and express as %.