LECTURE 4:

ASSET & LIABILITY VALUATION

REVENUE RECOGNITION
OPERATING ACTIVITIES

1
 Asset and Liability Valuation
 Revenue recognition
 Revenue reporting challenges

◦ Long term contract

◦ Installment sales
 Expense recognition
 Income tax

2
Asset & Liability Valuation
 Historical values
◦ Acquisition cost (assets)
◦ Adjusted acquisition cost (assets)
◦ Initial present value (assets and liabilities)
 Current value
◦ Fair value (assets and liabilities)
◦ Current replacement cost (assets)
◦ Net realiasable value (assets)

3
Asset & Liability Valuation
 Historical cost:
◦ Acquisition cost: Land, good will, prepayments, intangibles with
indefinite lives
◦ Adjusted acquisition cost: Building, equipment, other depreciable
assets, intangible with limited lives
 Current values
◦ Fair value: investments in marketable equity securities, trading
debt securities, available for sale, financial instruments, derivatives
 Combination of historical cost and current values
◦ Current replacement cost of long lived assets
◦ LCM for inventory, NRV for receivables

4
Income recognition
 Economic value changes recognised on the
balance sheet and income statement when
realised
◦ When historical values are used, valuation changes in
assets and liabilities are not recognised until they are
realised
◦ Eg: Land at cost $120,000
◦ After two years, the land is sold for $300,000
◦ Amount recognised on income statement=?

5
Income recognition
 Economic value changes recognised on the
balance sheet and income statement when occur
◦ When assets and liabiities are valued at current value,
each period they are revalued to fair value and unrealised
gains and losses are recognised in income statement.
◦ Eg: Inventory is valued at $882m
◦ At period end, market price of inventory is $838m
◦ Amount recognised on income statement=?

6
Income recognition
 Economic value changes recognised on the
balance sheet when they occur but recognised on
the income statement when realised
◦ Certain assets and liabilities are revalue to fair value each
period, but the value change is unrealised until the firm
sells the asset or settle the liability.
◦ Eg:Marketable securities are acquired at $4.5m
◦ At period end, fair value is $4.9m
◦ Amount recognised on income statement=?

7
Revenue recognition-
US GAAP
 There is a contract between the buyer and the
seller
 Provide all or substantial portion of the product to

be delivered or the services to be performed

 Price can be determined
 Collectibility is reasonably assured

8
Revenue recognition- IFRS
 Significant risks and rewards of ownership of the
goods are transferred to the buyer
 The seller ceases to have control over the goods

sold
 The amount of revenue can be measured reliably
 It is probable that seller will obtain economic

benefits
 The cost of sale can be reliably measured.

9
Revenue recognition
 Recognition points
◦ During the period of production
◦ At the completion of production
◦ At the time of sale
◦ During the period while receivables are outstanding
◦ At the time of cash receipts

1
0
 Long term contracts:
◦ Question: How to allocate revenue over the contractual period?
◦ Uncertainties involved in long term contracts
 A risk that purchasers will be dissatisfied with the quality of future
work and demand additional work or reimbursement
 A risk that the cost of providing the future service will be greater than
anticipated
◦ Methods to account for long term contracts
 Percentage of completion
 Completed contract

4
Long term contract - Example
 ABC has a contract to construct a building for $2m
to be received in equal installments over 4 years. A
reliable estimate of total cost of this contract is
$1.6m. ABC incurred cost of $400K and $500K for
first & second year respectively.
 Calculate the revenue and profit to be recognised in

each of the first two years.

1
2
 Revenue recognition when cash collectibility is
uncertain: Installment sales
◦ Installment method: firm recognizes revenue as it collects
portions of the selling price in cash and recognizes
corresponding portions of the cost of good or service sold.
◦ Cost-recovery method: Revenues and expenses will be equal
and equal to cash receipts in each period until full cost recovery
occurs

5
Installment sale - Example
 During X0, ABC sold $20,000 of service on
installment with a cost of $10,000
 During X0 and X1, ABC collected $8,000 and

$12,000 respectively. What are the sales and gross

profit to be reported in X0 and X1?
 If the cost of service was unclear. The project was

completed during X1 at which time the company

had incurred total costs of $10,000. Under cost
recovery, what are the sales and gross profit to be
reported in X0 and X1?

1
4
Expense recognition-Accrual
 Matching principles
◦ Costs directly associated with revenues are recognised in
the period of recognising revenues
◦ Costs not directly associated with revenues are
recognised in the period when a firm consumes the
services or benefits of the costs in operations

7
Cost of sale
 To measure COGS, firms should consider cost-flow
assumptions
◦ FIFO results in lower COGS
◦ LIFO results in higher COGS
◦ Weighted average
◦ LIFO liquidation: results in lower COGS

8
Conversion from LIFO to FIFO
 Firms using LIFO are required to disclose the
difference in inventory between LIFO & FIFO (LIFO
reserve)
 FIFO E/I = LIFO E/I + Ending LIFO reserve
 FIFO COGS = LIFO COGS - LIFO reserve

9
Expenses
 SG&A
 Advertising and marketing
 Compensation
 Depreciation, Amortisation, Depletion
 Bad debt expense
 Warranty expense

10
Income tax - Key terms
 Taxable Income: Income (as determined by the tax
code) subject to tax on the tax return
 Taxes Payable: Tax liability (owed) based on

taxable income from the current period tax return

 Income Taxes Paid: Actual cash outflow for

income taxes owed, including payments from other

tax periods.
 Accounting Profit: Income (earnings) before

income tax expense on the income statement.

 Income Tax Expense: Expense based on pretax

income on the current period

incomestatementincome statement. 1
9
DTA & DTL
 A deferred tax liability(DTL) and deferred tax asset
(DTA) are created when accounting standards and
tax regulations recognize certain revenue and
expense items at different times.
 A DTL is created on the balance sheet when a

temporary difference results in lower taxable

income versus pretax income and lower taxes due
in the current period and higher taxes due in a
future period.

2
0
DTL & DTA
 A DTA is reported on the balance sheet when a
temporary difference results in higher taxable
income versus pretax income and higher taxes due
in the current period and lower taxes due in a future
period. A DTA is recorded when the difference is
expected to be recovered in future periods.

2
1
 Example
Income statement Tax return
Revenue 6,000 6,000
Depreciation (1) -1,000 -1,800
Other expenses -1,500 -1,500
Warranty expense (2) -600 -200
Tax exempt bond interest +500 n/a
Loss on asset write down (3) -100 0
Pretax income 3,300 Taxable income 2,500

Income tax expense 1,120 Tax rate @40%

Net income 2,180 1,000
2
2
Example
(1) The tax return uses accelerated depreciation and
a shorter average life
(2) Estimated as 10% of revenue for income
statement, actual expenditure of $200 deducted
on tax return
(3) Only deductible on tax return when realised

2
3
Income tax differences
 Permanent Differences result primarily from revenues
or expenses that affect pretax income or taxable
income, but not both.
◦ Example: Tax-exempt interest on a municipal bond is included
on the income statement but not on the tax return (it is not
taxable income).
 Temporary Differences result from the use of different
methods to allocate revenues or expenses (deductions)
between periods in determining pretax income and
taxable income
◦ Example: Straight-line depreciation is often used on the income
statement, while an accelerated method is used on the tax
return
◦ on the tax re 2
4
Temporary differences
 Depreciation:
◦ The additional $800 of depreciation expense is a
temporary difference caused by an accelerated method
used on the tax return.
◦ It implies that future tax deductions will be lower than the
expense shown on the income statement.
◦ This creates a higher future tax bill when the temporary
difference reverses and therefore, a deferred tax liability
(DTL).

DTL = Temporary Difference x Statutory Tax Rate

= $800 x 0.40 = $320
2
5
Temporary differences
 Warranty Expense:
◦ Warranty expense is recorded as an estimate on the
income statement at the time of sale, but cannot be
deducted on the tax return until actually incurred (paid).
◦ Only when it is actually incurred (in the future) will it be
deducted from taxable income on the tax return.
◦ This creates a lower future tax bill when the temporary
difference reverses and therefore, a deferred tax asset
(DTA).
DTA = Temporary Difference x Statutory Tax Rate
= $400 x 0.40 = $160
Back loads the tax deduction
2
6
Temporary differences
 Asset Write-down:
◦ The unrealized loss on the write-down of an impaired asset
(-100) is a temporary difference that will not be recognized
on the tax return until the asset is actually derecognized.
◦ The loss on the income statement is added back when
computing taxable income and represents a future tax
deduction.
◦ A future tax deduction creates a deferred tax asset today and
a lower future tax bill when the actual loss is realized.
DTA = Temporary Difference x Statutory Tax Rate
= $100 x 0.40 = $40

2
7
Permanent differences
 Tax-exempt Interest:
◦ Municipal bond interest is generally exempt from federal
income taxes.
◦ This represents a permanent difference between the
reported income statement and the filed tax return.
◦ Permanent differences imply no future tax implications and
therefore do not create deferred tax liabilities or assets.

2
8
Calculating income tax exp
Income Tax Expense Calculation:

Income Taxes expense

= Income tax payable + Δ DTL - Δ Net DTA

Completing our example:

Income Tax exp

= $1,000 + $320 - ($160 + 40) - $0 = $1,120

2
9
 Exercise 2.8
 Problem 2.9
 Problem 2.10
 Problem 2.17
 Problem 8-19
 Problem 8-21

23