Now I'd like to mention, another very important thing in accounting and illustrate that on an example throughout this episode. So, I'd like to mention a cool basis versus cash basis in accounting. Now, oftentimes, to the extent we're interested in cash flows, and this is the case evaluation, it seems for us that the cash basis accounting might be good. This is basically when we record all transactions only when cash arrives or is being spent. However, in all modern accounting systems a complete different approach is being used and this is a cool accounting. And this cool basis is the result of the principles that we've studied, of which one of the most important principles is the matching principle. So, the general idea here will be illustrated by this episode that is entitled, Revenue and Expense Recognition. So the story here is that we recognize our revenues and the expenses not when we collect cash from them. Why is that so? It seems kind of, if not strange, but at least not very natural, artificial. Well not quite. Let's say a few words about The Revenue and Expense Recognition. Sometimes people use the term realization. Now the story here is as follows. Well, let's say that this is the business cycle. Remember, we talk about an enterprise as a going concern. So, that keeps, let's say going on, and on, and on. And let's say, this is a very simple manufacturing process in which we will start here. This will be a reference point. So here, first, we let's say, buy raw materials. So this is with cash and that goes here. Then, starts the manufacturing process that takes some time over here. Then, let's say, here we complete the manufacturing and this is the process of sales. And then, finally, maybe we sold on credit and then, finally, this is cash collection. And the question is, when in this circle can we recognize revenue? Well it's better to ask, what is the earliest point of revenue recognition? Now, this is not such a trivial question but normally, people say that in order to be able to recognize revenue, we have to be sure that the following conditions have been met and these conditions, I'll put here. First of all, service has been produced, I will emit verbs. Then, the next thing is that the costs, I'll put it like, are clear. That means that not incurred costs are negligible and or predictable. So basically, we already know how much money we spent on the service produced and if we will have to spend some more, it's either a very small amount or we know that with certain accuracy. And also, this is with respect to costs. And by the same tokens that collections to be made are known with accuracy. So basically, the idea is that, let me give you an example that sort of illustrates that. Supposedly here at this point, our client immediately paid cash in advance, the total amount, so we have cash on hand. Does that mean that we can recognize revenue? Well no. Why? Because strictly speaking, neither of these conditions have been met. The service has not yet been provided, the costs are not known, because we got the money. But maybe something that happens during this process that is not known or not predicted. We can say, "Well, collections have been made." So strictly speaking, this is number one and number two that haven't been met. So from here, we will move on to some bases for recognition and then, we will see in this example where that happens. So this is Bases for Revenue Recognition. And, well, we can start with the purchase of raw materials. Well, this is sort of a very special case but we can think about that. Then, the next thing is the order. So, someone gave us an order and we recognize really well. It's kind of clear, for example here, we purchased raw materials but we may not have an order. So we will not have any revenue at all. Here, we do have an order but what if the client cancels that? Well, let's say that now we go into the production process. Well, that's great, we may produce it. But, what if the client at this point cancels? Maybe pay us some penalty. So, the most stuff on bases used is delivery. When you delivered your goods or services with respect to this order and then this final product has been accepted. Here, most often at this point, we can say that we can recognize revenue. Then, also goes collection bases. Which is kind of great because basically even if you delivered, but if the client pays you later, well, as we'll know in the near future, some of your accounts maybe uncollectable. And finally, this is the so-called complete completed obligation basis. Let's say that you got an order produced, delivered and collected all cash, but what if your product or service has a long-term or maybe a lifetime warranty? So in this case, strictly speaking, you have to be sure that the cost of this warranty will not exceed a certain amount or will be well predictable. Then, in this case because basically if you recognize revenue at this point, maybe there is a case when something gets broken or goes out of order, and then because of these obligations, you will have to compensate the buyer by either just changing that or doing some fix and maintenance and so on and so forth. So here basically, we see that this is the overall situation and like I said, the advance payment, as an example, may be strictly speaking recognize still to deliver because for example collection is sort of a material in the case of an advance. But all these must be completed and also your obligations still exist there. Now, there is a very special situation here. If you talk about long-term contract. Let's say, you are a shipyard and you got an order from the government to build a warship. So, it takes a couple of years and there are certain stages here. You first you make the body, then you install the engine and all the necessary stuff, then later on you do all other things and then you also put all these missiles, planes, whatever. So, clearly that takes a lot of time, maybe years and also if for example, the government says we'll pay you when you deliver the final product and the cost may be whatever, a couple of hundred million dollars. That is unlikely to be the case because then you will have to raise this huge amount of money and to feed your construction process. So normally in these cases, there are, so I put like long-term contracts. Like one case, like I said is the completed contract, but in case of the warship that they made, this is highly unrealistic arrangement and then the more likely is the so-called percentage of completion. Well, in reality you may get some advance to feed your working capital and so on and so forth. And let's say then, when you finish the body you got this percentage of the amount, when you finish the power equipment, you get another installment, and so on and so forth. But the problem with this percentage of completion and you don't have to talk only about the military ship, you can also talk about construction of a building, for example. So you get the walls then the roof and then you get all the inner equipment, and then you have also all these landscape works on your terrain. But here with these percentages, this is clearly a potential conflict sitting here because you have to be sure that first of all, the estimates are reasonable and then also that both parties, in this case, they sort of output [inaudible] behave themselves, that means that they have the right and the ability to enforce proper negotiations. Let's say, I built just the foundation of the house and said that this is 60 percent of the cost and then the client says well, wait a minute. If for any reason I will say no and then he'll say, well fine you got the 60 percent, you're fine but I've add best the foundation. So, you can say, well it's not actually 60, it's 15. And then, you'll start tough negotiations and unless you have the ability to come at the point in which you agree, that creates a problem. So basically, this is the situation in which sometimes you are bound to see some problems here. And I would say that, as may be funny but it's not so funny, an example when in real construction like in housing, you always see that gloomy reality is such that it is longer, worse and more expensive. And how that happens, no one knows but whoever was at any moment in time linked to that, knows that unfortunately in construction that happens. Well, if you talk about, sometimes this percentage of completion is easy to realize. Let's say, you've contracted to build a 100 mile long a piece of highway and then let's say, if you build 10 miles, then you say this is 10 percent of the contract, 20 miles, 20 percent. This is sort of natural, but not always it's so easy to do. So, wrapping up this episode, I'm saying that this idea of recognition of revenues, again I didn't talk much about costs but also keep in mind this conservatism principle. We can say, well we recognize revenues as it has been shown here but costs, we can incur as early as we can, so upfront. Well this is not so true either. So, if for example, some of these costs are supposed to be incurred later, then we still have to keep in mind this matching principles. So, we have to properly recognize costs with respect to your revenue recognition. And this is one of the areas in which we see that sometimes this called accounting treatment provides a better basis or leads to better results compared to the situation which would count only cash inflows and outflows. Well, so this episode sort of wraps up the first, if you will, introductory phase of all the issues that are important to be studied in Financial Accounting and from now on, we will provide some overviews of how some assets and then later liabilities and pieces of net worth are being recorded and treated in Accounting. So starting from the next episode, we will and this week we will study only current assets and this week, we'll talk about receivables and inventories.
