Question

No handwriting and photo (managerial accounting)

a-To makes income taxable, income must be realized and recognized. Explain in your own words the difference between income realization and income recognition, then provide a short numerical example to indicate the difference

b-Illustrate the concept of ROI with a suitable numerical example. How ROI is different from Residual Income? Explain in your own words

Answer 1

1. Income Realization: - Realization of income means when the business receives the cash in exchange of goods or service or when the business actually realized the selling price in cash. Generally small businesses uses cash method of accounting to record the transaction it means it doesn’t record the income until it realized and doesn’t record the expenses until it paid. Which businesses using the cash method rely on realized income when determining how well they’re performing, account receivables aren’t counted as revenue. This method can also be advantageous from the tax perspective. Since income isn't recorded or recognized until received, a company doesn't have to pay taxes on outstanding unpaid invoices, but only on money it's already received.

Income Recognition: - Realization concept deals with revenue recognition. It refers to the application of accrual concept towards the recognition of revenue. Under this principle, revenue is recognized by the seller when it is earned irrespective whether cash from the transaction has been received or not. According to this principle revenue must be recognized when the seller transfers the risks and rewards associated with the ownership of the goods to the buyer. This is generally deemed to occur when the goods are actually transferred to the buyer. Where goods are sold on credit terms, revenue is recognized along with a corresponding receivable which is subsequently settled upon the receipt of the due amount from the customer. In case of the rendering of services, revenue is recognized on the basis of stage of completion of the services specified in the contract. Any receipts from the customer in excess or short of the revenue recognized in accordance with the stage of completion are accounted for as prepaid income or accrued income as appropriate.

Example:-A customer placed an order on 1^st January of $50,000. On receipt of the order the manufacturer manufactured goods and delivered it to the customer on 1^st February who made payment of goods on 1^st March in full amount.

Under Income Realization: - The business will record the revenue on 1^st March as the payment received in cash from the customer.

Under Income Recognition: - The business will record as revenue on 1^st February when the ownership of the goods delivered to the customer and he becomes legally liable to pay.

Comparison between Income Realization and Income Recognition

Income Recognition	Income Realization
It is used under accrual method.	It is used under cash method.
Under this revenue is recorded when the ownership of the goods or services transferred to the owner.	Under this revenue is recorded when cash actually realized in hand or account.
Generally used this method in large businesses.	Generally used this method in small businesses.
First revenue recognition happened during the transaction.	Revenue realized happened after the revenue recognition during the transaction.

2. ROI (Return on Investment):- ROI is a financial ratio which helps to calculate the gain or loss generated on an investment relative to the amount invested. ROI is usually expressed as percentage and typically used for personal financial decision, to compare a company's profitability, or to compare the efficiency of different investments. It is simple and easy to calculate and universally understood.

Formula of the ROI: - Net Return on Investment (Final value of investment – Initial value of investment) ÷ Cost of Investment × 100

Example: - Let’s assume you brought 500 shares of Google Co. for $25 each in 2013. In 2014 you sold the shares $27. You earned the dividend of $1000 over the one-year holding period. You also spent $100 on trading commission when you bought and sold the shares.

So, ROI = ($27 - $25) × 500 + $1000 - $100 ÷ $25 × 500 × 100 = 15.2%

Residual Income: - It is a measure of performance based on the investment in asset. It compares the profit actually earned to the minimum level of profit required for the business. It is profit earned less interest or minimum return on the capital that has been employed to generate the profit.

Formula of Residual Income (RI): - Divisional net profit – Imputed Interest

Example: - You invested in the Google Co. amounted to $5m and the profit is $500,000 was generated in the first year of trading. The weighted average cost of capital for the group is 10%.

Residual Income: - Divisional Net Profit                            $500,000

                         Imputed Interest ($500,000 × 10%)        $50,000

                            RI ($500,000 - $50,000 )                      $450,000

Difference: - ROI is expressed in terms of percentage when the RI expressed in terms of money. ROI is easy to calculate and easy to understand where RI has some drawbacks that it can be difficult to calculate the minimum required rate of return or cost of capital for a business and ultimately the measure is not as well understood. ROI the basic objective is to maximize the rate of return percentage where RI is favored for reasons of goal congruence and managerial effort.