Chapter 5 Lecture

PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

Income Measurement and Profitability Analysis

5

Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Realization Principle

Record revenue when:Record revenue when:

AND there is reasonable certainty as to the

collectibility of the asset to be received (usually

cash).

the earnings process is complete or virtually

complete.

Revenues are inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of

both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s

ongoing major or central operations.

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SEC Staff Accounting Bulletin No. 101

Staff Accounting Bulletin No. 101 provides additional criteria for judging whether or not

the realization principle is satisfied:

1. Persuasive evidence of an arrangement exists.

2. Delivery has occurred or services have been performed.

3. The seller’s price to the buyer is fixed or determinable.

4. Collectibility is reasonably assured.

Staff Accounting Bulletin No. 101 provides additional criteria for judging whether or not

the realization principle is satisfied:

1. Persuasive evidence of an arrangement exists.

2. Delivery has occurred or services have been performed.

3. The seller’s price to the buyer is fixed or determinable.

4. Collectibility is reasonably assured.

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Realization Principle

Revenue recognition is often tied to delivery of the product from the seller to the buyer.

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U. S. GAAP vs. IFRS

• Earnings process is complete or virtually complete.

• Reasonable certainty as to the collectibility of the asset to be received.

Revenue recognition criteria for U.S. GAAP and IFRS include:

• Revenue and costs can be measured reliably.

• Probable that economic benefits will flow to the seller.

• Risk and rewards are transferred to buyer and seller does not manage or control the goods.

• Stage of completion can be measured reliably.

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Revenue Recognition at Delivery

When the product or service has been delivered to the

customer and cash has been received or a receivable has

been generated that has reasonable assurance of

collectibility.

When the product or service has been delivered to the

customer and cash has been received or a receivable has

been generated that has reasonable assurance of

collectibility.

Recognize RevenueRecognize Revenue

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Revenue Recognition After Delivery

1. Installment Sales Method

2. Cost Recovery Method

1. Installment Sales Method

2. Cost Recovery Method

When we are unable to make reasonable estimates of uncollectible amounts or customer returns of products, we delay recognizing revenue from the sale until the

uncertainty has been resolved.

When we are unable to make reasonable estimates of uncollectible amounts or customer returns of products, we delay recognizing revenue from the sale until the

uncertainty has been resolved.

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Installment Sales MethodOn November 1, 2011, the Belmont Corporation, a real estate developer, sold a tract of land for $800,000. The

sales agreement requires the customer to make four equal annual payments of $200,000 plus interest on each November 1, beginning November 1, 2011. The land cost $560,000 to develop. The company’s fiscal

year ends on December 31.

Gross Profit $240,000 ÷ $800,000

= 30%

Gross Profit $240,000 ÷ $800,000

= 30%

Date Cash

Collected Cost(70%)

Gross Profit (30%)

Nov. 1, 2011 $ 200,000 $ 140,000 $ 60,000 Nov. 1, 2012 200,000 140,000 60,000 Nov. 1, 2013 200,000 140,000 60,000 Nov. 1, 2014 200,000 140,000 60,000 Totals $ 800,000 $ 560,000 $ 240,000

Amount Allocated to:

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Installment Sales Method

This entry records the Realized Gross Profit by adjusting the Deferred Gross Profit account.

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Cost Recovery MethodOn November 1, 2011, the Belmont Corporation, a real estate developer, sold a tract of land for $800,000. The

sales agreement requires the customer to make four equal annual payments of $200,000 plus interest on each November 1, beginning November 1, 2011. The land cost $560,000 to develop. The company’s fiscal

year ends on December 31.

Date Cash

Collected Cost

RecoveryGross Profit Recognized

Nov. 1, 2011 $ 200,000 $ 200,000 $ - Nov. 1, 2012 200,000 200,000 - Nov. 1, 2013 200,000 160,000 40,000 Nov. 1, 2014 200,000 - 200,000 Totals $ 800,000 $ 560,000 $ 240,000

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Cost Recovery Method

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Right of Return

In most situations, even though the right to return merchandise exists, revenues

and expenses can be appropriately recognized at point of delivery.

Estimate the returns

Reduce both Sales and Cost of

Goods Sold

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Consignment Sales

Sometimes a company arranges for another company to sell its product under consignment.

Because the consignor retains the risks and

rewards of ownership of the product and title does not pass to the consignee,

the consignor does not record a sale until the

consignee sells the goods and title passes to the

eventual customer.

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Revenue Recognition Prior to Delivery

Completed Contract Method

Completed Contract Method

Percentage-of-Completion

Method

Percentage-of-Completion

Method

Long-term Contracts

Long-term Contracts

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Completed Contract and Percentage-of-Completion Methods Compared

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Accounting for the Cost of Construction and Accounts Receivable

With both the completed contract and percentage-of-completion methods, all costs of construction are

recorded in an asset account called construction in progress.

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Gross Profit Recognition—General Approach

In both methods the same amounts of revenue, cost,

and gross profit are recognized.

In both methods we add gross profit to the

construction in progress asset.

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Gross Profit Recognition—General Approach

The same journal entry is recorded to close out the billings on construction contract and construction in progress

accounts under the completed contract and percentage-of-completion methods.

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Timing of Gross Profit Recognition Under the Completed Contract Method

Under the completed contract method, all revenues and expenses related to the project are

recognized when the contract is completed.

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Timing of Gross Profit Recognition Under the Percentage-of-Completion Method

Using the percentage-of-completion method, we recognize a portion of the estimated gross profit

each period based on progress to date.

We determine the amount of gross profit recognized in each period using the following logic:

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Percentage-of-Completion Method Allocation of Gross Profit

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Percentage-of-Completion Method Allocation of Gross Profit

Notice that the gross profit recognized in each period is added to the construction in progress account.

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Percentage-of-Completion Method Allocation of Gross Profit

The income statement for each year will report the appropriate revenue and cost of

construction amounts.

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Income Recognition

The same total amount of profit or loss is recognized under both the completed contract and the percentage-of-completion methods, but the timing of recognition differs.

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Balance Sheet Recognition

Billings on construction contract are subtracted from construction in progress to determine

balance sheet presentation.

CIP > Billings Asset

Billings > CIP Liability

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Balance Sheet Recognition

The balance in the construction in progress account differs between methods because of the earlier gross profit recognition that occurs under

the percentage-of-completion method.

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Long-term Contract Losses

Periodic Loss for Profitable Projects

Determine periodic loss and record loss

as a credit to the Construction in

Progress account.

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U. S. GAAP vs. IFRS

• Requires percentage-of-completion when reliable estimates can be made.

• Requires completed contract method when reliable estimates can’t be made.

There are similarities and differences between IFRS and U.S. GAAP when considering revenue

recognition for long-term construction contracts.

• Requires percentage-of-completion when reliable estimates can be made.

• Requires cost recovery method when reliable estimates can’t be made.

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U. S. GAAP vs. IFRSNotice that revenue recognition occurs earlier under the cost recovery method than under the completed contract method, but gross profit recognition occurs at the end of

the contract for both methods.

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Software and Other Multiple- Deliverable Arrangements

If a sale includes multiple elements (software, future upgrades, postcontract customer support, etc.), the revenue should be allocated to the elements that have stand-alone value (e.g., aren’t contingent). Otherwise, defer revenue recognition until the last item delivered.

•Software: base allocation on VSOE

•Other: can use estimated selling prices. This includes tangible products that contain essential software.

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U. S. GAAP vs. IFRS

• Revenue should be allocated to the various elements based on the stand-alone selling prices of the individual elements. These can be estimated for non-software arrangements if VSOE is not available, but have to use VSOE for software arrangements.

IFRS contains very little guidance about multiple-deliverable arrangements.

• May be necessary to apply the recognition criteria to the separately identifiable components of a single transaction.

• Allocation of total revenue to individual components are based on fair value.

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Franchise Sales

Initial Franchise Fees

Generally are recognized at a

point in time when the earnings

process is virtually complete.

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U. S. GAAP vs. IFRS

• Has over 100 revenue-related standards that sometimes contradict each other.

The FASB and IASB are currently working on a new, comprehensive approach to revenue

recognition.

• Has two primary standards that also sometimes contradict each other and that don’t offer guidance in some important areas (like multiple deliverables).

The Boards appear committed to improving accounting in this area.

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Activity Ratios

Asset Turnover Ratio Net Sales ÷ Average Total Assets

Receivables Turnover Ratio Net Sales ÷ Average Accounts Receivable

Average Collection Period 365 ÷ Receivables Turnover Ratio

Inventory Turnover Ratio Cost of Goods Sold ÷ Average Inventory

Average Days in Inventory 365 ÷ Inventory Turnover Ratio

Activity Ratios

Whenever a ratio divides an income statement balance by a

balance sheet balance, the average for the year is used in

the denominator.

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Profitability Ratios

Profit Margin on Sales Net Income ÷ Net Sales

Return on Assets Net Income ÷ Average Total Assets

Return on Shareholders' Equity Net Income ÷ Average Shareholders' Equity

Profitability Ratios

Return on Equity Key ComponentsProfitability

ActivityFinancial Leverage

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This is called the DuPont framework because the DuPont

Company was a pioneer in emphasizing this relationship.

DuPont Framework

Return on equity =

Profit margin X

Asset turnover X

Equity multiplier

Net incomeAvg. total

equity=

Net incomeTotal sales X

Total salesAvg. total

assetsX

Avg. total assetsAvg. total equity

The DuPont Framework helps identify how profitability, activity, and financial leverage trade off to determine

return to shareholders:

Return on equity =

Return on assets X

Equity multiplier

Net incomeAvg. total

equity=

Net incomeAvg. total

assetsX

Avg. total assetsAvg. total equity

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Appendix 5: Interim Reporting

Issued for periods of less than a year, typically as quarterly

financial statements.

Serves to enhance the timeliness of financial

information.

Fundamental debate centers on the choice between the discrete and integral part

approaches.

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Interim Reporting

Reporting Revenues and Expenses

With only a few exceptions, the same accounting principles

applicable to annual reporting are used for interim reporting.

Reporting Unusual Items

Discontinued operations and extraordinary items are reported

entirely within the interim period in which they occur.

Earnings Per ShareQuarterly EPS calculations follow the same procedures as annual

calculations.

Reporting Accounting Changes

Accounting changes made in an interim period are reported by

retrospectively applying the changes to prior financial statements.

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Minimum Disclosures1. Sales, income taxes, and net income2. Earnings per share3. Seasonal revenues, costs, and expenses4. Significant changes in estimates for income

taxes5. Discontinued operations, extraordinary items,

and unusual or infrequent items6. Contingencies7. Changes in accounting principles or estimates8. Information about fair value of financial

instruments and the methods and assumptions used to estimate fair values

9. Significant changes in financial position

End of Chapter 5