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 collectability of the

asset to be received (usually cash).

the earnings process is complete or virtually

complete.

Revenues are inflows or other enhancements of assets … 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(top of page 235)

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. Collectability 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. Collectability is reasonably assured.

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Revenue Recognition at Delivery(pages 238-239)

When the product or service has been:

1)delivered to the customer and

2) cash has been received or reasonable assurance of

collectability.

When the product or service has been:

1)delivered to the customer and

2) cash has been received or reasonable assurance of

collectability.

Recognize RevenueRecognize Revenue

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Rev Recog. @ Delivery(pages 238-239)

•

• A = L + Sq + Rev -Exp

• AcctRec 5.0 = sales 5.0

• Inventory -4.1 = c of c/s -4.1

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Revenue Recognition After Delivery(pages 238-245)

Two Methods: 1) Installment Sales Method

a) Cash is the key

2) Cost Recovery Method

a) Cash is the key, but …

Two Methods: 1) Installment Sales Method

a) Cash is the key

2) Cost Recovery Method

a) Cash is the key, but …

• 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.

• 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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Case Study: Install. Sale (page 240)

• On 11/1/2011, the B Corporation 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 11/1/2011.

• land cost $560,000 to develop.

• company’s fiscal year ends on December 31.

• Note: expected gross profit:• $240,000 ÷ $800,000 = 30%

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Install. Method Illust. 5-1 (page 240)

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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Install. Sales journal entries(page 241)

1) On the sale date

2) As cash is collecteda) Notice: deferred gross profit is

a “contra account” to the receivable

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if high degree of uncertainty:Cost Recovery Method

• On 11/1/2011, the B Corporation 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 11/1/2011.

• land cost $560,000 to develop.

• company’s fiscal year ends on December 31.

• Note: expected gross profit:• $240,000 ÷ $800,000 = 30%

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Cost Recovery Method (page 242)

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 journal entries(pages 242-243)

1) On the sale date

2) As cash is collecteda) Notice: deferred gross profit is

a “contra account” to the receivable

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Right of Return – Normal Situation(page 243-244)

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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Right of Return in Special Situations

• Intel Corp:–review graphic 5-6 (p. 244)

• Helicos Biosciences:–review graphic 5-7 (p. 244)

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Consignment SalesSonic Solutions Graphic 5-8 (p. 245)Sometimes a company arranges for another

company to sell its product under consignment.

…consignor retains the risks and rewards of

ownership … and title does not pass to the consignee, hence:

the consignor does not record a sale until the

consignee sells the goods

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Revenue Recognition Prior to Delivery(pages 245-258)

Completed Contract Method

Completed Contract Method

Percentage-of-Completion

Method

Percentage-of-Completion

Method

Long-term Contracts

Long-term Contracts

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• Harding Case – next slide (and on page 246)• Journal entries for:

– *** Cost of construction– *** Accounts receivable (billings)– *** Cash collected– xxx Gross profit recognition

• *** = same entries for both methods

• xxx = different entries

% of Completion Method or Completed Contract Method

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Accounting for the Cost of Construction & Accounts Receivable (page 247)

For both methods, journal entries for: 1) costs, 2) billings, and 3) cash receipts are the SAME!

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Types of accounts???

1) Construction in progress – debit balance a) Asset - similar to work-in-process inventory

2) Billings on construction contract – credit balancea) contra account to #1

3) If #1 balance is larger than #2 – net asset on the balance sheet

4) If #2 is larger than #1 – net liability on the balance sheet

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Entries for Gross Profit Recognition:Different depending on Method (page 248)

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Where Did the %-of-Completion Numbers Come From? (page 250)

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Observation: %-of-Completion Method: Key Balance Sheet Accounts

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

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Observation: %-of-Completion Method Income Statement (page 251)

The journal entries (slide #21) result in the income statement for each year reporting:

1) revenue and, 2) cost of construction amounts.

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Observation: 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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Observation: Balance Sheet Accounts might show either a Net Asset or Net Liability position (page 252)

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Amounts on the Balance Sheets for %-of-completion

• costs profits• 2011: 1,500,000 + 500,000 = $2,000,000• billings (1,200,000)• net asset $ 800,000

• 2012: $2,500,000 + 625,000 = $3,125,000• billings (3,200,000)• net liability $ 75,000

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Anticipated Long-Term Contract Losses:Type I - loss in one year (page 253)

• In 2011, @ 40% completion, we recognized $500,000 of gross profit (40% of $1,250,000)

• assume that in 2012, @ 60% completion, we estimate total gross profit for the project will be only $400,000.

• 60% of $400,000 = $240,000 (correct recognition at this point in time)

• We must record a LOSS of $260,000 in 2012– Profit in 2011 of $500,000, loss in 2012 of $260,000– Adds up to total profit recognition of $240,000

• See 2012 journal entry on bottom of page 253 to record 2012 loss of $260,000!

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Long-Term Contract Losses:Type II - expected total loss for project (p. 254)

• In 2011, @ 40% completion, we recognized $500,000 of gross profit (40% of $1,250,000)

• assume that in 2012, we estimate that the project will have a loss (in total) of $100,000

• We must fully recognize this loss in 2012:

– Since profit in 2011 of $500,000 was recorded– We record a loss in 2012 of $600,000

• 2011 profit of $500,000• 2012 loss of $600,000• Total loss = $100,000

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U. S. GAAP vs. IFRS

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

Both require percentage-of-completionmethod, but …

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

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Other Revenue Recognition Topics

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Software and Other Multiple- Deliverable Arrangements (p. 259)

• If a sale includes multiple elements …

• such as: software, future upgrades, postcontract customer support, etc.

• the revenue should be allocated to the elements that have stand-alone value

• for software: base allocation on sales price if sold separately (VSOE = vendor specific objective evidence)

• if VSOE does not exist, defer revenue recognition until the last item delivered.

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Franchise Sales (pages 260-261)

Initial Franchise Fees

Revenue recognition is challenging:

Generally 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

End of Chapter 5