Income Measurement and Profitability Analysis Chapter 5 Income Measurement and Profitability Analysis Chapter 5: Income Measurement and Profitability Analysis The focus of this chapter is revenue recognition. We first discuss the general circumstance in which revenue is recognized when a good or service is delivered. Then we discuss circumstances in which revenue should be deferred until after delivery or should be recognized prior to delivery. The chapter also includes an appendix describing requirements for interim financial reporting. This chapter focuses on revenue recognition practices that will be in effect up to the adoption of the FASB’s new revenue recognition standard, Accounting Standards Update (ASU) No. 2014–09, “Revenue from Contracts with Customers.” (The IFRS version is IFRS No. 15.) ASU 2014-09 was issued on May 28, 2014, but it is unlikely that firms will be required to adopt it before periods beginning after 12/15/2017. Revenue recognition under that standard is the focus of chapter 5 in the eighth edition of this textbook. PowerPoint Authors: Susan Coomer Galbreath, PhD., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, PhD., CPA, CIA Cynthia J. Rooney, PhD., CPA

Realization Principle LO5-1 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. Record revenue when: What is revenue? According to the FASB, “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.” In other words, revenue tracks the inflow of net assets that occurs when a business provides goods or services to its customers. Revenue recognition criteria help ensure that an income statement reflects the actual accomplishments of a company for the period. In other words, revenue should be recognized in the period or periods that the revenue-generating activities of the company are performed. The realization principle requires that two criteria be satisfied before revenue can be recognized: The earnings process is complete or virtually complete and There is reasonable certainty as to the collectability of the asset to be received (usually cash). Premature revenue recognition reduces the quality of reported earnings and can cause serious problems for the reporting company. The earnings process is complete or virtually complete. There is reasonable certainty as to the collectability of the asset to be received (usually cash). AND

SEC Staff Accounting Bulletin No. 101 and 104 LO5-1 Additional criteria for judging whether or not the realization principle is satisfied: Persuasive evidence of an arrangement exists. Delivery has occurred or services have been performed. The seller’s price to the buyer is fixed or determinable. Collectability is reasonably assured. As part of its crackdown on earnings management, the SEC issued additional guidance, summarized in Staff Accounting Bulletin (SAB) No. 101 and later in SAB 104, indicating the SEC’s views on revenue. The SABs provide additional criteria for judging whether or not the realization principle is satisfied:   Persuasive evidence of an arrangement exists. Delivery has occurred or services have been rendered. The seller’s price to the buyer is fixed or determinable. Collectability is reasonably assured. In addition to these four criteria, the SABs also pose a number of revenue recognition questions relating to each of the criteria. The questions provide the facts of the scenario and then the SEC offers its interpretive response. These responses and supporting explanations provide guidance to companies with similar revenue recognition issues. After SAB No. 101 was issued, many companies needed to change their revenue recognition methods to comply with it. In most cases, the changes resulted in a deferral of revenue recognition. In addition to these four criteria, the SABs also answer a number of revenue recognition questions relating to each of the criteria.

Realization Principle LO5-1 Revenue recognition is often tied to delivery of the product from the seller to the buyer. Production Percentage of completion method Revenue recognition prior to delivery Delivery Point of delivery & completed contract method At delivery Cash Collection Installment & cost recovery methods After delivery This illustration relates various revenue-recognition methods to critical steps in the earnings process. Recall that the realization principle indicates that the central issues for recognizing revenue are (a) judging when the earnings process is substantially complete and (b) whether there is reasonable certainty as to the collectibility of the cash to be received. Often this decision is straightforward and tied to delivery of the product from the seller to the buyer. At delivery, the earnings process is virtually complete and the seller receives either cash or a receivable. At other times, though, recognizing revenue upon delivery may be inappropriate. It may be that revenue should be deferred to a point after delivery because the seller is unable to estimate whether the buyer will return the product or pay the receivable. Or, sometimes revenue should be recognized at a point prior to delivery because the earnings process occurs over multiple reporting periods and the company can better inform financial statement users by making reliable estimates of revenue and cost prior to delivery.

Revenue recognition criteria for U.S. U.S. GAAP vs. IFRS LO5-1 Revenue recognition criteria for U.S. GAAP and IFRS include: Earnings process is complete or virtually complete. Reasonable certainty as to the collectibility of the asset to be received. Revenue and costs can be measured reliably. Probability 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. IAS No. 18 governs most revenue recognition under IFRS. Similar to U.S. GAAP, it defines revenue as “the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants.” IFRS allows revenue to be recognized when the following conditions have been satisfied: The amount of revenue and costs associated with the transaction can be measured reliably. It is probable that the economic benefits associated with the transaction will flow to the seller. (For sales of goods) the seller has transferred to the buyer the risks and rewards of ownership, and doesn't effectively manage or control the goods. (For sales of services) the stage of completion can be measured reliably. These general conditions typically will lead to revenue recognition at the same time and in the same amount as would occur under U.S. GAAP, but there are exceptions. For example, later in this chapter we discuss differences between IFRS and U.S. GAAP that may affect the timing of revenue recognition with respect to multiple-deliverable contracts. More generally, IFRS has much less industry-specific guidance than does U.S. GAAP, leading to fewer exceptions to applying these revenue recognition conditions.

Concept Check √ According to the realization principle, revenue should be recorded when the earnings process is judged to be complete or virtually complete and: there is reasonable certainty as to the collectibility of the asset (usually cash) to be received. the asset (usually cash) has been received. the customer has provided the asset (usually cash) or a note in lieu of payment. there is absolute certainly as to the collectability of the asset (usually cash) to be received. The realization principle requires both that the earnings process is virtually complete and that collectibility of the asset is reasonably certain.

Revenue Recognition at Delivery LO5-2 Revenue Recognition at Delivery Recognize Revenue 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 collectability. While revenue usually is earned during a period of time, it often is recognized at one specific point in time when both revenue recognition criteria are satisfied, that is, 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. Revenue from the sale of products usually is recognized at the point of product delivery. The product delivery date occurs when legal title to the goods passes from seller to buyer, which depends on the terms of the sales agreement. For service revenue, if there is one final service that is crucial to the earnings process, revenues and costs are deferred and recognized after this service has been performed. For example, a moving company will pack, load, transport, and deliver household goods for a fixed fee. Although packing, loading, and transporting all are important to the earning process, delivery is the culminating event of the earnings process. So, the entire service fee is recognized as revenue after the goods have been delivered.

Is the Seller a Principal or Agent? Has primary responsibility for delivering product or service and is vulnerable to risks associated with delivery and collection. Agent Does not have primary responsibility for delivering product or service but acts as a facilitator that earns a commission Regardless of whether we are dealing with a product or a service, an important consideration is whether the seller is acting as a “principal” or as an “agent.” Here’s the difference. A principal has primary responsibility for delivering a product or service, and typically is vulnerable to risks associated with delivering the product or service and collecting payment from the customer. In contrast, an agent doesn’t primarily deliver goods or services, but acts as a facilitator that earns a commission for helping sellers transact with buyers. If the company is a principal, the company should recognize as revenue the gross (total) amount received from a customer. If instead the company is an agent, it recognizes as revenue only the net commission it receives for facilitating the sale. Recognizes as revenue the gross (total) amount received from a customer. Recognizes as revenue the net commission it receives for facilitating the sale.

Concept Check √ Fitness Stratagem offers biometric testing for $1,250. They also have a list of independent personal trainers who pay a 10% fee when clients are referred to them. Fitness Stratagem (1) performed three biometric tests and (2) received a commission from pairing one client to a personal trainer who earned $300 by providing a training session. Fitness Stratagem is operating as a(n): Principal Agent Neither Both Fitness Stratagem is principal for the biometric testing. LO5–2 Fitness Stratagem acts as a principal for the biometric testing. Fitness Stratagem acts as an agent between clients and personal trainers. Fitness Stratagem acts as agent between clients and personal trainers.

Concept Check √ Recall that Fitness Stratagem offers biometric testing for $1,250. They also have a list of independent personal trainers who pay a 10% fee when clients are referred to them. Fitness Stratagem (1) performed three biometric tests and (2) received a commission from pairing one client to a personal trainer who earned $300 by providing a training session. Fitness Stratagem’s Income Statement would reflect the following for these transactions: $4,050 revenue $3,780 revenue $3,750 revenue $1,280 revenue LO5–2 $3,750 for biometric testing, and $30 for fitness trainer fee. $1,250 x 3 = $3,750 for biometric testing $300 x 10% = $30 for fitness trainer fee Total = $3,750 + $30 = $3,780.

Revenue Recognition after Delivery LO5-2 Recognizing revenue at delivery of the product or service assumes we are able to make reasonable estimates of amounts due from customers that potentially might be uncollectible and amounts not collectible due to customers returning the products they purchased. At times, however, uncertainties are so severe that they could cause a delay in recognizing revenue from a sale of a product or service. Recognizing revenue when goods and services are delivered assumes we are able to make reasonable estimates of amounts due from customers that potentially might be uncollectible. For product sales, this also includes amounts not collectible due to customers returning the products they purchased. Otherwise, we would violate one of the requirements of the revenue realization principle we discussed earlier—that there must be reasonable certainty as to the collectability of cash from the customer. In this section we address a few situations in which uncertainties are so severe that they could cause a delay in recognizing revenue from a sale of a product or service. For each of these situations, notice that the accounting is essentially the same—deferring recognition of the gross profit arising from a sale of a product or service until uncertainties have been resolved. Installment sales can be accounted for using the installment sales method or the cost recovery method. The installment sales method recognizes the gross profit by applying the gross profit percentage on the sale to the amount of cash actually collected. The cost recovery method defers all gross profit recognition until cash equal to the cost of the item sold has been collected. Installment Sales Method Cost Recovery Method

Installment Sales Method LO5-2 On November 1, 2016, 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, 2016. The land cost $560,000 to develop. The company’s fiscal year ends on December 31. Amount Allocated to: Date Cash Collected Cost (70%) Gross Profit (30%) Nov. 1, 2016 $200,000 $140,000 $60,000 Nov. 1, 2017 $200,000 $140,000 $60,000 Nov. 1, 2018 $200,000 $140,000 $60,000 Nov. 1, 2019 $200,000 $140,000 $60,000 To deal with the uncertainty of collection, the installment sales method recognizes revenue and costs only when cash payments are received. Each payment is assumed to be composed of two components: (1) a partial recovery of the cost of the item sold and (2) a gross profit component. These components are determined by the gross profit percentage applicable to the sale. On November 1, 2016, 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, 2016. The land cost $560,000 to develop. The company’s fiscal year ends on December 31. Let’s see how Belmont Corporation will account for this sale using the installment sales method. One of the first things we need to do is to calculate the gross profit percentage as shown on the slide. TOTALS $800,000 $560,000 $240,000 Gross Profit $240,000 ÷ $800,000 = 30%

Installment Sales Method LO5-3 Make Installment Sale: November 1, 2016 Installment receivables……………………………….....$800,000 Inventory………………………………………………. $560,000 Deferred gross profit…………………………………. $240,000 To record installment sale. During 2016, Belmont Corporation collected $200,000 on its installment sales Collect Cash: November 1, 2016 Cash…………………...……………………………….....$200,000 Installment Receivables…………………………….. $200,000 To record cash from installment sale. In the first entry, installment sales receivable is debited for $800,000. Inventory is credited for the portion of the receivable that represents the cost of the land sold. The difference is deferred gross profit. Deferred gross profit is a contra account to the installment sales receivable. When payments are received, gross profit is recognized. The second set of entries records the collection of the first installment and recognizes the gross profit component of the payment, $60,000. Realized gross profit gets closed to income summary as part of the normal year-end closing process and is included in net income in the income statement. The income statement for 2016would report a gross profit from installment sales of $60,000. Sales and cost of goods sold usually are not reported in the income statement under the installment method, just the resulting gross profit. Journal entries to record the remaining three payments on November 1, 2017, 2018, and 2019, are identical. Deferred gross profit…………………...…………………$60,000 Realized gross profit………………………………….. $60,000 To recognize gross profit from installment sale. This entry records the realized gross profit by adjusting the deferred gross profit account.

Cost Recovery Method LO5-3 On November 1, 2016, 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, 2016. The land cost $560,000 to develop. The company’s fiscal year ends on December 31. Date Cash Cost Gross Profit Collected Recovery Recognized In situations where there is an extremely high degree of uncertainty regarding the ultimate cash collection on an installment sale, an even more conservative approach, the cost recovery method, can be used. This method defers all gross profit recognition until the cost of the item sold has been recovered. The gross profit recognition pattern applying the cost recovery method to the Belmont Corporation situation is illustrated on this slide. Now, let’s use the same data for Belmont Corporation and use the cost recovery method. One of the first things to notice is that under this method, gross profit will not be recognized until 2018. Nov. 1, 2016 $200,000 $200,000 Nov. 1, 2017 $200,000 $200,000 Nov. 1, 2018 $200,000 $160,000 $40,000 Nov. 1, 2019 $200,000 $ 0 $200,000 TOTALS $800,000 $560,000 $240,000

Cost Recovery Method Make Installment Sale: November 1, 2016 LO5-3 Make Installment Sale: November 1, 2016 Installment receivables……………………………….....$800,000 Inventory………………………………………………. $560,000 Deferred gross profit…………………………………. $240,000 To record installment sale. Collect Cash: November 1, 2016, 2017, 2018, and 2019 Cash…………………...……………………………….....$200,000 Installment Receivables…………………………….. $200,000 To record cash from installment sale. November 1, 2016 and 2017 No entry for gross profit. November 1, 2018 Deferred gross profit…………………...……………….. $40,000 Realized gross profit………………………………… $40,000 To recognize gross profit from installment sale. November 1, 2019 Deferred gross profit…………………...………………..$200,000 Realized gross profit………………………………… $200,000 This slide summarizes all the entries using the cost recovery method. Notice that the first entry is exactly the same and that the other entries have the same structure as the entries we just did using the installment sales method, but the timing of the gross profit realization differs between the two methods. In the first entry, installment sales receivable is debited for $800,000. Inventory is credited for the portion of the receivable that represents the cost of the land sold. The difference is deferred gross profit. The second entry records the $200,000 Belmont Corporation collected on its installment sales. The entry is to debit cash and credit installment sales receivable. Belmont Corporation will make this same entry on November 1, 2016, 2017, 2018, and 2019. The third entry on November 1, 2018, records the realized gross profit by adjusting the deferred gross profit account. The amount of the entry is $40,000, which is the amount of the cost recovered at this payment date. The fourth entry on November 1, 2019, records the remainder of the realized gross profit of $200,000 and adjusts the deferred gross profit account.

Concept Check √ On September 15, 2016, Bridger Company sold a tract of land to Great Divide Construction for $1,000,000. Great Divide agreed to pay $250,000 annual installments for 4 years beginning on September 30, 2016. Land development cost Bridger Company $775,000. Using the installment sales method, what is the gross profit percentage? 77.5% 10.29% 29% 22.5% $1,000,000 – $775,000 = $225,000 $225,000 ÷ $1,000,000 = 22.5% LO5–3 Installment receivables……………………………….....$1,000,000 Land inventory (or other cash costs)………………. $775,000 Deferred gross profit…………………………………. $225,000 To record installment sale. To record the installment sale. Installment Receivables…….....$1,000,000 Land inventory (or other cash costs) $775,000 Deferred gross profit……............... $225,000

Concept Check √ When the 2016 installment is paid by Great Divide Construction, Bridger Company’s 2016 gross profit will be increased by: $62,500 $193,750 $56,250 $1,000,000 Cash Collected x Gross Profit Percentage $250,000 x 22.5% = $56,250 LO5–3 To record cash collection from installment sale. Cash ............................................................................................ 250,000 Installment receivables ........................................................... 250,000 To recognize gross profit from installment sale. Deferred gross profit .................................................................. 56,250 Realized gross profit .............................................................. 56,250 To record cash collection from installment sale. Cash ....... ... ... ............................... $250,000 Installment receivables............... $250,000 To recognize gross profit from installment sale. Deferred gross profit .........................$56,250 Realized gross profit .................... $56,250

Right of Return LO5-4 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 Retailers usually give their customers the right to return merchandise if they are not satisfied. In most situations, even though the right to return merchandise exists, revenues and expenses can be appropriately recognized at point of delivery. Based on past experience, a company usually can estimate the returns that will result for a given volume of sales. These estimates are used to reduce both sales and cost of goods sold in anticipation of returns. The purpose of the estimates is to avoid overstating gross profit in the period of sale and understating gross profit in the period of return. Because the return of merchandise can negate the benefits of having made a sale, the seller must meet specific criteria before revenue is recognized in situations when the right of return exists. The most critical of these criteria is that the seller must be able to make reliable estimates of future returns. In some situations, these criteria are not satisfied at the point of delivery of the product. For example, manufacturers of semiconductors like Intel Corporation and Motorola Corporation usually sell their products through independent distributor companies. Economic factors, competition among manufacturers, and rapid obsolescence of the product motivate these manufacturers to grant the distributors the right of return if they are unable to sell the semiconductors. So, revenue recognition often is deferred beyond the delivery point to the date the products actually are sold by the distributor to an end user. Reduce both sales and cost of goods sold

Concept Check √ Based on past experience, a company can usually estimate the returns that will result for a given volume of sales. These estimates are used to reduce: sales and cost of goods sold in anticipation of returns accounts receivable and cost of goods sold in anticipation of returns sales revenue in anticipation of returns none of the above LO5–4 Because the return of merchandise can negate the benefits of having made a sale, the seller must meet specific criteria before revenue is recognized in situations when the right of return exists. The most critical of these criteria is that the seller must be able to make reliable estimates of future returns. Because the return of merchandise can negate the benefits of having made a sale, the seller must meet specific criteria before revenue is recognized in situations when the right of return exists. The most critical of these criteria is that the seller must be able to make reliable estimates of future returns.

Consignment Sales LO5-4 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. Sometimes a company arranges for another company to sell its product under consignment. The “consignor” physically transfers the goods to the other company (the consignee), but the consignor retains legal title. If the consignee can’t find a buyer within an agreed-upon time, the consignee returns the goods to the consignor. However, if a buyer is found, the consignee remits the selling price (less commission and approved expenses) to the consignor. 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 (revenue and related expenses) until the consignee sells the goods and title passes to the eventual customer. Of course, that means goods on consignment still are part of the consignor’s inventory.

Revenue Recognition Prior to Delivery LO5-5 Completed Contract Method Long-term Contracts Percentage-of Completion Method The types of companies that make use of long-term contracts are many and varied. A recent survey of reporting practices of 600 large public companies indicates that approximately one in every four companies engages in long-term contracts. And they are not just construction companies. In fact, even services such as research, installation, and consulting often are contracted for on a long-term basis. The general revenue recognition criteria described in the realization principle suggest that revenue should be recognized when a long-term project is finished (that is, when the earnings process is virtually complete). This is known as the completed contract method of revenue recognition. The problem with this method is that all revenues, expenses, and resulting income from the project are recognized in the period in which the project is completed; no revenues or expenses are reported in the income statements of earlier reporting periods in which much of the work may have been performed. Net income should provide a measure of periodic accomplishment to help predict future accomplishments. Clearly, income statements prepared using the completed contract method do not fairly report each period’s accomplishments when a project spans more than one reporting period. Much of the earnings process is far removed from the point of delivery. The percentage-of-completion method of revenue recognition for long-term construction and other projects is designed to help address this problem. By this approach, we recognize revenues (and expenses) over time by allocating a share of the project’s expected revenues and expenses to each period in which the earnings process occurs, that is, the contract period. Although the contract usually specifies total revenues, the project’s expenses are not known until completion. Consequently, it’s necessary for a company to estimate the project’s future costs at the end of each reporting period in order to estimate total gross profit to be earned on the project.

Completed Contract and Percentage-of- Completion Methods Compared LO5-5 At the beginning of 2016, the Harding Construction Company received a contract to build an office building for $5 million. The project is estimated to take three years to complete. According to the contract, Harding will bill the buyer in installments over the construction period according to a prearranged schedule. Information related to the contract is as follows: Construction costs incurred during the year $1,500,000 $1,000,000 $1,600,000 Construction costs incurred in prior years - $1,500,000 $2,500,000 Cumulative construction costs $1,500,000 $2,500,000 $4,100,000 Estimated costs to complete at end of year $2,250,000 $1,500,000 - Total estimated and actual construction costs $3,750,000 $4,000,000 $4,100,000 Billings made during the year $1,200,000 $2,000,000 $1,800,000 Cash Collections during year $1,000,000 $1,400,000 $2,600,000 2016 2017 2018 At the beginning of 2016, the Harding Construction Company received a contract to build an office building for $5 million. The project is estimated to take three years to complete. According to the contract, Harding will bill the buyer in installments over the construction period according to a prearranged schedule. Information related to the contract is shown on this slide. Construction costs include the labor, materials, and overhead costs directly related to the construction of the building. Notice how the total of estimated and actual construction costs changes from period to period. Cost revisions are typical in long-term contracts in which costs are estimated over long periods of time.

Gross Profit Recognition—General Approach LO5-5 2016 2017 2018 Completed Contract Construction in progress (gross profit) $900,000 Cost of construction $4,100,000 Revenue from long-term contracts $5,000,000 To record gross profit. Percentage-of-Completion Construction in progress (gross profit) $500,000 $125,000 $275,000 Cost of construction $1,500,000 $1,000,000 $1,600,000 Revenue from long-term contracts $2,000,000 $1,125,000 $1,875,000 The top portion shows the journal entries to recognize revenue, cost of construction (think of this as cost of goods sold), and gross profit under the completed contract method, while the bottom portion shows the journal entries that achieve this for the percentage-of-completion method. It’s important to understand two key aspects of these journal entries. First, the same amounts of revenue, cost, and gross profit are recognized under both the completed contract and percentage-of-completion methods. The only difference is timing. Second, notice that in both methods we add gross profit (the difference between revenue and cost) to the construction in progress asset. That may seem odd—why add profit to what is essentially an inventory account? The key here is that, when the Harding Construction Company recognizes gross profit, Harding Construction is acting like it has sold some portion of the asset to the customer, but Harding Construction keeps the asset in Harding Construction’s own balance sheet (in the construction in progress account) until delivery to the customer. Putting recognized gross profit into the construction in progress account just updates that account to reflect the total value (cost + gross profit = sales price) of the customer’s asset. However, don’t forget that the billings on construction contract account is contra to the construction in progress account. Over the life of the construction project, Harding Construction will bill the customer for the entire sales price of the asset. Therefore, at the end of the contract, the construction in progress account (containing total cost and gross profit) and the billings on construction contract account (containing all amounts billed to the customer) will have equal balances that exactly offset to create a net value of zero. 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.

Accounting for the Cost of Construction and Accounts Receivable LO5-5 With both the completed contract and percentage-of- completion methods, all costs of construction are recorded in an asset account called construction in progress. Construction in progress $1,500,000 $1,000,000 $1,600,000 Cash, materials, etc. $1,500,000 $1,000,000 $1,600,000 To record construction costs. Accounts receivable $1,200,000 $2,000,000 $1,800,000 Billings on construction contract $1,200,000 $2,000,000 $1,800,000 Cash $1,000,000 $1,400,000 $2,600,000 Accounts Receivable $1,000,000 $1,400,000 $2,600,000 To record cash collections. 2016 2017 2018 With both the completed contract and percentage-of-completion methods, all costs of construction are recorded in an asset account called construction in progress. This account is equivalent to the asset work-in-process inventory in a manufacturing company. This is logical since the construction project is essentially an inventory item in process for the contractor. Notice that periodic billings are credited to billings on construction contract. This account is a contra account to the construction in progress asset. At the end of each period, the balances in these two accounts are compared. If the net amount is a debit, it is reported in the balance sheet as an asset. Conversely, if the net amount is a credit, it is reported as a liability.

Gross Profit Recognition—General Approach LO5-5 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. 2016 2017 2018 Billings on construction contract $5,000,000 Construction in progress $5,000,000 To close accounts. When title officially passes to the customer, Harding Construction will prepare a journal entry that removes the contract from its balance sheet by debiting billings on construction contract and crediting construction in progress for the entire value of the contract. As shown on this slide, 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.

Timing of Gross Profit Recognition Under the Completed Contract Method LO5-5 Under the completed contract method, all revenues and expenses related to the project are recognized when the contract is completed. Completed Contract Construction in Progress Billings on Construction Contract 2016 construction costs $1,500,000 $1,200,000 2016 billings End balance, 2016 $1,500,000 $2,000,000 2017 billings 2017 construction costs $1,000,000 $1,800,000 2018 billings End balance, 2017 $2,500,000 $5,000,000 Balance, before closing 2018 construction costs $1,600,000 2018 gross profit $900,000 Balance before closing $5,000,000 The timing of gross profit recognition under the completed contract method is simple. As the name implies, all revenues and expenses related to the project are recognized when the contract is completed. As shown earlier and in the T-accounts provided here, completion occurs in 2018 for the Harding Construction example. Prior to then, construction in progress includes only costs, showing a balance of $1,500,000 and $2,500,000 of cost at the end of 2016 and 2017, respectively, and including $4,100,000 of cost when the project is completed in 2018. Harding includes an additional $900,000 of gross profit in construction in progress when the project is completed in 2018 because the asset is viewed as “sold” on that date. The company records revenue of $5,000,000, cost of construction (similar to cost of goods sold) of $4,100,000, and the resulting $900,000 gross profit on that date.

Timing of Gross Profit Recognition Under the Percentage-of-Completion Method LO5-5 Under the percentage-of-completion method, profit is recognized over the life of the project as the project is completed. We determine the amount of gross profit recognized in each period using the following logic: gross profit recognized this period total estimated gross profit percentage completed to date recognized in prior periods = x — ( ) Under the percentage-of-completion method, profit is recognized over the life of the project as the project is completed. Progress to date can be estimated as the proportion of the project’s cost incurred to date divided by total estimated costs, or by relying on an engineer’s or architect’s estimate. Regardless of the specific approach used to estimate progress to date, under the percentage-of-completion method we determine the amount of gross profit recognized in each period using the following logic: Gross profit recognized this period = (total estimated gross profit × percentage completed to date) − gross profit recognized in prior periods, where total estimated gross profit = total estimated revenue – total estimated cost.

Percentage-of-completion Method Allocation of Gross Profit Contract price (A) $5,000,000 $5,000,000 $5,000,000 Construction costs Construction costs incurred during the year $1,500,000 $1,000,000 $1,600,000 Construction costs incurred in prior years $1,500,000 $2,500,000 Cumulative construction costs $1,500,000 $2,500,000 $4,100,000 Estimated remaining costs to complete $2,250,000 $1,500,000 Total costs (estimated + actual) (B) $3,750,000 $4,000,000 $4,100,000 Total gross profit (A-B) $1,250,000 $1,000,000 $900,000 Multiplied by: X X X Percentage-of-completion: Actual costs to $1,500,000 $2,500,000 $4,100,000 date divided by the estimated total project cost $3,750,000 $4,000,000 $4,100,000 = 40% = 62.5% = 100% Equals: Gross profit earned to date $500,000 $625,000 $900,000 Less: Gross profit recognized in prior periods ($500,000) $625,000) Gross profit recognized currently $500,000 $125,000 $275,000 2016 2017 2018 This slide illustrates the calculation of gross profit for each of the years for our Harding Construction Company example, with progress to date estimated using the cost-to-cost ratio. Earlier we showed the journal entries used to recognize gross profit in each period.

Percentage-of-Completion Method Allocation of Gross Profit The income statement for each year will report the appropriate revenue and cost of construction amounts. 2016 Revenue recognized ($5,000,000 x 40%) $2,000,000 Cost of construction ($1,500,000) Gross profit $500,000 2017 Revenue recognized to date ($5,000,000 x 62.5%) $3,125,000 Less: revenue recognized in 2016 $2,000,000 Revenue recognized $1,125,000 Cost of construction ($1,000,000) Gross profit $125,000 2018 Revenue recognized to date ($5,000,000 x 100%) $5,000,000 Less: revenue recognized in 2016 and 2017 $3,125,000 Revenue recognized $1,875,000 Cost of construction ($1,600,000) Gross profit $275,000 Income statements are more informative if the sales revenue and cost components of gross profit are reported rather than the net figure alone. So, the income statement for each year will report the appropriate revenue and cost of construction amounts. For example, in 2016, the gross profit of $500,000 consists of revenue of $2,000,000 (40% of the $5,000,000 contract price) less the $1,500,000 cost of construction. In subsequent periods, we calculate revenue by multiplying the percentage of completion by the contract price and then subtracting revenue recognized in prior periods, similar to the way we calculate gross profit each period. The cost of construction, then, is the difference between revenue and gross profit. In most cases, cost of construction also equals the construction costs incurred during the period. The table on this slide shows the revenue and cost of construction recognized in each of the three years of our example. Of course, as you can see in this illustration, we could have initially determined the gross profit by first calculating revenue and then subtracting cost of construction.

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. Percentage of Completion Construction in Progress Billings on Construction Contract 2016 construction costs $1,500,000 $1,200,000 2016 billings 2016 gross profit $500,000 $2,000,000 2017 billings Ending balance, 2016 $2,000,000 $1,800,000 2018 billings 2017 construction costs $1,000,000 2017 gross profit $125,000 $5,000,000 Balance, Ending balance, 2017 $3,125,000 before closing 2018 construction costs $1,600,000 2018 gross profit $275,000 Balance, before closing $5,000,000 The T-accounts for the percentage-of-completion method are illustrated on this slide. Notice that the gross profit recognized in each period is added to the construction in progress account.

Concept Check √ Robertson Construction entered into a contract to construct a tunnel for a fixed price of $12,000,000. Robertson recognizes revenue using the percentage-of-completion method. Here are some facts: Estimated Additional Cost incurred Cost to Complete 2016 $ 3,000,000 $6,000,000 2017 5,000,000 2,000,000 2018 2,500,000 0 What is Robertson’s percentage completion in 2016? 25% 33.33% 37.5% D. 100% $3M ÷ ($3M + $6M) = 33.33% (or 1/3) complete.

Concept Check √ Robertson Construction entered into a contract to construct a tunnel for a fixed price of $12,000,000. Robertson recognizes revenue using the percentage-of-completion method. Here are some facts: Estimated Additional Cost incurred Cost to Complete 2016 $3,000,000 $6,000,000 2017 5,000,000 2,000,000 2018 2,500,000 0 How much revenue would Robertson recognize in 2016? $4,000,000 $5,000,000 $6,000,000 $12,000,000 $3M ÷ ($3M + $6M) = 33.33% (or 1/3) complete. $12M x 1/3 = $4M revenue recognized in 2016.

Concept Check √ Robertson Construction entered into a contract to construct a tunnel for a fixed price of $12,000,000. Robertson recognizes revenue using the percentage-of-completion method. Here are some facts: Estimated Additional Cost incurred Cost to Complete 2016 $3,000,000 $6,000,000 2017 5,000,000 2,000,000 2018 2,500,000 0 What is Robertson’s percentage completion in 2017? 50% 66.67% 80% 88.89% ($3M + $5M) ÷ ($3M + $5M + $2M) = 80% complete.

Concept Check √ Robertson Construction entered into a contract to construct a tunnel for a fixed price of $12,000,000. Robertson recognizes revenue using the percentage-of-completion method. Here are some facts: Estimated Additional Cost incurred Cost to Complete 2016 $3,000,000 $6,000,000 2017 5,000,000 2,000,000 2018 2,500,000 0 How much revenue would Robertson recognize in 2017? $5,000,000 $5,600,000 $8,000,000 $9,600,000 ($3M + $5M) ÷ ($3M + $5M + $2M) = 80% complete. $12M x 80% = $9.6M = total revenue to date. $9.6M − $4M = $5.6M = revenue recognized in 2017

Concept Check √ Robertson Construction entered into a contract to construct a tunnel for a fixed price of $12,000,000. Robertson recognizes revenue using the percentage-of-completion method. Here are some facts: Estimated Additional Cost incurred Cost to Complete 2016 $3,000,000 $6,000,000 2017 5,000,000 2,000,000 2018 2,500,000 0 How much revenue would Robertson recognize in 2018? $0 $2,000,000 $2,400,000 $12,000,000 100% complete. $12M x 100% = $12M = total revenue to date. $12M – ($4M + $5.6M) = $2.4M = revenue recognized in 2018

Percentage-of-Completion Completed Contract Income Recognition LO5-6 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. Percentage-of-Completion Completed Contract Gross profit recognized: 2016 $500,000 2017 $125,000 2018 $275,000 $900,000 Total gross profit $900,000 $900,000 Earlier we illustrated the journal entries that would determine the amount of revenue, cost, and therefore gross profit that would appear in the income statement under the percentage-of-completion and completed contract methods. Comparing the gross profit patterns produced by each method of revenue recognition demonstrates the essential difference as shown on this slide. Although both methods yield identical gross profit of $900,000 for the entire three-year period, the timing differs. The completed contract method defers all gross profit to 2018, when the project is completed. Obviously, the percentage-of-completion method provides a better measure of the company’s economic activity and progress over the three-year period. That’s why the percentage-of-completion method is preferred, and, as mentioned previously, the completed contract method should be used only when the company is unable to make dependable estimates of future costs necessary to apply the percentage-of-completion method.

Balance Sheet Recognition LO5-6 Billings on construction contract are subtracted from construction in progress to determine balance sheet presentation. CIP > Billings Asset In the balance sheet, the construction in progress (CIP) account (containing costs and profit) is offset against the billings on construction contract account, with CIP > Billings shown as an asset and Billings > CIP shown as a liability. Because a company may have some contracts that have a net asset position and others that have a net liability position, we usually will see both net assets and net liabilities shown in a balance sheet at the same time. Construction in progress in excess of billings essentially represents an unbilled receivable. Companies include it in their balance sheets as a component of accounts receivable, as part of inventory, or on its own line. The construction company is incurring construction costs (and recognizing gross profit using the percentage-of-completion method) for which it will be paid by the buyer. If the construction company bills the buyer an amount exactly equal to these costs (and profits recognized) then the accounts receivable balance properly reflects the claims of the construction company. If, however, the amount billed is less than the costs incurred (plus profits recognized) the difference represents the remaining claim to cash—an asset. On the other hand, billings in excess of construction in progress essentially indicates that the overbilled accounts receivable overstates the amount of the claim to cash earned to that date and must be reported as a liability. This is similar to the unearned revenue liability that is recorded when a customer pays for a product or service in advance. The advance is properly shown as a liability representing the obligation to provide the good or service in the future. Billings > CIP Liability

Balance Sheet Recognition LO5-6 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. Percentage-of-Completion: Current Assets: Accounts receivable $200,000 $800,000 Costs and profit ($2,000,000) in excess of billings ($1,200,000) $800,000 Current liabilities: Billings ($3,200,000) in excess of costs and profit ($3,125,000) $75,000 Completed Contract: Accounts receivable $200,000 $800,000 Costs ($1,500,000) in excess of billings ($1,200,000) $300,000 Billings ($3,200,000) in excess of costs ($2,500,000) $700,000 Balance Sheet (End of Year) 2016 2017 The balance sheet presentation for the construction-related accounts by both methods is shown on this slide. 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.

Long-term Contract Losses Periodic Loss for Profitable Projects Loss Projected for Entire Project Determine periodic loss and record loss as a credit to the construction in progress account Estimated loss is fully recognized in the first period the loss is anticipated and is recorded by a credit to construction in progress account Unfortunately, losses sometimes occur on long-term contracts. Losses are recognized in the period in which they are determined, regardless of the revenue recognition method used. For a periodic loss on an overall profitable project, the loss is recorded as a credit to the construction in progress account if the project is accounted for under the percentage-of-completion method. No entry is made under the completed contract method. For an overall loss on the entire project, the estimated loss is fully recognized in the first period the loss is anticipated and is recorded by a credit to the construction in progress account.

U.S. GAAP vs. IFRS LO5-6 There are similarities and differences between IRFS and U.S. GAAP when considering revenue recognition for long-term contruction contracts. Requires percentage-of- completion when reliable estimates can be made. Requires completed contract method when reliable estimates can’t be made. Requires percentage-of- completion when reliable estimates can be made. Requires cost recovery method when reliable estimates can’t be made. IAS No. 11 governs revenue recognition for long-term construction contracts. Like U.S. GAAP, that standard requires the use of the percentage-of-completion method when reliable estimates can be made. However, unlike U.S. GAAP, IAS No. 11 requires the use of the cost recovery method rather than the completed contract method when reliable estimates can’t be made. Under the cost recovery method, contract costs are expensed as incurred, and an offsetting amount of contract revenue is recognized to the extent that it is probable that costs will be recoverable from the customer. No gross profit is recognized until all costs have been recovered, which is why this method is also sometimes called the “zero-profit method.” Note that under both the completed contract and cost recovery methods no gross profit is recognized until the contract is essentially completed, but revenue and construction costs will be recognized earlier under the cost recovery method than under the completed contract method. Also, under both methods an expected loss is recognized immediately.

U.S. GAAP vs. IFRS LO5-6 Notice 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. 2016 2017 2018 Completed Contract Construction in progress (gross profit) $900,000 Cost of construction $4,100,000 Revenue from long-term contracts $5,000,000 To record gross profit. Cost Recovery Construction in progress (gross profit) $900,000 Cost of construction $1,500,000 $1,000,000 $1,600,000 Revenue from long-term contracts $1,500,000 $1,000,000 $2,500,000 To see the difference between the completed contract and cost recovery methods, this slide shows a comparison of the revenue, cost, and gross profit recognition under the two methods. Notice 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. As a result, gross profit as a percentage of revenue differs between the two methods at various points in the life of the contract.

Software and Other Multiple Deliverable Arrangements LO5-6 If a sale includes multiple elements (software, future upgrades, post contract customer support, etc.), the revenue should be allocated to the various elements based on “vendor- specific objective evidence” (VSOE) of fair values of the individual elements. The software industry is a key economic component of our economy. Microsoft alone reported revenues in excess of $70 billion for its 2011 fiscal year. Yet, the recognition of software revenues has been a controversial accounting issue. The controversy stems from the way software vendors typically package their products. It is not unusual for these companies to sell multiple software deliverables in a bundle for a lump-sum contract price. The bundle often includes product, upgrades, post contract customer support, and other services. The critical accounting question concerns the timing of revenue recognition. The American Institute of Certified Public Accountants (AICPA) issued authoritative guidance in this area. The AICPA position indicates that if an arrangement includes multiple elements, the revenue from the arrangement should be allocated to the various elements based on ‘Vendor-Specific Objective Evidence’ (VSOE) of fair values of the individual elements. It doesn’t matter what separate prices are indicated in the multiple-element contract. Rather, the VSOE of fair values are the sales prices of the elements when sold separately by that vendor. If VSOE doesn’t exist, revenue recognition is deferred until VSOE is available or until all elements of the arrangement are delivered.

Software and Other Multiple Deliverable Arrangements LO5-6 The FASB’s Emerging Issues Task Force (EITF) issued guidance to broaden the application of this basic perspective to other arrangements that involve “multiple deliverables,” such as sales of appliances with maintenance contracts, cellular phone contracts that come with a “free phone,” and even painting services that include sales of paint as well as labor. Sellers offering other multiple-deliverable contracts now are allowed to estimate selling prices when they lack VSOE from stand-alone sales prices. Using estimated selling prices allows earlier revenue recognition than would be allowed if sellers had to have VSOE in order to recognize revenue. More recently, the FASB’s Emerging Issues Task Force (EITF) issued guidance to broaden the application of this basic perspective to other arrangements that involve “multiple deliverables.” Examples of such arrangements are sales of appliances with maintenance contracts, cellular phone contracts that come with a “free phone,” and even painting services that include sales of paint as well as labor. Other examples are products that contain both hardware and software essential to the functioning of the product, such as computers and smart phones that are always sold with an operating system. Now, as with software-only contracts, sellers allocate total revenue to the various parts of a multiple-deliverable arrangement on the basis of the relative stand-alone selling prices of the parts. Sellers must defer revenue recognition for parts that don’t have stand-alone value, or whose value is contingent upon other undelivered parts. However, unlike software-only arrangements, sellers offering other multiple-deliverable contracts now are allowed to estimate selling prices when they lack VSOE from stand-alone sales prices. Using estimated selling prices allows earlier revenue recognition than would be allowed if sellers had to have VSOE in order to recognize revenue. For some sellers this change had a huge effect. As an example, consider and the highly successful iPhone. Apple used to defer revenue on iPhones and other products because it didn’t have VSOE of the sales price of future software upgrades included with the phones. This practice resulted in over $12 billion of deferred (unearned) revenue as of the end of fiscal 2009. The adoption of the new accounting principles increased the Company’s net sales by $6.4 billion, $5.0 billion, and $572 million for 2009, 2008 and 2007, respectively. After this accounting change, Apple recognizes almost all of the revenue associated with an iPhone at the time of sale. The only amount deferred is the small amount of revenue estimated for future software upgrade rights.

Concept Check √ Graham Software sells their software package for $60,000, which includes a year of free technical support. Without technical support, the software package sells for $55,000. A year of technical support sells for $11,000. How much revenue is recognized when software is delivered? $66,000 $60,000 $55,000 $50,000 Vendor Specific Objective Evidence: Calculated as a percentage of the value before package discount LO5–6 $55,000 ÷ $66,000 = 5/6 Software is 5/6 of Fair Value $60,000 x 5/6 = $50,000

U.S. GAAP vs. IFRS LO5-6 IFRS contains very little guidance about multiple-deliverable arrangements. Revenue should be allocated to the various elements based on “vendor-specific objective evidence” (VSOE) of fair values of the individual elements. May be necessary to apply the recognition criteria to the separately identifiable components of a single transaction. Allocation of total revenue to individual components is based on fair value, with no requirements to focus on VSOE. IFRS contains very little guidance about multiple-deliverable arrangements. IAS No. 18 simply states that: ”. . . in certain circumstances, it is necessary to apply the recognition criteria to the separately identifiable components of a single transaction in order to reflect the substance of the transaction” and gives a couple of examples. Allocations of total revenue to individual components are based on fair value, with no requirements to focus on VSOE. Also, IFRS tends to encourage focus on the underlying economics of revenue transactions, so particular contractual characteristics like contingencies may matter less under IFRS than they do under U.S. GAAP.

Franchise Sales Initial Franchise Fees Continuing Franchise Fees LO5-6 Initial Franchise Fees Continuing Franchise Fees Generally are recognized at a point in time when the earnings process is virtually complete. Recognized over time as the services are performed. The use of franchise arrangements has become increasingly popular in the United States over the past 30 years. In the franchise arrangement, the franchisor grants to the franchisee the right to sell the franchisor’s products and use its name for a specified period of time. The fees paid by the franchisee to the franchisor usually comprise the initial franchise fee and the continuing franchise fee. Continuing franchise fees are paid to the franchisor for continuing rights as well as for advertising and promotion and other services provided over the life of the franchise agreement. These fees sometimes are a fixed annual or monthly amount, a percentage of the volume of business done by the franchise, or a combination of both. Continuing franchise fees are recognized over time as the services are performed. The challenging revenue recognition issue pertains to the initial franchise fee. The initial franchise fee is usually a fixed amount that may be payable in installments. In many cases, the initial franchise fee covers significant services to be performed in the future. And, if the fee is payable in installments over an extended period of time, it creates an additional concern of collectability. Specific guidance for revenue recognition of the initial franchise fee is provided in U.S. GAAP, which requires that substantially all of the initial services of the franchisor required by the franchise agreement be performed before the initial franchise fee can be recognized as revenue. In situations where the initial franchise fee is collectible in installments, the installment sales method or cost recovery method should be used for profit recognition, if a reasonable estimate of uncollectibility cannot be made.

U.S. GAAP vs. IFRS LO5-6 The FASB and IASB have jointly issued a new revenue recognition standard. Has over 200 revenue-related standards that sometimes contradict each other. Has two primary standards that also sometimes contradict each other and that don’t offer guidance in some important areas (like multiple deliverables). The FASB recently issued a new revenue recognition standard, Accounting Standards Update (ASU) No. 2014–09, “Revenue from Contracts with Customers.” That standard is almost completely converged with a newly issued IFRS counterpart, IFRS No. 15. ASU 2014-09 was issued on May 28, 2014, but it is unlikely that firms will be required to adopt it before periods beginning after 12/15/2017. Why change? Currently, the FASB has over 200 revenue-related standards that sometimes contradict each other and that treat similar economic events differently. The IASB has two primary standards (IAS No. 11 and IAS No. 18) that also sometimes contradict each other and that don’t offer guidance in some important areas (like multiple deliverables). And, although both the FASB and IASB define revenue in terms of flows of assets and liabilities, the FASB guidance typically bases revenue recognition on the earnings process, while the IASB standards base it on the transfer of the risks and rewards of ownership, which can lead to different outcomes. So, the accounting guidance on revenue recognition could use some improvement. The Boards’ new approach is similar in many ways to the current U.S. guidance for recognizing revenue on multiple-deliverable contracts. The focus is on contracts between a seller and a buyer. A seller identifies all of its distinct performance obligations under a contract, determines the transaction price of the contract, and then allocates that price to the various performance obligations according to the estimated stand-alone selling prices of those obligations. The seller then recognizes revenue as each of those performance obligations is satisfied. For many types of sales arrangements, adopting the ASU will not change current practice. However, it will create consistency in revenue recognition across industries, and in some areas it will change practice considerably. For example, estimates of variable future payments will be included in revenue to a greater extent than exists currently, affecting revenue recognition on many contracts that peg future payments to future outcomes. Also, the installment method will not exist.

Activity Ratios LO5-7 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 measure a company’s efficiency in managing its assets. Although, in concept, the activity or turnover can be measured for any asset, activity ratios are most frequently calculated for accounts receivable, inventory, and total assets. The asset turnover ratio is calculated as net sales divided by average total assets. This ratio measures how efficiently a company utilizes all of its assets to generate revenue. The receivables turnover ratio is calculated as net sales divided by average accounts receivable. Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator. The denominator is determined by adding beginning and ending net accounts receivable and dividing by two. This ratio measures how many times a company converts its receivables into cash each year. The higher the ratio, the shorter the average time between credit sales and cash collection. The average collection period is calculated as 365 divided by the receivables turnover ratio. This ratio is an approximation of the number of days the average accounts receivable balance is outstanding. The inventory turnover ratio is calculated as cost of goods sold divided by average inventory. The denominator is determined by adding beginning and ending inventory and dividing by two. This ratio measures the number of times merchandise inventory is sold and replaced during the year. A relatively high ratio, say compared to a competitor, usually is desirable. However, as with most ratios, care must be taken in interpretation. For example, a high ratio could indicate comparative strength in a company’s sales force or it could indicate a relatively low inventory level, which could lead to stockouts and lost sales. The average days in inventory is calculated as 365 divided by the inventory turnover ratio. This ratio indicates the number of days it normally takes to sell inventory. Whenever a ratio divides an income balance by a balance sheet balance, the average for the year is used in the denominator.

Profitability Ratios LO5-7 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 attempt to measure a company’s ability to earn an adequate return relative to sales or resources devoted to operations. Three common profitability ratios are the profit margin on sales, the return on assets, and the return on shareholders’ equity. Profit margin on sales is calculated as net income divided by net sales. This ratio indicates the portion of each dollar of revenue that is available to cover expenses. Return on assets is calculated as net income divided by average total assets. Profit margin and asset turnover combine to yield return on assets , which measures the return generated by a company’s assets. Return on equity is calculated as net income divided by average shareholders’ equity. This ratio measures the ability of management to generate net income from the resources the owners provide. In addition to monitoring return on equity, investors want to understand how that return can be improved. There are three key components to the return on equity: Profitability is measured by the profit margin (Net Income divided by Sales). A higher profit margin indicates that a company is generating more profit from each dollar of sales. Activity is measured by asset turnover (Sales divided by Average Total Assets). A higher asset turnover indicates that a company is using its assets efficiently to generate more sales from each dollar of assets. Financial Leverage is measured by the equity multiplier (Average Total Assets divided by Average Total Equity). A high equity multiplier indicates that relatively more of the company’s assets have been financed with debt. Leverage can provide additional return to the company’s equity holders. The receivables turnover ratio is calculated as net sales divided by average accounts receivable. Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator. The denominator is determined by adding beginning and ending net accounts receivable and dividing by two. This ratio measures how many times a company converts its receivables into cash each year. The higher the ratio, the shorter the average time between credit sales and cash collection. The average collection period is calculated as 365 divided by the receivables turnover ratio. This ratio is an approximation of the number of days the average accounts receivable balance is outstanding. The inventory turnover ratio is calculated as cost of goods sold divided by average inventory. The denominator is determined by adding beginning and ending inventory and dividing by two. This ratio measures the number of times merchandise inventory is sold and replaced during the year. A relatively high ratio, say compared to a competitor, usually is desirable. However, as with most ratios, care must be taken in interpretation. For example, a high ratio could indicate comparative strength in a company’s sales force or it could indicate a relatively low inventory level, which could lead to stockouts and lost sales. The average days in inventory is calculated as 365 divided by the inventory turnover ratio. This ratio indicates the number of days it normally takes to sell inventory. Return on Equity Key Components Profitability Activity Financial Leverage

DuPont Framework LO5-7 The DuPont framework helps identify how profitability, activity, and financial leverage trade off to determine return to shareholders: Return on equity = Profit margin x Asset turnover x Equity multiplier Net income Avg. total equity Net income Total sales Total sales Avg. total assets Avg. total assets Avg. total equity x = Because profit margin and asset turnover combine to equal return on assets, the DuPont framework can also be written as: Return on equity = Return on assets x Equity multiplier Part I The DuPont framework shows that return on equity depends on profitability, activity, and financial leverage. In equation form, the DuPont framework is profit margin times asset turnover times the equity multiplier. Notice that total sales and average total assets appear in the numerator of one ratio and the denominator of another. Although the DuPont framework computations use the term “total sales,” it refers to “net sales,” which is sales net of sales returns and allowances. Part II So, they cancel to yield net income divided by average total equity, or return on assets. This provides another way to compute ROE as return on assets times the equity multiplier. Net income Avg. total equity Net income Avg. total assets Avg. total assets Avg. total equity = x

Concept Check √ E A C D B 365 ÷ Inventory Turnover Ratio A. Receivables turnover ratio D. Average Collection Period B. Inventory turnover ratio E. Average Days in Inventory C. Asset turnover ratio Match these activity ratios with their descriptions Company’s efficiency in collecting receivables Average age of accounts receivable How quickly inventory is sold. How long it normally takes to sell inventory How company utilizes its assets to generate revenue Answer Description 365 ÷ Inventory Turnover Ratio Net Sales ÷ Average Accounts Receivable Net Sales ÷ Average Total Assets 365 ÷ Receivables Turnover Ratio Cost of Goods Sold ÷ Average Inventory E A LO5–7 Average Days in Inventory indicates the number of days it normally takes to sell inventory. The receivables turnover ratio provides an indication of a company’s efficiency in collecting receivables. The asset turnover ratio provides an indication of how efficiently a company utilizes all of its assets to generate revenue. Average calculation period indicates the average age of accounts receivable. The inventory turnover ratio shows the number of times the average inventory balance is sold during a reporting period. It indicates how quickly inventory is sold. C D B

Concept Check √ A C B Net income ÷ Net Sales Match these profitability ratios with their descriptions A. Profit margin on sales ratio C. Return on assets ratio B. Return on shareholders’ equity Profit generated by each dollar of sales Profit generated by each dollar of assets Profit generated by each dollar of equity Answer Description Net income ÷ Net Sales Net income ÷ Average Total Assets Net income ÷ Average Shareholders’ Equity A LO5–7 C B

Appendix 5: Interim Reporting LO5-7 Issued for periods of less than a year, typically as quarterly financial statements. Serves to enhance the timeliness of financial information. Appendix 5: Interim Reporting Financial statements covering periods of less than a year are called interim reports. Companies registered with the SEC, which includes most public companies, must submit quarterly reports. Though there is no requirement to do so, most also send quarterly reports to their shareholders and typically include abbreviated, unaudited interim reports as supplemental information within their annual reports. For accounting information to be useful to decision makers, it must be available on a timely basis. One of the objectives of interim reporting is to enhance the timeliness of financial information. In addition, quarterly reports provide investors and creditors with additional insight on the seasonality of business operations that might otherwise get lost in annual reports. However, the downside to these benefits is the relative unreliability of interim reporting. With a shorter reporting period, questions associated with estimation and allocation are magnified. The fundamental debate regarding interim reporting centers on the choice between the discrete and integral part approaches. Fundamental debate centers on the choice between the discrete and integral part approaches.

Interim Reporting LO5-7 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 are reported entirely within the interim period in which they occur. Earnings Per Share Quarterly EPS calculations follow the same procedures as annual calculations. Part I With only a few exceptions, the same accounting principles applicable to annual reporting are used for interim reporting of revenues and expenses. For example, costs and expenses subject to year-end adjustments, such as depreciation and bad debt expense, are estimated and allocated to interim periods in a systematic way. Part II On the other hand, discontinued operations should be reported separately in the interim period in which they occur. That is, these amounts should not be allocated among individual quarters within the fiscal year. Part III Quarterly EPS calculations follow the same procedures as annual calculations, which is consistent with the discrete view. Part IV Accounting changes made in an interim period are reported by retrospectively applying the changes to prior interim financial statements. Then in financial reports of subsequent interim periods of the same fiscal year, we disclose how that change affected income from continuing operations, net income, and related per share amounts for the postchange interim period. Reporting Accounting Changes Accounting changes made in an interim period are reported by retrospectively applying the changes to prior financial statements.

U.S. GAAP vs. IFRS LO5-7 IAS No. 34 requires that a company apply the same accounting policies in its interim financial statements as it applies in its annual financial statements. Costs for repairs, property taxes, and advertising that do not meet the definition of an asset at the end of an interim period are accrued or deferred and then charged to each of the periods they benefit. Costs for repairs, property taxes, and advertising that do not meet the definition of an asset at the end of an interim period are expensed entirely in the period in which they occur. IAS No. 34 requires that a company apply the same accounting policies in its interim financial statements as it applies in its annual financial statements. Therefore, IFRS takes much more of a discrete-period approach than does U.S. GAAP. For example, costs for repairs, property taxes, and advertising that do not meet the definition of an asset at the end of an interim period are expensed entirely in the period in which they occur under IFRS, but are accrued or deferred and then charged to each of the periods they benefit under U.S. GAAP. This difference would tend to make interim period income more volatile under IFRS than under U.S. GAAP. However, as in U.S. GAAP, income taxes are accounted for based on an estimate of the tax rate expected to apply for the entire year. This difference would tend to make an interim period income more volatile.

Appendix 5: Interim Reporting LO5-7 Minimum Disclosures Sales, income taxes, and net income Earnings per share Seasonal revenues, costs, and expenses Significant changes in estimates for income taxes Discontinued operations, extraordinary items, and unusual or infrequent items Contingencies Changes in accounting principles or estimates Information about fair value of financial instruments and the methods and assumptions used to estimate fair values Significant changes in financial position Appendix 5: Interim Reporting Complete financial statements are not required for interim reporting, but certain minimum disclosures are required as follows: sales, income taxes, and net income earnings per share seasonal revenues, costs, and expenses significant changes in estimates for income taxes discontinued operations, extraordinary items, and unusual or infrequent items contingencies changes in accounting principles or estimates information about fair value of financial instruments and the methods and assumptions used to estimate fair values significant changes in financial position.

End of Chapter 5