1. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Income Measurement and Profitability Analysis 5

2. 5-2 Learning Objectives Discuss the general objective of the timing of revenue recognition, list the two general criteria that must be satisfied before revenue can be recognized, and explain why these criteria usually are satisfied at a specific point in time.

3. 5-3 Revenue Recognition Revenue should be recognized in the period or periods that the revenue- generating activities of the company are performed.

4. 5-4 Realization Principle 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.

5. 5-5 SEC Staff Accounting Bulletin No. 101 The SEC issued Staff Accounting Bulletin No. 101 to crackdown on earnings management. The bulletin provides additional guidance to determine if 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. The SEC issued Staff Accounting Bulletin No. 101 to crackdown on earnings management. The bulletin provides additional guidance to determine if 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.

6. 5-6 Completion of the Earnings Process Within a Single Reporting Period 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 Revenue

7. 5-7 Learning Objectives Describe the installment sales and cost recovery methods of recognizing revenues for certain installment sales and explain the unusual conditions under which these methods might be used.

8. 5-8 Significant Uncertainty of Collectibility 1.Installment Sales Method 2.Cost Recovery Method 1.Installment Sales Method 2.Cost Recovery Method When uncertainties about collectibility exist, revenue recognition is delayed.

9. 5-9 Installment Sales 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.

10. 5-10 Installment Sales Method Clarke, Inc. had the following installment sales in addition to its regular sales. $45,000 ÷ $200,000 = 22.50%

11. 5-11 Installment Sales Method Clarke, Inc. had the following installment sales in addition to its regular sales. At Dec. 31, 2007, Clarke, Inc. is still owed $30,000 from the 2006 sales and $75,000 from the 2007 sales.

12. 5-12 Installment Sales Method Deferred gross profit is the difference between the selling price and the cost of the inventory.

13. 5-13 Installment Sales Method During 2005, Clarke collected $100,000 on its installment sales. This entry records the Realized Gross Profit by adjusting the Deferred Gross Profit account.

14. 5-14 Installment Sales Method During 2006, Clarke sold $250,000 on installments and collected $50,000 on its 2005 installment sales and $195,000 on its 2006 installment sales.

15. 5-15 Installment Sales Method

16. 5-16 Installment Sales Method

17. 5-17 Installment Sales Method Balance Sheet

18. 5-18 Cost Recovery Method Clarke, Inc. had the following installment sales in addition to its regular sales. The company uses the to account for installment sales. Clarke, Inc. had the following installment sales in addition to its regular sales. The company uses the cost recovery method to account for installment sales. $45,000 ÷ $200,000 = 22.50%

19. 5-19 Cost Recovery Method The following schedule shows the pattern of cash collections for the three year period. Under the cost recovery method profit is not recognized until the seller has recovered all of the cost of the goods sold.

20. 5-20 Cost Recovery Method The entries are exactly the same as under the Installment Method—EXCEPT that there is not an entry to realize gross profit. Since we have not collected cash in excess of COGS, no gross profit is recognized in 2005.

21. 5-21 Cost Recovery Method In 2006, let’s concentrate on the entries relating to 2005 sales only. Now can we recognize some profit?

22. 5-22 Cost Recovery Method Here are the entries we would make in 2007 relating to 2005 sales. We have fully recovered the $155,000 cost during 2007, so the entire deferred gross profit will be recognized.

23. 5-23 Learning Objectives Discuss the implications for revenue recognition of allowing customers the right of return.

24. 5-24 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.

25. 5-25 Learning Objectives Identify situations that call for the recognition of revenue over time and distinguish between the percentage-of-completion and completed contract methods of recognizing revenue for long-term contracts.

26. 5-26 Completion of the Earnings Process Over Multiple Reporting Periods Completed Contract Method Percentage-of- Completion Method Long-term Contracts

27. 5-27 Completed Contract Method Recognizes revenue at a point in time when the earnings process is complete

28. 5-28 Completed Contract Method Geller Construction entered into a three-year contract to build a containment vessel for Southeast Power Company for a contract price of $1,400,000. Presented below is information about the contract. Let’s see how Geller will account for the revenues and cost of this project using the completed contract method.

29. 5-29 Completed Contract Method Gross profit is not recognized until project is complete.

30. 5-30 Completed Contract Method Classified as an asset Classified as a liability

31. 5-31 Completed Contract Method Gross profit is not recognized until project is complete.

32. 5-32 Completed Contract Method

33. 5-33 Completed Contract Method Gross profit is recognized in year 3 since project is complete. Remember that the contract price was $1,400,000.

34. 5-34 Completed Contract Method Entry to transfer title to the customer.

35. 5-35 Percentage-of-Completion Method Cost incurred to date Gross profit estimate Measuring Progress Toward Completion Estimate of project’s total cost

36. 5-36 Percentage-of-Completion Method Total costs incurred to date Percent complete = Most recent estimate of total project cost Let’s look at an example.

37. 5-37 Percentage-of-Completion Method Geller Construction entered into a three-year contract to build a containment vessel for Southeast Power Company for a contract price of $1,400,000. Presented below is information about the contract. Let’s see how Geller will account for the revenues and cost of this project using the percentage-of-completion method.

38. 5-38 Percentage-of-Completion Method

39. 5-39 Percentage-of-Completion Method Contra account to CIP Entries are identical to the entries for the completed contract method.

40. 5-40 Percentage-of-Completion Method Classified as an asset Classified as a liability

41. 5-41 Percentage-of-Completion Method

42. 5-42 Percentage-of-Completion Method Closing Entry

43. 5-43 Percentage-of-Completion Method

44. 5-44 Percentage-of-Completion Method

45. 5-45 Percentage-of-Completion Method

46. 5-46 Percentage-of-Completion Method

47. 5-47 Percentage-of-Completion Method

48. 5-48 Percentage-of-Completion Method

49. 5-49 Percentage-of-Completion Method Entry to transfer title to the customer.

50. 5-50 Long-term Contract Losses Periodic Loss for Profitable Projects Determine periodic loss and record loss as a credit to the Construction in Progress account. Loss Projected for Entire Project Estimated loss is fully recognized in the first period the loss is anticipated and is recorded by a credit to Construction in Progress account.

51. 5-51 Learning Objectives Discuss the revenue recognition issues involving software and franchise sales.

52. 5-52 Software Revenue Recognition Statement of Position 97-2 If a sale includes multiple elements (software, future upgrades, postcontract customer support, etc.), the revenue should be allocated to the various elements based on the relative fair value of the individual elements. This will likely result in a portion of the proceeds received from the sale of software being deferred and recognized as revenue in future periods.

53. 5-53 Franchise Sales Source: SFAS 45 Initial Franchise Fees Generally are recognized at a point in time when the earnings process is virtually complete. Continuing Franchise Fees Recognized over time as the services are performed.

54. 5-54 Learning Objectives Identify and calculate the common ratios used to assess profitability.

55. 5-55 Receivables Turnover Ratio Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator. Net Sales Average Accounts Receivable Receivables Turnover Ratio = This ratio measures how many times a company converts its receivables into cash each year.

56. 5-56 Average Collection Period This ratio is an approximation of the number of days the average accounts receivable balance is outstanding. 365 Receivables Turnover Ratio Average Collection Period =

57. 5-57 Inventory Turnover Ratio This ratio measures the number of times merchandise inventory is sold and replaced during the year. Cost of Goods Sold Average Inventory Inventory Turnover Ratio =

58. 5-58 Average Days in Inventory This ratio indicates the number of days it normally takes to sell inventory. 365 Inventory Turnover Ratio Average Days in Inventory =

59. 5-59 Asset Turnover Ratio This ratio measures how efficiently a company utilizes all of its assets to generate revenue. Net Sales Average Total Assets Asset Turnover Ratio =

60. 5-60 Profit Margin on Sales Profit Margin on Sales Net Income Net Sales = This ratio indicates the portion of each dollar of revenue that is available to cover expenses.

61. 5-61 Return on Total Assets Return on Total Assets Net Income Average Total Assets = This ratio measures how well assets have been employed.

62. 5-62 Return on Equity Return on Equity Net Income Average Shareholders’ Equity = This ratio measures the ability of management to generate net income from the resources the owners provide.

63. 5-63 Appendix 5 Interim Reporting

64. 5-64 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.

65. 5-65 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 Share Quarterly 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.

66. 5-66 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 Significant changes in financial position

67. 5-67 End of Chapter 5