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Chapter 05 - Income Measurement and Profitability Analysis

CHAPTER 5
INCOME MEASUREMENT AND PROFITABILITY ANALYSIS

Overview
The timing of revenue recognition is critical to income measurement. Revenue affects income, and, under the matching principle, expenses are recognized in the period in which the related revenues are recognized, so revenue recognition determines the recognition of some expenses as well. The focus of this chapter is revenue recognition. We also continue our discussion of financial statement analysis.

Learning Objectives
1. 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. 2. Describe the installment sales and cost recovery methods of recognizing revenue for some types of installment sales and explain the unusual conditions under which these methods might be used. 3. Discuss the implications for revenue recognition of allowing customers the right of return. 4. 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. 5. Discuss the revenue recognition issues involving multiple-deliverable contracts, software, and franchise sales. 6. Identify and calculate the common ratios used to assess profitability. 7. Discuss the primary differences between U.S. GAAP and IFRS with respect to revenue recognition.

Lecture Outline Part A: Revenue Recognition


I. Revenue Recognition in General A. FASB definition: 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 entitys 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. (T5-1) B. The realization principle requires that two criteria be satisfied before revenue can be recognized: 1. The earnings process is judged to be complete or virtually complete. 2. There is reasonable certainty as to the collectibility of the asset to be received.

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C. Staff Accounting Bulletin No. 101 summarized the SECs views on revenue recognition. The bulletin 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 rendered. 3. The sellers price to the buyer is fixed or determinable. 4. Collectibility is reasonably assured. D. IFRS revenue recognition concepts focus on transfer of economic benefits. IFRS allows revenue to be recognized when the following conditions have been satisfied: 1. The amount of revenue and costs associated with the transaction can be measured reliably, 2. It is probable that the economic benefits associated with the transaction will flow to the seller, 3. (for sales of goods) the seller has transferred to the buyer the risks and rewards of ownership, and doesnt effectively manage or control the goods, 4. (for sales of services) the stage of completion can be measured reliably. These requirements are similar to U.S. GAAP, and revenue typically is recognized at a similar point under IFRS and U.S. GAAP. (T5-2) II. Revenue Recognition at Delivery A. While revenue usually is earned during a period of time, revenue often is recognized at one specific point in time when both revenue recognition criteria are satisfied. B. Revenue from the sale of products usually is recognized at the point of product delivery, but can be delayed past delivery if material uncertainties exist or allowed prior to delivery for long-term contracts. (T5-3, T5-4) C. Service revenue often is recognized over time, in proportion to the amount of service performed. If there is one final service that is critical to the earnings process, revenues and costs are deferred and recognized after this service has been performed. Revenue Recognition after Delivery A. Significant uncertainties about cash collection could cause a delay in recognizing revenue from the sale of a product or a service. (T5-3, T5-4) B. Installment sales 1. Revenue recognition for most installment sales takes place at the point of delivery, because reliable estimates of potential uncollectible amounts can be made. 2. When exceptional uncertainty exists, two accounting methods are available: a. The installment sales method. b. The cost recovery method. 3. The installment sales method recognizes gross profit by applying the gross profit percentage on the sale to the amount of cash actually received. (T5-5) 4. The cost recovery method defers all gross profit recognition until cash equal to the cost of the item sold has been received. (T5-6) F. Right of Return (T5-7)

III.

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1. When the right of return exists, revenue cannot be recognized at the point of delivery unless the seller is able to make reliable estimates of future returns. In most retail situations, reliable estimates can be made and revenue and costs are recognized at point of delivery. 2. Otherwise, revenue and cost recognition is delayed until the uncertainty is resolved. IV. Revenue Recognition prior to Delivery A. It often is desirable to recognize revenue over time for longterm contracts. (T5-3, T5-4) The types of companies that make use of long-term contracts are many and varied, although they are most prevalent in the construction industry. (T5-8) In these situations, there are two methods of accounting for revenue and expense recognition: 1. The completed contract method. 2. The percentage-of-completion method. C. Much of the accounting is the same under both of these methods (T5-9, T5-10) 1. All costs of construction are recorded in an asset (inventory) account called construction in progress. 2. Period billings are credited to billings on construction contract, a contra account to the construction in progress account. This serves to reduce the carrying value of the physical asset (construction in progress) when a financial asset (accounts receivable) is also recognized; otherwise the project would be double-counted on the balance sheet. 3. Construction in progress is debited for the amount of gross profit recognized. The same total amount of gross profit is recognized under the two methods the only difference is timing. (T5-10, T5-11) D. The completed contract method is equivalent to recognizing revenue at the point of delivery, that is, when the project is complete. 1. No revenues or expenses are recognized until the project is complete. (T5-10, T5-11) 2. The completed contract method does not properly portray a company's performance over the construction period and should only be used in unusual situations when forecasts of costs to complete the project are highly uncertain. E. The percentage-of-completion method allocates a fair share of a project's revenues and expenses to each reporting period during construction. How is that fair share determined? (T5-12) 1. The allocation of project profit is accomplished by estimating progress to date. 2. Progress to date (the percentage of completion) can be estimated as the proportion of the project's cost incurred to date divided by total estimated costs, by project milestones, or by relying on an engineer's or architect's estimate. The cost to cost approach is most common. 3. To determine periodic gross profit (revenues less expenses), the percentage of completion is multiplied by estimated gross profit to determine gross profit earned to date, and then the current period's gross profit is determined by subtracting from this amount the gross profit recognized in previous periods. 4. Periodic revenues are determined by multiplying the percentage of completion by the total contract price and then subtracting revenue recognized in prior periods. In most cases, the cost of construction equals the construction costs incurred during the period. (T5-13)

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F.

Balance sheet effects: Construction in progress is compared to billings on construction contract. (T5-14) 1. A debit balance indicates costs (plus profits for the percentage-of-completion method) in excess of billings and is reported as an asset. 2. A credit balance indicates billings in excess of costs (plus profits for the percentage-ofcompletion method) and is reported as a liability. G. Long-term contract losses 1. A loss could occur on a profitable project if the estimated costs to complete were underestimated in prior periods. 2. An estimated loss on a long-term contract is fully recognized in the first period that the loss is anticipated, regardless of the revenue recognition method used. (T5-15) 3. Recognized losses on long-term contracts reduce the construction in progress account. H. IFRS: IAS No. 11 governs revenue recognition for long-term construction contracts. (T5-16) 1. Like U.S. GAAP, the international standard requires the use of percentage-ofcompletion accounting when estimates can be made precisely. 2. Unlike U.S. GAAP, the international standard requires the use of the cost recovery method rather than the completed contract method when estimates cannot be made precisely enough to allow percentage-of-completion accounting. a. Under the cost recovery method, contract costs are expensed as incurred, and an exactly offsetting amount of contract revenue is recognized, such that no gross profit is recognized until all costs have been incurred. b. Under both the cost recovery and completed contract 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. V. Industry-Specific Revenue Issues A. Multiple-deliverable arrangements (T5-17) 1. If a software arrangement (sale) includes multiple elements, the revenue from the arrangement should be allocated to the various elements based on the relative fair values of the individual elements (Vendor-specific objective evidence). 2. More generally, if an arrangement contains multiple deliverables, revenue should be allocated to individual deliverables if that qualify for separate revenue recognition (e.g., they must have value on a stand-alone basis). Otherwise, revenue is delayed until completion of later deliverables. The revenue is allocated based on relative selling prices, and those prices can be estimated if they are not available. 3. IFRS: IAS No. 18 is the general revenue recognition standard in IFRS. There is not much guidance about multiple-deliverable contracts or industry-specific revenue recognition in IFRS. B. In a franchise sale, the fees to be paid by the franchisee to the franchisor usually comprise (1) the initial franchise fee, and (2) continuing franchise fees. (T5-18) 1. GAAP requires that the franchisor has substantially performed the services promised in the franchise agreement and that the collectibility of the initial franchise fee is reasonably assured before the fee can be recognized.

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2. Continuing franchise fees are paid to the franchisor for continuing rights as well as for advertising and promotion and other services over the life of the agreement and are recognized by the franchisor as revenue in the period received, which corresponds to the periods the services are performed.

Part B: Profitability Analysis


I. Activity Ratios (T5-19) A. Activity ratios measure a company's efficiency in managing its assets. B. The asset turnover ratio measures a company's efficiency in using assets to generate revenue and is calculated by dividing a company's net sales or revenues by the average total assets available for use during the period. C. The receivables turnover ratio offers an indication of how quickly a company is able to collect its accounts receivable. 1. The ratio is calculated by dividing a period's net credit sales by the average net accounts receivable. 2. An extension of this ratio is the average collection period, which is computed by dividing 365 days by the receivable turnover ratio. D. The inventory turnover ratio measures a company's efficiency in managing its investment in inventory. 1. The ratio is calculated by dividing the period's cost of goods sold by the average inventory balance. 2. An extension of this ratio is the average days in inventory, which is computed by dividing 365 days by the inventory turnover ratio. Profitability Ratios (T5-20) A. Profitability ratios assist in evaluating various aspects of a company's profit-making activities. B. The profit margin on sales measures the amount of net income achieved per sales dollar and is computed by dividing net income by net sales. C. The return on assets (ROA) indicates a company's overall profitability. 1. It is calculated by dividing net income by average total assets. 2. The return on assets can also be computed by multiplying the profit margin on sales by the asset turnover. D. The return on shareholders' equity measures the return to suppliers of equity capital. It is calculated by dividing net income by average shareholders' equity. DuPont Framework (T5-21) A. The DuPont Framework helps identify how profitability, activity, and financial leverage trade off to determine return to shareholders. In equation form, it is:

II.

III.

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Return on equity Net income Ave. total equity

= =

Profit margin Net income Total sales

X X

Asset turnover Total sales Ave. total assets

X Equity multiplier X Ave. total assets Ave. total equity

B. Because profit margin and asset turnover combine to equal return on assets, the DuPont framework can also be written as: Return on equity Net income Ave. total equity = = Return on assets Net income Ave. total assets X Equity multiplier X Ave. total assets Ave. total equity

Appendix: Interim Reporting


A. Interim reports are issued for periods of less than a year, typically as quarterly financial statements. B. With only a few exceptions, the same accounting principles applicable to annual reporting are used for interim reporting. C. Complete financial statements are not required for interim reporting, but certain minimum disclosures are required: 1. Sales, income taxes, extraordinary items, cumulative effect of accounting principle changes, and net income. 2 Earnings per share. 3 Seasonal revenues, costs, and expenses. 4. Significant changes in estimates for income taxes. 5. Discontinued operations, extraordinary items, and unusual or infrequent items. 6. Contingencies. 7. Changes in accounting principles or estimates. 8. Significant changes in financial position.

PowerPoint Slides A PowerPoint presentation of the chapter is available at the textbook website.

Teaching Transparency Masters The following can be reproduced on transparency film as they appear here, or you can use the disk version of this manual and first modify them to suit your particular needs or preferences.

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DEFINITION AND REALIZATION PRINCIPLE


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 entitys 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.

The realization principle requires that two criteria be satisfied before revenue can be recognized: The earnings process is judged complete or virtually complete (the earnings process refers to the activity or activities performed by the company to generate revenue). There is reasonable certainty as to the collectibility of the asset to be received (usually cash).
T5-1

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INTERNATIONAL FINANCIAL REPORTING STANDARDS Revenue Recognition Concepts.


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: 1. The amount of revenue and costs associated with the transaction can be measured reliably, 2. It is probable that the economic benefits associated with the transaction will flow to the seller, 3. (for sales of goods) the seller has transferred to the buyer the risks and rewards of ownership, and doesnt effectively manage or control the goods, 4. (for sales of services) the stage of completion can be measured reliably. Note: 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 (e.g., multiple-deliverable contracts). More generally, IFRS has much less industry-specific guidance that does U.S. GAAP, leading to fewer exceptions to applying these revenue recognition conditions.

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RELATION BETWEEN EARNINGS PROCESS AND REVENUE RECOGNITION METHODS

Graphic 5-2

In most situations, the revenue recognition criteria are satisfied at the point of product delivery.
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REVENUE RECOGNITION
Usually Recognize Revenue for: Nature of the Revenue Revenue Recognition Prior to Delivery, Because: Dependable estimates of progress are available. Sale of a Product Sale of a Service

Dependable estimates of progress are not available.

Each period during the earnings process (e.g., long-term construction contract) in proportion to its percentage of completion (percentage-ofcompletion method ) At the completion of the project (completed contract method )

Each period during the earnings process (e.g., rental period) in proportion to its percentage of performance.

Not applicable

Revenue Recognition at Delivery

When product is delivered and title transfers

When the key activity is performed

Revenue Recognition After Delivery, Because: Payments are significantly uncertain Reliable estimates of product returns are unavailable The product sold is out on consignment

When cash is collected (installment sales or cost recovery method) When critical event occurs that reduces product return uncertainty When the consignee sells the product to the ultimate consumer

When cash is collected

Not applicable

Not applicable

T5-4, Graphic 5-3

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INSTALLMENT SALES METHOD

The installment sales method recognizes gross profit by applying the gross profit percentage on the sale to the amount of cash actually received.

On November 1, 2011, the Belmont Corporation, a real estate developer, sold a tract of land for $800,000. The sales agreement requires the customer to make four equal annual payments of $200,000 plus interest on each November 1, beginning November 1, 2011. The land cost $560,000 to develop. The companys fiscal year ends on December 31.
Illustration 5-1

Gross Profit Recognition Date Nov. 1, 2011 Nov. 1, 2012 Nov. 1, 2013 Nov. 1, 2014 Totals Cash Collected $200,000 200,000 200,000 200,000 $800,000 Cost Recovery ($560/$800=70%) $140,000 140,000 140,000 140,000 $560,000 Gross Profit ($240/$800=30%) $ 60,000 60,000 60,000 60,000 $240,000

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INSTALLMENT SALES METHOD


(continued) Journal Entries Nov. 1, 2011 To record installment sale Installment receivables................................................... Inventory..................................................................... Deferred gross profit...................................................

800,000 560,000 240,000

Nov. 1, 2011 To record cash collection from installment sale Cash................................................................................ 200,000 Installment receivables............................................... 200,000 To recognize gross profit from installment sale Deferred gross profit....................................................... 60,000 Realized gross profit................................................... 60,000

T5-5 (continued)

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COST RECOVERY METHOD


The cost recovery method defers all gross profit recognition until cash equal to the cost of the item sold has been recovered.

On November 1, 2011, the Belmont Corporation, a real estate developer, sold a tract of land for $800,000. The sales agreement requires the customer to make four equal annual payments of $200,000 plus interest on each November 1, beginning November 1, 2011. The land cost $560,000 to develop. The companys fiscal year ends on December 31.
Illustration 5-1

Gross Profit Recognition Date Nov. 1, 2011 Nov. 1, 2012 Nov. 1, 2013 Nov. 1, 2014 Totals Cash Collected $200,000 200,000 200,000 200,000 $800,000 Cost Recovery $200,000 200,000 160,000 -0$560,000 Gross Profit $ -0-040,000 200,000 $240,000

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COST RECOVERY METHOD


(continued) Journal Entries

Nov. 1, 2011 To record installment sale Installment receivables........................................ 800,000 Inventory.......................................................... 560,000 Deferred gross profit........................................ 240,000 To record cash collection from installment sale Nov. 1, 2011, 2012, 2013, and 2014 Cash..................................................................... 200,000 Installment receivables..................................... 200,000 To recognize gross profit from installment sale Nov. 1, 2011 and 2012 No entry Nov. 1, 2013 Deferred gross profit............................................ Realized gross profit........................................ 40,000

40,000

Nov. 1, 2014 Deferred gross profit............................................ 200,000 Realized gross profit........................................ 200,000

T5-6 (continued)

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RIGHT OF RETURN
When the right of return exists, revenue cannot be recognized at the point of delivery unless the seller is able to make reliable estimates of future returns. In most retail situations, reliable estimates can be made and revenue and costs are recognized at point of delivery. Otherwise, revenue and cost recognition is delayed until the uncertainty is resolved.

Disclosure of Revenue Recognition Policy Intel Corporation Notes: Revenue Recognition The company recognizes net revenue when the earnings process is complete, as evidenced by an agreement with the customer, transfer of title and acceptance, if applicable, as well as fixed pricing and probable collectibility. Because of frequent sales price reductions and rapid technology obsolescence in the industry, sales made to distributors under agreements allowing price protection and/or right of return are deferred until the distributors sell the merchandise.
Graphic 5-6

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COMPANIES ENGAGED IN LONG-TERM CONTRACTS

Company Oracle Corp.

Type of Industry or Product Computer software, license and consulting fees Lockheed Martin Corporation Aircraft, missiles and spacecraft EDS Information technology and outsourcing Northrop Grumman Newport News Shipbuilding Nortel Networks Corp Networking solutions and services to support the Internet SBA Communications Corp Telecommunications Layne Christensen Company Water supply services and geotechnical construction Kaufman & Broad Home Corp. Commercial and residential construction Raytheon Company Defense electronics Foster Wheeler Corp. Construction, petroleum and chemical facilities Halliburton Construction, energy services Allied Construction Products Corp. Large metal stamping presses
Graphic 5-10

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COMPLETED CONTRACT AND PERCENTAGE-OFCOMPLETION METHODS: AN EXAMPLE


At the beginning of 2011, 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:
2011 Construction costs incurred during the year Construction costs incurred in prior years Cumulative construction costs Estimated costs to complete at end of year Total estimated and actual construction costs Billings made during the year Cash collections during year $1,500,000 -01,500,000 2,250,000 $3,750,000 $1,200,000 1,000,000 2012 $1,000,000 1,500,000 2,500,000 1,500,000 $4,000,000 $2,000,000 1,400,000 2013 $1,600,000 2,500,000 4,100,000 -0$4,100,000 $1,800,000 2,600,000

Illustration 52

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JOURNAL ENTRIES
2011 BOTH METHODS: Construction in progress Cash, materials, etc. To record construction costs. Accounts receivable Billings on construction contract To record progress billings. Cash Accounts receivable To record cash collections. COMPLETED CONTRACT: Construction in progress (gross profit) Cost of construction Revenue from long-term contracts To record gross profit. Billings on construction contract Construction in progress To close accounts. 2012 2013 1,500,000 1,000,000 1,600,000 1,500,000 1,000,000 1,600,000 1,200,000 2,000,000 1,800,000 1,200,000 2,000,000 1,800,000 1,000,000 1,400,000 2,600,000 1,000,000 1,400,000 2,600,000

900,000 4,100,000 5,000,000 5,000,000 5,000,000

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 To record gross profit. Billings on construction contract Construction in progress To close accounts. 5,000,000 5,000,000

Illustrations 5-2a-c

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A COMPARISON OF THE TWO METHODS INCOME RECOGNITION


Percentage-ofCompletion Gross profit recognized: 2011 2012 2013 Total gross profit $500,000 125,000 275,000 $900,000 Completed Contract -0-0$900,000 $900,000

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CALCULATING GROSS PROFIT UNDER THE PERCENTAGE-OF-COMPLETION METHOD


2011 2012 2013

Contract price Construction costs: Construction costs incurred during the year Construction costs incurred in prior years Cumulative construction costs to date Estimated costs to complete at end of year Total estimated and actual construction costs Total gross profit (estimated for 2011 & 2012, actual in 2013): Contract price minus total estimated and actual costs Multiplied by: Percentage-of-completion: Actual costs to date divided by the estimated total project cost Equals: Gross profit earned to date Minus: Gross profit recognized in prior periods Equals: Gross profit recognized in current period

$5,000,000 $1,500,000 -0$1,500,000 2,250,000 $3,750,000

$5,000,000 $1,000,000 1,500,000 $2,500,000 1,500,000 $4,000,000

$5,000,000 $1,600,000 2,500,000 $4,100,000 -0$4,100,000

$1,250,000 X $1,500,000 $3,750,000 = 40% _________ $ 500,000

$1,000,000 X $2,500,000 $4,000,000 = 62.5% __________ $ 625,000

$900,000 X $4,100,000 $4,100,000 = 100% _________ $ 900,000

- 0_________ $ 500,000 (500,000) __________ $ 125,000

(625,000) _________ $ 275,000

Illustration 5-2d

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REVENUE AND COST OF CONSTRUCTION: PERCENTAGE-OF-COMPLETION METHOD


2011 Revenue recognized in 2011 ($5,000,000 x 40%) Cost of construction Gross profit 2012 Revenue recognized to date ($5,000,000 x 62.5%) Less: Revenue recognized in 2011 Revenue recognized in 2012 Cost of construction Gross profit 2011 Revenue recognized to date ($5,000,000 x 100%) Less: Revenue recognized in 2011 and 2012 Revenue recognized in 2013 Cost of construction Gross profit $3,125,000 (2,000,000) $1,125,000 1,000,000 $ 125,000 $5,000,000 (3,125,000) $1,875,000 1,600,000 $ 275,000
Illustration 5-2e

$2,000,000 1,500,000 $ 500,000

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BALANCE SHEET PRESENTATION


Balance Sheet (End of year) 2011 Percentage-of-completion: Current assets: Accounts receivable Costs and profit ($2,000,000) in excess of billings ($1,200,000) Current liabilities: Billings ($3,200,000) in excess of costs and profit ($3,125,000) Completed contract: Current assets: Accounts receivable Costs ($1,500,000) in excess of billings ($1,200,000) Current liabilities: Billings ($3,200,000) in excess of costs ($2,500,000) $ 200,000 800,000 2012 $800,000 75,000

$ 200,000 300,000

$800,000 700,000 Illustration 5-2f

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LONG-TERM CONTRACT LOSSES


An estimated loss on a long-term contract is fully recognized in the first period that the loss is anticipated, regardless of the revenue recognition method used.
2011 Construction costs incurred during the year Construction costs incurred in prior years Cumulative construction costs Estimated costs to complete at end of year Total estimated and actual construction costs $1,500,000 -01,500,000 2,250,000 $3,750,000 2012 $1,260,000 $1,500,000 2,760,000 2,340,000 $5,100,000 2013 $2,440,000 $2,760,000 5,200,000 -0$5,200,000

Comparison of Periodic Gross Profit (Loss) Percentage-ofcompletion Gross profit (loss) recognized: 2011 2012 2013 Total project loss $500,000 (600,000) (100,000) $(200,000)

Completed Contract -0$(100,000) (100,000) $(200,000)

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INTERNATIONAL FINANCIAL REPORTING STANDARDS Long-Term Construction Contracts.


IAS No. 11 governs revenue recognition for long-term construction contracts. Like U.S. GAAP, IAS No. 11 requires use of percentage-of-completion accounting when estimates can be made precisely. Unlike U.S. GAAP, IAS No. 11 requires use of the cost recovery method rather than the completed contract method when estimates cannot be made precisely enough to allow percentage-of-completion accounting. Under the cost recovery method, contract costs are expensed as incurred, and an exactly offsetting amount of contract revenue is recognized, such that no gross profit is recognized until all costs have been incurred. Under both the cost recovery and completed contract 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.

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SOFTWARE AND OTHER MULTIPLEDELIVERABLE ARRANGEMENTS


If a software arrangement (sale) includes multiple elements, the revenue from the arrangement should be allocated to the various elements based on VSOE (vendor-specific objective evidence) of the individual elements. More generally, for multiple-deliverable arrangements, revenue should be allocated to individual deliverables that qualify for separate revenue recognition. Otherwise, revenue is delayed until completion of later deliverables. Revenue is allocated according to the deliverables relative selling prices. These can be estimated if items arent sold separately.
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FRANCHISE SALES
On March 31, 2011, the Red Hot Chicken Wing Corporation entered into a franchise agreement with Thomas Keller. In exchange for an initial franchise fee of $50,000, Red Hot will provide initial services to include the selection of a location, construction of the building, training of employees, and consulting services over several years. $10,000 is payable on March 31, 2011, with the remaining $40,000 payable in annual installments which include interest at an appropriate rate. In addition, the franchisee will pay continuing franchise fees of $1,000 per month for advertising and promotion provided by Red Hot, beginning immediately after the franchise begins operations. Thomas Keller opened his Red Hot franchise for business on September 30, 2011.

Initial Franchise Fee


March 31, 2011 To record franchise agreement and down payment Cash................................................................................ 10,000 Note receivable............................................................... 40,000 Unearned franchise fee revenue.................................. 50,000 Sept. 30, 2011 To recognize franchise fee revenue Unearned franchise fee revenue...................................... Franchise fee revenue................................................. 50,000 50,000

Continuing Franchise Fees


To recognize continuing franchise fee revenue Cash (or accounts receivable)......................................... 1,000 Service revenue........................................................... 1,000

Illustration 5-3

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ACTIVITY RATIOS
Activity ratios measure a company's efficiency in managing its assets.
= Net sales Average total assets Net sales Average accounts receivable (net) 365 Receivables turnover ratio Cost of goods sold Average Inventory 365 Inventory turnover ratio

Asset turnover ratio

Receivables turnover ratio

Average collection period

Inventory turnover ratio

Average days in inventory =

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PROFITABILITY RATIOS
Profitability ratios assist in evaluating various aspects of a company's profit-making activities.
= Net income Net sales Net income Average total assets

Profit margin on sales

Return on assets

Return on shareholders' equity

Net income Average shareholders' equity

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DUPONT FRAMEWORK
The DuPont Framework helps identify how profitability, activity, and financial leverage trade off to determine return to shareholders:
Return on equity Net income Avg. total equity = Profit margin Asset turnover X Total sales Avg. total assets X Equity multiplier

Net income = Total sales X

Avg. total assets X Avg. total equity

Because profit margin and asset turnover combine to equal return on assets, the DuPont framework can also be written as:
Return on equity Net income Avg. total equity = = Return on assets Net income Avg. total assets X Equity multiplier

Avg. total assets X Avg. total equity

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Chapter 05 - Income Measurement and Profitability Analysis

Suggestions for Class Activities 1. Real World Scenario


The following is an excerpt from an article that appeared in the August 25, 2002 edition of The Seattle Times: When Cutter & Buck revealed two weeks ago that it padded sales figures in 2000 by recording $5.8 million in shipments that were mostly returned, the news came as a surprise to many investors. But it wasnt the first time the Seattle sportswear retailers shipping and accounting practices have been called into question. Shortly before co-founder Joey Rodolfo left in 1997, he accused the company of shipping orders months before customers were expecting them, a method of prematurely booking sales. Some customers and former employees say early shipments persisted for years after Rodolfo raised the issue. And late last week, Chief Executive Fran Conley said an internal investigation has found that early shipments were more extensive than I had known and may force the company to further restate sales figures. Shipping and booking orders ahead of schedule to meet short-term sales goals a practice sometimes called channel stuffing is not, by definition, illegal. But by essentially borrowing from future sales to claim bigger current sales and profit, it can be used to boost a companys bottom line and create a misleading appearance of growth for investors. Suggestions: This article provides a good way to introduce the topic of channel stuffing . When a company stuffs the channel, it ships inventory ahead of schedule filling its distribution channels with more product than is needed. Since companies often record sales as soon as they ship products, channel stuffing can make it appear that business is booming. Is this practice legal? Is it an acceptable practice according to GAAP? Is it an ethical practice? Points to note: Channel stuffing is not an uncommon practice. There are many examples you can find for your students. A text case references the Sunbeam incident that occurred in the late 90s. More recent examples include Microsoft, Novell, Network Associates, and AOL. GAAP do not address channel stuffing specifically. The key is whether or not the practice leads to excessive future sales returns that are not adequately provided for by the seller. There may be an issue with respect to the legality of the practice if it can be shown that the practice resulted in misleading information to the investing public. And there are ethical dimensions to the practice as well.

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Chapter 05 - Income Measurement and Profitability Analysis

2.

Research Activity

Probably most of your students have purchased merchandise via the Internet. You can buy the products of many companies on line. Some of these companies, such as Amazon.com, often act merely as intermediaries between the manufacturer and the consumer. Revenue recognition for this type of transaction has been controversial. If Amazon sells something to a customer for $100 that costs $80, the profit on the transaction is clearly $20. But should Amazon recognize $100 in revenue and $80 in cost of goods sold (the gross method), or should it recognize only the $20 in gross profit (the net method)? Suggestions: Discuss with your class the implications of one reporting method versus the other. Why should it make a difference? What factors might dictate whether or not Amazon should recognize the transaction gross versus net? Have them access Amazons most recent financial statements using Edgar (at http://www.sec.gov/edgar.shtml). Or, you can show them Amazons disclosure note and discuss the contents of the note. The following is a portion of the companys revenue recognition disclosure note that appeared in its 2008 financial statements: We recognize revenue from product sales or services rendered when the following four revenue recognition criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the selling price is fixed or determinable, and collectibility is reasonably assured. Additionally, revenue arrangements with multiple deliverables are divided into separate units of accounting if the deliverables in the arrangement meet the following criteria: the delivered item has value to the customer on a standalone basis; there is objective and reliable evidence of the fair value of undelivered items; and delivery of any undelivered item is probable. We evaluate the criteria outlined in Emerging Issues Task Force (EITF) Issue No. 99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent, in determining whether it is appropriate to record the gross amount of product sales and related costs or the net amount earned as commissions. Generally, when we are primarily obligated in a transaction, are subject to inventory risk, have latitude in establishing prices and selecting suppliers, or have several but not all of these indicators, revenue is recorded gross. If we are not primarily obligated and amounts earned are determined using a fixed percentage, a fixed-payment schedule, or a combination of the two, we generally record the net amounts as commissions earned.

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Chapter 05 - Income Measurement and Profitability Analysis

3.

Google Analysis

Have students, individually or in groups, go to the most recent Google annual report using Edgar which can be located at: http://www.sec.gov/edgar.shtml. Ask them to: 1. Compute the receivables turnover ratio, the profit margin on sales, the return on assets ratio, and the return on shareholders' equity ratio for the most three years. Are there any discernible trends? How might they be interpreted? 2. Read the "Revenues" section of "Management's Discussion and Analysis of Results of Operations and Financial Condition." Has there been any significant shift over the last three years in the company's service revenue mix? 3. Use Edgar to locate the most recent annual report information for Yahoo, Googles competitor. Using the most recent annual report information for both companies, compare the receivables turnover ratio, the profit margin on sales, the return on assets ratio, and the return on shareholders' equity ratio. Are there any differences in the way the companies recognize revenue? 4. Note: another peer comparison of this nature is Federal Express vs. United Parcel Service.

4.

Professional Skills Development Activities


The following are suggested assignments from the end-of-chapter material that will help your students develop their communication, research, analysis and judgment skills.

Communication Skills. In addition to Communication Case 5-15, Judgment Case 5-14 can be adapted to ask students to choose one of the two alternatives and write a memo supporting their position. Communication Case 5-5, Judgment Case 5-4, and IFRS Case 5-17 do well as group assignments. Research Case 5-6 and Ethics Case 5-8 create good class discussions. Problem 512 and Analysis Case 5-21 are suitable for student presentation(s). Research Skills. In their careers, our graduates will be required to locate and extract relevant information from available resource material to determine the correct accounting practice, perhaps identifying the appropriate authoritative literature to support a decision. Research Cases 5-11, 5-12 and 5-13 provides an excellent opportunity to help students develop this skill. Analysis Skills. The Broaden Your Perspective section includes Analysis Cases that direct students to gather, assemble, organize, process, or interpret data to provide options for making business and investment decisions. In addition to Analysis Case 5-21; Exercises 5-20, 5-21, and 5-22; Problems 5-11, 5-12, 5-13, and 5-14, and Judgment Case 5-17 also provide opportunities to develop and sharpen analytical skills.

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Chapter 05 - Income Measurement and Profitability Analysis

Judgment Skills. The Broaden Your Perspective section includes Judgment Cases that require students to critically analyze issues to apply concepts learned to business situations in order to evaluate options for decision-making and provide an appropriate conclusion. In addition to Judgment Cases 5-2, 5-3, 5-4, 5-9, 5-10, 5-13, 5-14, and 5-22 Real World Case 5-1 also requires students to exercise judgment.

5.

Ethical Dilemma
The chapter contains the following ethical dilemma:

ETHICAL DILEMMA
The Precision Parts Corporation manufactures automobile parts. The company has reported a profit every year since the companys inception in 1977. Management prides itself on this accomplishment and believes one important contributing factor is the companys incentive plan that rewards top management a bonus equal to a percentage of operating income if the operating income goal for the year is achieved. However, 2011 has been a tough year, and prospects for attaining the income goal for the year are bleak. Tony Smith, the companys chief financial officer, has determined a way to increase December sales by an amount sufficient to boost operating income over the goal for the year and earn bonuses for all top management. A reputable customer ordered $120,000 of parts to be shipped on January 15, 2012. Tony told the rest of top management I know we can get that order ready by December 31 even though it will require some production line overtime. We can then just leave the order on the loading dock until shipment. I see nothing wrong with recognizing the sale in 2011, since the parts will have been manufactured and we do have a firm order from a reputable customer. The companys normal procedure is to ship goods f.o.b. destination and to recognize sales revenue when the customer receives the parts.

You may wish to discuss this in class. If so, discussion should include these elements. Step 1The Facts: Precision Parts Corporation has reported profits since its inception and given top management bonuses when the operating income goal is achieved. In 2011, however, the company does not expect to achieve its profit goal. Tony Smith, the CFO, wants to record a sale in 2011 that will not be shipped until January 2012, so that management will receive bonuses for achieving the profit goal. The CFO is attempting to manipulate the recognition of revenue. The company's normal procedure is to recognize sales revenue when goods are shipped f.o.b. destination. Although sales revenue may be recognized when production ends if certainty of collection exists, nothing in the case indicates that there is reasonable certainty as to the collectibility of the revenue at the end of production.

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Chapter 05 - Income Measurement and Profitability Analysis

Step 2The Ethical Issue and the Stakeholders: The ethical issue or dilemma is whether Tony Smith's obligation to top management to show a profit is greater than his obligation to provide information that is not misleading to users of financial statements. Stakeholders include Tony Smith, CFO, other corporate managers, auditors, present and future creditors, and current and future investors. Step 3Values: Values include competence, honesty, integrity, objectivity, loyalty to the company, and responsibility to users of financial statements. Step 4Alternatives: 1. Record the parts sales revenue in 2011. 2. Record the parts sales revenue in 2012, when the goods are shipped. Step 5Evaluation of Alternatives in Terms of Values: 1. Alternative 1 illustrates loyalty to the company and other top managers. 2. Alternative 2 exhibits the values of competence, honesty, integrity, objectivity, and responsibility to users of the financial statements. Step 6Consequences: Alternative 1 Positive consequences: Tony would enable other top managers to receive bonuses and permit the company to meet their operating income goal. Negative consequences: Users of the financial statements would be misinformed. Users of financial statements may sue the company upon learning the truth if the amount of revenue is material and affects their financial decisions. Auditors may refuse to give a positive opinion on the fair presentation of the financial statements. Tony may lose the respect of the rest of top management and his job. Alternative 2 Positive consequences: Users of financial statements would receive more relevant and reliable reported revenue. Tony would maintain his integrity. He may receive praise for being honest and keep his job. Negative consequences: Tony may incur the disfavor of the rest of top management for not enabling others to receive a bonus. He may lose the trust of other managers and lose his job. Step 7Decision: Student(s) must decide their course of action.

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Chapter 05 - Income Measurement and Profitability Analysis

Assignment Chart
Questions
5-1 5-2 5-3 5-4 5-5 5-6 5-7 5-8 5-9 5-10 5-11 5-12 5-13 5-14 5-15 5-16 5-17 5-18 5-19 Learning Objective(s) 1 1 2 2 2 3 1 4 4 4,7 4 4 5 5,7 5 6 6 6 1 Learning Objective(s) 1 2 2 2 3 4 4 4 4,7 4 5 5,7 5 6 6 6 6 Est. time Topic (min.) Revenue recognition criteria 5 Revenue recognition at point of delivery 5 Installment sales 5 Installment sales and cost recovery methods 5 Deferred gross profitinstallment sales method 5 Right of return 5 Consignment sale 5 Service revenue 5 Percentage-of-completion and completed contract methods 5 IFRS; cost recovery method for long-term contracts 5 Billings on construction contract 5 Estimated loss on construction project 5 Software sales 5 IFRS; multiple-deliverable arrangements 5 Franchise fee revenue recognition 5 Activity ratios 5 Profitability ratios 5 DuPont framework 5 Interim reports [based on Appendix] 5 Est. time (min.) 5 10 10 10 5 10 10 5 10 10 10 10 5 5 10 10 10

Brief Exercises
5-1 5-2 5-3 5-4 5-5 5-6 5-7 5-8 5-9 5-10 5-11 5-12 5-13 5-14 5-15 5-16 5-17

Topic Point of delivery recognition Installment sales method Cost recovery method Installment sales method Right of return Percentage-of-completion method; profit recognition Percentage-of-completion method; balance sheet Completed contract method IFRS; cost recovery method for long-term contracts Long-term contract accounting; loss on entire project Multiple-deliverable contracts IFRS; multiple deliverable contracts Franchise sales Turnover ratios Profitability ratios DuPont framework Inventory turnover ratio

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Chapter 05 - Income Measurement and Profitability Analysis

Exercises
5-1 5-2 5-3 5-4 5-5 5-6 5-7 5-8 5-9 5-10 5-11 5-12 5-13 5-14 5-15 5-16 5-17 5-18 5-19 5-20 5-21 5-22 5-23 5-24 5-25 5-26 5-27 5-28

Learning Objective(s) 1 2 2 2 1,2 2 2 1,2 4 4,7 4 4 4 4 5 5 5,7 5 2,3,4,5,6 6 6 6 6 1 1 1 4 2,3,4

Topic Service revenue Installment sales method Installment sales method; journal entries Installment sales; alternative recognition methods Journal entries; point of delivery, installment sales, and cost recovery methods Installment sales and cost recovery methods; solve for unknowns Installment sales method and repossession.

Est. time (min.) 15 20 15 15 25 10 20 15 20 30 30 20 50 25 10 15 15 10 15 10 10 10 10 10 10 10 10 15

Real estate sales; gain recognition Percentage-of-completion and completed contract methods IFRS; long-term contract; percentage of completion and completed contract methods Percentage-of-completion method; loss projected on entire project Completed contract method; loss projected on entire project Income (loss) recognition; percentage-of-completion and completed contract methods compared Percentage-of-completion method; solve for unknowns Revenue recognition; software Revenue recognition; Multiple-deliverable contracts IFRS; multiple-deliverable contracts Revenue recognition; franchise sales Concepts; terminology Inventory turnover; calculation and evaluation Evaluating efficiency of asset management Profitability ratios DuPont framework Interim financial statements; income tax expense [based on Appendix] Interim reporting; recognizing expenses [based on Appendix] Interim financial statements; reporting expenses [based on Appendix] Percentage-of-completion, codification Percentage-of-completion, installment, and cost-recovery methods, right of return, codification

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Chapter 05 - Income Measurement and Profitability Analysis

CPA Review Questions


5-1 5-2 5-3 5-4 5-5 5-6

Learning Objective(s) 1 2 2 4 4 4 Learning Objective(s) 1 4 4 Learning Objective(s) 2 2 2 2 4 4 4,7 4 4 2,5 6 6 6 6 1

Topic Revenue recognition upon delivery Installment sales method Installment sales method Percentage-of-completion method Percentage-of-completion method Percentage-of-completion method

Est. time (min.) 3 3 3 2 3 3 Est. time (min.) 3 3 3

CMA Review Questions


5-1 5-2 5-3

Topic Revenue recognition upon delivery and bad debts Percentage-of-completion method Percentage-of-completion method

Problems
5-1 5-2 5-3 5-4 5-5 5-6 5-7 5-8 5-9 5-10 5-11 5-12 5-13 5-14 5-15

Est. time Topic (min.) Income statement presentation; installment sales method 25 [Chapters 4 and 5] Installment sales and cost recovery methods 30 Installment sales; alternative recognition methods 30 Installment sales and cost recovery methods, multiple 30 years Percentage-of-completion method 45 Completed contract method 40 IFRS; Construction accounting 40 Construction accounting; loss projected on entire project 25 Percentage-of-completion and completed contract methods 45 Franchise sales, installment sales method 25 Calculating activity and profitability ratios 20 Use of ratios to compare two companies in the same 40 industry; Johnson and Johnson, Pfizer Creating a balance sheet from ratios; chapters 3 and 5 50 Use of ratios to compare two companies in the same 40 industry; chapters 3 and 5 Interim financial reporting [based on Appendix] 15

Star Problems

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Chapter 05 - Income Measurement and Profitability Analysis

Real World Case 5-1 Judgment Case 5-2 Judgment Case 5-3 Judgment Case 5-4 Communication Case 5-5 Research Case 5-6 Research Case 5-7 Ethics Case 5-8 Judgment Case 5-9 Judgment Case 5-10 Research Case 5-11 Research Case 5-12 Judgment Case 5-13 Judgment Case 5-14 Communication Case 5-15 IFRS Case 5-16 IFRS Case 5-17 Trueblood Accounting Case 5-18 Trueblood Accounting Case 5-19 Real World Case 5-20 Analysis Case 5-21 Judgment Case 5-22 Integrating Case 5-23

Cases

Learning Objective(s) 1 1 1 1 1 4 1 1 1,2 1 3 1 1,4 4 4 1,4,7 4,7 1 5 5 6 6 6 7

Est. time Topic (min.) Revenue recognition and earnings management; Sunbeam 20 Revenue recognition 15 Revenue recognition for initial and monthly fees 15 Revenue recognition; trade-ins 20 Revenue recognition 20 Long-term contract accounting 45 Earnings management techniques for revenues 30 Revenue recognition 15 Revenue recognition ; installment sales 20 Revenue recognition; SAB 101 questions, codification 20 Revenue recognition; right of return; Hewlett Packard , 45 Advanced Micro Devices, codification Earnings management: gross vs. net and EITF 99-19; 30 Google, codification Revenue recognition, service sales 15 Revenue recognition; long-term construction contracts 15 Percentage-of-completion and completed contract methods 50 IFRS; Comparison of revenue recognition in Sweden and 15 the U.S.A.; Vodafone IFRS; Construction accounting 30 Revenue recognition for a license agreement 60 Revenue recognition for multiple-element contracts 45 Revenue recognition; franchise sales; Jack in the Box 50 Evaluating profitability and asset management 60 Relationships among ratios, chapters 3 and 5 30 Using ratios, chapters 3 and 5 45 IFRS, Multiple-deliverable contracts; British Airways Installment sales method; percentage-of-completion method, franchise sales; research 30

British Airways Case


CPA Simulation 5-1

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