Chapter 5

Income Measurement and Profitability Analysis

QUESTIONS FOR REVIEW OF KEY TOPICS

Question 5-1
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 (usually cash).

Question 5-2
At the time production is completed, there usually exists significant uncertainty as to the collectibility of the asset to be received. We dont know if the product will be sold, nor the selling price, nor the buyer if eventually the product is sold. Because of these uncertainties, revenue recognition usually is delayed until the point of product delivery.

Question 5-3
If the installment sale creates a situation where there is significant uncertainty concerning cash collection and it is not possible to make an accurate assessment of future bad debts, revenue and cost recognition should be delayed beyond the point of delivery.

Question 5-4
The installment sales method recognizes gross profit by applying the gross profit percentage on the sale to the amount of cash actually received each period. The cost recovery method defers all gross profit recognition until cash has been received equal to the cost of the item sold.

Question 5-5
Deferred gross profit is a contra installment receivable account. The balance in this account is subtracted from gross installment receivables to arrive at installment receivables, net. The net amount of the receivables represents the portion of remaining payments that represent cost recovery.

Question 5-6
Because the return of merchandise can retroactively negate the benefits of having made a sale, the seller must meet certain 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 certain situations, these criteria are not satisfied at the point of delivery of the product.

Answers to Questions (continued) Question 5-7

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
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retains legal title. If the consignee cant 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 revenue (and related costs) until the consignee sells the goods and title passes to the eventual customer.

Question 5-8
For service revenue, 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. On the other hand, in many instances, service revenue activities occur over extended periods and recognizing revenue at any single date within that period would be inappropriate. Instead, its more meaningful to recognize revenue over time in proportion to the performance of the activity.

Question 5-9
The completed contract method of recognizing revenues and costs on long-term construction contracts is equivalent to recognizing revenue at point of delivery, i.e., when the construction project is complete. The percentage-of-completion method assigns a fair share of the projects expected revenues and costs to each period in which the earnings process takes place, i.e., the construction period. The fair share means the project's costs incurred each period as a percentage of the project's total estimated costs. The completed contract method should only be used when the lack of dependable estimates or inherent hazards cause forecasts of future costs to be doubtful.

Question 5-10
The billings on construction contract account is a contra account to the asset, construction in progress. At the end of each reporting period, the balances in these two accounts are compared. If the net amount is a debit, it is reported on the balance sheet as an asset. Conversely, if the net amount is a credit, it is reported as a liability.

Question 5-11
An estimated loss on a long-term contract must be fully recognized in the first period the loss is anticipated, regardless of the revenue recognition method used.

Question 5-12
These SOPs require that if an arrangement 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, regardless of any separate prices stated within the contract for each element.

Answers to Questions (continued) Question 5-13

Specific guidelines for revenue recognition of the initial franchise fee are provided by SFAS 45. A key to these guidelines is the concept of substantial performance. It requires that substantially all of the initial services of the franchisor required by the franchise agreement have been performed before the initial franchise fee can be recognized as revenue. The term substantial requires professional judgment
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on the part of the accountant. In situations when the initial franchise fee is collectible in installments, even after substantial performance has occurred, the installment sales or cost recovery method should be used for profit recognition, if a reasonable estimate of uncollectibility cannot be made.

Question 5-14
Receivables turnover ratio Inventory turnover ratio Asset turnover ratio = = = Net sales Average accounts receivable (net) Cost of goods sold Average inventory Net sales Average total assets

Activity ratios are designed to provide information about a companys effectiveness in managing assets. Activity or turnover of certain assets measures the frequency with which those assets are replaced. The greater the number of times an asset turns over, the less cash a company must devote to that asset, and the more cash it can commit to other purposes.

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Answers to Questions (concluded) Question 5-15

Profit margin on sales Return on assets Return on shareholders' equity = = = Net income Net sales Net income Average total assets Net income Average shareholders' equity

A fundamental element of an analysts task is to develop an understanding of a firms profitability. Profitability ratios provide information about a companys ability to earn an adequate return relative to sales or resources devoted to operations. Resources devoted to operations can be defined as total assets or only those assets provided by owners, depending on the evaluation objective.

Question 5-16
These perspectives are referred to as the discrete and integral part approaches. Current interim reporting requirements and existing practice generally view interim reports as integral parts of annual statements. However, the discrete approach is applied to some items. Most revenues and expenses are recognized in interim periods as incurred. However, if an expenditure clearly benefits more than just the period in which it is incurred, the expense should be spread among the periods benefited. Examples include annual repair expenses, property tax expense, and advertising expenses incurred in one quarter that clearly benefit later quarters. These are assigned to each quarter through the use of accruals and deferrals. On the other hand, major events such as discontinued operations, extraordinary items, and unusual or infrequent items should be reported separately in the interim period in which they occur.

Exercise 5-1
Requirement 1 2003 Cost recovery % : $216,000 = 60% (gross profit % = 40%) $360,000 2004 Cost recovery %: $245,000 = 70% (gross profit % = 30%) $350,000 2003 gross profit:
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Cash collection from 2003 sales = $150,000 x 40% 2004 gross profit: Cash collection from 2003 sales = $100,000 x 40% Cash collection from 2004 sales = $120,000 x 30% Total 2004 gross profit

= = =

$60,000 $ 40,000 36,000 $76,000

Requirement 2 2003 deferred gross profit balance: 2003 initial gross profit ($360,000 - 216,000) Less: Gross profit recognized in 2003 Balance in deferred gross profit account 2004 deferred gross profit balance: 2003 initial gross profit ($360,000 - 216,000) Less: Gross profit recognized in 2003 Gross profit recognized in 2004 2004 initial gross profit ($350,000 - 245,000) Less: Gross profit recognized in 2004 Balance in deferred gross profit account

$144,000 (60,000) $84,000 $ 144,000 (60,000) (40,000) 105,000 (36,000) $113,000

Exercise 5-2
2003 To record installment sales Installment receivables .................................................................. Inventory ................................................................................... Deferred gross profit .................................................................

360,000 216,000 144,000

2003 To record cash collections from installment sales Cash ............................................................................................... 150,000 Installment receivables ............................................................. 2003 To recognize gross profit from installment sales Deferred gross profit...................................................................... 60,000 Realized gross profit .................................................................

150,000

60,000

2004 To record installment sales Installment receivables .................................................................. Inventory ................................................................................... Deferred gross profit ................................................................. 2004

350,000 245,000 105,000

To record cash collections from installment sales

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Installment receivables ............................................................. Cash ...............................................................................................

220,000

220,000

2004 To recognize gross profit from installment sales Deferred gross profit...................................................................... 76,000 Realized gross profit .................................................................

76,000

Exercise 5-7
Requirement 1 Contract price Actual costs to date Estimated costs to complete Total estimated costs Gross profit (estimated in 2003) 2003 $2,000,000 300,000 1,200,000 1,500,000 $ 500,000 2004 $2,000,000 1,875,000 -01,875,000 $ 125,000

Gross profit recognition: 2003: $ 300,000 = 20% x $500,000 = $100,000 $1,500,000 2004: Requirement 2 2003 2004 Requirement 3 Balance Sheet At December 31, 2003 Current assets: Accounts receivable Costs and profit ($400,000*) in excess of billings ($360,000) * Costs ($300,000) + profit ($100,000) $ 110,000 40,000 $125,000 - $100,000 = $25,000 $ -0$125,000

Exercise 5-7 (concluded)

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Requirement 4 Balance Sheet At December 31, 2003 Current assets: Accounts receivable Current liabilities: Billings ($360,000) in excess of costs ($300,000) $ 110,000 $ 60,000

Exercise 5-8
Requirement 1 Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (loss) (actual in 2005) Gross profit (loss) recognition: 2003: $2,000,000 = 33.3333% x $2,000,000 = $666,667 $6,000,000 2004: $(100,000) - 666,667 = $(766,667) 2003 $8,000,000 2,000,000 4,000,000 6,000,000 $2,000,000 2004 $8,000,000 4,500,000 3,600,000 8,100,000 $ (100,000) 2005 $8,000,000 8,300,000 -08,300,000 $ (300,000)

2005: $(300,000) - (100,000) = $(200,000)

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Exercise 5-8 (continued) Requirement 2 Construction in progress Various accounts To record construction costs. Accounts receivable Billings on construction contract To record progress billings. Cash Accounts receivable To record cash collections. Construction in progress (gross profit) Cost of construction Revenue from long-term contracts (33.3333% x $8,000,000) To record gross profit. Cost of construction (2) Revenue from long-term contracts Construction in progress (loss) To record expected loss. 2003 2004 2,000,000 2,500,000 2,000,000 2,500,000 2,500,000 2,500,000 2,250,000 2,250,000 2,475,000 2,475,000 2,750,000 2,750,000

666,667 2,000,000 2,666,667 2,544,000 (1) 1,777,333 766,667

(1) and (2): Percent complete = $4,500,000 $8,100,000 = 55.55% Revenue recognized to date: 55.55% x $8,000,000 = Less: Revenue recognized in 2003 (above) Revenue recognized in 2004 Plus: Loss recognized in 2004 (above) Cost of construction, 2004

$4,444,000 (2,666,667) 1,777,333 (1) 766,667 $2,544,000 (2)

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Exercise 5-8 (concluded) Requirement 3 Balance Sheet Current assets: Accounts receivable Costs and profit ($2,666,667*) in excess of billings ($2,500,000) Current liabilities: Billings ($5,250,000) in excess of costs less loss ($4,400,000) * Costs ($2,000,000) + profit ($666,667) 2003 $250,000 166,667 2004 $525,000

$850,000

Exercise 5-12
Requirement 1 Revenue should be recognized as follows: Software date of shipment, July 1, 2003 Technical support evenly over the 12 months of the agreement Upgrade date of shipment, January 1, 2004 The amounts are determined by an allocation of total contract price in proportion to the individual fair values of the components if sold separately: Software Technical support Upgrade Total Requirement 2 $210,000 $270,000 x $243,000 $30,000 $270,000 x $243,000 $30,000 $270,000 x $243,000 = = = $189,000 27,000 27,000 $243,000

July 1, 2003 To record sale of software Cash ............................................................................................... Revenue..................................................................................... Unearned revenue ($27,000 + 27,000) .....................................

243,000 189,000 54,000

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Exercise 5-15
List A h d g a b i c k l m f j e a. b. cost. 3. Return on shareholders' equity c. 4. Profit margin on sales d. 5. Cost recovery method e. 6. 7. 8. 9. 10. 11. 12. 13. Percentage-of-completion method f. Completed contract method g. Asset turnover h. Receivables turnover i. Right of return j. Billings on construction contract k. Installment sales method l. Consignment sales m. 1. Inventory turnover 2. Return on assets List B Net income divided by net sales. Defers recognition until cash collected equals Defers recognition until project is complete. Net income divided by assets. Risks and rewards of ownership retained by seller. Contra account to construction in progress. Net income divided by shareholders' equity. Cost of goods sold divided by inventory. Recognition is in proportion to work completed. Recognition is in proportion to cash received. Net sales divided by assets. Net sales divided by accounts receivable. Could cause the deferral of revenue recognition beyond delivery point.

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Exercise 5-17
Turnover ratios for Anderson Medical Supply Company for 2003: Inventory turnover ratio = = Receivables turnover ratio = = Average collection period = = Asset turnover ratio = = $4,800,000 [$900,000 + 700,000] 2 6 times $8,000,000 [$700,000 + 500,000] 2 13.33 times 365 13.33 27.4 days $8,000,000 [$4,300,000 + 3,700,000] 2 2 times

The company turns its inventory over 6 times per year compared to the industry average of 5 times per year. The asset turnover ratio also is slightly better than the industry average (2 times per year versus 1.8 times). These ratios indicate that Anderson is able to generate more sales per dollar invested in inventory and in total assets than the industry averages. However, Anderson takes slightly longer to collect its accounts receivable (27.4 days compared to the industry average of 25 days).

Exercise 5-18
Requirement 1 a. Profit margin on sales b. Return on assets c. Return on shareholders equity Requirement 2 Retained earnings beginning of period Add: Net income Less: Retained earnings end of period Dividends paid $150 $5,400 = 2.8% $150 [($1,900 + 1,700) 2] = 8.3% $150 [($550 + 500) 2] = 28.6% $100,000 150,000 250,000 150,000 $100,000

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Problem 5-4
Requirement 1 Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (loss) (actual in 2005) Gross profit (loss) recognition: 2003: $2,400,000 = 30.0% x $2,000,000 = $600,000 $8,000,000 2004: $6,000,000 = 75.0% x $2,000,000 = $1,500,000 - 600,000 = $900,000 $8,000,000 2005: $1,800,000 - 1,500,000 = $300,000 2003 $10,000,000 2,400,000 5,600,000 8,000,000 $ 2,000,000 2004 $10,000,000 6,000,000 2,000,000 8,000,000 $ 2,000,000 2005 $10,000,000 8,200,000 -08,200,000 $ 1,800,000

Requirement 2 2003 Construction in progress Various accounts To record construction costs. Accounts receivable Billings on construction contract To record progress billings. Cash Accounts receivable To record cash collections. Construction in progress (gross profit) Cost of construction (cost incurred) Revenue from long-term contracts (1) To record gross profit. 2004 2005

2,400,000 3,600,000 2,200,000 2,400,000 3,600,000 2,200,000 2,000,000 4,000,000 4,000,000 2,000,000 4,000,000 4,000,000 1,800,000 3,600,000 4,600,000 1,800,000 3,600,000 4,600,000 600,000 900,000 300,000

2,400,000 3,600,000 2,200,000 3,000,000 4,500,000 2,500,000

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Problem 5-4 (continued) (1) Revenue recognized: 2003: 30% x $10,000,000 = 2004: 75% x $10,000,000 = Less: Revenue recognized in 2003 Revenue recognized in 2004 2005: 100% x $10,000,000 = Less: Revenue recognized in 2003 & 2004 Revenue recognized in 2005 Requirement 3 Balance Sheet Current assets: Accounts receivable Construction in progress Less: Billings Costs and profit in excess of billings Requirement 4 Costs incurred during the year Estimated costs to complete as of year-end Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (actual in 2005) 2003 $2,400,000 5,600,000 2003 $10,000,000 2,400,000 5,600,000 8,000,000 $ 2,000,000 2004 $3,800,000 3,100,000 2004 $10,000,000 6,200,000 3,100,000 9,300,000 $ 700,000 2005 $3,200,000 2005 $10,000,000 9,400,000 -09,400,000 $ 600,000 2003 $ 200,000 $3,000,000 (2,000,000) 1,000,000 $7,500,000 (6,000,000) 1,500,000 2004 $600,000 $3,000,000 $7,500,000 (3,000,000) $4,500,000 $10,000,000 (7,500,000) $2,500,000

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Problem 5-4 (concluded) Gross profit (loss) recognition: 2003: $2,400,000 = 30.0% x $2,000,000 = $600,000 $8,000,000 2004: $6,200,000 = 66.6667% x $700,000 = $466,667 - 600,000 = $(133,333) $9,300,000 2005: $600,000 - 466,667 = $133,333 2003 $2,400,000 5,600,000 2003 $10,000,000 2,400,000 5,600,000 8,000,000 $ 2,000,000 2004 $3,800,000 4,100,000 2004 $10,000,000 6,200,000 4,100,000 10,300,000 $ (300,000) 2005 $3,900,000 2005 $10,000,000 10,100,000 -010,100,000 $ (100,000)

Requirement 5 Costs incurred during the year Estimated costs to complete as of year-end Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (loss) (actual in 2005) Gross profit (loss) recognition: 2003: $2,400,000 = 30.0% x $2,000,000 = $600,000 $8,000,000 2004: 2005: $(300,000) - 600,000 = $(900,000) $(100,000) - (300,000) = $200,000

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Problem 5-5
Requirement 1 Year 2003 2004 2005 Total gross profit Requirement 2 2003 2004 2005 2,400,000 3,600,000 2,200,000 2,400,000 3,600,000 2,200,000 2,000,000 4,000,000 4,000,000 2,000,000 4,000,000 4,000,000 1,800,000 3,600,000 4,600,000 1,800,000 3,600,000 4,600,000 1,800,000 8,200,000 10,000,000 Gross profit recognized -0-0$1,800,000 $1,800,000

Construction in progress Various accounts To record construction costs. Accounts receivable Billings on construction contract To record progress billings. Cash Accounts receivable To record cash collections. Construction in progress (gross profit) Cost of construction (costs incurred) Revenue from long-term contracts (contract price) To record gross profit. Requirement 3 Balance Sheet Current assets: Accounts receivable Construction in progress Less: Billings Costs in excess of billings

2003 $ 200,000 $2,400,000 (2,000,000) 400,000 $6,000,000 (6,000,000)

2004 $ 600,000 -0-

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Problem 5-5 (concluded) Requirement 4 Costs incurred during the year Estimated costs to complete as of year-end Year 2003 2004 2005 Total gross profit Requirement 5 Costs incurred during the year Estimated costs to complete as of year-end Year 2003 2004 2005 Total project loss 2003 $2,400,000 5,600,000 2004 $3,800,000 4,100,000 2005 $3,900,000 2003 $2,400,000 5,600,000 2004 $3,800,000 3,100,000 Gross profit recognized -0-0$600,000 $600,000 2005 $3,200,000 -

Gross profit (loss) recognized -0$(300,000) 200,000 $(100,000)

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Problem 5-9
Requirement 1 Receivables turnover J&J Pfizer Average collection period = J&J Pfizer = = = = = Net sales Accounts receivable $29,139 $4,464 $29,574 $5,489 = 6.53 times = 5.39 times

365 Receivables turnover 365 6.53 365 5.39 = 55.9 days = 67.7 days

On average, J&J collects its receivables in 12 days less than Pfizer. Inventory turnover J&J Pfizer Average days in inventory = J&J Pfizer = = = = = 365 Inventory turnover 365 3.12 365 1.82 = 117 days = 201 days Cost of goods sold Inventories $8,861 $2,842 $4,907 $2,702 = 3.12 times = 1.82 times

On average, it takes Pfizer nearly twice as long as J & J to sell its inventory.

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Problem 5-9 (continued) Requirement 2 Rate of return on assets J&J Pfizer = = = Net income Total assets $4,800 $31,321 $3,718 $33,510 = = 15.3% 11.1%

The return on assets indicates a company's overall profitability, ignoring specific sources of financing. In this regard, J&Js profitability is more than that of Pfizer. Requirement 3 Profitability can be achieved by a high profit margin, high turnover, or a combination of the two. Rate of return on assets = = J&J = = Pfizer = = Net income Net sales $ 4,800 $29,139 16.47% $ 3,718 $29,574 12.57% x Profit margin x on sales Asset turnover

Net sales x Total assets x x $29,139 $31,321 .9303 times = 15.3%

$29,574 $33,510 x .8825 times = 11.1%

J&Js profit margin is much higher than that of Pfizer, and its asset turnover is slightly higher than Pfizer. These differences combine to produce a higher return on assets for J&J.

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Problem 5-9 (concluded) Requirement 4 Rate of return on shareholders equity J&J Pfizer = = = Net income Shareholders equity $4,800 $18,808 $3,718 $16,076 = 25.5% = 23%

J&J provides a greater return to shareholders.

Real World Case 5-1

Requirement 1 A bill and hold strategy accelerates the recognition of revenue. In this case, sales that would normally have occurred in 1998 were recorded in 1997. Assuming a positive gross profit on these sales, earnings in 1997 is inflated. Requirement 2 A customer would probably not be expected to pay for goods purchased using this bill and hold strategy until the goods were actually received. Receivables would therefore increase. Requirement 3 Sales that would normally have been recorded in 1998 were recorded in 1997. This bill and hold strategy shifted sales revenue and therefore earnings from 1998 to 1997. Requirement 4 Earnings quality refers to the ability of reported earnings (income) to predict a companys future earnings. Sunbeams earnings management strategy produced a 1997 earnings figure that was not indicative of the companys future profit-generating ability.

Judgment Case 5-7

Requirement 1 The three methods that could be used to recognize revenue and costs for this situation are (1) point of delivery, (2) the installment sales method, and (3) the cost recovery method. 2003 gross profit under the three methods: (1) point of delivery: $80,000 - 40,000 = $40,000
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(2) installment sales method: $40,000 = 50% = gross profit % $80,000 50% x $30,000 (cash collected) = $15,000 (3) cost recovery method: No gross profit recognized since cost ($40,000) exceeds cash collected ($30,000). Requirement 2 Customers sometimes are allowed to pay for purchases in installments over long periods of time. Uncertainty about collection of a receivable normally increases with the length of time allowed for payment. In most situations, the increased uncertainty concerning the collection of cash from installment sales can be accommodated satisfactorily by estimating uncollectible amounts. In these situations, point of delivery revenue recognition should be used. If, however, the installment sale creates a situation where there is significant uncertainty concerning cash collection making it impossible to make an accurate assessment of future bad debts, revenue and cost recognition should be delayed. The installment sales method and the cost recovery method are available to handle such situations. These methods should be used only in situations involving exceptional uncertainty. The cost recovery method is the more conservative of the two.

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