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Additional Topics in

Income
Determination

Revsine/Collins/Johnson/Mittelstaedt: Chapter 3

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, All


Learning objectives
1. When is it appropriate to recognize revenue before or after the
point of sale?

2. Revenue recognition details for long-term construction contracts,


agricultural commodities, and installment sales.

3. Revenue principles for franchise sales, right of return, and


“bundled” software sales.

4. How GAAP income determination invites “earnings management”,


the various techniques used, and recent SEC guidance intended to
thwart such activities.

5. How error corrections and prior period restatements are reported.

RCJM: Chapter 3 © 2009 3-2


Recall the criteria for revenue
recognition

Time of sale is
used in most
industries

Condition 1: The critical event in the process of earning the


revenue has taken place.

Condition 2: The amount of revenue that will be collected is


reasonably assured and is measurable with a
reasonable degree of reliability.

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Revenue recognition prior to
sale:
Long-term construction projects
 Before construction begins, a formal contract has been signed.
 The buyer is assured and the contract price is specified.

 Consequently, both revenue recognition conditions are satisfied


prior to the time of sale.
 Condition 1: The critical event is actual construction, thus revenue is
earned over time as the project progresses toward completion.
 Condition 2: Measurability is satisfied because there’s a firm contract
with a known buyer at a set price.
 In addition, construction costs can be estimated with reasonable
accuracy so that expenses can be matched with revenues.

 Percentage-of-completion method: revenue is recognized in


proportion to the “work done” each period.

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Example: Solid Construction
Corp.
 Contract price is $1,000,000 and
construction costs are estimated
to be $800,000.

Original estimate
was $800,000

How much gross profit must be recognized each year?

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Percentage-of-completion for
2008 (Year 1)

Percentage of $240,000 Cost incurred


Step 1: 30% = =
completion ratio $800,000 Estimated total costs

Step 2: Estimated total $200,000 = $1,000,000 - $800,000


contract profit

Step 3: Estimated profit $60,000 = $200,000 x 30%


earned to date

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Percentage-of-completion for
2009 (Year 2)

$544,000
Step1: Percentage of 30% 64% =
completion ratio $850,000

Step2: Estimated total $200,000 $150,000 = $1,000,000 - $850,000


contract profit

Step3: Estimated profit $60,000


$60,000 $96,000 = $150,000 x 64%
earned to date

Step4: Incremental profit $36,000 = $96,000 - $60,000


earned

RCJM: Chapter 3 © 2009 3-7


Percentage-of-completion for
2010 (Year 3)

Step1: Percentage of 30% 64% 100%


completion ratio
Step2: Estimated total $200,000 $150,000 $150,000
contract profit
Step3: Estimated profit $60,000 $96,000 $150,000
earned to date
Step4: Incremental profit $36,000 $54,000
earned

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Percentage-of-completion:
Balance sheet presentation

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Completed-contract
method:
Long-term construction projects
 Suppose it is not possible to determine expected costs with a high degree of reliability.
 Percentage-of-completion then becomes inappropriate because “matching” fails.
 Completed-contract method postpones all revenue recognition (and expenses) until the
period of project completion.

RCJM: Chapter 3 © 2009 3-10


Revenue recognition prior to
sale:
Commodities
 Revenue recognition conditions:
 Condition 1: The critical event is extraction (mining) or harvesting
(agriculture), and occurs before the sale (i.e., formal transfer of title).
 Condition 2: The precise time at which measurability is satisfied is open to
some dispute.

 Revenue recognition could occur when the sales transaction is completed, or


earlier at extraction or harvest (i.e., when the critical event is satisfied).

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Commodities:
Completed-transaction (sales) method
 Condition 2 is not satisfied until the eventual selling price is known.
 Accordingly, only the 100,000 bushels sold on Sept. 30, 2008 are
included in 2008 revenue.

 Revenue (and related expenses) for the remaining 10,000 bushels is


postponed to 2009 when those bushels are sold.

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Commodities:
Market-price (production) method
 Because producers face an established market price for the
commodity, Condition 2 is satisfied continuously.

 Accordingly, all 110,000 bushels produced in 2008 are included in


2008 revenue under the production method.
Recognition
Matching

Net realizable
value

 As a result, the inventory of 10,000 bushels is shown at market


value of $35,000.
DR Crop inventory $15,000
CR Market gain on unsold inventory $15,000

RCJM: Chapter 3 © 2009 3-13


Commodities:
Market-price (production) method
continued
 The farmer is engaging in two activities: corn production and commodity
speculation (10,000 bushels held in inventory).

 Subsequent changes in the market price give rise to speculative gains and
losses, called inventory holding gains and losses.

 At the start of 2009, the market price drops from $3.50 to $3.00. The
inventory is “marked-to-market” to reflect the loss:

DR Inventory (holding) loss on speculation $5,000 = 10,000 x


CR Crop inventory $5,000 ($3.50 - $3.00)

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Commodities:
Market-price (production) method
continued
 Fearing a further market price decline, the farmer immediately
sells all 10,000 bushels at $3.00:

DR Cost of goods sold $30,000


CR Crop inventory $30,000

DR Cash $30,000
CR Crop revenue $30,000

The inventory book value is $30,000 at the time of sale:


Production cost (10,000 x $2.00) $20,000
Market gain at harvest (10,000 x $1.50) 15,000
Inventory holding loss (10,000 x $0.50) ( 5,000)
$30,000

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Commodities:
Comparison of revenue recognition
methods

 In practice, the completed-transaction method is more prevalent.

 However, the market price method conforms to GAAP when readily


determinable prices are continuously available.

 Dual advantages of the market price method:


 Recognizes two income streams—one from farming and another from
commodity speculation.
 Conforms more closely to the income recognition conditions (critical
event and measurability).

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Revenue recognition after the
sale:
Installment sales method
 Sometimes revenue is not recognized at the point of sale even
though a valid sale has taken place.
 High risk of not receiving cash from the buyer (Conditions 1 and 2 are
not met).
 Or there is no reasonable basis for estimating uncollectible accounts
(Condition 2 is not met).

 Conditions 1 and 2 are both satisfied over time as cash


collections take place.

 So, revenue recognition occurs as cash is collected (i.e., as


installment payments are made).

RCJM: Chapter 3 © 2009 3-17


Revenue recognition after the
sale:
Installment sales method example
 The amount of revenue recognized each period depends on two things:
 Installment-sales gross-profit percentage
 Amount of cash collected on installment accounts receivable.

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Revenue recognition after the
sale:
Installment sales calculations

Installment Sales Income:


Cash collections from 2008 sales $300,000 $600,000
Gross-profit % 30% 30%
Income recognized $90,000 $180,000
Cash collections from 2009 sales $340,000
Gross-profit % 32%
Income recognized $108,800
Total income recognized $288,800

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Revenue recognition after the
sale:
Installment sales income statement

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Revenue recognition after the
sale:
Cost recovery method
 GAPP allows this approach when:
 Collections on installment sales occur over an extended period.
 There is no reasonable basis for estimating collectibility.

 Under the cost recovery method:


 No profit is recognized until cash payments from the buyer exceed
the seller’s cost of goods sold.
 After the seller’s cost has been recovered, any excess cash collected
is recorded as recognized gross profit.

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Specialized transactions:
Franchised sales
Exercise right to sell
product or service

Franchisor Franchisee Customer


Seller Buyer
1. Initial franchisee fee
2. Continuing (periodic) fees

 Continuing franchise fees are recorded as revenue in the period they are
earned and received.
 The initial franchise fee is comprised of two elements:
 Payment for the right to operate a franchise in a given area.

Payment for services to be performed later by the franchisor.
 The issue: How much of the initial franchise fee should be recognized as
revenue up front by the franchisor?

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Specialized transactions:
Franchise sales example
 SFAS No. 45 says:
 recognize revenue for the initial franchise fee only when all material
services and conditions have been substantially performed by
franchisor.
 But, there is no “bright line” test.

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Specialized transactions:
Sales with right of return
Sell with right of return

Seller Buyer Customer


Resale
Cash payment or
obligation to pay

 SFAS No. 45 says the following six criteria must be met for a
seller to record revenue at the time of sale:
 Seller’s price to buyer is substantially fixed at the date of sale.
 Buyer has paid seller, or is obligated to pay and the obligation is not
contingent on resale.
 Buyer’s obligation does not change in the event of theft, destruction, or
damage of the product.
 The buyer has economic substance and is distinct from seller.
 Seller does not have significant obligations for future performance to bring
about resale.
 The amount of future returns can be reasonably estimated.

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Specialized transactions:
Bundled sales
 Oracle sells a database Revenue
software “bundle” for $1.5 recognized:
Over 5-year
million. The “bundle” includes: Customer support $150 period
 Staff training Upgrade $300
As installed
 “Free” software upgrades
 On-going customer support for
Training $450 When completed
five years.

 How much revenue should Software $600 When delivered


Oracle record up front? and installed
 SOP 97-2 provides guidance.
Oracle’s software
and services bundle

RCJM: Chapter 3 © 2009 3-25


Earnings management
 Determining when revenue has been earned (critical event) and is
realized (measurability)—the two revenue recognition conditions
—often requires judgment.

 Managers can sometimes exploit the flexibility in GAAP to


manipulate reported earnings in ways that mask the company’s
underlying performance.

 Some managers have even resorted to outright financial fraud


(but that’s rare).

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Earnings management:
Avoiding a loss or earnings
disappointment

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Popular earnings management
devices
 “Big bath” restructuring charges: Excessive restructuring write-offs that
overstate estimated charges for future expenditures.

 Creative acquisition accounting: Abuses linked to purchased “in-process


R&D” that SFAS No. 2 requires to be expensed at the date of acquisition.

 Miscellaneous “cookie jar reserves” for bad debts, loan losses, warranties
and other accruals: Reserve too much in good times and cut back on
estimated charges, or even reverse previous charges, in bad times. A
convenient income smoothing device.

 Intentional errors deemed to be “immaterial” and intentional bias in


estimates.

 Premature or aggressive revenue recognition (details to follow).

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Revenue recognition abuses
 The SEC says revenue is earned (critical event) and realized
(measurability) when all of the following are met:
 Pervasive evidence of an exchange agreement exists.
 Delivery has occurred or services have been rendered.
 The seller’s price to the buyer is fixed or determinable.
 Collectibility is reasonably assured.

 SEC Staff Accounting Bulletin (SAB) No. 104 illustrates


troublesome areas of revenue recognition.

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Revenue recognition abuses:
SAB No. 104 examples

Goods shipped No revenue can be


on consignment recognized at delivery.

Seller can’t recognize revenue until


Sales with
delivery… except certain buy and hold
delayed delivery transactions.

Postpone revenue recognition


Goods sold on
until merchandise is delivered
lay-away to customer.

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Revenue recognition abuses:
SAB No. 104 examples

Non refundable Earned as services are delivered over


up-front fees the full term of service engagement.

Gross vs. net basis Revenue should be recognized on a


for internet resellers “net” basis as commission revenue.

Revenue should be recognized


Capacity over time as the capacity is
swaps brought on line and used by
customers.

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Accounting errors
 Accounting errors and “irregularities” can occur for several reasons:
 Simple oversight.
 Unintentional misapplication of GAAP, especially where judgment is
required.
 Intentional attempts to exploit the flexibility in GAAP.
 Outright financial fraud.

 Parties charged with discovering accounting errors and irregularities:


 The company’s internal audit staff and audit committee.
 External auditors.
 SEC staff surveillance of filings.

 Once discovered, accounting errors and irregularities must be


corrected and disclosed. Most are corrected through a prior period
adjustment.

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Accounting restatements:
GAO study of irregularities for 1997-2002

Total number of restatement Reasons for earnings


announcements, 1997 - 2002 restatements, 1997 - 2002

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Accounting restatements:
Share price reaction to announced
restatements

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Accounting restatement
disclosures:
An example

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Summary
 The “critical event” and “measurability” conditions for revenue
recognition are typically satisfied at the point of sale.

 There are circumstances—long-term construction contracts,


production of natural resources and agricultural commodities—
where it is appropriate to recognize revenue prior to the sale.

 There are also circumstances where revenue recognition may be


delayed until after the sale—installment sales and cost recovery
methods:
 There is considerable uncertainty about collectibility.
 There are significant costs that will be incurred after the sale that are
difficult to predict.

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Summary concluded
 Franchise sales, sales with right of return, and bundled sales
pose challenging revenue recognition issues.

 Management can sometimes exploit the flexibility in GAAP


revenue recognition rules to hide or misrepresent economic
performance.

 Once discovered, accounting errors and irregularities must be


corrected and disclosed. Most are corrected through a prior
period adjustment.

RCJM: Chapter 3 © 2009 3-37