Income Measurement and Profitablity Analysis Chapter 5 Income Measurement and Profitablity Analysis Chapter 5: Income Measurement and Profitability Analysis

Realization Principle Record revenue when: AND there is reasonable certainty as to the collectibility of the asset to be received (usually cash). the earnings process is complete or virtually complete. Revenue recognition criteria helps ensure that an income statement reflects the actual accomplishments of a company for the period. In other words, revenue should be recognized in the period or periods that the revenue-generating activities of the company are performed. The realization principle requires that two criteria be satisfied before revenue can be recognized: the earnings process is complete or virtually complete and there is reasonable certainty as to the collectibility of the asset to be received (usually cash). Premature revenue recognition reduces the quality of reported earnings and can cause serious problems for the reporting company.

SEC Staff Accounting Bulletin No. 101 The SEC issued Staff Accounting Bulletin No. 101 to crackdown on earnings management. The bulletin provides additional criteria for judging whether or not the realization principle is satisfied: Persuasive evidence of an arrangement exists. Delivery has occurred or services have been performed. The seller’s price to the buyer is fixed or determinable. Collectibility is reasonably assured. The SEC issued Staff Accounting Bulletin No. 101 to crackdown on earnings management. The bulletin provides additional criteria for judging whether or not the realization principle is satisfied: Persuasive evidence of an arrangement exists. Delivery has occurred or services have been performed. The seller’s price to the buyer is fixed or determinable. Collectibility is reasonably assured. Soon after Staff Accounting Bulletin No. 101 was issued, many companies changed their revenue recognition methods. In most cases, the changes resulted in a deferral of revenue recognition.

Completion of the Earnings Process within a Single Reporting Period Recognize Revenue When the product or service has been delivered to the customer and cash has been received or a receivable has been generated that has reasonable assurance of collectibility. 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, that is, when the product or service has been delivered to the customer and cash has been received or a receivable has been generated that has reasonable assurance of collectibility. Revenue from the sale of products usually is recognized at the point of product delivery. For service revenue, if there is one final service that is crucial to the earnings process, revenues and costs are deferred and recognized after this service has been performed.

Significant Uncertainty of Collectibility When uncertainties about collectibility exist, revenue recognition is delayed. Installment Sales Method Cost Recovery Method At times, revenue recognition is delayed due to a high degree of uncertainty related to ultimate cash collection. One such situation occasionally occurs when products or services are sold on the installment basis. Many large retail stores sell certain products on an installment plan where customers are allowed to pay for purchases over a long period of time. Increasingly, the length of time allowed for payment usually increases the inevitable uncertainty about whether the store actually will collect a receivable. Installment sales can be accounted for using the installment sales method or the cost recovery method. The installment sales method recognizes the gross profit by applying the gross profit percentage on the sale to the amount of cash actually collected. The cost recovery method defers all gross profit recognition until cash equal to the cost of the item sold has been collected.

Installment Sales Method On November 1, 2009, 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, 2009. The land cost $560,000 to develop. The company’s fiscal year ends on December 31. On November 1, 2009, 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, 2009. The land cost $560,000 to develop. The company’s fiscal year ends on December 31. Let’s see how Belmont Corporation will account for this sale using the installment sales method. One of the first things we need to do is to calculate the gross profit percentage as shown on the slide. Gross Profit $240,000 ÷ $800,000 = 30%

Installment Sales Method During 2009, Belmont Corporation collected $200,000 on its installment sales. Part I In the first entry, Installment Sales Receivable is debited for $800,000. Inventory is credited for the portion of the receivable that represents the cost of the land sold. The difference is Deferred Gross Profit. Deferred Gross Profit is a contra account to the installment sales receivable. The second entry records the $200,000 Belmont Corporation collected on its installment sales during 2009. The entry is to debit Cash and credit Installment Sales Receivable. Part II When payments are received, gross profit is recognized. The third entry records the Realized Gross Profit by adjusting the Deferred Gross Profit account. The amount of the entry is calculated by applying the gross profit percentage of 30% to the cash collected of $200,000. The income statement for 2009 would report a gross profit from installment sales of $60,000. Sales and cost of goods sold usually are not reported in the income statement under the installment method, just the resulting gross profit. This entry records the Realized Gross Profit by adjusting the Deferred Gross Profit account.

Cost Recovery Method On November 1, 2009, 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, 2009. The land cost $560,000 to develop. The company’s fiscal year ends on December 31. In situations where there is an extremely high degree of uncertainty regarding the ultimate cash collection on an installment sale, an even more conservative approach, the cost recovery method, can be used. The cost recovery method defers all gross profit recognition until cash equal to the cost of the item sold has been collected. Now, let’s use the same data for Belmont Corporation and use the cost recovery method to account for the installment sale. One of the first things to notice is that under this method, gross profit will not be recognized until 2011.

Cost Recovery Method This slide summarizes all the entries using the cost recovery method. Notice that the entries have the same structure as the entries we just did using the installment sales method, but the timing of the gross profit realization differs between the two methods. In the first entry, Installment Sales Receivable is debited for $800,000. Inventory is credited for the portion of the receivable that represents the cost of the land sold. The difference is Deferred Gross Profit. The second entry records the $200,000 Belmont Corporation collected on its installment sales during 2009. The entry is to debit Cash and credit Installment Sales Receivable. Belmont Corporation will make this same entry on November 1, 2009, 2010, 2011, and 2012. The third entry on November 1, 2011, records the Realized Gross Profit by adjusting the Deferred Gross Profit account. The amount of the entry is $40,000 which is the amount of the cost recovered at this payment date. The forth entry on November 1, 2012, records the remainder of the Realized Gross Profit of $200,000 and adjusts the Deferred Gross Profit account.

Reduce both Sales and Cost of Goods Sold Right of Return In most situations, even though the right to return merchandise exists, revenues and expenses can be appropriately recognized at point of delivery. Estimate the returns In most situations, even though the right to return merchandise exists, revenues and expenses can be appropriately recognized at point of delivery. Based on past experience, a company usually can estimate the returns that will result for a given volume of sales. These estimates are used to reduce both sales and cost of goods sold in anticipation of returns. Reduce both Sales and Cost of Goods Sold

Completion of the Earnings Process over Multiple Reporting Periods Completed Contract Method Long-term Contracts Percentage-of-Completion Method In long-term contracts, revenue activities occur over extended periods and recognizing revenue at any single date within that period would be inappropriate. Completed Contract Method and the Percentage-of-Completion Method are two common methods used to record long-term contracts. The completed contract method recognizes revenue at a point in time when the earnings process is complete. The problem with this method is that all revenues, expenses, and resulting income from the project are recognized in the period in which the project is completed; no revenues or expenses are reported in the income statements of earlier reporting periods in which much of the work may have been performed. The percentage of completion method recognizes a portion of the estimated gross profit each period based on progress to date. Progress to date depends on three factors: the costs incurred to date, the most recent estimate of the project’s total cost, and the most recent gross profit estimate.

Companies Engaged in Long-term Contracts Here are some examples of companies engaged in long-term contracts and the type of industry they are in or the type of product they manufacture.

Completed Contract Method Geller Construction entered into a three-year contract to build a containment vessel for Southeast Power Company for a contract price of $1,400,000. Presented below is information about the contract: Geller Construction entered into a three-year contract to build a containment vessel for Southeast Power Company. Presented below is information about the contract. Review the data provided for years 2009, 2010, and 2011. Let’s see how Geller will account for the revenues and cost of this project using the completed contract method. We will begin with the entries for 2009. Let’s see how Geller will account for the revenues and cost of this project using the completed contract method.

Completed Contract Method Gross profit is not recognized until project is complete. The first entry records any costs used in the construction in the account Construction in Progress. The second entry records any periodic billings to the Billings on Construction Contract account. The Billings on Construction Contract account is a contra account to Construction in Progress. We will discuss this account more on the next slide. The third entry merely records cash collections. Notice that when using the Completed Contract Method, gross profit is not recognized until the project is complete.

Completed Contract Method Classified as an asset Classified as a liability The billings account 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. At the end of the period, the balances in the Construction in Progress account and the Billings on Construction Contract are compared. If the net difference is a debit, it is reported in the balance sheet as an asset. A debit balance essentially represents an unbilled receivable. Conversely, if the net difference is a credit, it is reported as a liability. A credit balance represents overbilled accounts receivable as compared to the costs incurred and thus, overstates the amount of the claim to cash earned to that date and must be reported as a liability. Let’s look at the entries for 2010.

Completed Contract Method Gross profit is not recognized until project is complete. These entries are the same as the ones for 2009—but with the amounts related to 2010.

Completed Contract Method In 2011, the first three entries are the same as the ones we have previously discussed. Since the project is completed in 2011, let’s see what new entries are required for that year.

Completed Contract Method Gross profit is recognized in year 3 since project is complete. Because the project is completed in 2011, we need to record the gross profit. In the fourth entry in 2011 we debit Cost of Construction to record the total costs incurred to date on the project. It may seem odd to be adding gross profit to what is essentially an inventory account? Remember, though, that when the company recognizes gross profit, they are acting like they have sold some portion of the asset to their customer, but they still keep the asset in their own balance sheet (in the construction in progress account) until they deliver it to the customer. Putting recognized gross profit into the construction in progress account just updates that account to reflect the total value (cost + gross profit = sales price) of their customer’s asset. Also, don’t forget that the Billings on construction contract account is contra to the construction in progress account. Over the life of the construction project, the company will bill their customer for the entire sales price of the asset. Therefore, at the end of the contract, the construction in progress account (containing total cost and gross profit) and the billings on construction contract account (containing all amounts billed to the customer) will have equal balances that exactly offset to create a net value of zero. We credit Revenue from Long-term Contract to record the total revenue (or billings) on the project. The difference is a debit to Construction in Progress to record the additional cost of the asset that relates to the actual markup (or gross profit). This asset account will be reduced when title passes to the buyer. The last entry on this slide reflects the closing entry that will take place at the end of the accounting cycle to close revenues and expenses. Let’s look at the last entry for this project to transfer title to the buyer. Remember that the contract price was $1,400,000.

Completed Contract Method Entry to transfer title to the customer. The T-accounts presented here represent the balances in the accounts prior to transferring title to the customer. When title passes to the customer, we debit the Billings on Construction Contract and credit the asset account, Construction in Progress.

Percentage-of-Completion Method Geller Construction entered into a three-year contract to build a containment vessel for Southeast Power Company for a contract price of $1,400,000. Presented below is information about the contract: Recall the information for Geller Construction’s contract with Southeast Power Company. All contract information is the same as we used earlier for the completed contract method. Now, let’s see how Geller will account for the revenues and cost of this project using the percentage-of-completion method. Review the data provided for years 2009, 2010, and 2011. We will begin with the entries for 2009. Let’s see how Geller will account for the revenues and cost of this project using the percentage-of-completion method.

Percentage-of-Completion Method The first entry records any costs used in the construction in the account Construction in Progress. Cost of Construction is debited for the cost incurred during this year. Revenue from Long-term Contract is credited for the portion of revenue earned this year. The difference is debited to Construction in Progress to record the additional cost of the asset that relates to the actual markup (or gross profit).

Percentage-of-Completion Method Measuring Progress Toward Completion Cost incurred to date Estimate of project’s total cost Gross profit estimate The percentage of completion method recognizes a portion of the estimated gross profit each period based on progress to date. Progress to date can be estimated as the proportion of the project’s cost incurred to date divided by total estimated costs, or by relying on an engineer’s or architect’s estimate. Assuming that Geller estimates progress to date using the typical “cost to cost” approach, progress to date depends on three factors: the cost incurred to date, the most recent estimate of the project’s total cost, and the most recent gross profit estimate. Total costs incurred to date Percent complete = Most recent estimate of total project cost

Percentage-of-Completion Method First, we determine the gross profit by subtracting the total project cost (actual plus estimated costs to complete) from the contract price. In this case, the gross profit is $150,000 for the entire contract. Next, we determine that the project is 20% complete by dividing the actual costs to date by the estimated total project cost. Last, we determine the gross profit to recognize currently. We accomplish this by taking the total project gross profit of $150,000 determined in part one and multiplying times the percentage complete of 20%. Since this is the first year of construction, no gross profit has been recognized in earlier years.

Percentage-of-Completion Method Contra account to CIP At the end of the period, the balances in the Construction in Progress account and the Billings on Construction Contract are compared. If the net difference is a debit, it is reported in the balance sheet as an asset. A debit balance essentially represents an unbilled receivable. Conversely, if the net difference is a credit, it is reported as a liability. A credit balance represents overbilled accounts receivable as compared to the costs incurred and thus overstates the amount of the claim to cash earned to that date and must be reported as a liability. Compared to the completed contract method, the percentage-of-completion method will have higher construction in progress because it contains gross profit in addition to cost. This will produce a higher asset (or lower liability) on the balance sheet. Now, let’s see the entries to record the cash collection and the closing entry for 2009. Classified as an asset Classified as a liability

Percentage-of-Completion Method Closing Entry At the end of the period, the revenue and expense accounts will be closed to retained earnings. Now, let’s look at next year’s entries.

Percentage-of-Completion Method These entries are the same as the ones for 2009—but with the amounts related to 2010.

Percentage-of-Completion Method In 2010 we follow a similar process that we did for the first year. First, we determine the gross profit by subtracting the total project cost (actual plus estimated costs to complete) from the contract price. In this case, the gross profit is $175,000. Next, we determine that the project is 65.31% complete by dividing the actual costs to date by the estimated total project cost. Last, we determine the gross profit to recognize currently. We accomplish this by taking the total project gross profit of $175,000 determined in part one and multiplying times the percentage complete of 65.31%. This provides us with the total gross profit to date of $114,286, which includes gross profit earned in the first year. So, to determine the gross profit for 2010, we need to subtract $30,000 from the $114,286 to arrive at $84,286, which is gross profit for the current year.

Percentage-of-Completion Method Cost of Construction is debited for the cost incurred during this year. Revenue from Long-term Contract is credited for the portion of revenue earned this year. The difference is debited to Construction in Progress to record the additional cost of the asset that relates to the actual markup (or gross profit). The last entry is the closing entry for 2010.

Percentage-of-Completion Method At this point, these journal entries for 2011 should be very familiar. But, take a minute to review them just to be sure you understand them.

Percentage-of-Completion Method In 2011, we follow a similar process that we did for last year. The main difference is that in this year the project is 100% complete. Take a minute and review the computations for this year.

Percentage-of-Completion Method These journal entries for 2011 should be very familiar. So, let’s move on to the entry to transfer the asset to the customer.

Percentage-of-Completion Method Entry to transfer title to the customer. The T-accounts presented here represent the balances in the accounts prior to transferring title to the customer. When title passes to the customer, we debit the Billings on Construction Contract and credit the asset account, Construction in Progress.

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

International Accounting Standards and Long-term Contracts Under the International Financial Reporting Standards, International Accounting Standard (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. Under the International Financial Reporting Standards, International Accounting Standard (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. 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.

Software and Other Multiple Deliverable Arrangements Statement of Position 97-2 If a sale includes multiple elements (software, future upgrades, postcontract customer support, etc.), the revenue should be allocated to the various elements based on the relative fair value of the individual elements. This will likely result in a portion of the proceeds received from the sale of software being deferred and recognized as revenue in future periods. The software industry is a key economic component of our economy. Throughout the 1990’s, the recognition of software revenue was a controversial issue. The controversy stemmed from the way software vendors typically package their products. It is not unusual for these companies to sell multiple software deliverables in a bundle for a lump-sum price. The bundle often includes product, upgrades, postcontract customer support, and other services. The critical accounting question concerns the timing of revenue recognition. In 1997, the American Institute of Certified Public Accountants issued Statement of Position 97-2 to address inconsistencies in practice. Statement of Position 97-2 states that if a sale includes multiple elements (software, future upgrades, postcontract customer support, etc.), the revenue should be allocated to the various elements based on the relative fair value of the individual elements. This will likely result in a portion of the proceeds received from the sale of software being deferred and recognized as revenue in future periods.

Other Multiple Deliverable Arrangements 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. More generally, for multiple-deliverable arrangements, revenue should be allocated to individual deliverables that qualify for separate revenue recognition (e.g., they must have value on a stand-alone basis and there must be objective and reliable evidence of the fair value of the undelivered parts). Otherwise, revenue is delayed until completion of later deliverables.

Franchise Sales Initial Franchise Fees Continuing Franchise Fees Generally are recognized at a point in time when the earnings process is virtually complete. Continuing Franchise Fees Recognized over time as the services are performed. The use of franchise arrangements has become increasingly popular in the United States over the past 30 years. In the franchise arrangement, the franchisor grants to the franchisee the right to sell the franchisor’s products and use its name for a specified period of time. The fees paid by the franchisee to the franchisor usually comprise the initial franchise fee and the continuing franchise fee. Continuing franchise fees are paid to the franchisor for continuing rights as well as for advertising and promotion and other services provided over the life of the franchise agreement. These fees sometimes are a fixed annual or monthly amount, a percentage of the volume of business done by the franchise, or a combination of both. Continuing franchise fees are recognized over time as the services are performed. The challenging revenue recognition issue pertains to the initial franchise fee. The initial franchise fee is usually a fixed amount that may be payable in installments. In many cases, the initial franchise fee covers significant services to be performed in the future. And, if the fee is payable in installments over an extended period of time, it creates an additional concern of collectibility. Specific guidance for revenue recognition of the initial franchise fee is provided in Statement of Financial Accounting Standards Number 45, “Accounting for Franchise Fee Revenue.” This standard requires that substantially all of the initial services of the franchisor required by the franchise agreement be performed before the initial franchise fee can be recognized a revenue. In situations where the initial franchise fee is collectible in installments, the installment sales method or cost recovery method should be used for profit recognition, if a reasonable estimate of uncollectibility cannot be made. Source: SFAS 45