INCOME MEASUREMENT AND PROFITABLITY ANALYSIS Chapter 5 © 2009 The McGraw-Hill Companies, Inc.

McGraw-Hill /Irwin Slide 2 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.

McGraw-Hill /Irwin Slide 3 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: 1.Persuasive evidence of an arrangement exists. 2.Delivery has occurred or services have been performed. 3.The seller’s price to the buyer is fixed or determinable. 4.Collectibility is reasonably assured. The SEC issued Staff Accounting Bulletin No. 101 to crackdown on earnings management. The bulletin provides additional 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 performed. 3.The seller’s price to the buyer is fixed or determinable. 4.Collectibility is reasonably assured.

McGraw-Hill /Irwin Slide 4 Completion of the Earnings Process within a Single Reporting Period When the product or service has been delivered to the customer and cash has been received or a receivable has been generated that has reasonable assurance of collectibility. Recognize Revenue

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

McGraw-Hill /Irwin Slide 6 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, The land cost $560,000 to develop. The company’s fiscal year ends on December 31. Gross Profit $240,000 ÷ $800,000 = 30%

McGraw-Hill /Irwin Slide 7 Installment Sales Method During 2009, Belmont Corporation collected $200,000 on its installment sales. This entry records the Realized Gross Profit by adjusting the Deferred Gross Profit account.

McGraw-Hill /Irwin Slide 8 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, The land cost $560,000 to develop. The company’s fiscal year ends on December 31.

McGraw-Hill /Irwin Slide 9 Cost Recovery Method

McGraw-Hill /Irwin Slide 10 Right of Return In most situations, even though the right to return merchandise exists, revenues and expenses can be appropriately recognized at point of delivery. Estimate the returns Reduce both Sales and Cost of Goods Sold

McGraw-Hill /Irwin Slide 11 Completion of the Earnings Process over Multiple Reporting Periods Completed Contract Method Percentage-of- Completion Method Long-term Contracts

McGraw-Hill /Irwin Slide 12 Companies Engaged in Long-term Contracts

McGraw-Hill /Irwin Slide 13 Completed Contract Method Geller Construction entered into a three-year contract to build a containment vessel for Southeast Power Company for a contract price of $1,400,000. Presented below is information about the contract: Let’s see how Geller will account for the revenues and cost of this project using the completed contract method.

McGraw-Hill /Irwin Slide 14 Completed Contract Method Gross profit is not recognized until project is complete.

McGraw-Hill /Irwin Slide 15 Completed Contract Method Classified as an asset Classified as a liability

McGraw-Hill /Irwin Slide 16 Completed Contract Method Gross profit is not recognized until project is complete.

McGraw-Hill /Irwin Slide 17 Completed Contract Method

McGraw-Hill /Irwin Slide 18 Completed Contract Method Gross profit is recognized in year 3 since project is complete. Remember that the contract price was $1,400,000.

McGraw-Hill /Irwin Slide 19 Completed Contract Method Entry to transfer title to the customer.

McGraw-Hill /Irwin Slide 20 Percentage-of-Completion Method Geller Construction entered into a three-year contract to build a containment vessel for Southeast Power Company for a contract price of $1,400,000. Presented below is information about the contract: Let’s see how Geller will account for the revenues and cost of this project using the percentage-of-completion method.

McGraw-Hill /Irwin Slide 21 Percentage-of-Completion Method

McGraw-Hill /Irwin Slide 22 Percentage-of-Completion Method Cost incurred to date Gross profit estimate Measuring Progress Toward Completion Estimate of project’s total cost Total costs incurred to date Percent complete = Most recent estimate of total project cost

McGraw-Hill /Irwin Slide 23 Percentage-of-Completion Method

McGraw-Hill /Irwin Slide 24 Percentage-of-Completion Method Classified as an asset Classified as a liability Contra account to CIP

McGraw-Hill /Irwin Slide 25 Percentage-of-Completion Method Closing Entry

McGraw-Hill /Irwin Slide 26 Percentage-of-Completion Method

McGraw-Hill /Irwin Slide 27 Percentage-of-Completion Method

McGraw-Hill /Irwin Slide 28 Percentage-of-Completion Method

McGraw-Hill /Irwin Slide 29 Percentage-of-Completion Method

McGraw-Hill /Irwin Slide 30 Percentage-of-Completion Method

McGraw-Hill /Irwin Slide 31 Percentage-of-Completion Method

McGraw-Hill /Irwin Slide 32 Percentage-of-Completion Method Entry to transfer title to the customer.

McGraw-Hill /Irwin Slide 33 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.

McGraw-Hill /Irwin Slide 34 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. 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.

McGraw-Hill /Irwin Slide 35 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.

McGraw-Hill /Irwin Slide 36 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.

McGraw-Hill /Irwin Slide 37 Franchise Sales Source: SFAS 45 Initial Franchise Fees Generally are recognized at a point in time when the earnings process is virtually complete. Continuing Franchise Fees Recognized over time as the services are performed.

McGraw-Hill /Irwin Slide 38 Activity Ratios Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator.

McGraw-Hill /Irwin Slide 39 Profitability Ratios Return on Equity Key Components Profitability Activity Financial Leverage

McGraw-Hill /Irwin Slide 40 This is called the DuPont framework because the DuPont Company was a pioneer in emphasizng this relationship. Because profit margin and asset turnover combine to equal return on assets, the DuPont framework can also be written as: DuPont Framework Return on equity = Profit margin X Asset turnover X Equity multiplier Net income Avg. total equity = Net income Total sales X Avg. total assets X Avg. total equity The DuPont Framework helps identify how profitability, activity, and financial leverage trade off to determine return to shareholders: Return on equity = Return on assets X Equity multiplier Net income Avg. total equity = Net income Avg. total assets X Avg. total equity

McGraw-Hill /Irwin Slide 41 Appendix 5: Interim Reporting Issued for periods of less than a year, typically as quarterly financial statements. Serves to enhance the timeliness of financial information. Fundamental debate centers on the choice between the discrete and integral part approaches.

McGraw-Hill /Irwin Slide 42 Interim Reporting Reporting Revenues and Expenses With only a few exceptions, the same accounting principles applicable to annual reporting are used for interim reporting. Reporting Unusual Items Discontinued operations and extraordinary items are reported entirely within the interim period in which they occur. Earnings Per Share Quarterly EPS calculations follow the same procedures as annual calculations. Reporting Accounting Changes Accounting changes made in an interim period are reported by retrospectively applying the changes to prior financial statements.

McGraw-Hill /Irwin Slide 43 Minimum Disclosures Sales, income taxes, and net income Earnings per share Seasonal revenues, costs, and expenses Significant changes in estimates for income taxes Discontinued operations, extraordinary items, and unusual or infrequent items Contingencies Changes in accounting principles or estimates Significant changes in financial position

McGraw-Hill /Irwin End of Chapter 5 © 2008 The McGraw-Hill Companies, Inc.