© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 5 Income Measurement and Profitability Analysis

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-2 Revenue Recognition Revenue should be recognized in the period or periods that the revenue- generating activities of the company are performed.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-3 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-4 SEC Staff Accounting Bulletin No. 101 The SEC issued Staff Accounting Bulletin No. 101 to crackdown on earnings management. The bulletin provides additional guidance to determine if 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 guidance to determine if 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-5 Revenue Recognition at Delivery The product or service has been delivered to the customer and cash has been received or is receivable. Revenue is earned and realized at the point of sale.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-6 Significant Uncertainty of Collectibility 1.Installment Sales Method 2.Cost Recovery 1.Installment Sales Method 2.Cost Recovery When uncertainties about collectibility exist, revenue recognition is delayed.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-7  Sale and cost of sale recorded as usual.  Compute gross margin rate on the installment sales.  Recognize gross margin as cash is received.  Gross margin not realized is deferred until a future period. Installment Sales Method

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-8 Installment Sales Method Clarke, Inc. had the following installment sales in addition to its regular sales. $45,000 ÷ $200,000 = 22.50%

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-9 Installment Sales Method Clarke, Inc. had the following installment sales in addition to its regular sales. At Dec. 31, 2005, Clarke, Inc. is still owed $30,000 from the 2004 sales and $75,000 from the 2005 sales.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-10 Installment Sales Method During 2003, Clarke collected $100,000 on its installment sales. Deferred gross profit is the difference between the selling price and the cost of the inventory.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-11 Installment Sales Method This entry records the Realized Gross Profit by adjusting the Deferred Gross Profit account.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-12 Installment Sales Method During 2004, Clarke collected $50,000 on its 2003 installment sales and $195,000 on its 2004 installment sales.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-13 Installment Sales Method During 2004, Clarke collected $50,000 on its 2003 installment sales and $195,000 on its 2004 installment sales.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-14 Installment Sales Method

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-15 Installment Sales Method

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-16 Installment Sales Method Balance Sheet

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-17 Cost Recovery Method Clarke, Inc. had the following installment sales in addition to its regular sales. The company uses the to account for installment sales. Clarke, Inc. had the following installment sales in addition to its regular sales. The company uses the cost recovery method to account for installment sales. $45,000 ÷ $200,000 = 22.50%

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-18 Cost Recovery Method The following schedule shows the pattern of cash collections for the three year period. Under the cost recovery method profit is not recognized until the seller has recovered all of the cost of the goods sold.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-19 Cost Recovery Method The entries are exactly the same as under the Installment Method—EXCEPT that there is not an entry to realize gross profit. Since we have not collected cash in excess of COGS, no gross profit is recognized in 2003.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-20 Cost Recovery Method In 2004, let’s concentrate on the entries relating to 2003 sales only. Now can we recognize some profit?

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-21 Cost Recovery Method Here are the entries we would make in 2005 relating to 2003 sales. We have fully recovered the $155,000 cost during 2005, so the entire deferred gross profit will be recognized.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-22 Revenue Recognition Over Time Completed Contract Method Percentage-of- Completion Method Long-term Construction Contracts

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-23 Percentage-of-Completion Method Cost incurred to date Gross profit estimate Measuring Progress Toward Completion Estimate of project’s total cost

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-24 Percentage-of-Completion Method Total costs incurred to date Percent complete = Most recent estimate of total project cost Let’s look at an example.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-25 Percentage-of-Completion Method Geller Construction entered into a three- year contract to build a containment vessel for Southeast Power Company. 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-26 Percentage-of-Completion Method $250,000 ÷ $1,250,000 = 20%

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-27 Percentage-of-Completion Method

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-28 Percentage-of-Completion Method Contra account to CIP

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-29 Percentage-of-Completion Method Classified as an asset Classified as a liability

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-30 Percentage-of-Completion Method

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-31 Percentage-of-Completion Method Closing Entry

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-32 Percentage-of-Completion Method $800,000 ÷ $1,225,000 = 65.31%

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-33 Percentage-of-Completion Method

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-34 Percentage-of-Completion Method $800,000 - $250,000 last year = $550,000

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-35 Percentage-of-Completion Method $775,000 - $250,000 last year = $525,000

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-36 Percentage-of-Completion Method $695,000 - $225,000 last year = $470,000

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-37 Percentage-of-Completion Method

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-38 Percentage-of-Completion Method Closing Entry

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-39 Percentage-of-Completion Method

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-40 Percentage-of-Completion Method

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-41 Percentage-of-Completion Method

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-42 Percentage-of-Completion Method Entry to transfer title to the customer.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-43 Completed Contract Method Geller Construction entered into a three- year contract to build a containment vessel for Southeast Power Company. 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-44 Completed Contract Method Entries are identical to the entries for percentage of completion. Gross profit is not recognized until project is complete.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-45 Completed Contract Method Entries are identical to the entries for percentage of completion. Gross profit is not recognized until project is complete.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-46 Completed Contract Method Gross profit is recognized in year 3 since project is complete.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-47 Completed Contract Method Entry to transfer title to the customer.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-48 Software Revenue Recognition 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 the recording of unearned revenue for future services.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-49 Franchise Sales Initial franchise fees can be recognized as revenue only after the  Franchisor has substantially performed the initial services promised in the franchise agreement, and  Collectibility of the initial franchise fee is reasonable assured. Initial franchise fees can be recognized as revenue only after the  Franchisor has substantially performed the initial services promised in the franchise agreement, and  Collectibility of the initial franchise fee is reasonable assured. Source: SFAS 45

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-50 Let’s look at some activity ratios!

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-51 Receivables Turnover Ratio Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator. Net Sales Average Accounts Receivable Receivables Turnover Ratio = This ratio measures how many times a company converts its receivables into cash each year.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-52 Average Collection Period This ratio is an approximation of the number of days the average accounts receivable balance is outstanding. 365 Receivables Turnover Ratio Average Collection Period =

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-53 Inventory Turnover Ratio This ratio measures the number of times merchandise inventory is sold and replaced during the year. Cost of Goods Sold Average Inventory Inventory Turnover Ratio =

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-54 Average Days in Inventory This ratio indicates the number of days it normally takes to sell inventory. 365 Inventory Turnover Ratio Average Days in Inventory =

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-55 Asset Turnover Ratio This ratio measures how efficiently a company utilizes all of its assets to generate revenue. Net Sales Average Total Assets Asset Turnover Ratio =

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-56 Let’s look at some profitability ratios!

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-57 Profit Margin on Sales Profit Margin on Sales Net Income Net Sales = This ratio indicates the portion of each dollar of revenue that is available to cover expenses.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-58 Return on Total Assets Return on Total Assets Net Income Average Total Assets = This ratio measures how well assets have been employed.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-59 Return on Equity Return on Equity Net Income Average Shareholders’ Equity = This ratio measures the ability of management to generate net income from the resources the owners provide.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 5-60 End of Chapter 5