1. Income Measurement and Profitability Analysis
Chapter 5
Chapter 5: Income Measurement and Profitability Analysis
The focus of this chapter is revenue recognition. We first discuss the general circumstance in which revenue is recognized when a good or service is delivered. Then we discuss circumstances in which revenue should be deferred until after delivery or should be recognized prior to delivery. The chapter also includes an appendix describing requirements for interim financial reporting and a Where We’re Headed Supplement explaining in detail a proposed Accounting Standards Update (hereafter, “proposed ASU”) that the FASB and IASB plan to issue in 2012 that substantially changes how we account for revenue recognition.

2. Realization Principle
Revenues are inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.
Record revenue when:
What is revenue? According to the FASB, “Revenues are inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.” In other words, revenue tracks the inflow of net assets that occurs when a business provides goods or services to its customers.
Revenue recognition criteria help 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.
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.

3. SEC Staff Accounting Bulletin No. 101 and 104
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.
As part of its crackdown on earnings management, the SEC issued additional guidance, summarized in Staff Accounting Bulletin (SAB) No. 101 and later in SAB 104, indicating the SEC’s views on revenue. The SABs provide 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 rendered.
The seller’s price to the buyer is fixed or determinable.
Collectibility is reasonably assured.
In addition to these four criteria, the SABs also pose a number of revenue recognition questions relating to each of the criteria. The questions provide the facts of the scenario and then the SEC offers its interpretive response. These responses and supporting explanations provide guidance to companies with similar revenue recognition issues.
Soon after SAB No. 101 was issued, many companies changed their revenue recognition methods. In most cases, the changes resulted in a deferral of revenue recognition.
In addition to these four criteria, the SABs also pose a number of revenue recognition questions relating to each of the criteria.

4. Realization Principle
Revenue recognition is often tied to delivery of the product from the seller to the buyer.
This illustration relates various revenue-recognition methods to critical steps in the earnings process. Recall that the realization principle indicates that the central issues for recognizing revenue are (a) judging when the earnings process is substantially complete and (b) whether there is reasonable certainty as to the collectibility of the cash to be received. Often this decision is straightforward and tied to delivery of the product from the seller to the buyer. At delivery, the earnings process is virtually complete and the seller receives either cash or a receivable. At other times, though, recognizing revenue upon delivery may be inappropriate. It may be that revenue should be deferred to a point after delivery because the seller is unable to estimate whether the buyer will return the product or pay the receivable. Or, sometimes revenue should be recognized at a point prior to delivery because the earnings process occurs over multiple reporting periods and the company can better inform financial statement users by making reliable estimates of revenue and cost prior to delivery.

5. Revenue Recognition at Delivery
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, it 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. The product delivery date occurs when legal title to the goods passes from seller to buyer, which depends on the terms of the sales agreement.
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. For example, a moving company will pack, load, transport, and deliver household goods for a fixed fee. Although packing, loading, and transporting all are important to the earning process, delivery is the culminating event of the earnings process. So, the entire service fee is recognized as revenue after the goods have been delivered.

6. Is the Seller a Principal or Agent?
Has primary responsibility for delivering product or service and is vulnerable to risks associated with delivery and collection.
Agent
Does not have primary responsibility for delivering product or service but acts as a facilitator that earns a commission
Regardless of whether we are dealing with a product or a service, an important consideration is whether the seller is acting as a “principal” or as an “agent.” Here’s the difference. A principal has primary responsibility for delivering a product or service, and typically is vulnerable to risks associated with delivering the product or service and collecting payment from the customer. In contrast, an agent doesn’t primarily deliver goods or services, but acts as a facilitator that earns a commission for helping sellers transact with buyers.
If the company is a principal, the company should recognize as revenue the gross (total) amount received from a customer. If instead the company is an agent, it recognizes as revenue only the net commission it receives for facilitating the sale.
Recognizes as revenue the gross (total) amount received from a customer.
Recognizes as revenue the net commission it receives for facilitating the sale.

7. Revenue Recognition after Delivery
Recognizing revenue at delivery of the product or service assumes we are able to make reasonable estimates of amounts due from customers that potentially might be uncollectible and amounts not collectible due to customers returning the products they purchased.
Recognizing revenue when goods and services are delivered assumes we are able to make reasonable estimates of amounts due from customers that potentially might be uncollectible. For product sales, this also includes amounts not collectible due to customers returning the products they purchased. Otherwise, we would violate one of the requirements of the revenue realization principle we discussed earlier—that there must be reasonable certainty as to the collectibility of cash from the customer. In this section we address a few situations in which uncertainties are so severe that they could cause a delay in recognizing revenue from a sale of a product or service. For each of these situations, notice that the accounting is essentially the same—deferring recognition of the gross profit arising from a sale of a product or service until uncertainties have been resolved.
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
Cost Recovery Method

8. 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
Retailers usually give their customers the right to return merchandise if they are not satisfied. 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. The purpose of the estimates is to avoid overstating gross profit in the period of sale and understating gross profit in the period of return. Because the return of merchandise can negate the benefits of having made a sale, the seller must meet specific 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 some situations, these criteria are not satisfied at the point of delivery of the product. For example, manufacturers of semiconductors like Intel Corporation and Motorola Corporation usually sell their products through independent distributor companies. Economic factors, competition among manufacturers, and rapid obsolescence of the product motivate these manufacturers to grant the distributors the right of return if they are unable to sell the semiconductors. So, revenue recognition often is deferred beyond the delivery point to the date the products actually are sold by the distributor to an end user.
Reduce both sales and cost of goods sold

9. Consignment Sales
Sometimes a company arranges for another company to sell its product under consignment.
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 a sale until the consignee sells the goods and title passes to the eventual customer.
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 retains legal title. If the consignee can’t 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 a sale (revenue and related expenses) until the consignee sells the goods and title passes to the eventual customer. Of course, that means goods on consignment still are part of the consignor’s inventory.

10. Revenue Recognition Prior to Delivery
Completed Contract Method
Long-term Contracts
Percentage-of-Completion Method
The types of companies that make use of long-term contracts are many and varied. A recent survey of reporting practices of 600 large public companies indicates that approximately one in every four companies engages in long-term contracts. And they are not just construction companies. In fact, even services such as research, installation, and consulting often are contracted for on a long-term basis.
The general revenue recognition criteria described in the realization principle suggest that revenue should be recognized when a long-term project is finished (that is, when the earnings process is virtually complete). This is known as the completed contract method of revenue recognition. 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. Net income should provide a measure of periodic accomplishment to help predict future accomplishments. Clearly, income statements prepared using the completed contract method do not fairly report each period’s accomplishments when a project spans more than one reporting period. Much of the earnings process is far removed from the point of delivery.
The percentage-of-completion method of revenue recognition for long-term construction and other projects is designed to help address this problem. By this approach, we recognize revenues (and expenses) over time by allocating a share of the project’s expected revenues and expenses to each period in which the earnings process occurs, that is, the contract period. Although the contract usually specifies total revenues, the project’s expenses are not known until completion. Consequently, it’s necessary for a company to estimate the project’s future costs at the end of each reporting period in order to estimate total gross profit to be earned on the project.

11. 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 the construction in progress account.

12. Software and Other Multiple Deliverable Arrangements
If a sale includes multiple elements (software, future upgrades, post contract customer support, etc.), the revenue should be allocated to the various elements based on ‘vendor-specific objective evidence’ (VSOE) of fair values of the individual elements.
The software industry is a key economic component of our economy. Microsoft alone reported revenues in excess of $70 billion for its 2011 fiscal year. Yet, the recognition of software revenues has been a controversial accounting issue. The controversy stems 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 contract price. The bundle often includes product, upgrades, post contract customer support, and other services. The critical accounting question concerns the timing of revenue recognition.
The American Institute of Certified Public Accountants (AICPA) issued authoritative guidance in this area. The AICPA position indicates that if an arrangement includes multiple elements, the revenue from the arrangement should be allocated to the various elements based on ‘Vendor-Specific Objective Evidence’ (VSOE) of fair values of the individual elements. It doesn’t matter what separate prices are indicated in the multiple-element contract. Rather, the VSOE of fair values are the sales prices of the elements when sold separately by that vendor. If VSOE doesn’t exist, revenue recognition is deferred until VSOE is available or until all elements of the arrangement are delivered.

13. Software and Other Multiple Deliverable Arrangements
The FASB’s Emerging Issues Task Force (EITF) issued guidance to broaden the application of this basic perspective to other arrangements that involve “multiple deliverables,” such as sales of appliances with maintenance contracts, cellular phone contracts that come with a “free phone,” and even painting services that include sales of paint as well as labor.
Sellers offering other multiple-deliverable contracts now are allowed to estimate selling prices when they lack VSOE from stand-alone sales prices. Using estimated selling prices allows earlier revenue recognition than would be allowed if sellers had to have VSOE in order to recognize revenue.
More recently, the FASB’s Emerging Issues Task Force (EITF) issued guidance to broaden the application of this basic perspective to other arrangements that involve “multiple deliverables.” Examples of such arrangements are sales of appliances with maintenance contracts, cellular phone contracts that come with a “free phone,” and even painting services that include sales of paint as well as labor. Other examples are products that contain both hardware and software essential to the functioning of the product, such as computers and smart phones that are always sold with an operating system. Now, as with software-only contracts, sellers allocate total revenue to the various parts of a multiple-deliverable arrangement on the basis of the relative stand-alone selling prices of the parts. Sellers must defer revenue recognition for parts that don’t have stand-alone value, or whose value is contingent upon other undelivered parts. However, unlike software-only arrangements, sellers offering other multiple-deliverable contracts now are allowed to estimate selling prices when they lack VSOE from stand-alone sales prices. Using estimated selling prices allows earlier revenue recognition than would be allowed if sellers had to have VSOE in order to recognize revenue.
For some sellers this change had a huge effect. As an example, consider and the highly successful iPhone. Apple used to defer revenue on iPhones and other products because it didn’t have VSOE of the sales price of future software upgrades included with the phones. This practice resulted in over $12 billion of deferred (unearned) revenue as of the end of fiscal The adoption of the new accounting principles increased the Company’s net sales by $6.4 billion, $5.0 billion, and $572 million for 2009, 2008 and 2007, respectively. After this accounting change, Apple recognizes almost all of the revenue associated with an iPhone at the time of sale. The only amount deferred is the small amount of revenue estimated for future software upgrade rights.

14. 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 U.S. GAAP, which 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 as 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.

15. Activity Ratios
Activity ratios measure a company’s efficiency in managing its assets. Although, in concept, the activity or turnover can be measured for any asset, activity ratios are most frequently calculated for accounts receivable, inventory, and total assets.
The asset turnover ratio is calculated as net sales divided by average total assets. This ratio measures how efficiently a company utilizes all of its assets to generate revenue.
The receivables turnover ratio is calculated as net sales divided by average accounts receivable. Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator. The denominator is determined by adding beginning and ending net accounts receivable and dividing by two. This ratio measures how many times a company converts its receivables into cash each year. The higher the ratio, the shorter the average time between credit sales and cash collection.
The average collection period is calculated as 365 divided by the receivables turnover ratio. This ratio is an approximation of the number of days the average accounts receivable balance is outstanding.
The inventory turnover ratio is calculated as cost of goods sold divided by average inventory. The denominator is determined by adding beginning and ending inventory and dividing by two. This ratio measures the number of times merchandise inventory is sold and replaced during the year. A relatively high ratio, say compared to a competitor, usually is desirable. However, as with most ratios, care must be taken in interpretation. For example, a high ratio could indicate comparative strength in a company’s sales force or it could indicate a relatively low inventory level, which could lead to stockouts and lost sales.
The average days in inventory is calculated as 365 divided by the inventory turnover ratio. This ratio indicates the number of days it normally takes to sell inventory.
Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator.

16. Return on Equity Key Components
Profitability Ratios
Return on Equity Key Components
Profitability
Activity
Financial Leverage
Profitability ratios attempt to measure a company’s ability to earn an adequate return relative to sales or resources devoted to operations. Three common profitability ratios are the profit margin on sales, the return on assets, and the return on shareholders’ equity.
Profit margin on sales is calculated as net income divided by net sales. This ratio indicates the portion of each dollar of revenue that is available to cover expenses.
Return on assets is calculated as net income divided by average total assets. Profit margin and asset turnover combine to yield return on assets , which measures the return generated by a company’s assets.
Return on equity is calculated as net income divided by average shareholders’ equity. This ratio measures the ability of management to generate net income from the resources the owners provide. In addition to monitoring return on equity, investors want to understand how that return can be improved.
There are three key components to the return on equity:
Profitability is measured by the profit margin (Net Income divided by Sales). A higher profit margin indicates that a company is generating more profit from each dollar of sales.
Activity is measured by asset turnover (Sales divided by Average Total Assets). A higher asset turnover indicates that a company is using its assets efficiently to generate more sales from each dollar of assets.
Financial Leverage is measured by the equity multiplier (Average Total Assets divided by Average Total Equity). A high equity multiplier indicates that relatively more of the company’s assets have been financed with debt. Leverage can provide additional return to the company’s equity holders.

17. DuPont Framework
The DuPont framework helps identify how profitability, activity, and financial leverage trade off to determine return to shareholders:
Return on
equity =
Profit margin X
Asset
turnover
Equity
multiplier
Net income
Avg. total
Total sales
Avg. total assets
Avg. total equity
Because profit margin and asset turnover combine to equal return on assets, the DuPont framework can also be written as:
Part I
The DuPont framework shows that return on equity depends on profitability, activity, and financial leverage. In equation form, the DuPont framework is profit margin times asset turnover times the equity multiplier. Notice that total sales and average total assets appear in the numerator of one ratio and the denominator of another. Although the DuPont framework computations use the term “total sales,” it refers to “net sales,” which is sales net of sales returns and allowances.
Part II
So, they cancel to yield net income divided by average total equity, or return on assets. This provides another way to compute ROE as return on assets times the equity multiplier.
This is called the DuPont framework because the DuPont Company was a pioneer in emphasizing this relationship.
Return on equity =
Return on assets X
Equity
multiplier
Net income
Avg. total equity
Avg. total assets

18. 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.
Appendix 5: Interim Reporting
Financial statements covering periods of less than a year are called interim reports. Companies registered with the SEC, which includes most public companies, must submit quarterly reports. Though there is no requirement to do so, most also send quarterly reports to their shareholders and typically include abbreviated, unaudited interim reports as supplemental information within their annual reports.
For accounting information to be useful to decision makers, it must be available on a timely basis. One of the objectives of interim reporting is to enhance the timeliness of financial information. In addition, quarterly reports provide investors and creditors with additional insight on the seasonality of business operations that might otherwise get lost in annual reports.
However, the downside to these benefits is the relative unreliability of interim reporting. With a shorter reporting period, questions associated with estimation and allocation are magnified. The fundamental debate regarding interim reporting centers on the choice between the discrete and integral part approaches.
Fundamental debate centers on the choice between the discrete and integral part approaches.

19. 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.
Part I
With only a few exceptions, the same accounting principles applicable to annual reporting are used for interim reporting of revenues and expenses. For example, costs and expenses subject to year-end adjustments, such as depreciation and bad debt expense, are estimated and allocated to interim periods in a systematic way.
Part II
On the other hand, discontinued operations and extraordinary items should be reported separately in the interim period in which they occur. That is, these amounts should not be allocated among individual quarters within the fiscal year. The same is true for items that are unusual or infrequent but not both. Notice that treatment of these items is more consistent with the discrete view than the integral part view.
Part III
Quarterly EPS calculations follow the same procedures as annual calculations, which is consistent with the discrete view.
Part IV
Accounting changes made in an interim period are reported by retrospectively applying the changes to prior interim financial statements. Then in financial reports of subsequent interim periods of the same fiscal year, we disclose how that change affected income from continuing operations, net income, and related per share amounts for the postchange interim period.
Reporting Accounting Changes
Accounting changes made in an interim period are reported by retrospectively applying the changes to prior financial statements.

20. Appendix 5: Interim Reporting
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
Information about fair value of financial instruments and the methods and assumptions used to estimate fair values
Significant changes in financial position
Appendix 5: Interim Reporting
Complete financial statements are not required for interim reporting, but certain minimum disclosures are required as follows:
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
information about fair value of financial instruments and the methods and assumptions used to estimate fair values
significant changes in financial position.

21. Revenue Recognition: A Chapter Supplement
Core Revenue Recognition Principle
A company must recognize revenue when goods or services are transferred to customers in an amount that reflects the consideration the company expects to receive in exchange for those goods or services.
Key Steps in Applying the Principle
Identify a contract with a customer.
Identify the performance obligation(s) in the contract.
Determine the transaction price.
Allocate the transaction price to the performance obligations.
Recognize revenue when each performance obligation is satisfied.
Revenue Recognition: A Chapter Supplement
The FASB and the IASB are collaborating on several major new standards designed in part to move U.S. GAAP and IFRS closer together (convergence). This reading is based on their joint Exposure Draft of a new revenue recognition Accounting Standards Update (proposed ASU) and “tentative decisions” of the Boards after receiving feedback from the Exposure Draft as of the date this text went to press.
In June 2010 the FASB and IASB issued identical Exposure Drafts (ED) for a new ASU entitled “Revenue from Contracts with Customers,” and followed up with another Exposure Draft in 2011.  The purpose of the proposed ASU is to improve revenue recognition guidance and in the process to eliminate current revenue recognition differences among industries and between U.S. GAAP and IFRS. It appears likely that the proposed ASU will become effective for fiscal years starting no sooner than 2015.
The core revenue recognition principle and key application steps of the proposed ASU are as follows:
Core Revenue Recognition Principle: A company must recognize revenue when goods or services are transferred to customers in an amount that reflects the consideration the company expects to receive in exchange for those goods or services.
Key Steps in Applying the Principle
Identify a contract with a customer.
Identify the performance obligation(s) in the contract.
Determine the transaction price.
Allocate the transaction price to the performance obligations.
Recognize revenue when each performance obligation is satisfied.

22. End of Chapter 5
End of Chapter 5.