Chapter 5 AND. Income Measurement and Profitability Analysis. Revenue Recognition. Realization Principle 5-1

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1 5-1 Chapter 5 Income Measurement and Profitability Analysis 5-2 Revenue Recognition Revenue should be recognized in the period or periods that the revenuegenerating activities of the company are performed. 5-3 Realization Principle Record revenue when: 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).

2 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 if the realization principle is satisfied: Persuasive evidence of of an an arrangement exists Delivery has occurred or or services have been performed The seller s price to to the buyer is is fixed or or determinable Collectibilityis reasonably assured. 5-5 Revenue Recognition at Delivery Revenue is earned and realized at the point of sale. The product or service has been delivered to the customer and cash has been received or is receivable. 5-6 Significant Uncertainty of Collectibility When uncertainties about collectibility exist, revenue recognition is delayed. 1. Installment Sales 2. Cost Recovery

3 Installment Sales 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. 5-8 Installment Sales Clarke, Inc. had the following installment sales in addition to its regular sales Installment sales $200,000 $250,000 $275,000 Cost of sales 155, , ,000 Gross profit $45,000 $60,000 $55,000 Gross profit percentage 22.50% 24.00% 20.00% $45,000 $200,000 = 22.50% 5-9 Installment Sales Clarke, Inc. had the following installment sales in addition to its regular sales Installment sales $200,000 $250,000 $275,000 Cost of sales 155, , ,000 Gross profit $45,000 $60,000 $55,000 Gross profit percentage 22.50% 24.00% 20.00% Cash Collections At Dec. 31, 2005, Clarke, Inc. is still owed $30,000 from the 2004 sales and $75,000 from the 2005 sales Installment sales $ 200,000 $ 250,000 $ 275,000 Cash Collected: From 2003 Sales (100,000) (50,000) (50,000) From 2004 Sales (195,000) (25,000) From 2005 Sales (200,000)

4 Installment Sales During 2003, Clarke collected $100,000 on its installment sales. Installment sales receivable ,000 Inventory 155,000 Deferred gross profit ,000 Cash 100,000 Installment sales receivable ,000 Deferred gross profit is the difference between the selling price and the cost of the inventory Installment Sales This entry records the Realized Gross Profit by adjusting the Deferred Gross Profit General account. Journal Installment sales receivable ,000 Inventory 155,000 Deferred gross profit ,000 Cash 100,000 Installment sales receivable ,000 Deferred gross profit ,500 Realized gross profit 22,500 ($100,000 collected x 22.50%) 5-12 Installment Sales During 2004, Clarke collected General $50,000 Journalon its 2003 installment sales and Description $195,000 on its 2004 installment Debit sales. Credit Installment sales receivable ,000 Inventory 190,000 Deferred gross profit ,000 Cash 245,000 Installment sales receivable ,000 Installment sales receivable ,000 Deferred gross profit ,250 Deferred gross profit ,800 Realized gross profit 58,050

5 Installment Sales During 2004, Clarke collected General $50,000 Journalon its 2003 installment sales and Description $195,000 on its 2004 installment Debit sales. Credit Installment sales receivable ,000 Inventory 190,000 Deferred gross profit ,000 Cash collections $ 50, % $ 11,250 Cash 245,000 Cash collections , % 46,800 Installment sales receivable ,000 $ 58,050 Installment sales receivable ,000 Deferred gross profit ,250 Deferred gross profit ,800 Realized gross profit 58, Installment Sales Cash Collection on Installment Sales in $ 50, % $ 11, , % 6, , % 40,000 $ 275,000 $ 57,250 Installment sales receivable ,000 Inventory 220,000 Deferred gross profit ,000 Cash 275,000 Installment sales receivable ,000 Installment sales receivable ,000 Installment sales receivable ,000 Deferred gross profit ,250 Deferred gross profit ,000 Deferred gross profit ,000 Realized gross profit 57,250 McGraw-Hill Companies, 2004 The Inc Installment Sales Deferred Gross Profit ,500 45, , ,250 - Deferred Gross Profit ,800 60, ,000 7,200 Deferred Gross Profit ,000 55, ,000

6 Installment Sales Balance Sheet Installment accounts receivable $ 105,000 Less: Deferred gross profit (22,200) Net Installment accounts receivable $ 82,800 Installment sales receivable 2004 $ 30,000 Installment sales receivable ,000 Installment accounts receivable $ 105,000 Deferred gross profit 2004 $ 7,200 Deferred gross profit ,000 Deferred gross profit $ 22, Cost Recovery 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 Installment sales $200,000 $250,000 $275,000 Cost of sales 155, , ,000 Gross profit $45,000 $60,000 $55,000 Gross profit percentage 22.50% 24.00% 20.00% $45,000 $200,000 = 22.50% 5-18 Cost Recovery The following schedule shows the pattern of cash collections for the three year period. Year of Collection Year of Sale $100,000 $50,000 $50, ,000 25, ,000 COGS $ 155,000 $ 190,000 $ 220,000 Under the cost recovery method profit is not recognized until the seller has recovered all of the cost of the goods sold.

7 Cost Recovery Installment receivable ,000 Inventory 155,000 Deferred gross profit ,000 Cash 100,000 Installment receivable ,000 The entries are exactly the same as under the Installment 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 Cost Recovery In 2004, let s concentrate on the entries relating to 2003 sales only. Cash 50,000 Installment receivable ,000 Now can we recognize some profit? 2003 Cost of goods sold $ 155,000 Cash collections (100,000) Cash collections (50,000) Unrecovered cost 5,000 We have not fully recovered the cost, so no profit is recognized in The McGraw-Hill Companies, Inc Cost Recovery Here are the entries we would make in 2005 relating to 2003 sales. Cash 50,000 Installment receivable ,000 Deferred gross profit 45,000 Realized gross profit 45,000 We have fully recovered the $155,000 cost during 2005, so the entire deferred gross profit will be recognized.

8 Revenue Recognition Over Time Long-term Construction Contracts Completed Contract Percentage-of- Completion 5-23 Measuring Progress Toward Completion Cost incurred to to date Estimate of of project s total cost Gross profit estimate 5-24 Percent complete = Total costs incurred to date Most recent estimate of total project cost Let s look at an example.

9 Geller Construction entered into a threeyear contract to build a containment vessel for Southeast Power Company. Presented below is information about the contract. Year 1 Year 2 Year 3 Cost incurred to date $250,000 $800,000 $1,200,000 Estimated cost to complete 1,000, ,000 0 Progress billing to date 250, ,000 1,400,000 Cash collections to date 225, ,000 1,100,000 Contract price $1,400,000 Let s see how Geller will account for the revenues and cost of this project using the percentage-of-completion method Year 1 Costs to date $250,000 Cost to complete 1,000,000 Estimated total cost $1,250,000 Percent complete to date 20.00% Percent completed earlier Percent completed this year Total revenue Percent completed this year Revenue this year Revenue recorded earlier Revenue in last year Costs this year Gross profit $250,000 $1,250,000 = 20% 5-27 Year 1 Costs to date $250,000 Cost to complete 1,000,000 Estimated total cost $1,250,000 Percent complete to date 20.00% Percent completed earlier Percent completed this year Total revenue $ 1,400,000 Percent completed this year 20.00% Revenue this year $ 280,000 Revenue recorded earlier Revenue in last year Costs this year 250,000 Gross profit $ 30,000

10 Construction in progress 250,000 Cash, materials, etc. 250,000 Accounts receivable 250,000 Billings on construction contract 250,000 Cash 225,000 Accounts receivable 225,000 Contra account to CIP Year 1 Cost incurred to date $250,000 Estimated cost to complete 1,000,000 Progress billing to date 250,000 Cash collections to date 225, The McGraw-Hill Contract price $1,400,000 Companies, Inc Construction in progress 250,000 Cash, materials, etc. 250,000 Accounts receivable 250,000 Billings on construction contract 250,000 Construction Cashin Progress Construction 225,000 in Progress - Billings on Construction Accounts receivable Contract - Billings on Construction 225,000 Contract Debit Balance (Unbilled Receivable) Credit Balance (Overbilled Receivable) Classified as an asset Classified as a liability 5-30 Construction in progress 250,000 Cash, materials, etc. 250,000 Accounts receivable 250,000 Billings on construction contract 250,000 Cash 225,000 Accounts receivable 225,000 Cost of construction 250,000 Construction in progress 30,000 Revenue from Total long-term revenue contract $ 1,400, ,000 Percent completed this year 20.00% Revenue this year $ 280,000 Revenue recorded earlier Revenue in last year Costs this year 250,000 Gross profit $ 30,000

11 Construction in progress 250,000 Cash, materials, etc. 250,000 Accounts receivable 250,000 Billings on construction contract 250,000 Cash 225,000 Closing Entry Accounts receivable 225,000 Cost of construction 250,000 Construction in progress 30,000 Revenue from long-term contract 280,000 Revenue from long-term contract 280,000 Cost of construction 250,000 Retained earnings The McGraw-Hill 30, Companies, Inc Financial Statements Balance Sheet Cash (25,000) Accounts Receivable 25,000 Construction in progress (CIP) 280,000 Billings on CIP (250,000) 30,000 30,000 Retained earnings 30,000 Income Statement Revenue from long-term contract 280,000 Cost of construction (250,000) Net income 30, Year 1 Year 2 Costs to date $250,000 $800,000 Cost to complete 1,000, ,000 Estimated total cost $1,250,000 $1,225,000 Percent complete to date 20.00% 65.31% Percent completed earlier % Percent completed this year 45.31% Total revenue $ 1,400,000 Percent completed this year 20.00% $800,000 $1,225,000 = 65.31% Revenue this year $ 280,000 Revenue recorded earlier Revenue in last year Costs this year 250,000 Gross profit $ 30,000

12 Year 1 Year 2 Costs to date $250,000 $800,000 Cost to complete 1,000, ,000 Estimated total cost $1,250,000 $1,225,000 Percent complete to date 20.00% 65.31% Percent completed earlier % Percent completed this year 45.31% Total revenue $ 1,400,000 $ 1,400,000 Percent completed this year 20.00% 45.31% Revenue this year $ 280,000 $ 634,340 Revenue recorded Total earlier expenses $ 800,000 Expenses last year Revenue in last year (250,000) Costs this year Current expenses $ 550, , ,000 Gross profit $ 30,000 $ 84, Construction in progress 550,000 Cash, materials, etc. 550,000 $800,000 - $250,000 last year = $550,000 Year 1 Year 2 Cost incurred to date $250,000 $800,000 Estimated cost to complete 1,000, ,000 Progress billing to date 250, ,000 Cash collections to date 225, ,000 Companies, Inc. Contract price $1,400, The McGraw-Hill 5-36 Construction in progress 550,000 Cash, materials, etc. 550,000 Accounts receivable 525,000 Billings on construction contract 525,000 $775,000 - $250,000 last year = $525,000 Year 1 Year 2 Cost incurred to date $250,000 $800,000 Estimated cost to complete 1,000, ,000 Progress billing to date 250, ,000 Cash collections to date 225, ,000 Companies, Inc. Contract price $1,400, The McGraw-Hill

13 Construction in progress 550,000 Cash, materials, etc. 550,000 Accounts receivable 525,000 Billings on construction contract 525,000 Cash 470,000 Accounts receivable 470,000 $695,000 - $225,000 last year = $470,000 Year 1 Year 2 Cost incurred to date $250,000 $800,000 Estimated cost to complete 1,000, ,000 Progress billing to date 250, ,000 Cash collections to date 225, ,000 Companies, Inc. Contract price $1,400, The McGraw-Hill 5-38 Construction in progress 550,000 Cash, materials, etc. 550,000 Accounts receivable 525,000 Billings on construction contract 525,000 Cash 470,000 Accounts receivable 470,000 Cost of construction 550,000 Construction in progress 84,340 Revenue from long-term contract 634,340 Total revenue $ 1,400,000 Percent completed this year 45.31% Revenue this year $ 634,340 Revenue recorded earlier Revenue in last year Costs this year 550,000 Gross profit $ 84, The McGraw-Hill Companies, Inc Construction in progress 550,000 Cash, materials, etc. 550,000 Accounts receivable 525,000 Billings on construction contract 525,000 Cash 470,000 Closing Entry Accounts receivable 470,000 Cost of construction 550,000 Construction in progress 84,340 Revenue from long-term contract 634,340 Revenue from long-term contract 634,340 Cost of construction 550,000 Retained earnings 84,340

14 Year 1 Year 2 Year 3 Costs to date $250,000 $800,000 $1,200,000 Cost to complete 1,000, ,000 0 Estimated total cost $1,250,000 $1,225,000 $1,200,000 Percent complete to date 20.00% 65.31% % Percent completed earlier % Percent completed this year 45.31% Total revenue $ 1,400,000 $ 1,400,000 Percent completed this year 20.00% 45.31% Revenue this year $ 280,000 $ 634,340 Revenue recorded earlier Revenue in last year Costs this year 250, ,000 Gross profit $ 30,000 $ 84, Year 1 Year 2 Year 3 Costs to date $250,000 $800,000 $1,200,000 Cost to complete 1,000, ,000 0 Estimated total cost $1,250,000 $1,225,000 $1,200,000 Percent complete to date 20.00% 65.31% % Percent completed earlier % Percent completed this year 45.31% Total revenue $ 1,400,000 $ 1,400,000 $ 1,400,000 Percent completed this year 20.00% 45.31% Revenue this year $ 280,000 $ 634,340 Revenue recorded earlier 914,340 Revenue in last year $ 485,660 Costs this year 250, , ,000 Gross profit $ 30,000 $ 84,340 $ 85, Construction in progress 400,000 Cash, materials, etc. 400,000 Accounts receivable 625,000 Billings on construction contract 625,000 Cash 405,000 Accounts receivable 405,000 Cost of construction 400,000 Construction in progress 85,660 Revenue from long-term contract 485,660 Revenue from long-term contract 485,660 Cost of construction 400,000 Retained earnings 85,660

15 Construction in Progress Year 1 250,000 30,000 Year 2 550,000 84,340 Year 3 400,000 85,660 1,400,000 Billings on Construction Contract 250,000 Year 1 525,000 Year 2 625,000 Year 3 1,400,000 Entry to transfer title to the customer. Billings on construction contract 1,400,000 Construction in progress 1,400, Completed Contract Geller Construction entered into a threeyear contract to build a containment vessel for Southeast Power Company. Presented below is information about the contract. Year 1 Year 2 Year 3 Cost incurred to date $250,000 $800,000 $1,200,000 Estimated cost to complete 1,000, ,000 0 Progress billing to date 250, ,000 1,400,000 Cash collections to date 225, ,000 1,100,000 Contract price $1,400,000 Let s see how Geller will account for the revenues and cost of this project using the completed contract method Construction in progress 250,000 Cash, materials, etc. 250,000 Accounts receivable 250,000 Billings on construction contract 250,000 Cash 225,000 Accounts receivable 225,000 Completed Contract Entries are identical to the entries for percentage of completion. Gross profit is not recognized until project is complete. Year 1 Cost incurred to date $250,000 Estimated cost to complete 1,000,000 Progress billing to date 250,000 Cash collections to date 225, The Companies, Inc. Contract price $1,400,000 McGraw-Hill

16 Construction in progress 550,000 Cash, materials, etc. 550,000 Accounts receivable 525,000 Billings on construction contract 525,000 Cash 470,000 Accounts receivable 470,000 Completed Contract Entries are identical to the entries for percentage of completion. Gross profit is not recognized until project is complete. Year 1 Year 2 Cost incurred to date $250,000 $800,000 Estimated cost to complete 1,000, ,000 Progress billing to date 250, ,000 Cash collections to date 225, ,000 Companies, Inc. Contract price $1,400, The McGraw-Hill 5-47 Completed Contract Construction in progress 400,000 Cash, materials, etc. 400,000 Accounts receivable 625,000 Billings on construction contract 625,000 Cash 405,000 Accounts receivable 405,000 Cost of construction 1,200,000 Construction in progress 200,000 Revenue from long-term contract 1,400,000 Gross profit is recognized in year 3 since project is complete. Revenue from long-term contract 1,400,000 Cost of construction 1,200,000 Retained earnings 200, Completed Contract Construction in Progress Year 1 250,000 Year 2 550,000 Year 3 400,000 Year 3 200,000 1,400,000 Billings on Construction Contract 250,000 Year 1 525,000 Year 2 625,000 Year 3 1,400,000 Entry to transfer title to the customer. Billings on construction contract 1,400,000 Construction in progress 1,400,000

17 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 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. Source: SFAS Let s look at some activity ratios!

18 Receivables Turnover Ratio Receivables Turnover Ratio = Net Sales 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. This ratio measures how many times a company converts its receivables into cash each year Average Collection Period Average Collection Period = 365 Receivables Turnover Ratio This ratio is an approximation of the number of days the average accounts receivable balance is outstanding Inventory Turnover Ratio Inventory Turnover Ratio = Cost of Goods Sold Average Inventory This ratio measures the number of times merchandise inventory is sold and replaced during the year.

19 Average Days in Inventory Average Days in Inventory = 365 Inventory Turnover Ratio This ratio indicates the number of days it normally takes to sell inventory Asset Turnover Ratio Asset Turnover Ratio = Net Sales Average Total Assets This ratio measures how efficiently a company utilizes all of its assets to generate revenue Let s look at some profitability ratios!

20 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 Return on Total Assets Return on Total Assets = Net Income Average Total Assets This ratio measures how well assets have been employed 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.

21 End of Chapter 5

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