2. Realization Principle Record revenue when: Revenues are inflows or other enhancements of assets … from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations . AND there is reasonable certainty as to the collectability of the asset to be received (usually cash). the earnings process is complete or virtually complete.
13. Right of Return – Normal Situation (page 243-244) 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
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15. Consignment Sales Sonic Solutions Graphic 5-8 (p. 245) Sometimes a company arranges for another company to sell its product under consignment. … consignor retains the risks and rewards of ownership … and title does not pass to the consignee, hence: the consignor does not record a sale until the consignee sells the goods
19. Accounting for the Cost of Construction & Accounts Receivable (page 247) For both methods, journal entries for: 1) costs, 2) billings, and 3) cash receipts are the SAME!
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21. Entries for Gross Profit Recognition : Different depending on Method (page 248)
22. Where Did the %-of-Completion Numbers Come From? (page 250)
23. Observation : %-of-Completion Method : Key Balance Sheet Accounts Notice that the gross profit recognized in each period is added to the construction in progress account.
24. Observation : %-of-Completion Method Income Statement (page 251) The journal entries (slide #21) result in the income statement for each year reporting: 1) revenue and, 2) cost of construction amounts.
25. Observation : Income Recognition The same total amount of profit or loss is recognized under both the completed contract and the percentage-of-completion methods, but the timing of recognition differs .
26. Observation: Balance Sheet Accounts might show either a Net Asset or Net Liability position (page 252)
33. Franchise Sales (pages 260-261) Initial Franchise Fees Revenue recognition is challenging: Generally when the earnings process is virtually complete.
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35. 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.
37. DuPont Framework This is called the DuPont framework because the DuPont Company was a pioneer in emphasizing this relationship. 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 X Equity multiplier Net income Avg. total equity = Net income Total sales X Total sales Avg. total assets X Avg. total assets Avg. total equity Return on equity = Return on assets X Equity multiplier Net income Avg. total equity = Net income Avg. total assets X Avg. total assets Avg. total equity
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 to a point after delivery or should be recognized at a point prior to delivery. We also continue our discussion of financial statement analysis.
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 collectability 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.
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. Collectability 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.
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 collectability. Revenue from the sale of products usually is recognized at the point of product delivery. The point of delivery refers to the date legal title to the product passes from seller to buyer. 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.
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 collectability 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.
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 certain 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 certain 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.
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.
Revenue recognition when an earnings process is virtually complete is inappropriate for certain types of long-term contracts. 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.
With both the completed contract and percentage-of-completion methods, all costs of construction are recorded in an asset account called construction in progress. This account is equivalent to the asset work-in-process inventory in a manufacturing company. This is logical since the construction project is essentially an inventory item in process for the contractor. Notice that periodic billings are credited to billings on construction contract. This account is a contra account to the construction in progress asset. At the end of each period, the balances in these two accounts are compared. If the net amount is a debit, it is reported in the balance sheet as an asset. Conversely, if the net amount is a credit, it is reported as a liability. Note that a problem that could occur with these sorts of transactions is double accounting – having both a physical asset (construction in progress) and a financial asset (accounts receivable or, once the receivable is collected, cash) on the books at the same time. We avoid this problem by having billings as a contra account to construction in progress. Recognizing the financial asset (accounts receivable) serves to reduce the net carrying value of the physical asset (construction in progress less billings).
This slide illustrates the calculation of gross profit for each of the years for our Harding Construction Company example, with progress to date estimated using the cost-to-cost ratio. Earlier we showed the journal entries used to recognize gross profit in each period.
The T-accounts for the percentage-of-completion method are illustrated on this slide. Notice that the gross profit recognized in each period is added to the construction in progress account.
Income statements are more informative if the sales revenue and cost components of gross profit are reported rather than the net figure alone. So, the income statement for each year will report the appropriate revenue and cost of construction amounts. For example, in 2011, the gross profit of $500,000 consists of revenue of $2,000,000 (40% of the $5,000,000 contract price) less the $1,500,000 cost of construction. In subsequent periods, we calculate revenue by multiplying the percentage of completion by the contract price and then subtracting revenue recognized in prior periods, similar to the way we calculate gross profit each period. The cost of construction, then, is the difference between revenue and gross profit. In most cases, cost of construction also equals the construction costs incurred during the period. The table on this slide shows the revenue and cost of construction recognized in each of the three years of our example. Of course, as you can see in this illustration, we could have initially determined the gross profit by first calculating revenue and then subtracting cost of construction.
Earlier we illustrated the journal entries that would determine the amount of revenue, cost, and therefore gross profit that would appear in the income statement under the percentage-of-completion and completed contract methods. Comparing the gross profit patterns produced by each method of revenue recognition demonstrates the essential difference as shown on this slide. Although both methods yield identical gross profit of $900,000 for the entire 3-year period, the timing differs. The completed contract method defers all gross profit to 2013, when the project is completed. Obviously, the percentage-of-completion method provides a better measure of the company’s economic activity and progress over the three-year period. That’s why the percentage-of-completion method is preferred, and, as mentioned previously, the completed contract method should be used only when the company is unable to make dependable estimates of future costs necessary to apply the percentage-of-completion method.
The balance sheet presentation for the construction-related accounts by both methods is shown on this slide. The balance in the construction in progress account differs between methods because of the earlier gross profit recognition that occurs under the percentage-of-completion method.
IAS No. 11 governs revenue recognition for long-term construction contracts. Like U.S. GAAP, that standard requires the use of the percentage-of-completion method when reliable estimates can be made. However, unlike U.S. GAAP, IAS No. 11 requires the use of the cost recovery method rather than the completed contract method when reliable estimates can’t be made. Under the cost recovery method, contract costs are expensed as incurred, and an offsetting amount of contract revenue is recognized to the extent that it is probable that costs will be recoverable from the customer. No gross profit is recognized until all costs have been recovered, which is why this method is also sometimes called the “zero-profit method.” Note that under both the completed contract and cost recovery 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. Also, under both methods an expected loss is recognized immediately.
The software industry is a key economic component of our economy. Microsoft alone reported revenues in excess of $58 billion for its 2009 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. For non-software arrangements, revenue now can be allocated to deliverables that have stand-alone value (e.g., aren’t contingent on the delivery of other items) based on the selling prices of those elements. Unlike for software, estimated selling prices can be used. This is a departure from prior guidance (EITF 00-21), which required objective and reliable value of fair value. And, this extends to products that involve both hardware and software for which the software is an integral part of the product. So, for example, if a vendor sells a computer that includes an operating system that is essential to the computer’s operation, and also includes ongoing customer support, revenue can be allocated to the computer and the customer support based on estimated selling prices.
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 collectability. Specific guidance for revenue recognition of the initial franchise fee is provided in 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 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 uncollectability cannot be made.
The FASB and IASB are currently working on a new, comprehensive approach to revenue recognition. Why? Currently, the FASB has over 100 revenue-related standards that sometimes contradict each other and that treat similar economic events differently. The IASB has two primary standards (IAS No. 11 and IAS No. 18) that also sometimes contradict each other and that don’t offer guidance in some important areas (like multiple deliverables). And, although both the FASB and IASB define revenue in terms of flows of assets and liabilities, the FASB guidance typically bases revenue recognition on the earnings process, while the IASB standards base it on the transfer of the risks and rewards of ownership, which can lead to different outcomes. So, the accounting guidance on revenue recognition could use some improvement. The Boards are working on a new approach that defines revenue as resulting from inflows and outflows of assets and liabilities that underlie the “performance obligations” inherent in a contract between a company (the “seller”) and its customer. Revenue is recognized when the seller satisfies a performance obligation by transferring a promised asset (a good or a service) to the customer, with “transfer” having occurred when the customer controls the asset (a service is viewed as an asset that is consumed immediately by the customer, so it typically doesn’t appear in the customer’s balance sheet as an asset). Revenue is measured at the transaction price (the amount of consideration that the customer promises when the contract is made). If a contract requires that the seller provide multiple goods and services, the seller estimates the stand-alone selling price of each of those goods and services and allocates the transaction price to each good and service on that basis. For many types of sales arrangements, adopting this new approach would not change current practice much, but in some areas it would change practice considerably. For example, because revenue is recognized only when the seller transfers control of the asset to the buyer, percentage-of-completion accounting would not be allowed unless the customer controls the asset being constructed. On the other hand, some performance obligations that now are ignored from a revenue recognition standpoint (like a warranty that is not sold separately and which we will discuss in Chapter 13) would now be viewed as producing revenue, with estimation necessary to allocate part of the transaction price to the warranty. It is likely that this comprehensive revenue standard will be controversial, and it could change or even be abandoned before implementation. However, the Boards appear committed to improving accounting in this area.
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.
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 their 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.
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. 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.
