5
Income 5-1
Chapter Measurement and Profitability Analysis
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
Slide 5-2
Realization Principle
Record revenue when: Record revenue when: The earnings process is complete or virtually complete = Sale There is reasonable certainty as to the collectibility of the asset to be received (usually cash).
2004 The McGraw-Hill Companies, Inc.
AND
McGraw-Hill/Irwin
Slide 5-3
Revenue Recognition with Right of Return - SFAS No. 48
Record at time of sale only if:
Price is fixed at date of sale Buyer will pay Buyer pays for goods he/she damages Buyer separate from seller Seller not involved in subsequent resale Future returns can be estimated
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
5-2
Slide 5-4
SEC Staff Accounting Bulletin No. 101
Issued to crackdown on earnings Issued to crackdown on earnings management. Provides additional management. Provides additional guidance to determine if the realization guidance to determine if the realization principle is satisfied: principle is satisfied:
1. Persuasive evidence of a sales arrangement 1. Persuasive evidence of a sales arrangement exists. exists. 2. Delivery has occurred or services have been 2. Delivery has occurred or services have been performed. performed. 3. The seller's price to the buyer is fixed or 3. The seller's price to the buyer is fixed or determinable. determinable. 4. Collectibility is reasonably assured. 4. Collectibility is reasonably assured.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
Slide 5-5
Point of Sale
FOB Shipping Point Title passes when the goods leave the seller Buyer assumes cost and responsibility for goods in transit CIF (FOB Destination Point) Title passes when goods arrive at customer location Seller assumes cost and responsibility for goods in transit
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
Slide 5-6
Significant Uncertainty of Collectibility
When uncertainties about When uncertainties about collectibility exist, revenue collectibility exist, revenue recognition is delayed. recognition is delayed.
1. Installment Sales Method 1. Installment Sales Method 2. Cost Recovery Method 2. Cost Recovery Method
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
5-3
Slide 5-7
Installment Sales Method
Sale and cost of sale recording postponed. 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.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
Slide 5-8
Cost Recovery Method
Sale and cost of sale recording postponed. All cash received is applied against cost of item sold. Recognize gross profit only after all costs recovered and based on additional cash received.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
Slide 5-9
Right of Return
In most situations, even though the right to return merchandise exists, revenues and expenses can be appropriately recognized at point of delivery. Estimate the returns. Reduce Sales and/or Cost of Goods Sold.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
5-4
Slide 5-10
Consignment Sales
Place inventory with another company for sale No sale recorded until the other company sells. Seller retains risk of loss. Should put inventory into a separate account to track items with others.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
Slide 5-11
Revenue Recognition Over Time
Service revenue earned as time passes - not when cash collected. Initially record cash receipt unearned and revenue. Recognize revenue over period of expected service Season pass to 6 Flags; Office rental income
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
Slide 5-12
Revenue Recognition Over Time
Completed Completed Contract Method Contract Method Long-term Long-term Construction Construction Contracts Contracts
Percentage-ofPercentage-ofCompletion Completion Method Method
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
5-5
Slide 5-13
Construction in Progress Account
Clearing Account Additions = costs incurred to date + Gross profit recognized to date Reductions = Progress billings = Revenue recognized over life of contract
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
Slide 5-14
Completed Contract Method
Recognition of profit deferred until completion of contract. All costs and billings recorded same as Percentage of Completion Method. Potential for large swings in earnings resulting from timing of big contracts. Estimated losses recorded currently not deferred until completion.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
Slide 5-15
Percentage-of-Completion Method
Recognize profit as project progresses. 3 items needed to determine interim profit reporting: Costs incurred to date. Estimate of the project's total cost Gross profit estimate Profit recorded in proportion to costs incurred not cash received or billings. Estimated loss recorded currently.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
5-6
Slide 5-16
Percentage-of-Completion Method
Total costs incurred to date Percent complete = Most recent estimate of total project cost
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
Slide 5-17
Receivables Turnover Ratio
Receivables Turnover = Ratio Net Sales (Credit 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.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
Slide 5-18
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.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
5-7
Slide 5-19
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.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
Slide 5-20
Average Days in Inventory
Average 365 Days in = Inventory Turnover Ratio Inventory
This ratio indicates the number of days it normally takes to sell inventory.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
Slide 5-21
Net Profit Margin on Sales
Net Profit on Sales = Net Income Net Sales
This ratio indicates the portion of each dollar of revenue that is available to shareholders.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
5-8
Slide 5-22
Return on Total Assets
Return on = Total Assets Net Income Average Total Assets
This ratio measures how well assets have been employed.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.
Slide 5-23
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.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.