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FIN Chapter 5 - Income Measurement and Profitability...

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Unformatted text preview: Income Measurement and Profitability Analysis Revenue Recognition Criteria help ensure that an income Criteria statement reflects the actual accomplishments of a company for the period. period. Ensure proper cutoff (no duplication of Ensure activity or omission of information across time periods) time Realization Principle The earnings process is judged to be complete or The virtually complete virtually – Means that revenue is recognized at or near the end of the Means earnings process (unless collectibility is uncertain) earnings – Exception – sometimes it is better to recognize revenue over Exception time in proportion to the performance accomplished by the seller (i.e., percentage of completion) (i.e., – If recognition is too early, earnings quality decreases (some If revenue may never actually transpire) – can result in subsequent restatements which are costly (i.e., recordkeeping, credibility, investor losses, increased cost of capital) credibility, There is reasonable certainty as to the collectibility of the There asset to be received (usually cash). asset Staff Accounting Bulletin (SAB) No. 101 SEC issued in light of earnings management problems Provides specific guidelines for revenue recognition – – – – 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 Caused many companies to delay their revenue Caused recognition. recognition. SEC wants to make sure that the risk and rewards of SEC ownership have transferred to the buyer in order for the seller to recognize the revenue. seller Earnings Process Earnings Process Revenue is recognized at one specific Revenue Completion of the Earnings Process within a Single Reporting Period point when both revenue recognition criteria are satisfied (earnings process complete and collectibility is certain) complete When Collectibility is Reasonably Certain Sale of products – revenue recognition usually occurs at Sale the point of sale (or point of product delivery) the – Point of delivery refers to the date legal title to the product Point passes from the seller to the buyer. passes If f.o.b. (free on board) shipping point – title passes at the point of If shipment (the seller’s loading dock) shipment If f.o.b. destination – title passes at the buyer’s receiving dock Use the Allowance for Doubtful Accounts to account for Use the risk of uncertainty of collection. the Sale of services – revenues and costs are deferred if Sale there are any remaining services that are critical to the earnings process. earnings – Other services may be earned throughout the earnings process Other – does each part of the service add “stand-alone” value to the customer? customer? Significant Uncertainty of Collectibility Defer recognition of gross profit (revenue Defer less cost of goods or services sold) until uncertainty is resolved. uncertainty Must be fully disclosed in the footnotes Must (usually Summary of Significant Accounting Policies) Accounting Installment Sales Customers are allowed to pay for goods over Customers time - common among retailers time The longer the payment term, the more risky The cash collections become cash Allowance for Doubtful Accounts is usually Allowance sufficient for accounting for the uncertainty. sufficient – Preferable as long as bad debts can be reasonably Preferable estimated – achieves proper matching estimated Installment Sales When a reasonable estimate of bad debts When is not possible, the revenue and expense recognition should be delayed (i.e., the gross profit should be delayed) gross – Customers are poor credit risk or real estate Customers industry (i.e., small down payments and very lengthy repayment periods) lengthy Installment Sales Can delay gross profit using two methods: – Installment Sales Method Recognizes the gross profit proportionately to the Recognizes amount of cash received by the customer (as the cash is received) cash – Cost Recovery Method No gross profit is recognized until full amount of No costs are recovered through customer payments costs Installment Sales First compute the gross profit percentage for the First period in which the sale occurs period At the time the sale is made: – Establish the installment receivable – this reflects the Establish entire amount the customer should eventually pay entire – Remove the merchandise from inventory – Establish the Deferred Gross Profit (equal to Establish Installment Sales less Cost of Installment Sales) Installment Deferred Gross Profit is a contra asset account (reduces the Deferred receivables account) Installment Sales When cash is received: – Record the receipt of cash and the corresponding Record decrease in the Installment Sales Receivable decrease – Recognize a portion of the Deferred Gross Profit Calculated as gross profit percentage multiplied by cash Calculated payment received payment Debit Deferred Gross Profit and Credit Realized Gross Profit Realized Gross Profit increases Gross Profit – Note that full amount of revenue is not included in Note Total Revenue on the Income Statement because it is uncertain that the entire amount of Installment Sales will ever be recognized will Installment Sales Other Method – footnote 12 on page 234. Other Acceptable but more complicated than above. above. E5­3, p. 267 Work in class Installment Sales Balance Sheet: Installment Receivables $XXXX Less: Deferred Gross Profit (XXXX) Less: (XXXX) Installment Receivables (net) $XXXX Will be current or noncurrent depending Will on when the receivables are expected to be settled in their entirety be Installment Sales Income Statement – Realized Gross Profit is usually listed just Realized below regular Gross Profit OR may include the amount of Cash Collections as Installment Sales and [Cash Collections * (1 – GP%)] as the Cost of Installment Sales (difference in presentation, not accounting) presentation, – Realized Gross Profit is closed to Income Realized Summary at the end of the accounting period. Summary Installment Sales Repossession of Merchandise Sold on Repossession Installment Sales Method Installment – Journal entry would include the following: Record repossessed merchandise back into inventory (at Record amount that it can be resold for or current fair value) amount Write off the customer’s remaining Installment Receivable Remove amount of Deferred Gross Profit that has not yet Remove (nor will ever be) recognized (computed as GP% * Installment Receivable balance) Installment Record gain or loss if necessary. E5­7, p. 268 Work in class Cost Recovery Method Defers all gross profit recognition until cash Defers equal to the cost of the sold item has been received. received. Journal entry at time of sale is same as Journal Installment Sales method. Installment When cash is received, debit cash and credit the When Installment Receivable, but no Realized Gross Profit entry until the cost is recovered (and then recognized as excess cash over cost is received) received) Right of Return Can usually estimate amount of returns based on past Can operating history operating – Would use a Sales Return Allowance account (will cover in Would Chapter 7) Chapter If the seller cannot make reliable estimates of future If returns, then the entire revenue recognition must be delayed till some other event (i.e., product sold by customer to another party, right of return contractually expires, quality of product has been assessed and product is accepted by customer) product – Common in technology sector where products obsolesce very Common quickly quickly – Similar to Installment Sales or Cost Recovery Method – Deferred Gross Profit is converted to Realized Gross Profit when Deferred right of return can be reasonably estimated or no longer exists. right Consignment Sales Consignor – transfers goods to another party Consignor (consignee) to sell the goods on their behalf (consignee) – Legal title remains with the consignor until sold to a third party – Risks and rewards of ownership remain with the consignor – Still part of consignor’s inventory (do not count in consignee’s Still inventory) inventory) If sale to third party does not occur within specific time If period, goods revert back to consignor (i.e., no sale takes place) takes If sale to third party occurs, consignee remits the selling If price less a commission to the consignor Service Revenue Earned over Time Completion of the Earnings Process over Multiple Reporting Periods – Service revenue is often recognized over Service time, in proportion to the amount of service performed. performed. Long­Term Contracts Construction, research, consulting, etc. Completed Contract Method – recognizes revenue when earnings Completed process is complete process – Poor matching of expenses and revenues with related cash flows Percentage-of-Completion Method – recognizes revenue throughout Percentage-of-Completion the earnings process the – Allocate a share of the project’s revenues and expenses to each Allocate reporting period during construction reporting – Requires the seller to know what the contract price is, and to be able to Requires estimate future costs to complete the project estimate – Required by US GAAP and IFRS unless impossible to make reliable Required estimates of revenues, expenses, and progress toward completion. estimates – If can’t make reasonable estimates, then must use Cost Recovery If Method under IFRS (rather than Completed Contract method) Method Must disclose method under Summary of Significant Accounting Must Policies Policies Accounting for the Cost of Construction and Accounts Receivable Accounting for costs, billings to the customer, Accounting and cash receipts are the same under both percentage-of-completion and completed contract. contract. Use account called “Construction in Progress” Use which is a work in process inventory account. which – When construction expenses are incurred: Dr. Construction in Progress Cr. Cash, materials, etc. Accounting for the Cost of Construction and Accounts Receivable Most contracts specify for periodic progress billings to be Most made by the buyer to the seller to offset the cash expenditures over the construction period. However, there is likely a delay between when the seller However, bills the buyer and the buyer pays the cash. bills When the billings are sent out by the seller: Dr. Accounts Receivable Cr. Billings on Construction Contract When cash is received from the buyer: Dr. Cash Cr. Accounts Receivable Balance Sheet Presentation: The “Billings” account (a financial asset) is sort of a contra-inventory The account that is netted against the work in process account “Construction in Progress” (a physical asset) “Construction At the balance sheet date, the amounts in Construction in Progress At (CIP) and Billings on Construction Contract are compared: (CIP) – If CIP > Billings, then the excess is reported as an asset (unbilled If receivable) receivable) – If Billings > CIP, then the excess is reported as a liability (unearned If revenue) revenue) – If we didn’t net them out, the common amount would be “double If counted” on the B/S counted” – Most companies have both assets and liabilities because of numerous Most simultaneous contracts in progress. simultaneous Any remaining A/R is also reported as an asset. Gross Profit Recognition – General Approach The same total amount of gross profit is The recognized under Percentage-ofrecognized Completion and Completed Contract, but Completion the timing of gross profit recognition across periods differs. across Timing of Gross Profit Recognition Under the Completed Contract Method In the last period of the contract, all revenue, In expense and gross profit are recognized with the following entry: following Dr. CIP for the amount of the gross profit on the Dr. contract (revenue less expense) contract Dr. Cost of Construction for the total costs of the project Dr. (COGS-like account) (COGS-like Cr. Revenue from LT Contracts for total contract price – Notice that the CIP account will be the sum of all the Notice construction costs plus the gross profit = revenues. construction Timing of Gross Profit Recognition Under the Completed Contract Method At the end of the contract period, Billings At should also equal revenues. should Also, the CIP and Billings accounts should Also, be closed at the completion of the contract: contract: Dr. Billings Cr. CIP Timing of Gross Profit Recognition Under the Percentage­of­Completion Method Profit is recognized over the life of the Profit project as the project is completed. project Progress to date can be estimated as the Progress proportion of the project’s cost incurred to date divided by the total estimated costs (or by relying on a expert’s opinion such as an architect or engineer) as – Percentage Completed to Date = Total Costs Percentage Incurred To Date/Total Estimated Costs Incurred Timing of Gross Profit Recognition Under the Percentage­of­Completion Method Total Estimated Gross Profit = Contract Price Total minus Total Estimated Costs minus Gross Profit Recognized in Current Period = Gross (Total Estimated Gross Profit multiplied by Percentage Completed to Date) minus Gross Profit Recognized in Prior Periods Profit Next calculate amount of revenue to be Next recognized in the current period = (Contract Price multiplied by Percentage Completed to Date) minus Revenue Recognized in Prior Periods Periods Timing of Gross Profit Recognition Under the Percentage­of­Completion Method Cost of Construction for Current Period = Cost Revenue Recognized in Current Period minus Gross Profit Recognized in Current Period Gross – Cannot use current costs because may need to be Cannot adjusted if a loss is projected. adjusted End of Period Journal Entry: Dr. CIP for amount of Gross Profit Recognized in Dr. Current Period Current Dr. Cost of Construction for Current Period Cr. Revenue Recognized in Current Period E5­10, p. 268 Work in class Long­Term Contract Losses Not all contracts generate gross profit Cost overruns can either temporarily or Cost permanently erode the profitability of a contract contract Periodic Loss Occurs for Profitable Project When Estimated Total Gross Profit is still When expected to be positive expected – Estimated Total Gross Profit = Contract Price minus Estimated Total Estimated Costs Total – Compute Gross Profit to be Recognized to Date = Compute to Percentage Complete multiplied by Estimated Total Gross Profit Gross – If Gross Profit to be Recognized to Date < Gross If to Profit Recognized to Date, then must record a loss on the project: the – Gross Loss = Gross Profit Recognized to Date minus Gross Gross Profit to be Recognized to Date to Periodic Loss Occurs for Profitable Project Cost of Construction for Current Period = Cost Revenue Recognized in Current Period plus Gross Loss Dr. Cost of Construction for Current Period Period Cr. Revenue Recognized in Current Cr. Period Period Cr. Construction in Progress (amount of Cr. Gross Loss) Gross Note that this entry reduces the Gross Note Profit Recognized to Date Loss is Projected for the Entire Project Difference here is Estimated Total Gross Profit < 0 Difference meaning that Estimated Total Costs > Contract Price meaning An estimated loss is fully recognized in the first period An the loss is anticipated regardless of the revenue recognition method (conservatism) recognition Entry must remove Gross Profit recognized in prior Entry periods plus adjust for anticipated loss periods Estimated Total Gross Loss = Estimated Total Costs Estimated minus Contract Price minus Gross Loss for Current Period = Gross Profit Recognized Gross to Date plus Estimated Total Gross Loss to Loss is Projected for the Entire Project Cost of Construction for Current Period = Cost Revenue Recognized in Current Period plus Gross Loss for Current Period plus Dr. Cost of Construction for Current Dr. Period Period Cr. Revenue Recognized in Current Cr. Period Period Cr. Construction in Progress (amount of Cr. Gross Loss for Current Period) Gross E5­11 and E5­12, p. 269 Work in class Software and Other Multiple­ Deliverable Arrangements Bundled products including software, upgrades, Bundled postcontract customer support, and other services. services. Since hybrid of product and services, when Since should revenue be recognized? should – AICPA Statement of Position (SOP) 97-2 says AICPA following: following: If arrangement includes multiple elements, the revenue from If the arrangement should be allocated to the various elements based on the relative fair values of the individual elements based Stated prices can deviate from fair values so must use fair Stated values values Software and Other Multiple­ Deliverable Arrangements EITF 00-21 broadened revenue recognition to EITF other arrangements with multiple deliverables other – Examples: appliances with maintenance contracts, Examples: cell phone contracts that have built-in service contracts, any bundled arrangement contracts, – States sellers must separately record revenue for a States part of an arrangement if the part has value to the customer on a stand-alone basis and there is objective and reliable fair value of the undelivered parts. parts. – If part of an arrangement doesn’t qualify for separate If accounting, recognition of the revenue from that part is delayed until all other revenue is recognized. is Apple’s MD&A Franchise Sales The franchisor (the name brand group) The grants to the franchisee the right to sell the franchisor’s products and use its name for a specified period of time. specified Fees to be paid by the franchisee are Fees comprised of comprised – Initial Franchise Fee – Continuing Franchise Fees Initial Franchise Fee Gives franchisee right to use name and sell its Gives products Might also include assistance in location Might identification, facility construction, and training identification, Usually fixed in amount Payable in one lump sum or in installments When is earnings process complete? – SFAS No. 45 establishes concept of substantial SFAS performance performance Initial Franchise Fee If services to be provided by franchisor after If contract signed are substantial but collection of initial franchise fee installments is relatively certain then journal entry is: certain Dr. Cash Dr. Note Receivable Cr. Unearned Franchise Fee Revenue As services are performed: Dr. Unearned Franchise Fee Revenue Cr. Franchise Fee Revenue Initial Franchise Fee If collectibility of initial franchise fees was If uncertain and could not be reasonably estimated (Allowance for Doubtful Accounts), then combine with Installment Sales Method Sales – Unearned Franchise Fee Revenue would Unearned become Deferred Franchise Fee Revenue become Continuing Franchise Fees Paid to franchisor for continuing rights such as Paid advertising, promotion and other services over the life of the franchise agreement the May be fixed annual or monthly amount or May based on a percentage of volume based Recognized over time by the franchisor as Recognized services are performed. services Dr. Cash Cr. Service Revenue If any expenses are incurred by the franchisor, If they would be recognized in period that is related to the revenue generation. related E5­17, p. 270 Work in class Production Basis of Revenue Recognition In limited cases, revenue can be recognized at In completion of production (but before sale to buyer). buyer). Writes inventory up to market value – Units must be interchangeable – Immediate marketability at quoted prices Examples, agricultural products, precious Examples, metals, minerals, etc. metals, Must be fully disclosed in Summary of Must Significant Accounting Policies Significant Profitability Analysis Activity Ratios – measure a company’s Activity efficiency in managing its assets; higher is better better Profitability Ratios – evaluate a company’s Profitability profit-making activities; higher is better profit-making Activity Ratios Asset Turnover = Net Sales / Average Total Assets – Measures a company’s efficiency in using assets to generate Measures revenue revenue – Indicates how quickly a company is able to collect its accounts Indicates receivable receivable – The number of days the average accounts receivable is The outstanding outstanding – Should be in agreement with credit terms offered to customers Receivables Turnover = Net Sales / Average A/R (net) Average Collection Period = 365 / Receivables Turnover Inventory Turnover = Cost of Goods Sold / Average Inventory Inventory Inventory – Measures a company’s efficiency in managing its inventory Average Days in Inventory = 365 / Inventory Turnover Profitability Ratios Analysts often adjust net income for transitory items and Analysts convert assets to net operating assets (remove financial assets and subtract operating liabilities) assets Profit Margin on Sales = Net Income / Net Sales – Measures amount of net income achieved per dollar of sales Return on Assets = Net Income / Average Total Assets – Measures earning power per dollar of investment – Ignores whether investment was financed with debt or equity Return on Assets = Profit Margin on Sales multiplied by Return Asset Turnover Asset Margin vs. Turnover Profitability Ratios Return on Shareholders’ Equity = Net Return Income / Average Total SE Income – Measures return to shareholders’ investment Financial Leverage (Equity Multiplier) = Financial Average Total Assets / Average Total SE Average Return on Shareholders’ Equity = Return Return on Assets x Financial Leverage on E5­21, p. 272 Work in class Interim Reporting Not responsible for this material. ...
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