Chapter 5

1. Chapter 5 Income Measurement and Profitability Analysis

2. Revenue Recognition Revenue should be recognized in the period or periods that the revenue-generating activities of the company are performed.

3. The earnings process is complete or virtually complete. There is reasonable certainty as to the collectibility of the asset to be received (usually cash). AND Realization Principle Record revenue when:

4. 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 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.

5. Revenue Recognition at Delivery Revenue is earned and realized at thepoint of sale. The product or service has been delivered to the customer and cash has been received or is receivable.

6. Significant Uncertainty of Collectibility When uncertainties about collectibility exist, revenue recognition is delayed. • Installment Sales Method • Cost Recovery

7. 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. Installment Sales Method

8. $45,000 ÷ $200,000 = 22.50% Installment Sales Method Clarke, Inc. had the following installment sales in addition to its regular sales.

9. Installment Sales Method Clarke, Inc. had the following installment sales in addition to its regular sales. At Dec. 31, 2005, Clarke, Inc. is still owed $30,000 from the 2004 sales and $75,000 from the 2005 sales.

10. Installment Sales Method During 2003, Clarke collected $100,000 on its installment sales. Deferred gross profit is the difference between the selling price and the cost of the inventory.

11. Installment Sales Method This entry records the Realized Gross Profit by adjusting the Deferred Gross Profit account.

12. Installment Sales Method During 2004, Clarke collected $50,000 on its 2003 installment sales and $195,000 on its 2004 installment sales.

13. Installment Sales Method During 2004, Clarke collected $50,000 on its 2003 installment sales and $195,000 on its 2004 installment sales.

14. Installment Sales Method

15. Installment Sales Method

16. Installment Sales Method Balance Sheet

17. Cost Recovery Method 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. $45,000 ÷ $200,000 = 22.50%

18. Cost Recovery Method The following schedule shows the pattern of cash collections for the three year period. Under the cost recovery method profit is not recognized until the seller has recovered all of the cost of the goods sold.

19. Cost Recovery Method The entries are exactly the same as under the Installment Method—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 2003.

20. Cost Recovery Method In 2004, let’s concentrate on the entries relating to 2003 sales only. Now can we recognize some profit?

21. Cost Recovery Method Here are the entries we would make in 2005 relating to 2003 sales. We have fully recovered the $155,000 cost during 2005, so the entire deferred gross profit will be recognized.

22. Revenue Recognition Over Time Completed Contract Method Long-term Construction Contracts Percentage-of-Completion Method

23. Percentage-of-Completion Method Measuring Progress Toward Completion Cost incurred to date Estimate of project’s total cost Gross profit estimate

24. Total costs incurred to date Percent complete = Most recent estimate of total project cost Let’s look at an example. Percentage-of-Completion Method

25. Percentage-of-Completion Method Geller Construction entered into a three-year contract to build a containment vessel for Southeast Power Company. Presented below is information about the contract. Let’s see how Geller will account for the revenues and cost of this project using the percentage-of-completion method.

26. $250,000 ÷ $1,250,000 = 20% Percentage-of-Completion Method

27. Percentage-of-Completion Method

28. Contra account to CIP Percentage-of-Completion Method

29. Classified as an asset Classified as a liability Percentage-of-Completion Method

30. Percentage-of-Completion Method

31. Closing Entry Percentage-of-Completion Method

32. $800,000 ÷ $1,225,000 = 65.31% Percentage-of-Completion Method

33. Percentage-of-Completion Method

34. Percentage-of-Completion Method $800,000 - $250,000 last year = $550,000

35. Percentage-of-Completion Method $775,000 - $250,000 last year = $525,000

36. Percentage-of-Completion Method $695,000 - $225,000 last year = $470,000

37. Percentage-of-Completion Method

38. Closing Entry Percentage-of-Completion Method

39. Percentage-of-Completion Method

40. Percentage-of-Completion Method

41. Percentage-of-Completion Method

42. Percentage-of-Completion Method Entry to transfer title to the customer.

43. Completed Contract Method Geller Construction entered into a three-year contract to build a containment vessel for Southeast Power Company. Presented below is information about the contract. Let’s see how Geller will account for the revenues and cost of this project using the completed contract method.

44. Completed Contract Method Gross profit is not recognized until project is complete. Entries are identical to the entries for percentage of completion.

45. Completed Contract Method Gross profit is not recognized until project is complete. Entries are identical to the entries for percentage of completion.

46. Completed Contract Method Gross profit is recognized in year 3 since project is complete.

47. Completed Contract Method Entry to transfer title to the customer.

48. Software Revenue Recognition Statement of Position 97-2 If a sale includes multiple elements (software, future upgrades, postcontract customer support, etc.), therevenueshould be allocated to the various elements based on therelative fair valueof the individual elements. This will likely result in the recording ofunearned revenuefor future services.

49. Franchise Sales Initial franchise feescan 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 45

50. Let’s look at some activity ratios!