Income Measurement and Profitability Analysis
REVENUE RECOGNITION
Revenue Recognition Principle
Revenues are recognized when:
(1) It is realized or realizable
a) Revenue is realized when goods or services are exchanged for cash or receivables
b) Revenue is realizable when assets received are convertible to cash or receivable
(2) It is earned
a) Revenues are earned when the earnings process is complete
Quality of Earnings
Some publicly traded companies have had a tendency to recognize revenue prematurely. This
affects the quality of earnings and the transparency of overall financial reporting. To combat this
problem the SEC issued Staff Accounting Bulletin No. 101 that provides additional criteria that
must be followed in determining when revenue should be recognized. The additional criteria are
as follows:
1) Persuasive evidence of an arrangement exists.
2) Delivery has occurred or services have been rendered.
3) The seller’s price to the buyer is fixed or determinable.
4) Collectibility is reasonably assured.
REVENUE RECOGNITION AT A POINT IN TIME
The recognition of revenue depends of the type of business transaction involved. The following
is a table that lists the types of business transactions that might occur and the timing of revenue
recognition. This assumes that collectibility is reasonably certain.
Transaction
Source
Timing
Products
Sales
Date of sale
(date of delivery)
Services
Fees
Services
performed
Use of Assets
Interest, rents
Passage of time
Disposition of
Assets
Gain or loss
Date of sale or
trade-in
Completion of the Earnings Process within a Single Reporting Period
Revenue is normally recognized when a product is delivered (title transfers to the buyer) or the
service is performed. This is assuming that the two revenue recognition criteria above are
satisfied and that collectibility is reasonably certain.
Completion of Production Basis
Under certain circumstances revenue is recognized at the completion of production even though
the product has not been sold. The circumstances that would make this possible are:
1) The sales price is reasonably assured
2) The units of product are interchangeable
3) There are no significant costs involved in product distribution
Products that normally qualify for this type of accounting treatment are the harvesting of
agricultural crops and the mining of metals.
E:\Teaching\3321\web\module2\c5\tnotes\c5a.doc
1/31/2007
1
Income Measurement and Profitability Analysis
Installment Sales Accounting Method
The recognition of revenue is based on the collection of cash rather than the completion of the
sale. It is used in industries where collection is relatively uncertain. To accomplish this we use a
separate set of accounts to record “Installment Receivables” and “Deferred Gross Profit.”
Year of Installment Sale:
(1) Record all transactions as follows:
ACCOUNT
DEBIT
CREDIT
Installment receivables
$XX,XXX
Inventory
$XX,XXX
Deferred gross profit, (current year)
$X,XXX
To record installment sales and related deferred gross profit for the year.
(2) Calculate the gross profit percentage for all sales for the current year.
Amount
$100,000
60,000
$40,000
Installment sales
Cost of installment sales
Gross profit on installment sales
Percentage
100%
60%
40%
(3) Record the collection of installment receivables and the recognition of gross profit as
follows:
ACCOUNT
Cash
Installment receivables
To record cash collected on installment receivables
DEBIT
$XX,XXX
Deferred gross profit, (current year)
$X,XXX
Realized gross profit
To recognize gross profit on the collection of installment receivables
CREDIT
$XX,XXX
$X,XXX
Installment Collections on Prior Year Sales:
Apply each year’s gross profit percentage to the installment collections related to that year’s
sales as follows:
E:\Teaching\3321\web\module2\c5\tnotes\c5a.doc
1/31/2007
2
Income Measurement and Profitability Analysis
ACCOUNT
Cash
Installment receivables, (year 1)
Installment receivables, (year 2)
To record cash collected on installment receivables
DEBIT
$XX,XXX
CREDIT
$XX,XXX
$XX,XXX
Deferred gross profit, (year 1)
$X,XXX
Deferred gross profit, (year 2)
$X,XXX
Realized gross profit
To recognize gross profit on the collection of installment receivables
$X,XXX
Financial Statement Presentation
The gross profit realized in the current year is reported as a separate component of gross profit in
the income statement. If a company has regular sales and installment sales the income statement
would be presented as follows.
Sales
Cost of goods sold
Gross profit on sales
Gross profit realized on installment sales
Total gross profit
$500,000
400,000
100,000
16,200
$116,200
Cost Recovery Method
The cost recovery method is use primarily in the real estate industry. It is used when the
collection of the selling price is uncertain. The same procedure is used as we demonstrated in
the installment method except that during the earlier periods no gross profit is recognized. We
do not recognize any gross profit until all of the costs have been recovered.
Deposit Method
Under the deposit method the seller has not performed on the contract but has received cash from
the buyer. The seller records the cash deposit as a credit to a current liability account. When the
seller has completed the service or delivered the product then the deposit will be reclassified to
revenue and recognized in the income statement.
Buyback Agreements
There is no sale if a repurchase agreement is in place whereby the seller agrees to repurchase the
entire inventory at a set price which covers the holding costs. The inventory remains on the
seller’s books until the buyer resells the merchandise thus completing the transaction.
Right of Return
In industries where there is a high rate of returns, there are three possible alternatives to
recording revenue.
(1) Delay recording the sale until the privilege for return has expired
(2) Recording the sale and an estimate of future returns
(3) Recoding the sale and recording the returns as they occur
E:\Teaching\3321\web\module2\c5\tnotes\c5a.doc
1/31/2007
3
Income Measurement and Profitability Analysis
The following six conditions must be met to record the revenue from a sales transaction
recorded.
(1) Price must be determinable
(2) Buyer is obligated to pay seller with no contingencies
(3) Buyers obligation would not change because of changed conditions of inventory
(4) Buyer has economic substance in product
(5) Seller does not have significant obligations to effect the resale of the produce
(6) Amount of future returns can be reasonably estimated
If returned merchandise is a part of the normal business operations then an allowance should be
estimated for returns.
Trade Loading
In some industries, manufacturers will provide incentives to wholesalers to purchase more
product than can be resold. This overstates sales of the manufacturer.
Channel Stuffing
In order to inflate sales some manufacturers have offered deep discounts to distributors to
overbuy produce. The manufacturers then record the sale as complete as the product leaves the
sellers loading dock.
Consignment Sales
The consignor is the seller of the merchandise who ships the goods on consignment to the
consignee. The consignee is just an agent in the selling process and does not actually own the
goods. Therefore, at year-end the consignor (seller) should include the consigned goods in its
inventory even though it may still be in the physical possession of the consignee. No sale takes
place until the consignee sells the goods, deducts the commission earned and remits the
remainder of the selling price to the consignor.
REVENUE RECOGNITION OVER TIME
Service Revenue Earned over Time
When services are provided over an extended period of time, revenue is recognized in each
accounting period in which the services were provided and the revenue earned.
Long-Term Contracts
In construction-type contracts the builder (seller) will normally interim bill the customer (buyer)
as the contract progresses. There are two different methods of accounting for long-term
construction contracts.
(1) Percentage-of-Completion Method
At the end of each accounting period the contractor recognizes the percentage of revenue
earned on the contract. This requires the use of two new general ledger accounts.
a) Construction in Process (Inventory Account - Debit Balance)
This account reflects the accumulation of construction costs since the beginning of the
project and the periodic recognition of gross profit based on the percentage of completion
at the end of each accounting period.
E:\Teaching\3321\web\module2\c5\tnotes\c5a.doc
1/31/2007
4
Income Measurement and Profitability Analysis
b) Billings on Construction in Process (Contra-Inventory Account – Credit Balance)
(2) Completed-Contract Method
The contractor recognizes revenue earned on the contract at the end of the contract.
The general ledger accounts are used but there is no accumulation of gross profit during the
construction project. Gross profit is only recognized once the project is completed.
Percentage-of-Completion Method
There are various methods of measuring progress on long-term contracts. The most common
method used in construction projects is the cost-to-cost basis. The costs incurred to date are
compared with the currently estimated total costs to derive a percentage of completion as of the
end of the accounting period. The formula for determining the percentage completion is as
follows:
Costs incurred to date
Current estimate of total costs
=
Percentage complete
The percentage complete as of the end of the accounting period is used to calculate the revenue
to be recognized to date. At the end of the accounting period the percentage complete to date is
multiplied by the total revenue associated with the long-term contract to derive revenue
recognized to date. The following formula determining the revenue recognized to date is as
follows:
Percentage complete
X Estimated total revenue =
Revenue recognized to date
Normally we are interested in preparing financial statements for an accounting period so
therefore we need to know the revenue earned in the current accounting period. To derive this
amount the revenue recognized in prior periods is subtracted from the revenue recognized to date
to derive the current period revenue earned on the long-term contract. The following formula is
used to do this calculation.
Revenue recognized to date
-
Revenue recognized in prior periods =
Current period revenue
Example
The following fact pattern pertains to the long-term contract that Spencer Construction Company
has with Fido Chow, Inc.
2004
$100,000
400,000
120,000
90,000
Cost-to-date
Estimated cost-to-complete
Progress billings during the year
Cash collected during the year
E:\Teaching\3321\web\module2\c5\tnotes\c5a.doc
1/31/2007
2005
$300,000
200,000
350,000
200,000
2006
$550,000
130,000
250,000
5
Income Measurement and Profitability Analysis
At the beginning of the contract in 2004, the estimated costs are $500,000 and the contract price
is $600,000. Note that sometime in year 2006 it became clear that the total costs on this contract
were going to be more than originally estimated. The total estimated costs are reevaluated at the
end of each accounting period and adjusted based on the currently available information. Also
note, that the progress billings and the cash collections are reported for the current year. Be sure
you examine the fact pattern to determine if the amounts are being presented as year to date or
current year. It will affect the way you prepare your analysis.
Now that we have the fact pattern we can determine the percentage completion on a cost-to-cost
basis for each year. The following provides this analysis.
Percentage Complete
Costs incurred to-date
Costs to complete
Estimated total costs
2004
$100,000
400,000
$500,000
Costs incurred to-date
Estimated total costs
$100,000
$500,000
Percentage complete
20%
2005
$300,000
200,000
$500,000
$300,000
$500,000
60%
2006
$550,000
0
$550,000
$550,000
$550,000
100%
The revenue on this long-term contract is fixed as of the signing of the contract. We know that
the total revenue will be $600,000 so therefore using the above percentage completion we can
determine the amount of revenue that should be recognized.
Current Period Revenue
Contract price
Percentage complete to date
Revenue recognized to date
Revenue recognized in prior periods
Current period revenue
2004
$600,000
20%
120,000
0
$120,000
2005
$600,000
60%
360,000
120,000
$240,000
2006
$600,000
100%
600,000
360,000
$240,000
To derive the gross profit to be recognized during the current accounting period we need to
convert the costs incurred to date to the current period costs. The following provides this
analysis.
Current Period Costs
Costs incurred to date
Costs incurred in prior period
Current period costs
E:\Teaching\3321\web\module2\c5\tnotes\c5a.doc
2004
$100,000
0
$100,000
1/31/2007
2005
$300,000
100,000
$200,000
2006
$550,000
300,000
$250,000
6
Income Measurement and Profitability Analysis
Having determined the current period revenue and costs we can know calculate the gross profit
that should be recorded during each accounting period. The following provides this analysis.
Current gross profit
Current period revenue
Current period costs
Current period gross profit
2004
$120,000
100,000
$20,000
2005
$240,000
200,000
$40,000
2006
$240,000
250,000
($10,000)
Note that we were not aware of our higher construction costs until the last year. Normally this
would not be the case. At any time during the construction cycle estimated total costs may be
adjusted based on new information.
Now that we have completed the analysis we need to prepare the journal entries for each year’s
transactions. The following reflects the journal entries for 2004. During the year the
construction costs, billings and collections would be recorded as they take place. We are going
to record them as one general journal entry for the sake of simplicity.
Date
2004
2004
2004
Account
Construction in process
Accounts payable
To record construction costs during the year
Debit
$100,000
Accounts receivable
Billings on construction in process
To record progress billings
$120,000
Cash
Accounts receivable
To record collections on account
12/31/04 Construction in process
Construction expense
Revenue from long-term contracts
Credit
$100,000
$120,000
$90,000
$90,000
$20,000
100,000
$120,000
To record current period expenses and revenue on a long-term contract that
is 20% complete
Note that the “Construction expenses” and Revenue from long-term contract” accounts are
nominal accounts and will be closed out at the end of the accounting period.
The two accounts that we need to keep track of throughout the life of the long-term contract are
the “Construction in process” and “Billings on construction in process” accounts. The following
is the T-account analysis at the end of 2004.
E:\Teaching\3321\web\module2\c5\tnotes\c5a.doc
1/31/2007
7
Income Measurement and Profitability Analysis
T-Account: Contruction in Process
Date
Description
Debit
2004
Construction costs incurred in 2004
$100,000
12/31/04 Gross profit recognized for 2004
20,000
Balance at year-end
$120,000
Date
2004
T-Account: Billings on Construction in Process
Description
Debit
Progress billings for 2004
Balance at year-end
Credit
Credit
$120,000
$120,000
Now we will repeat this process for 2005. The following are the journal entries to record the
transactions and adjusting journal entries for 2005.
Date
2005
2005
2005
Account
Construction in process
Accounts payable
To record construction costs during the year
Debit
$200,000
Accounts receivable
Billings on construction in process
To record progress billings
$350,000
Cash
Accounts receivable
To record collections on account
$200,000
12/31/05 Construction in process
Construction expense
Revenue from long-term contracts
Credit
$200,000
$350,000
$200,000
$40,000
200,000
$240,000
To record current period expenses and revenue on a long-term contract that
is 60% complete
After these entries have been posted we should have the following balances in the T-accounts of
the “Construction in process” and Billings on construction in process” accounts.
E:\Teaching\3321\web\module2\c5\tnotes\c5a.doc
1/31/2007
8
Income Measurement and Profitability Analysis
Date
2004
12/31/04
2005
12/31/05
Date
2004
2005
T-Account: Contruction in Process
Description
Debit
Construction costs incurred in 2004
$100,000
Gross profit recognized for 2004
20,000
Construction costs incurred in 2005
200,000
Gross profit recognized for 2005
40,000
Balance at year-end
$360,000
T-Account: Billings on Construction in Process
Description
Debit
Progress billings for 2004
Progress billings for 2005
Balance at year-end
Credit
Credit
$120,000
$350,000
$470,000
The activity for the final year of 2006 is listed below.
Date
2005
2005
2005
Account
Construction in process
Accounts payable
To record construction costs during the year
Debit
$250,000
Accounts receivable
Billings on construction in process
To record progress billings
$130,000
Cash
Accounts receivable
To record collections on account
$250,000
12/31/05 Construction in process
Construction expense
Revenue from long-term contracts
Credit
$250,000
$130,000
$250,000
$10,000
$250,000
240,000
To record current period expenses and revenue on a long-term contract that
is 100% complete
The following is the T-account analysis reflecting the accumulation of these entries to the two
accounts of which we have been keeping track.
E:\Teaching\3321\web\module2\c5\tnotes\c5a.doc
1/31/2007
9
Income Measurement and Profitability Analysis
Date
2004
12/31/04
2005
12/31/05
2006
12/31/06
Date
2004
2005
2006
T-Account: Construction in Process
Description
Debit
Construction costs incurred in 2004
$100,000
Gross profit recognized for 2004
20,000
Construction costs incurred in 2005
200,000
Gross profit recognized for 2005
40,000
Construction costs incurred in 2006
250,000
Gross profit recognized for 2006
Balance at year-end
$600,000
T-Account: Billings on Construction in Process
Description
Debit
Progress billings for 2004
Progress billings for 2005
Progress billings for 2006
Balance at year-end
Credit
$10,000
Credit
$120,000
350,000
130,000
$600,000
Please note that at the end of the long-term construction contract the balance in the “Construction
in Process” account is equal to the balance in the “Billings on Construction in Process” account.
The reason for this is that each year we recorded the gross profit in the “Construction in Process”
account and created two nominal accounts to reflect the current period expenses and revenue.
We are not ready to close the “Construction in Process” and the Billings on Construction in
Process” accounts. The final journal entry is presented below.
Date
Account
12/31/06 Billings on construction in process
Construction in process
To close the long-term contract accounts
Debit
$600,000
Credit
$600,000
Financial Statement Presentation
The difference between the Construction in Process and the Billings on Construction in Process
accounts is presented in the balance sheet as either a current asset (net debit balance) or a current
liability (net credit balance). The following is a balance sheet presentation at the end of each
year that the contract is not complete.
E:\Teaching\3321\web\module2\c5\tnotes\c5a.doc
1/31/2007
10
Income Measurement and Profitability Analysis
December 31, 2004
Current Assets
Construction in process
Less: progress billings
Costs and recognized profit in excess of billings
$120,000
120,000
$0
December 31, 2005
Current liabilities
Construction in process
Less: progress billings
Billings in excess of costs and recognized profit
$360,000
470,000
($110,000)
Completed-Contract Method
On rare occasions a company might use the completed-contract method. The same balance sheet
accounts will be used but there will be no adjusting journal entry at the end of the accounting
period. The company will accumulate costs and billings on the long-term contract until it is
complete. Once the contract is complete and accepted by the customer the balance sheet
accounts are closed and revenue and expenses are recorded in the income statement.
Losses on Long-Term Contracts
Overall Profitable Contracts: If the estimated costs increase resulting in less profit then
originally estimated, the loss in the current accounting period is recorded. This is a change in
accounting estimate.
Unprofitable Contracts: If the estimated costs increase resulting in a loss on the entire long-term
contract the entire loss is recorded in the period it is discovered.
SOFTWARE REVENUE RECOGNITION
Many computer companies sell hardware, software and support services under a single contract.
To the extent that the revenue has not been earned when received or billed the computer
company must defer the unearned revenue. The deferred revenue is recognized in the accounting
period(s) in which the services are performed or the revenue is earned.
FRANCHISE SALES
Franchises are a popular means of operating many retail business enterprises. The franchise fee
is normally comprised of two amounts. The franchisor receives an initial franchise fee for the
right to sell products or services under the franchisors name. This fee may be earned over a
period of months or years depending on the terms of the contract. In addition, the franchisee is
required to pay to the franchisor a periodic fee to cover continuing services such as advertising
and/or other continuing services provided by the franchisor. These fees are normally based on
the gross volume of the franchise and are recognized by the franchisor as earned.
E:\Teaching\3321\web\module2\c5\tnotes\c5a.doc
1/31/2007
11