Chapter
5
Income Measurement and Profitability Analysis
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
LO5-1 Discuss the timing of revenue recognition, list the two general criteria that must be satisfied
before revenue can be recognized, and explain why these criteria usually are satisfied when
products or services are delivered.
LO5-2 Discuss the principal/agent distinction that determines the amount of revenue to record.
LO5-3 Describe the installment sales and cost recovery methods of recognizing revenue and
explain the unusual conditions under which these methods might be used.
LO5-4 Discuss the implications for revenue recognition of allowing customers the right of return.
LO5-5 Identify situations requiring recognition of revenue over time and demonstrate the
percentage-of-completion and completed contract methods of recognizing revenue for longterm contracts.
LO5-6 Discuss the revenue recognition issues involving multiple-deliverable contracts, software,
and franchise sales.
LO5-7 Identify and calculate the common ratios used to assess profitability.
LO5-8 Discuss the primary differences between U.S. GAAP and IFRS with respect to revenue
recognition.
CHAPTER HIGHLIGHTS
PART A: REVENUE RECOGNITION
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.
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Our objective is to recognize revenue in the period or periods that the revenue-generating activities
of the company are performed. But we also must consider that recognizing revenue presumes that
an asset (usually cash) has been received or will be received in exchange for the goods or services
sold. Our judgment as to the collectibility of the cash from the sale of a product or service will,
therefore, impact the timing of revenue recognition. These two concepts of performance and
collectibility are captured by the general guidelines for revenue recognition in the realization
principle.
The realization principle requires that two criteria be satisfied before revenue can be recognized:
1. The earnings process is judged to be complete or virtually complete, (the earnings process
refers to the activity or activities performed by the company to generate revenue).
2. There is reasonable certainty as to the collectibility of the asset to be received (usually cash).
Revenue often is recognized at a point in time at or near the end of the earnings process. In other
situations, revenue is recognized over time.
Premature revenue recognition reduces the quality of reported earnings, particularly if those
revenues never materialize. As part of its crackdown on earnings management, the SEC issued
Staff Accounting Bulletin No. 101 summarizing the SEC’s views on revenue recognition. The
Bulletin provides additional criteria for judging whether or not the realization principle is satisfied:
1.
2.
3.
4.
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.
Soon after SAB No. 101 was issued, many companies changed their revenue recognition methods.
In most cases, the changes resulted in a deferral of revenue recognition.
IFRS revenue recognition concepts focus on transfer of economic benefits. IFRS allows revenue to
be recognized when the following conditions have been satisfied:
1. The amount of revenue and costs associated with the transaction can be measured reliably,
2. It is probable that the economic benefits associated with the transaction will flow to the
seller,
3. (for sales of goods) the seller has transferred to the buyer the risks and rewards of
ownership, and doesn’t effectively manage or control the goods,
4. (for sales of services) the stage of completion can be measured reliably.
These requirements are similar to U.S. GAAP, and revenue typically is recognized at a similar point
under IFRS and U.S. GAAP.
Revenue Recognition at Delivery
For product sales, the product delivery date refers to the date legal title to the product passes from
seller to buyer. In most cases, the realization principle criteria are satisfied at this point. The
earnings process is virtually complete and the only remaining uncertainty involves the ultimate cash
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collection. This remaining uncertainty can be accounted for by estimating and recording allowances
for possible product returns and for potential bad debts.
Service revenue, too, often is recognized at a point in time if there is one final activity that is
deemed critical to the earnings process. In this case, all revenue and costs are deferred until this
final activity 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. However, in many
instances, service revenue activities occur over extended periods and recognizing revenue at any
single date within that period would be inappropriate. Instead, it’s more meaningful to recognize
revenue over time in proportion to the performance of the activity. Rent revenue is an example.
It is important to determine whether a seller is a principal of an agent. A principal has primary
responsibility for delivering a product or service, and typically is vulnerable to risks associated with
delivering the product or service and collecting payment from the customer. An agent does not have
primary responsibility for delivering a product or service, and typically is not vulnerable to risks
associated with delivering the product or service and collecting payment from the customer. If the
seller is a principal, it should recognize as revenue the gross (total) amount received from a
customer. If the seller is an agent, it should recognize as revenue only the commission it receives
for facilitating the sale.
Revenue Recognition after Delivery
Recognizing revenue at a specific point in time 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 collectibility of cash from the
customer. There are a few situations when uncertainties could cause a delay in recognizing revenue
from a sale of a product or service. One such situation occasionally occurs when products (or
services) are sold on an installment basis.
Installment Sales
Revenue recognition for most installment sales takes place at point of delivery, because accurate
estimates can be made of potential uncollectible amounts. Two accounting methods, the
installment sales method and the cost recovery method are available for situations where there is
significant uncertainty concerning cash collection making it impossible to reasonably estimate bad
debts. The installment sales method recognizes revenue and costs only when cash payments are
made. The amount of gross profit recognized is determined by multiplying the gross profit
percentage (gross profit ÷ by sales price) by the cash collected. The cost recovery method defers all
gross profit until cash equal to the cost of the item sold has been received. These methods are
sometimes used for real estate sales.
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ILLUSTRATION
On April 16, 2013, the Aspen Real Estate Company sold land to a developer for $2,000,000. The
buyer will make five annual payments of $400,000 plus interest on each April 16, beginning in
2014. Aspen's cost of the land is $800,000. Let's ignore interest charges and concentrate on the
recognition of the $1,200,000 gross profit on the sale of land ($2,000,000 - 800,000).
Using point of delivery revenue recognition, all of the $1,200,000 in gross profit is recognized in
2013.
Using the installment sales method, the gross profit of $1,200,000 represents 60% of the sales
price ($1,200,000 ÷ $2,000,000). Therefore, as $400,000 of cash is collected each year beginning in
2014, $240,000 of gross profit is recognized.
Using the cost recovery method, no gross profit is recognized until the $800,000 in cost is
collected. Therefore, no gross profit is recognized in 2013, 2014 and 2015. Beginning in 2016,
100% of the cash collected is recognized as income.
The following table summarizes gross profit recognition for the three alternatives:
2013
2014
2015
2016
2017
2018
Totals
Point of delivery
$1,200,000
-0-0-0-0-0$1,200,000
Installment Sales Method
(60% x cash collection)
$ -0240,000
240,000
240,000
240,000
240,000
$1,200,000
Cost Recovery Method
$
-0-0-0400,000
400,000
400,000
$1,200,000
Right of Return
When the right of return exists, revenue cannot be recognized at the point of delivery unless the
seller is able to make reliable estimates of future returns. In most retail situations, even though the
right to return merchandise exists, reliable estimates can be made and revenue and costs are
recognized at point of delivery. Otherwise, revenue and cost recognition is delayed until such time
the uncertainty is resolved. For example, many semiconductor companies delay recognition of
revenue until the product is sold by their customer (the distributor) to an end-user.
Consignment Sales
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
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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 costs) until the consignee sells the goods and title passes
to the eventual customer.
Revenue Recognition Prior to Delivery
Long-Term Contracts
For long-term contracts, it usually is not appropriate to recognize revenue at the delivery point (that
is, when the project is completed). 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.
A more appropriate method of recognizing revenue is the percentage-of-completion method
which allocates a share of a project's revenue and expenses (revenues less project expenses = gross
profit) to each reporting period during the contract period. The allocation is based on progress to
date which can be estimated as the proportion of the project's cost incurred to date divided by total
estimated costs (cost-to-cost), or by relying on an engineer's or architect's estimate.
For long-term construction contracts, under both methods, the costs of construction are debited to
an inventory account, construction in progress. Using the percentage-of-completion method, this
account also includes gross profit recognized to date. Also under both methods, progress billings
are recorded with a debit to accounts receivable and a credit to billings on construction contract.
This account is a contra account to construction in progress, and serves to reduce the carrying value
of construction in progress by amounts billed to the customer to avoid simultaneously including
both the receivable and the inventory on the balance sheet. 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.
By waiting until the contract is complete, the completed contract method does not properly portray a
company’s performance over the construction period. The percentage-of-completion method is
preferable, and the completed contract method should be used in unusual situations when forecasts
of future costs are not dependable.
ILLUSTRATION
In 2013, the Calahan Construction Company contracted to build an office building for $3,000,000.
Construction was completed in 2015. Data relating to the contract are as follows ($ in thousands):
Costs incurred during the year ...............................
Estimated costs to complete as of year-end ...........
Billings during the year .........................................
Cash collections during the year ............................
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2013
$ 500
2,000
400
350
2014
$1,000
1,000
1,500
1,050
2015
$1,050
1,100
1,600
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Calculation of estimated gross profit:
Contract price
Actual costs to date
Estimated costs to complete
Total estimated costs
Estimated gross profit
Total actual costs
Actual gross profit
2013
$3,000
$ 500
2,000
2014
$3,000
2015
$3,000
$1,500
1,000
(2,500)
$ 500
$2,550
-0(2,500)
$ 500
(2,550)
$ 450
Gross profit recognition:
Completed contract method:
2013:
$ -02014:
$ -02015:
$ 450
Percentage-of-completion method (using cost-to-cost to estimate progress):
2013:
$ 500
= 20% x $500 = $100 gross profit to be recognized in 2013.
$2,500
2014:
$1,500
$2,500
2015:
= 60% x $500 = $300 - 100 (2013 gross profit already recognized) =
$200 gross profit to be recognized in 2014.
$450 - 300 (2013 and 2014 gross profit) = $150 gross profit to be recognized in
2015.
The journal entries to record Calahan's construction project are as follows
($ in thousands):
2013:
Construction in progress
Cash, materials, etc.
To record construction costs.
Percentage-ofCompletion Method
500
500
Accounts receivable
Billings on construction contract
To record progress billings.
400
Completed
Contract Method
500
500
400
400
400
(note: journal entries continued on next page)
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2013 (continued):
Percentage-ofCompletion Method
Cash
Accounts receivable
To record cash collection.
350
350
350
Construction in progress (gross profit)
100
Cost of construction (expense)
500
Revenue from long-term contracts
600
To record gross profit.
(revenue = 20% x $3 million; expense = cost incurred)
2014:
Construction in progress
Cash, materials, etc.
To record construction costs.
1,000
350
No income recognition
until project completion
1,000
1,000
Accounts receivable
Billings on construction contract
To record progress billings.
1,500
Cash
Accounts receivable
To record cash collection.
1,050
1,000
1,500
1,500
1,500
1,050
1,050
Construction in progress (gross profit)
200
Cost of construction (expense)
1,000
Revenue from long-term contracts
1,200
To record gross profit.
(revenue = 60% x $3 million less 2013 revenue;
expense = cost incurred)
2015:
Construction in progress
Cash, materials, etc.
To record construction costs.
Completed
Contract Method
1,050
1,050
No income recognition
until project completion
1,050
1,050
Accounts receivable
Billings on construction contract
To record progress billings.
1,100
Cash
Accounts receivable
To record cash collection.
1,600
1,050
1,100
1,100
1,100
1,600
1,600
1,600
(note: journal entries continued on next page)
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2015 (continued):
Percentage-ofCompletion Method
Construction in progress (gross profit)
150
Cost of construction (expense)
1,050
Revenue from long-term contracts
1,200
To record gross profit.
(revenue = $3 million less 2013 and 2014 revenue;
expense = cost incurred)
Billings on construction contract
3,000
Construction in progress
3,000
To close accounts once title transfers to the customer.
Completed
Contract Method
450
2,550
3,000
(All revenue and
cost recognized)
3,000
3,000
The balance sheet presentation for the construction-related accounts for 2013 and 2014 by both
methods is as follows:
Completed contract method:
Current assets:
Accounts receivable
Costs ($500) in excess of billings ($400)
Current liabilities:
Billings ($1,900) in excess of costs
($1,500)
2013
2014
$ 50
100
$500
Percentage-of-completion:
2013
Current assets:
Accounts receivable
$ 50
Costs and profit ($600) in excess of billings ($400) 200
Current liabilities:
Billings ($1,900) in excess of costs
and profit ($1,800)
400
2014
$500
100
An estimated loss on a long-term contract is fully recognized in the first period the loss is
anticipated regardless of the revenue recognition method used. In addition, under the percentageof-completion method, a loss is recognized for profitable contracts whenever previously recognized
gross profit exceeds the cumulative gross profit to date.
IFRS’ accounting for long-term contracts is similar to U.S. GAAP, except that IFRS requires use of
the cost recovery method rather than the completed contract method in circumstances where the
percentage-of-completion method would not be appropriate. 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
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recognized until all costs have been recovered, which is why this method is also sometimes called
the “zero-profit method.”
The FASB and IASB are working together on a revenue recognition project designed to provide a
single overall standard for revenue recognition. That project is discussed further in the Addendum
to Chapter 5.
Industry-Specific Revenue Issues
Software Revenue Recognition and Multiple-Element Contracts
It is not unusual for software companies to sell multiple software elements in a bundle for a lumpsum contract price. The bundle often includes product, upgrades, postcontract customer support
and other services. The critical accounting question concerns the timing of revenue recognition.
Current GAAP indicates that if an arrangement includes multiple elements, the revenue from the
arrangement should be allocated to the various elements based on the relative fair values of the
individual elements, regardless of any separate prices stated within the contract for each element.
More recently, the FASB’s Emerging Issues Task Force (EITF) issued guidance to broaden the
application of this basic perspective to other arrangements that involve “multiple deliverables.” In
such arrangements, sellers must separately record revenue for parts of the arrangement in proportion
to those parts’ selling prices when sold separately. However, if part of an arrangement does not
qualify for separate accounting, recognition of the revenue from that part is delayed until revenue
associated with the other parts is recognized. For example, if the usability of Product A is
contingent on the delivery of Product B, Product A does not qualify for separate revenue
recognition. This results in deferring revenue recognition unless parts of an arrangement clearly
qualify for separate revenue recognition. IFRS does not provide much guidance concerning revenue
recognition with respect to multiple-element contracts.
Franchise Sales
The fees to be paid by the franchisee to the franchisor usually comprise: (1) the initial franchise fee
and (2) continuing franchise fees. The services to be performed by the franchisor in exchange for
the initial franchise fee include the right to use its name and sell its products. The 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.
The continuing franchise fees usually do not present any accounting difficulty and are recognized by
the franchisor as revenue in the periods they are received, which correspond to the periods the
services are performed by the franchisor.
The initial franchise fee is recognized as revenue when the franchisor has substantially performed
the services promised in the franchise agreement and the collectibility of the fee is reasonably
assured. This could occur in increments or at one point in time.
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PART B: PROFITABILITY ANALYSIS
Chapter 3 provided an overview of financial statement analysis and introduced some of the common
ratios used in risk analysis to investigate a company’s liquidity and long-term solvency. We now
introduce ratios related to profitability analysis.
Activity Ratios
Activity ratios measure a company's efficiency in managing assets. Key activity ratios include (1)
receivables turnover, (2) inventory turnover, and (3) asset turnover. These ratios are calculated
as follows:
Asset turnover ratio
=
Receivables turnover ratio
=
Inventory turnover ratio
=
Net sales
Average total assets
Net sales
Average accounts receivable (net)
Cost of goods sold
Average inventory
The asset turnover ratio measures a company's efficiency using all of its assets to generate
revenue. The receivables turnover ratio offers an indication of how quickly a company is able to
collect its accounts receivable. A convenient extension of the receivables turnover ratio is the
average collection period. This measure is computed by dividing 365 days by the turnover ratio.
The result is an approximation of the number of days the average accounts receivable balance is
outstanding. The inventory turnover ratio measures a company's efficiency in managing its
investment in inventory. Similar to the receivables turnover, we can divide the inventory turnover
ratio into 365 days to compute the average days in inventory. This measure indicates the number
amount of days it normally takes to sell inventory.
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Profitability Ratios
Profitability ratios assist in evaluating various aspects of a company's profit-making activities.
Three common profitability measures are (1) the profit margin on sales, (2) the return on assets,
and (3) the return on shareholders' equity. These ratios are calculated as follows:
Profit margin on sales
=
Net income
Net sales
Return on assets
=
Net income
Average total assets
Return on shareholders' equity
=
Net income
Average shareholders' equity
The profit margin on sales measures the amount of net income achieved per sales dollar. Return
on assets indicates a company's overall profitability by measuring the amount of profit generated by
total assets employed. The return on shareholders' equity measures the return to suppliers of
equity capital.
The DuPont framework provides a convenient framework that breaks return on equity into three key
components:
Return on equity
Net income
Ave. total equity
=
Profit margin
=
Net income
Total sales
X
X
Asset turnover
X Equity multiplier
Total sales
Ave. total assets
X
Ave. total assets
Ave. total equity
ROA is determined by profit margin and asset turnover, so another way to compute ROE is by
multiplying return on assets by the equity multiplier:
Return on equity
Net income
Ave. total equity
=
=
Return on assets
Net income
Ave. total assets
X Equity multiplier
X
Ave. total assets
Ave. total equity
This version of the DuPont framework that the effect of ROA on ROE depends on how much debt
(or leverage) the company has in its capital structure. All else equal, using debt to purchase assets
provides more ROA for equity holders.
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APPENDIX 5: INTERIM REPORTING
Interim reports are issued for periods of less than a year, typically as quarterly financial statements.
Companies registered with the SEC, which include most public companies, must submit quarterly
reports. Interim reporting serves to enhance the timeliness of financial information. With only a
few exceptions, the same accounting principles applicable to annual reporting are used for interim
reporting.
Complete financial statements are not required for interim period reporting. Minimum disclosures
include the following:
•
•
•
•
•
•
•
•
Sales, income taxes, extraordinary items, cumulative effect of accounting principle changes, and
net income.
Earnings per share.
Seasonal revenues, costs, and expenses.
Significant changes in estimates for income taxes.
Discontinued operations, extraordinary items, and unusual or infrequent items.
Contingencies.
Changes in accounting principles or estimates.
Significant changes in financial positions.
ADDENDUM: WHERE WE’RE HEADED
As indicated earlier, the FASB and the IASB have been working on a converged revenue
recognition standard. The Addendum to Chapter 5 is based on the proposed ASU that emerged
from that project.
Under the ASU, the core revenue recognition principle is as follows: An entity shall recognize
revenue to depict the transfer of goods or services to customers in an amount that reflects the
consideration the entity expects to be entitled to receive in exchange for those goods or services.”
For many transactions, applying this principle will yield the same accounting as would applying the
realization principle discussed in the chapter, but the conceptual underpinnings are very different.
There are five key steps in applying the ASU:
1. Identify a contract with a customer.
2. Identify the separate performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the separate performance obligations.
5. Recognize revenue when (or as) the entity satisfies each performance obligation.
Let’s discuss each in turn.
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Step 1: Identify the contract.
For purposes of applying revenue recognition criteria, a contract needs to have the following
characteristics:
1. Commercial substance. The contract is expected to affect the seller’s future cash flows.
2. Approval. Each party to the contract has approved the contract and is committed to
satisfying their respective obligations.
3. Rights. Each party’s rights are specified as to the goods and services to be transferred.
4. Payment terms. The terms and manner of payment are specified.
5. Performance. A contract does not exist if each party can terminate a wholly unperformed
contract without penalty. A contract is wholly unperformed if no party has satisfied any of
their obligations.
Step 2: Identify separate performance obligations.
Sellers account for performance obligations separately if the performance obligations are distinct.
A performance obligation is distinct if either:
1. The seller regularly sells the good or service separately, or
2. A buyer could use the good or service on its own or in combination with goods or services
the buyer could obtain elsewhere.
A bundle of goods and services is treated as a single performance obligation if both of the following
two criteria are met:
1. The goods or services in the bundle are highly interrelated and the seller provides a
significant service of integrating the goods or services into the combined item(s) delivered
to a customer.
2. The bundle of goods or services is significantly modified or customized to fulfill the
contract.
Many construction contracts qualify under this definition, so are viewed as a single performance
obligation.
If multiple distinct goods or services have the same pattern of transfer to the customer, the seller can
treat them as a single performance obligation as a practical expediency.
Examples of separate performance obligations include options to receive additional goods or
services that provide a material right (but not a right of return). Also, extended warranties are
separate performance obligations (but not warranties for latent defects).
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Step 3: Determine the transaction price.
The transaction price include uncertain consideration that depends on the outcomes of future events,
estimated as either the most likely amount that will occur or a probability weighted amount that will
occur.
Uncollectible accounts do not affect the transaction price, and the ability to estimate bad debts does
not figure into whether to recognize revenue. As in current GAAP, an estimate of bad debts is
made and that estimate reduces income and the net balance of accounts receivable. However,
unlike current GAAP, bad debts are treated as a contra-revenue (like sales returns) rather than as an
expense.
The transaction price is affected by the time value of money if a contract has a significant financing
component. We assume that component is not significant if payment occurs within one year.
Consideration of the time value of money applies to prepayments (so we impute interest expense)
and receivables (so we impute interest revenue).
Step 4: Allocate the transaction price.
We allocate the transaction price to the separate performance obligations in proportion to the
standalone selling price of the goods or services underlying those performance obligations. This
approach is like current accounting for multiple-element arrangements. If actual observed selling
prices are not available, we can use estimated selling prices. And, if a contract gets modified
subsequently, we reallocate the transaction price to each separate performance obligation.
Step 5: Recognize revenue when (or as) performance obligations are satisfied.
General principle: We recognize revenue when the seller transfers control of the goods or services
to the buyer. Transfer of control is indicated by such factors as:
1. Buyer has an unconditional obligation to pay.
2. Buyer has legal title.
3. Buyer has physical possession.
4. Buyer assumes risks and rewards of ownership.
We recognize revenue over time if either:
1. The seller is creating or enhancing an asset that the buyer controls as the service is
performed, or
2. The seller is not creating an asset that that the buyer controls or that has alternative use to
the seller, and either:
a. The customer receives and consumes a benefit as the seller performs the service,
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b. Another seller would not need to re-perform the tasks performed to date if that other
seller were to fulfill the remaining obligation, or
c. The seller has the right to payment for performance even if the customer could cancel
the contract.
Remember, “integrated products and services” with interrelated risks and significant modification
(as in long-term construction contracts) are viewed as a single performance obligation.
The cumulative amount of revenue that can be recognized is limited to the amount that the seller is
reasonably assured to be entitled to receive. For example, if the buyer controls how much the seller
receives (because of, for example, commissions based on the buyer’s sales to end customers), the
seller is not reasonably assured of receiving the revenue until the buyer actually achieves those
sales.
SELF-STUDY QUESTIONS AND EXERCISES
Concept Review
1.
The realization principle states that revenue be recognized only after the earnings process is
and there is
of collection.
2.
The product delivery date occurs when
buyer.
3.
Revenue recognition is delayed until after the product has been delivered in situations
involving significant uncertainty as to the collectibility of the cash to be received, caused either
by the possibility of the product being
or, with credit sales, the possibility of
failure to collect the receivable.
4.
When a seller is viewed as a
and cost of sales; when a seller is viewed as an
revenue their commission for facilitating a sale.
5.
The
method allocates a share of a long-term project’s revenues
and expenses to each reporting period during the contract period.
6.
The
method recognizes gross profit by applying the gross profit
percentage on the sale to the amount of cash actually received.
7.
The
method defers all gross profit recognition until cash equal to the
cost of the item sold has been received.
8.
Because the return of merchandise can retroactively negate the benefits of having made a sale,
several criteria should be satisfied before revenue is recognized in situations when the
exists.
Student Study Guide
to the goods passes from seller to
, the seller records total revenue
, the seller only records as
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Income Measurement and Profitability Analysis
9.
For a long-term construction project, the completed contract method records all costs of
construction in an asset (inventory) account called
; no income is recognized
until
.
10. With the percentage-of-completion method, progress to date usually is assumed to be the
proportion of the project’s cost incurred to date divided by
.
11. The completed contract method should be used only in situations where the company is unable
to make dependable estimates of
necessary to apply the percentage of
completion method.
12. The billings on construction contract account is a valuation (contra) account to
the asset
.
13. Disclosure of the method used to account for long-term contracts will appear in the
.
14. An estimated loss on a long-term contract is fully recognized in the
is anticipated, regardless of the revenue recognition method used.
the loss
15. GAAP require that the franchisor has
the services promised in the
franchise agreement and that the collectibility of the initial franchise fee is
before
the fee can be recognized as revenue.
16. Activity ratios measure a company's efficiency in managing its
.
17. The
ratio is calculated by dividing a period's net credit sales by the
average net accounts receivable.
18. The
indicates the average age of accounts receivables.
19. The
ratio shows the number of times the average inventory balance is
sold during a reporting period.
20. The
ratio measures a company's efficiency using assets to generate revenue.
21. The profit margin on sales measures the amount of net income achieved per
.
22. The
ratio expresses income as a percentage of the average total assets
available to generate that income.
23. The return on shareholders' equity ratio is obtained by dividing
by average
.
Question 24 is based on the Appendix.
24.
reporting serves to enhance the timeliness of financial information.
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Intermediate Accounting, 6/e
Income Measurement and Profitability Analysis
Addendum
Respond to these questions with the presumption that the guidance provided by the new Accounting
Standards Update is being applied
25. The transaction price is allocated to
performance obligations.
26. A performance obligation is distinct if either (1) the seller regularly
the
good or service separately, or (2) a buyer could
the good or service on its
own or in combination with goods or services the buyer could obtain elsewhere.
27. Uncertain consideration can be estimated in one of two ways: based either on the
or the
amount.
28. If payment occurs significantly before delivery, consideration of the time value of money
requires the seller to recognize interest
; if payment occurs significantly after
delivery, consideration of the time value of money requires the seller to recognize
interest
.
29. If the standalone selling price of a separate performance obligation is uncertain, the seller can
estimate it using the
method.
30. The seller is limited to recognizing only the amount of revenue that it is
to receive.
Answers:
1. virtually complete, reasonable certainty 2. legal title 3. returned 4. principal, agent
5.percentage-of-completion method 6. installment sales 7. cost recovery 8. right of return
9. construction in progress, project completion 10. total estimated costs 11. future costs
12. construction in progress 13. summary of significant accounting policies 14. first period
15. substantially performed, reasonably assured 16. assets 17. receivables turnover
18. average collection period 19. inventory turnover 20. asset turnover 21. sales dollar
22. return on assets 23. net income, shareholders’ equity 24. Interim 25. seperate 26. sells, use 27.
probability weighted, most likely 28. expense, revenue 29. residual
30. reasonably assured
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Income Measurement and Profitability Analysis
REVIEW EXERCISES
Exercise 1
On August 1, 2013, the Slezenger Sporting Goods Company sold inventory to Jack's Golfing
Hamlet for $100,000. Terms of the sale called for a down payment of $20,000 and two annual
installments of $40,000 due on each August 1, beginning August 1, 2014. Each installment also
will include interest on the unpaid balance applying an appropriate interest rate. The inventory cost
Foster $60,000.
Required:
1. Compute the amount of gross profit to be recognized from the installment sale in 2013, 2014,
and 2015 using point of delivery revenue recognition. Ignore interest charges.
2. Repeat requirement 1 applying the installment sales method.
3. Repeat requirement 1 applying the cost recovery method.
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Solution:
Requirement 1
2013:
2014:
2015:
$40,000 ($100,000 - 60,000)
-0-0-
Requirement 2
Gross profit percentage = 40% ($40,000 ÷ $100,000)
2013:
40% x $20,000 =
$8,000
2014:
40% x $40,000 =
$16,000
2015:
40% x $40,000 =
$16,000
Requirement 3
2013:
2014:
2015:
-0-0$40,000
Exercise 2
In the year 2013 Vitelli Brothers Construction contracted to build an office building for $6,000,000.
Data relating to the contract are as follows ($ in thousands):
Costs incurred during the year ....................
Estimated costs to complete as of year-end
Billings during the year ..............................
Cash collections during the year .................
2013
$1,000
3,000
3,000
2,500
2014
$3,000
3,000
3,500
Required:
1. Determine the gross profit that Vitelli Brothers should recognize in both 2013 and 2014 using
(1) the completed contract method and (2) the percentage-of-completion method.
Completed contract method:
Percentage-of-completion method:
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Income Measurement and Profitability Analysis
2. Show the 2013 year-end balance sheet presentation for the construction-related accounts by the
percentage-of-completion method only.
Solution:
Requirement 1
Completed contract method:
2013:
$0
2014:
$2,000 ($6,000 - 4,000)
Percentage-of-completion method:
2013:
$1,000
= 25% x $2,000 = $500
$4,000
2014:
$2,000 - 500 (2013 gross profit) = $1,500
Requirement 2
2013
Current assets:
Accounts receivable
Current liabilities:
Billings ($3,000) in excess of costs
and profit ($1,500)
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$
500
$1,500
Intermediate Accounting, 6/e
Income Measurement and Profitability Analysis
Exercise 3
Financial statements for Kiplinger Corporation for the year 2013 are shown below:
2013 Income Statement
Sales ...............................................................
Cost of goods sold ..........................................
Gross profit .................................................
Operating expenses ........................................
Interest expense ..............................................
Tax expense ...................................................
Net income ...................................................
($ in 000s)
$6,000
(4,200)
1,800
(1,100)
(150)
(200)
$ 350
Comparative Balance Sheets
December 31
2013
2012
Assets:
Cash .........................................................................
Accounts receivable .................................................
Inventory ..................................................................
Property, plant, and equipment (net) .......................
Total assets ........................................................
$ 500
500
600
1,400
$3,000
$ 350
300
400
1,350
$2,400
Liabilities and Shareholders’ Equity:
Current liabilities .....................................................
Bonds payable ..........................................................
Paid-in capital ..........................................................
Retained earnings.....................................................
Total liabilities and shareholders' equity ............
$750
1,000
400
850
$3,000
$ 500
1,000
400
500
$2,400
Required:
Calculate the following ratios for 2013:
1. Inventory turnover ratio
2. Average days in inventory
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Income Measurement and Profitability Analysis
3. Receivables turnover ratio
4. Average collection period
5. Asset turnover ratio
6. Profit margin on sales
7. Return on assets
8. Equity multiplier
9. Return on shareholders’ equity
10. Use the DuPont framework to show return on shareholders’ equity as a function of profit
margin, asset turnover and equity multiplier.
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Solution:
1. Inventory turnover ratio
$4,200 ÷ ([$600 + 400] ÷ 2) = 8.4
2.
Average days in inventory
365 ÷ 8.4 = 43.45 days
3.
Receivables turnover ratio
$6,000 ÷ ([$500 + 300] ÷ 2) = 15.0
4.
Average collection period
365 ÷ 15.0 = 24.33 days
5.
Asset turnover ratio
6.
Profit margin on sales
7.
Return on assets
$350 ÷ ([$3,000 + 2,400] ÷ 2) = 12.96%
8.
Equity multiplier
([$3,000 + 2,400] ÷ 2) / ([$1,250 + 900] ÷ 2) = 2.51
9.
Return on shareholders’ equity
10. DuPont framework
$6,000 ÷ ([$3,000 + 2,400] ÷ 2) = 2.22
$350 ÷ $6,000 = 5.83%
$350 ÷ ([$1,250 + 900] ÷ 2) = 32.56%
32.5% = 5.83% x 2.22 x 2.51
MULTIPLE CHOICE
Enter the letter corresponding to the response that best completes each of the following statements or
questions.
1. In general, revenue is recognized as earned when there is reasonable certainty as to the
collectibility of the asset to be received and:
a. The sales price has been collected.
b. The earnings process is virtually complete.
c. Production is completed.
d. A purchase order has been received.
2. Under IFRS, revenue for the sale of goods is recognized when the seller has transferred
to the buyer:
a. A signed invoice.
b. The risks and rewards of ownership.
c. Compelling evidence that substantive installation has occurred.
d. None of the above.
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Income Measurement and Profitability Analysis
3.
Western Appliance Company, which began business on January 1, 2013, appropriately
uses the installment sales method of accounting. The following data are available for
2013:
Installment sales
Cash collections on installment sales
Gross profit on sales
$350,000
150,000
40%
The gross profit on installment sales for 2013 should be:
Realized
Deferred
a.
$60,000
$80,000
b.
$80,000
$60,000
c.
$140,000
$80,000
d.
$140,000
60,000
4. The Pattison Company began operations on January 2, 2013, and appropriately uses the
installment sales method of accounting. The following data are available for 2013 and
2014:
Installment sales
Cash collections from:
2013 sales
2014 sales
Gross profit on sales
2013
$600,000
2014
$750,000
200,000
250,000
300,000
40%
30%
The deferred gross profit that would appear in the 2014 balance sheet is:
a. $180,000
b. $200,000
c. $285,000
d. $225,000
5. For profitable long-term contracts, income is recognized in each year under the:
Completed contract
Percentage-of-completion
method
method
a.
No
No
b.
Yes
No
c.
Yes
Yes
d.
No
Yes
6. When accounting for a long-term construction contract using the percentage-ofcompletion method, gross profit is recognized in any year is debited to:
a. Construction in progress.
b. Billings on construction contract
c. Deferred income
d. Accounts receivable
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7. When accounting for a long-term construction contract under IFRS, if the percentage-ofcompletion method is not appropriate, the seller should account for revenue using:
a. The cost recovery method.
b. The completed contract method
c. Either the cost recovery method or the completed contract method
d. Neither the cost recovery method or the completed contract method
8. When IFRS uses the cost recovery method to account for a long-term contract,
a. Revenue typically is recognized in excess of costs incurred early in the life of the
contract.
b. Costs in excess of revenue are typically recognized early in the life of the contract.
c. Revenue equal to costs are typically recognized early in the life of the contract.
d. Revenue is based on contract completion, not on costs, early in the life of the
contract
9. Hollywood Construction Company uses the percentage-of-completion method of
accounting for long-term construction contracts. During 2013, Hollywood began work
on a $3,000,000 fixed-fee construction contract, which was completed in 2016. The
accounting records disclosed the following data at year-end:
2013
2014
2015
Cumulative
contract costs
incurred
$ 200,000
1,100,000
2,000,000
Estimated
costs to complete
at end of year
$1,800,000
1,100,000
400,000
For the 2015 year, Hollywood should have recognized gross profit on this contract of:
a. $100,000
b. $500,000
c. $266,667
d. $225,000
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Income Measurement and Profitability Analysis
10. Sandlewood Construction Inc. uses the percentage-of-completion method of accounting
for long-term construction contracts. In 2013, Sandlewood began work on a
$10,000,000 construction contract, which was completed in 2014. The accounting
records disclosed the following data at the end of 2013:
Costs incurred
Estimated cost to complete
Progress billings
Cash collections
$5,400,000
3,600,000
4,100,000
3,200,000
How much gross profit should Sandlewood have recognized in 2013?
a. $700,000
b. $1,000,000
c. $600,000
d. $0
11. Based on the same data in question 7, in addition to accounts receivable, what would
appear in the 2013 balance sheet related to the construction accounts?
a. A current asset of $1,300,000
b. A current liability of $900,000
c. A current asset of $900,000
d. A current asset of $1,900,000
12. The Simpson Construction Company uses the percentage-of-completion method of
accounting for long-term construction contracts. In 2013, Simpson began work on a
construction contract. Information on this contract at the end of 2013 is as follows:
Cost incurred during the year
Estimated additional cost to complete
Gross profit recognized in 2013
$1,500,000
6,000,000
250,000
What is the contract price (total revenue) on this contract?
a. $7,000,000
b. $8,750,000
c. $7,500,000
d. $9,000,000
13. Smith Company earns a 12% return on assets. If net income is $720,000, average total
assets must be:
a. $86,400
b. $6,000,000
c. $6,086,400
d. $3,000,000
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14. The Esquire Company reported sales of $1,600,000 and cost of goods sold of $1,122,000
for the year ended December 31, 2013. Ending inventory for 2012 and 2013 was
$420,000 and $460,000, respectively. Esquire's inventory turnover for 2013 is:
a. 2.44
b. 2.55
c. 3.64
d. 3.48
The following data for the McQuire Corporation apply to questions 15 and 16:
Income statement:
Sales
Cost of goods sold
Net income
Balance sheets:
Accounts receivable
Total assets
Total shareholders' equity
2013
$2,500,000
1,300,000
200,000
$
2013
300,000
2,000,000
900,000
2012
$ 200,000
1,800,000
700,000
15. The accounts receivable turnover for 2013 is:
a. 10.0
b. 8.33
c. 5.2
d. 4.33
16. The return on shareholders' equity for 2013 is:
a. 20%
b. 8%
c. 22.22%
d. 25%
Question 17 is based on Appendix 5.
17. Which of the following is not a required disclosure for interim period reporting?
a. Earnings per share.
b. Extraordinary items.
c. General and administrative expenses.
d. Sales.
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Income Measurement and Profitability Analysis
Addendum
Respond to these questions with the presumption that the guidance provided by the new Accounting
Standards Update is being applied
18. Which of the following is not one of the steps for recognizing revenue?
a. Identify the separate performance obligations of the contract.
b. Identify the contract with the customer.
c. Estimate the total transaction price of the contract based on fair value.
d. Allocate the transaction price to the separate performance obligations.
19. Which of the following is true about the new revenue ASU?
a. The realization principle guides the ASU.
b. Construction contracts are typically broken into the various separate goods and
services that are included in them for purposes of revenue recognition.
c. The time value of money is considered when estimating all transaction prices.
d. Collectibility of the receivable is not considered when determining whether revenue
can be recognized.
20. Which of the following is not one of the characteristics of a contract for purposes of
revenue recognition?
a. Rights.
b. Reasonable profit margin.
c. Approval.
d. Commercial substance.
21. A performance obligation is separate if it meets which of the following conditions?
a. The seller regularly sells the good or service separately.
b. The buyer could use the good or service on its own.
c. The buyer could use the good or service in combination with goods or services the
buyer could obtain elsewhere.
d. All of the above.
22. Which of the following is a separate performance obligation?
a. An extended warranty.
b. A prepayment.
c. A right of return.
d. An option for the customer to purchase additional products under the same terms
enjoyed by other new customers.
23. Which of the following is an acceptable way to estimate uncertain consideration?
a. Most likely amount to be received.
b. Minimum amount considered likely to be received.
c. Probability-weighted estimate of the amount to be received.
d. Both a and c are acceptable.
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24. Lewis is selling a product with some of the transaction price depending on the outcome
of a future event. There is a 75% chance that the event will result in $100,000 of
consideration to Lewis, and a 25% chance that the event will result in $40,000 of
consideration to Lewis. Which of the following is not an appropriate estimate of the
amount of uncertain consideration for purposes of Lewis estimating the transaction
price?
a. $100,000.
b. $85,000.
c. $70,000.
d. a-c are all appropriate estimates.
25. Assume a prepayment is made six months in advance of delivery of a product. The
seller is likely to do which of the following with respect to the time value of money over
the life of the contract?
a. Recognize interest expense.
b. Recognize interest revenue.
c. Ignore the time value of money.
d. None of the above.
26. Under the ASU, bad debts:
a. Must be recognized as an expense.
b. Must be recognized as a contra-revenue.
c. Must be able to be estimated in order to recognize revenue.
d. Reduce the transaction price that is allocated to separate performance obligations.
27. Allocation of the transaction price to separate performance obligations:
a. Is based on relative standalone selling prices.
b. Cannot be based on estimated selling prices.
c. May not use the residual method when selling prices are uncertain.
d. Is not allowed when bad debts are material.
28. Winchell wrote a contract that involves two separate performance obligations. Product
A has a standalone selling price of $50, and product B has a standalone selling price of
$100. The price for the combined product is $120. How much of the transaction price
would be allocated to the performance obligation for delivering product A?
a. $50.
b. $40.
c. $30.
d. $20.
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Income Measurement and Profitability Analysis
29. Winchell wrote a contract that involves two separate performance obligations. Winchell
cannot estimate the standalone selling price of product A. Product B has a standalone
selling price of $100. The price for the combined product is $120. How much of the
transaction price would be allocated to the performance obligation for delivering product
A?
a. $50.
b. $40.
c. $30.
d. $20.
30. Which of the following is not an indicator that control of a good has passed from the
seller to the buyer?
a. Buyer has an unconditional obligation to pay.
b. Buyer has legal title.
c. Buyer has scheduled delivery.
d. Buyer has assumed the risk and rewards of ownership.
31. Which of the following is an indicator that revenue for a service can be recognized over
time ?
a. The seller is enhancing an asset that the buyer controls as the service is performed.
b. The seller is providing continuous effort to the buyer.
c. The seller can estimate the percent of work completed.
d. The sales price is fixed and determinable.
32. Assume a seller is not enhancing an asset that the buyer controls or that has an
alternative use to the seller. Which of the following is not an indicator that revenue for a
service can be recognized continuously?
a. The customer receives a benefit as the seller performs the service.
b. Another seller would not need to reperform the tasks performed to date if that other
seller were to fulfill the remaining obligation.
c. The seller has the right to payment for performance even if the customer could
cancel the contract.
d. The seller has significant experience with the customer and anticipates fulfillment
of the contract.
33. Which of the following is not an indicator that a seller is not reasonably assured to
receive an amount?
a. The seller could avoid paying an amount without breeching the contract.
b. The receivable is likely to prove uncollectible due to the customer’s financial
difficulties.
c. The seller lacks experience selling similar products and so may not be able to
estimate uncertain amounts.
d. Uncertain amounts are very difficult to estimate due to susceptibility to factors
beyond the seller’s control.
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Answers:
1. b.
6.
2. b.
7.
3. a.
8.
4. d.
9.
5. d.
10.
Student Study Guide
a.
b.
c.
a.
c.
11.
12.
13.
14.
15
d.
b.
b.
b.
a.
16
17
18
19
20
d.
c.
c.
d.
b.
21
22
23
24
25
d.
a.
d.
c.
c.
26
27
28
29
30
b.
a.
b.
d.
c.
31
32
33
a.
d.
b.
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Income Measurement and Profitability Analysis
CPA Exam Questions
1. b. The earnings process is completed upon delivery of the product. Therefore,
in 2014, revenue for 50,000 gallons at $3 each is recognized on January 15.
The payment terms do not affect revenue recognition.
2. d. The deferred gross profit in the balance sheet at December 31, 2014, should
be the balances in the accounts receivable accounts on that date for 2013 and
2014 sales multiplied by the appropriate gross profit percentage:
Accounts receivable: sales in
2013
2014
Total sales
$ 600,000
$ 900,000
Less: Collections to date
(300,000)
(300,000)
Less: Write-offs to date
(200,000)
(50,000)
Accounts receivable balance
100,000
550,000
x Gross profit rate
x 30%
x 40%
Deferred gross profit, 12/31/14 $ 30,000
$ 220,000
The combined deferred gross profit in the balance sheet is $250,000 ($30,000 +
$220,00)
3. a.
Year of sale
2013
2014
a. Gross profit realized
$240,000
$200,000
b. Percentage
30%
40%
c. Collections on sales (a/b)
$800,000
$500,000
Sales
1,000,000
2,000,000
Balance uncollected at December 31, 2014 $200,000
$1,500,000
The total uncollected balance is $1,700,000 ($200,000 + 1,500,000).
4. d. Construction-in-progress represents the costs incurred plus the cumulative
pro-rata share of gross profit under the percentage-of-completion method of
accounting.
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5. c.
2013 actual costs
Total estimated costs
Ratio
Contract price
Revenue
2013 actual costs
Gross profit
$20,000
÷ 60,000
= 1/3
x 100,000
33,333
–20,000
$13,333
6. d. Since the total cost of the contract, $3,100,000 ($930,000 + 2,170,000), is
projected to exceed the contract price of $3,000,000, the excess cost of
$100,000 must be recognized as a loss in 2013.
7. c. “Cash collection is at least reasonably possible” is not a requirement for revenue
recognition under IFRS.
8. a. Under the cost recovery approach, an amount of revenue is recognized that is
equal to cost incurred, so long as cost incurred is probable to be recovered.
Since $1,000,000 of cost was incurred, $1,000,000 of revenue is recognized.
9. a. IFRS does not provide extensive guidance determining how contracts are to
be separated into components for purposes of revenue recognition.
10. d. IFRS recognizes interim expenses more discretely than does U.S. GAAP,
such that the expense is recognized in the period in which it occurs rather
than being accrued as a prepaid expense asset when an amount is paid and
then amortized to expense over the year. Therefore, under IFRS Barrett
would recognize the entire $50,000 as expense in the first period, and not
accrue any prepaid expense asset. Under U.S. GAAP Barrett would accrue
an asset when it made the tax payment and then reduce the asset by $12,500
each interim period while recognizing $12,500 of expense each interim
period.
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Income Measurement and Profitability Analysis
CMA Exam Questions
1. c. Revenue is recognized when (1) realized or realizable and (2) earned. On
May 28, $500,000 of the sales price was realized while the remaining
$500,000 was realizable in the form of a receivable. The revenue was earned
on May 28 when the title of the goods passed to the purchaser. The costrecovery
method is not used because the receivable was not deemed
uncollectible until June 10.
2. d. Revenue is normally recorded at the time of the sale or, occasionally, at the
time cash is collected. However, sometimes neither the sales basis nor the
cash basis is appropriate, such as when a construction contract extends over
several accounting periods. As a result, contractors ordinarily recognize
revenue using the percentage-of-completion method so that some revenue is
recognized each year over the life of the contract. Hence, this method is an
exception to the general practice of recognizing revenue at the point of sale,
primarily because it better matches revenues and expenses.
3. b. Given that one-third of all costs have already been incurred ($6,000,000), the
company should recognize revenue equal to one-third of the contract price, or
$8,000,000. Revenues of $8,000,000 minus costs of $6,000,000 equals a gross
profit of $2,000,000.
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