CHAPTER 5
Income Measurement and Profitability Analysis
Overview
The timing of revenue recognition is critical to income measurement. Revenue affects income,
and, under the matching principle, expenses are recognized in the period in which the related
revenues are recognized, so revenue recognition determines the recognition of some expenses as
well. The focus of this chapter is revenue recognition. We also continue our discussion of financial
statement analysis.
Learning Objectives
● 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
long-term 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.
Lecture Outline
Part A: Revenue Recognition
I.
Revenue Recognition in General
A. FASB definition: “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. (T5-1)
B. The realization principle requires that two criteria be satisfied before revenue can be
recognized:
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1. The earnings process is judged to be complete or virtually complete.
2. There is reasonable certainty as to the collectibility of the asset to be received.
C. Staff Accounting Bulletin No.’s 101 and 104 summarized the SEC’s views on revenue
recognition. The bulletins provide additional criteria for judging whether or not the
realization principle is satisfied:
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.
D. 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. (T5-2)
II.
Revenue Recognition at Delivery
A. While revenue usually is earned during a period of time, revenue often is recognized at one
specific point in time when both revenue recognition criteria are satisfied.
B. It is important to determine whether a seller is a principal of an agent. (T5-3)
1. 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. If the seller is a principal, it should recognize as revenue
the gross (total) amount received from a customer.
2. 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 an agent, it should recognize as
revenue only the commission it receives for facilitating the sale.
C. Revenue from the sale of products usually is recognized at the point of product delivery,
but can be delayed past delivery if material uncertainties exist or allowed prior to delivery
for long-term contracts. (T5-4, T5-5)
D. Service revenue often is recognized over time, in proportion to the amount of service
performed. If there is one final service that is critical to the earnings process, revenues and
costs are deferred and recognized after this service has been performed.
III.
Revenue Recognition after Delivery
A. Significant uncertainties about cash collection could cause a delay in recognizing revenue
from the sale of a product or a service. (T5-4, T5-5)
B. Installment sales
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1. Revenue recognition for most installment sales takes place at the point of delivery,
because reliable estimates of potential uncollectible amounts can be made.
2. When exceptional uncertainty exists, two accounting methods are available:
a. The installment sales method.
b. The cost recovery method.
3. The installment sales method recognizes gross profit by applying the gross profit
percentage on the sale to the amount of cash actually received. (T5-6)
4. The cost recovery method defers all gross profit recognition until cash equal to the
cost of the item sold has been received. (T5-7)
C. Right of Return (T5-8)
1. 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, reliable estimates can be made and revenue and costs are recognized at point
of delivery.
2. Otherwise, revenue and cost recognition is delayed until the uncertainty is resolved.
IV.
Revenue Recognition prior to Delivery
A. It often is desirable to recognize revenue over time for long–term contracts. (T5-4, T5-5)
The types of companies that make use of long-term contracts are many and varied,
although they are most prevalent in the construction industry. (T5-9) In these situations,
there are two methods of accounting for revenue and expense recognition:
1. The completed contract method.
2. The percentage-of-completion method.
B. Much of the accounting is the same under both of these methods (T5-10, T5-11)
1. All costs of construction are recorded in an asset (inventory) account called
construction in progress.
2. Period billings are credited to billings on construction contract, a contra account to the
construction in progress account. This serves to reduce the carrying value of the
physical asset (construction in progress) when a financial asset (accounts receivable) is
also recognized; otherwise the project would be double-counted on the balance sheet.
3. Construction in progress is debited for the amount of gross profit recognized. The
same total amount of gross profit is recognized under the two methods – the only
difference is timing. (T5-11, T5-12)
C. The completed contract method is equivalent to recognizing revenue at the point of
delivery, that is, when the project is complete.
1. No revenues or expenses are recognized until the project is complete. (T5-11, T5-12)
2. The completed contract method does not properly portray a company's performance
over the construction period and should only be used in unusual situations when
forecasts of costs to complete the project are highly uncertain.
D. The percentage-of-completion method allocates a fair share of a project's revenues and
expenses to each reporting period during construction. How is that fair share determined?
(T5-13)
1. The allocation of project profit is accomplished by estimating progress to date.
2. Progress to date (the percentage of completion) can be estimated as the proportion of
the project's cost incurred to date divided by total estimated costs, by project
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milestones, or by relying on an engineer's or architect's estimate. The “cost to cost”
approach is most common.
3. To determine periodic gross profit (revenues less expenses), the percentage of
completion is multiplied by estimated gross profit to determine gross profit earned to
date, and then the current period's gross profit is determined by subtracting from this
amount the gross profit recognized in previous periods.
4. Periodic revenues are determined by multiplying the percentage of completion by the
total contract price and then subtracting revenue recognized in prior periods. In most
cases, the cost of construction equals the construction costs incurred during the period.
(T5-14)
E. Balance sheet effects: Construction in progress is compared to billings on construction
contract. (T5-15)
1. A debit balance indicates costs (plus profits for the percentage-of-completion method)
in excess of billings and is reported as an asset.
2. A credit balance indicates billings in excess of costs (plus profits for the percentage-ofcompletion method) and is reported as a liability.
F. Long-term contract losses
1. A loss could occur on a profitable project if the estimated costs to complete were
underestimated in prior periods.
2. An estimated loss on a long-term contract is fully recognized in the first period that the
loss is anticipated, regardless of the revenue recognition method used. (T5-16)
3. Recognized losses on long-term contracts reduce the construction in progress account.
G. IFRS: IAS No. 11 governs revenue recognition for long-term construction contracts.
(T5-17)
1. Like U.S. GAAP, the international standard requires the use of percentage-ofcompletion accounting when estimates can be made precisely.
2. Unlike U.S. GAAP, the international standard requires the use of the cost recovery
method rather than the completed contract method when estimates cannot be made
precisely enough to allow percentage-of-completion accounting.
a. Under the cost recovery method, contract costs are expensed as incurred, and an
exactly offsetting amount of contract revenue is recognized, such that no gross
profit is recognized until all costs have been incurred.
b. Under both the cost recovery and completed contract methods, no gross profit is
recognized until the contract is essentially completed, but revenue and construction
costs will be recognized earlier under the cost recovery method than under the
completed contract method.
V.
Industry-Specific Revenue Issues
A. Multiple-element arrangements (T5-18)
1. If a software arrangement (sale) 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 (Vendor-specific objective evidence”).
2. More generally, if an arrangement contains multiple elements, revenue should be
allocated to individual deliverables if that qualify for separate revenue recognition
(e.g., they must have value on a stand-alone basis). Otherwise, revenue is delayed until
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completion of later deliverables. The revenue is allocated based on relative selling
prices, and those prices can be estimated if they are not available.
3. IFRS: IAS No. 18 is the general revenue recognition standard in IFRS. There is not
much guidance about multiple-element contracts or industry-specific revenue
recognition in IFRS.
B. In a franchise sale, the fees to be paid by the franchisee to the franchisor usually comprise
(1) the initial franchise fee, and (2) continuing franchise fees. (T5-19)
1. GAAP requires that the franchisor has substantially performed the services promised in
the franchise agreement and that the collectibility of the initial franchise fee is
reasonably assured before the fee can be recognized.
2. Continuing franchise fees are paid to the franchisor for continuing rights as well as for
advertising and promotion and other services over the life of the agreement and are
recognized by the franchisor as revenue in the period received, which corresponds to
the periods the services are performed.
Part B: Profitability Analysis
I.
Activity Ratios (T5-20)
A. Activity ratios measure a company's efficiency in managing its assets.
B. The asset turnover ratio measures a company's efficiency in using assets to generate
revenue and is calculated by dividing a company's net sales or revenues by the average
total assets available for use during the period.
C. The receivables turnover ratio offers an indication of how quickly a company is able to
collect its accounts receivable.
1. The ratio is calculated by dividing a period's net credit sales by the average net
accounts receivable.
2. An extension of this ratio is the average collection period, which is computed by
dividing 365 days by the receivable turnover ratio.
D. The inventory turnover ratio measures a company's efficiency in managing its investment
in inventory.
1. The ratio is calculated by dividing the period's cost of goods sold by the average
inventory balance.
2. An extension of this ratio is the average days in inventory, which is computed by
dividing 365 days by the inventory turnover ratio.
II.
Profitability Ratios (T5-21)
A. Profitability ratios assist in evaluating various aspects of a company's profit-making
activities.
B. The profit margin on sales measures the amount of net income achieved per sales dollar
and is computed by dividing net income by net sales.
C. The return on assets (ROA) indicates a company's overall profitability.
1. It is calculated by dividing net income by average total assets.
2. The return on assets can also be computed by multiplying the profit margin on sales by
the asset turnover.
D. The return on shareholders' equity measures the return to suppliers of equity capital. It is
calculated by dividing net income by average shareholders' equity.
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III.
DuPont Framework (T5-22)
A. The DuPont Framework helps identify how profitability, activity, and financial leverage
trade off to determine return to shareholders. In equation form, it is:
Return on equity
=
Profit
margin
X
Net income
Ave. total equity
=
Net income
Total sales
X
Asset turnover
Total sales
Ave. total assets
X Equity multiplier
X
Ave. total assets
Ave. total equity
B. Because profit margin and asset turnover combine to equal return on assets, the DuPont
framework can also be written as:
Return on equity
=
Return on assets
Net income
Ave. total equity
=
Net income
Ave. total assets
X Equity multiplier
X
Ave. total assets
Ave. total equity
Appendix: Interim Reporting
A. Interim reports are issued for periods of less than a year, typically as quarterly financial
statements.
B. With only a few exceptions, the same accounting principles applicable to annual reporting
are used for interim reporting.
C. Complete financial statements are not required for interim reporting, but certain minimum
disclosures are required:
1. Sales, income taxes, extraordinary items, cumulative effect of accounting principle
changes, and net income.
2 Earnings per share.
3 Seasonal revenues, costs, and expenses.
4. Significant changes in estimates for income taxes.
5. Discontinued operations, extraordinary items, and unusual or infrequent items.
6. Contingencies.
7. Changes in accounting principles or estimates.
8. Significant changes in financial position.
SUPPLEMENT: WHERE WE’RE HEADED
A. Core revenue recognition principle: 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.” Note: for many
transactions, applying this principle will yield the same accounting as would applying the
realization principle, but the conceptual underpinnings are very different. (T5-23)
B. Key steps in applying the principle:
1. Identify a contract with a customer.
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2.
3.
4.
5.
Identify the separate performance obligations in the contract.
Determine the transaction price.
Allocate the transaction price to the separate performance obligations.
Recognize revenue when (or as) the entity satisfies each performance obligation.
(T5-23)
C. Step 1: Identify the contract. For purposes of applying revenue recognition criteria, a
contract needs to have the following characteristics: (T5-24)
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 transferred goods and services.
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.
D. Step 2: Identify separate performance obligations (T5-25)
1. A performance obligation is separate if it is distinct, which is the case if:
i. the seller regularly sells the good or service separately, or
ii. a buyer could use the good or service on its own or in combination with
goods or services the buyer could obtain elsewhere.
2. A bundle of goods and services is treated as a single performance obligation if both
of the following two criteria are met:
i. 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.
ii. The bundle of goods or services is significantly modified or customized to
fulfill the contract.
iii. Example: many construction contracts.
3. 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.
4. Examples of separate performance obligations: (T5-26)
i. Options to receive additional goods or services that provide a material right
(but not a right of return).
ii. Extended Warranties (but not warranties for latent defects).
E. Step 3: Determine the transaction price (T5-27)
1. Include uncertain consideration, estimated as either
i. most likely amount
ii. probability weighted amount (T5-28)
2. Uncollectible accounts:
i. Ability to estimate bad debts does not figure into whether to recognize
revenue.
ii. Treat bad debts as a contra-revenue (like sales returns) rather than as an
expense.
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3. Consider the time value of money if a contract has a significant financing
component. (T5-29)
i. Assume not significant if payment within one year.
ii. Applies to prepayments (impute interest expense) and receivables (impute
interest revenue).
F. Step 4: Allocate the transaction price. (T5-30)
1. To separate performance obligations
2. Note: this approach is like current accounting for multiple-element arrangements.
i. 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.
ii. Can use estimated selling prices. If can’t estimate, use the residual method.
(T5-31)
3. If contract gets modified subsequently, reallocate transaction price to each separate
performance obligation.
G. Step 5: Recognize revenue when (or as) performance obligations are satisfied. (T5-32)
1. Basic idea: Satisfy performance obligations (and so recognize revenue) when transfer
control to the buyer.
2. Satisfy over time if either:
i. The seller is creating or enhancing an asset that the buyer controls as the
service is performed, or
ii. The seller is not creating an asset that that the buyer controls or that has
alternative use to the seller, and either:
1. The customer receives and consumes a benefit as the seller performs.
2. Another seller would not need to re-perform the tasks performed to
date if that other seller were to fulfill the remaining obligation.
3. The seller has the right to payment for performance even if the
customer could cancel the contract.
iii. “Integrating products and services” with interrelated risks and significant
modification (as in long-term construction contracts) are viewed as a single
performance obligation.
iv. Amount recognized is limited to amount reasonably assured to be entitled to
receive.
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DEFINITION AND
REALIZATION PRINCIPLE
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.
The realization principle requires that two criteria be satisfied
before revenue can be recognized:

The earnings process is judged complete or virtually complete
(the earnings process refers to the activity or activities
performed by the company to generate revenue).

There is reasonable certainty as to the collectibility of the
asset to be received (usually cash).
T5-1
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INTERNATIONAL FINANCIAL REPORTING STANDARDS
Revenue Recognition Concepts.
IAS No. 18 governs most revenue
recognition under IFRS. Similar to U.S. GAAP, it defines revenue as “the gross
inflow of economic benefits during the period arising in the course of the ordinary
activities of an entity when those inflows result in increases in equity, other than
increases relating to contributions from equity participants.” 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.
Note: These general conditions typically will lead to revenue recognition at the same
time and in the same amount as would occur under U.S. GAAP, but there are
exceptions (e.g., multiple-deliverable contracts).
More generally, IFRS has much less industry-specific guidance that does U.S. GAAP,
leading to fewer exceptions to applying these revenue recognition conditions.
T5-2
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IS THE SELLER A
PRINCIPAL OR AN AGENT?
Principal:

Has primary responsibility for delivering a product or service,

Typically is vulnerable to risks associated with delivering the
product or service and collecting payment.
If the company is a principal, the company should
recognize as revenue the gross (total) amount received
from a customer.
Agent:

Does not have primary responsibility for delivering a product
or service,

Is not vulnerable to risks associated with delivering the
product or service and collecting payment.
If the company is an agent, the company should recognize
as revenue the net commission it receives for facilitating
the sale.
T5-3
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RELATION BETWEEN EARNINGS
PROCESS AND REVENUE
RECOGNITION METHODS
Illustration 5-2
 In most situations, the revenue recognition
criteria are satisfied at the point of product
delivery.
T5-4
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REVENUE RECOGNITION
Nature of the Revenue
Usually Recognize Revenue for:
Sale of a Product
Sale of a Service
Revenue Recognition
Prior to Delivery, Because:
Dependable estimates of
progress are available.
Each period during the earnings process
(e.g., long-term construction contract) in
proportion to its percentage of
completion (percentage-of-completion
method)
Not applicable
Dependable estimates of
progress are not available.
At the completion of the project
(completed contract method)
Not applicable
Revenue Recognition
at Delivery
When product is delivered and title
transfers
As the service is provided or the key
activity is performed
• Payments are
significantly uncertain
When cash is collected (installment sales
or cost recovery method)
When cash is collected
• Reliable estimates of
product returns are
unavailable
When critical event occurs that reduces
product return uncertainty
Not applicable
• The product sold is
out on consignment
When the consignee sells the product to
the ultimate consumer
Not applicable
Revenue Recognition
After Delivery, Because:
Illustration 5-3
T5-5
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INSTALLMENT SALES METHOD

The installment sales method recognizes gross profit by applying the
gross profit percentage on the sale to the amount of cash actually
received.
On November 1, 2013, the Belmont Corporation, a real estate developer, sold a tract
of land for $800,000. The sales agreement requires the customer to make four equal
annual payments of $200,000 plus interest on each November 1, beginning
November 1, 2013. The land cost $560,000 to develop. The company’s fiscal year
ends on December 31.
Illustration 5-1
Gross Profit Recognition
Date
Nov. 1, 2013
Nov. 1, 2014
Nov. 1, 2015
Nov. 1, 2016
Totals
Cash Collected
$200,000
200,000
200,000
200,000
$800,000
Cost Recovery
($560/$800=70%)
$140,000
140,000
140,000
140,000
$560,000
Gross Profit
($240/$800=30%)
$ 60,000
60,000
60,000
60,000
$240,000
T5-6
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INSTALLMENT SALES METHOD
(continued)
Journal Entries
Nov. 1, 2013
To record installment sale
Installment receivables ...................................................
Inventory.....................................................................
Deferred gross profit ..................................................
800,000
560,000
240,000
Nov. 1, 2013
To record cash collection from installment sale
Cash ................................................................................ 200,000
Installment receivables ...............................................
200,000
To recognize gross profit from installment sale
Deferred gross profit ......................................................
60,000
Realized gross profit...................................................
60,000
T5-6 (continued)
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COST RECOVERY METHOD

The cost recovery method defers all gross profit recognition
until cash equal to the cost of the item sold has been
recovered.
On November 1, 2013, the Belmont Corporation, a real estate developer,
sold a tract of land for $800,000. The sales agreement requires the
customer to make four equal annual payments of $200,000 plus interest on
each November 1, beginning November 1, 2013. The land cost $560,000
to develop. The company’s fiscal year ends on December 31.
Illustration 5-1
Gross Profit Recognition
Date
Nov. 1, 2013
Nov. 1, 2014
Nov. 1, 2015
Nov. 1, 2016
Totals
Cash Collected
$200,000
200,000
200,000
200,000
$800,000
Cost Recovery
$200,000
200,000
160,000
-0$560,000
Gross Profit
$ -0-040,000
200,000
$240,000
T5-7
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COST RECOVERY METHOD
(continued)
Journal Entries
Nov. 1, 2013 To record installment sale
Installment receivables ........................................ 800,000
Inventory ..........................................................
560,000
Deferred gross profit ........................................
240,000
To record cash collection from installment sale
Nov. 1, 2013, 2014, 2015, and 2016
Cash ..................................................................... 200,000
Installment receivables ....................................
200,000
To recognize gross profit from installment sale
Nov. 1, 2013 and 2014
No entry
Nov. 1, 2015
Deferred gross profit ...........................................
Realized gross profit ........................................
40,000
40,000
Nov. 1, 2016
Deferred gross profit ........................................... 200,000
Realized gross profit ........................................
200,000
T5-7 (continued)
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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,
reliable estimates can be made and revenue and costs are
recognized at point of delivery.

Otherwise, revenue and cost recognition is delayed until the
uncertainty is resolved.
Disclosure of Revenue Recognition Policy — Intel Corporation
Notes: Revenue Recognition
We recognize net product revenue when the earnings process is
complete, as evidenced by an agreement with the customer,
transfer of title and acceptance, if applicable, as well as fixed
pricing and probable collectibility. … Because of frequent sales
price reductions and rapid technology obsolescence in the
industry, we defer product revenue and related costs of sales
from sales made to distributors under agreements allowing price
protection and/or right of return until the distributors sell the
merchandise.
Illustration 5-8
T5-8
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COMPANIES ENGAGED IN LONG-TERM CONTRACTS
Company
Oracle Corp.
Type of Industry or Product
Computer software, license and consulting
fees
Lockheed Martin Corporation
Aircraft, missiles and spacecraft
Hewlett-Packard
Information technology
Northrop Grumman Newport News Shipbuilding
Nortel Networks Corp
Networking solutions and services to
support the Internet
SBA Communications Corp
Telecommunications
Layne Christensen Company
Water supply services and
geotechnical construction
Kaufman & Broad Home Corp.
Commercial and residential construction
Raytheon Company
Defense electronics
Foster Wheeler Corp.
Construction, petroleum and chemical
facilities
Halliburton
Construction, energy services
Allied Construction Products Corp. Large metal stamping presses
Illustration 5-11
T5-9
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COMPLETED CONTRACT AND PERCENTAGE-OFCOMPLETION METHODS: AN EXAMPLE
At the beginning of 2013, the Harding Construction Company received a contract to
build an office building for $5 million. The project is estimated to take three years
to complete. According to the contract, Harding will bill the buyer in installments
over the construction period according to a prearranged schedule. Information
related to the contract is as follows:
2013
Construction costs incurred
during the year
Construction costs incurred
in prior years
Cumulative construction costs
Estimated costs to complete
at end of year
Total estimated and actual
construction costs
Billings made during the year
Cash collections during year
2014
2015
$1,500,000
$1,000,000
$1,600,000
-01,500,000
1,500,000
2,500,000
2,500,000
4,100,000
2,250,000
1,500,000
-0-
$3,750,000
$1,200,000
1,000,000
$4,000,000
$2,000,000
1,400,000
$4,100,000
$1,800,000
2,600,000
Illustration 5–12
T5-10
© The McGraw-Hill Companies, Inc. 2013
5-20
Intermediate Accounting, 7/e
JOURNAL ENTRIES
2013
BOTH METHODS:
Construction in progress
Cash, materials, etc.
To record construction costs.
2014
2015
1,500,000
1,000,000
1,600,000
1,500,000
1,000,000
1,600,000
Accounts receivable
Billings on construction contract
To record progress billings.
1,200,000
2,000,000
1,800,000
1,200,000
2,000,000
1,800,000
Cash
Accounts receivable
To record cash collections.
1,000,000
1,400,000
2,600,000
1,000,000
1,400,000
2,600,000
COMPLETED CONTRACT:
Construction in progress
(gross profit)
Cost of construction
Revenue from long-term
contracts
To record gross profit.
Billings on construction contract
Construction in progress
To close accounts.
900,000
4,100,000
5,000,000
5,000,000
5,000,000
PERCENTAGE-OF-COMPLETION:
Construction in progress
(gross profit)
500,000
125,000
275,000
Cost of construction
1,500,000
1,000,000
1,600,000
Revenue from long-term
contracts
2,000,000
1,125,000
1,875,000
To record gross profit.
Billings on construction contract
Construction in progress
To close accounts.
5,000,000
5,000,000
Illustrations 5-12a-c
T5-11
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
5-21
A COMPARISON OF THE TWO METHODS —
INCOME RECOGNITION
Gross profit recognized:
2013
2014
2015
Total gross profit
Percentage-ofCompletion
Completed Contract
$500,000
125,000
275,000
$900,000
-0-0$900,000
$900,000
T5-12
© The McGraw-Hill Companies, Inc. 2013
5-22
Intermediate Accounting, 7/e
CALCULATING GROSS PROFIT UNDER THE
PERCENTAGE-OF-COMPLETION METHOD
2013
2014
2015
Contract price
$5,000,000
$5,000,000
$5,000,000
Construction costs:
Construction costs incurred during the year
Construction costs incurred in prior years
Cumulative construction costs to date
Estimated costs to complete at end of year
Total estimated and actual construction costs
$1,500,000
-0$1,500,000
2,250,000
$3,750,000
$1,000,000
1,500,000
$2,500,000
1,500,000
$4,000,000
$1,600,000
2,500,000
$4,100,000
-0$4,100,000
$1,250,000
$1,000,000
$900,000
X
X
X
$1,500,000
$3,750,000
= 40%
_________
$2,500,000
$4,000,000
= 62.5%
__________
$4,100,000
$4,100,000
= 100%
_________
$ 500,000
$ 625,000
$ 900,000
Total gross profit (estimated for 2013 &
2014, actual in 2015):
Contract price minus total estimated
and actual costs
Multiplied by:
Percentage-of-completion:
Actual costs to date divided by the
estimated total project cost
Equals:
Gross profit earned to date

Minus:
Gross profit recognized in prior periods

- 0_________
(500,000)
__________
(625,000)
_________
$ 500,000
$ 125,000
$ 275,000
Equals:
Gross profit recognized in current period
Ilustration 5-12d, T5-13
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
5-23
REVENUE AND COST OF CONSTRUCTION:
PERCENTAGE-OF-COMPLETION METHOD
2013
Revenue recognized in 2013 ($5,000,000 x 40%)
Cost of construction
Gross profit
2014
Revenue recognized to date ($5,000,000 x 62.5%)
Less: Revenue recognized in 2013
Revenue recognized in 2014
Cost of construction
Gross profit
2013
Revenue recognized to date ($5,000,000 x 100%)
Less: Revenue recognized in 2013 and 2014
Revenue recognized in 2015
Cost of construction
Gross profit
$2,000,000
1,500,000
$ 500,000
$3,125,000
(2,000,000)
$1,125,000
1,000,000
$ 125,000
$5,000,000
(3,125,000)
$1,875,000
1,600,000
$ 275,000
Illustration 5-12e
T5-14
© The McGraw-Hill Companies, Inc. 2013
5-24
Intermediate Accounting, 7/e
BALANCE SHEET PRESENTATION
Balance Sheet
(End of year)
2013
Percentage-of-completion:
Current assets:
Accounts receivable
Costs and profit ($2,000,000) in excess of billings ($1,200,000)
Current liabilities:
Billings ($3,200,000) in excess of costs and profit ($3,125,000)
$ 200,000
800,000
Completed contract:
Current assets:
Accounts receivable
Costs ($1,500,000) in excess of billings ($1,200,000)
Current liabilities:
Billings ($3,200,000) in excess of costs ($2,500,000)
$ 200,000
300,000
2014
$800,000
75,000
$800,000
700,000
Illustration 5-12f
T5-15
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
5-25
LONG-TERM CONTRACT LOSSES

An estimated loss on a long-term contract is fully recognized
in the first period that the loss is anticipated, regardless of the
revenue recognition method used.
Construction costs incurred
during the year
Construction costs incurred
in prior years
Cumulative construction costs
Estimated costs to complete
at end of year
Total estimated and actual
construction costs
2013
2014
2015
$1,500,000
$1,260,000
$2,440,000
-01,500,000
$1,500,000
2,760,000
$2,760,000
5,200,000
2,250,000
2,340,000
-0-
$3,750,000
$5,100,000
$5,200,000
Comparison of Periodic Gross Profit (Loss)
Gross profit (loss) recognized:
2013
2014
2015
Total project loss
Percentage-ofcompletion
Completed Contract
$500,000
(600,000)
(100,000)
$(200,000)
-0$(100,000)
(100,000)
$(200,000)
T5-16
© The McGraw-Hill Companies, Inc. 2013
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Intermediate Accounting, 7/e
INTERNATIONAL FINANCIAL REPORTING STANDARDS
Long-Term Construction Contracts.
IAS No. 11 governs revenue
recognition for long-term construction contracts. Like U.S. GAAP, IAS No. 11
requires use of percentage-of-completion accounting when estimates can be made
precisely. Unlike U.S. GAAP, IAS No. 11 requires use of the cost recovery method
rather than the completed contract method when estimates cannot be made precisely
enough to allow percentage-of-completion accounting. Under the cost recovery
method, contract costs are expensed as incurred, and an exactly offsetting amount of
contract revenue is recognized, such that no gross profit is recognized until all costs
have been incurred. Under both the cost recovery and completed contract methods,
no gross profit is recognized until the contract is essentially completed, but revenue
and construction costs will be recognized earlier under the cost recovery method than
under the completed contract method.
To see the difference, here is a version of Illustration 5-12B that compares cost and
gross profit recognition under the two methods:
COMPLETED CONTRACT:
Construction in progress
Cost of construction
Revenue
To record gross profit.
COST RECOVERY:
Construction in progress
Cost of construction
Revenue
To record gross profit.
900,000
4,100,000
5,000,000
1,500,000
900,000
1,000,000
1,600,000
1,500,000
1,000,000
2,500,000
T5-17
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
5-27
SOFTWARE AND OTHER
MULTIPLE-ELEMENT ARRANGEMENTS

If a software arrangement (sale) includes multiple elements, the
revenue from the arrangement should be allocated to the various
elements based on “VSOE” (vendor-specific objective evidence) of
the individual elements.

More generally, for multiple-element arrangements, revenue should
be allocated to individual deliverables that qualify for separate
revenue recognition. Otherwise, revenue is delayed until completion
of later deliverables.
Revenue is allocated according to the
deliverables’ relative selling prices. These can be estimated if items
aren’t sold separately.
T5-18
© The McGraw-Hill Companies, Inc. 2013
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Intermediate Accounting, 7/e
FRANCHISE SALES
On March 31, 2013, the Red Hot Chicken Wing Corporation entered into a
franchise agreement with Thomas Keller. In exchange for an initial franchise fee of
$50,000, Red Hot will provide initial services to include the selection of a location,
construction of the building, training of employees, and consulting services over
several years. $10,000 is payable on March 31, 2013, with the remaining $40,000
payable in annual installments which include interest at an appropriate rate. In
addition, the franchisee will pay continuing franchise fees of $1,000 per month for
advertising and promotion provided by Red Hot, beginning immediately after the
franchise begins operations. Thomas Keller opened his Red Hot franchise for
business on September 30, 2013.
Initial Franchise Fee
March 31, 2013 To record franchise agreement and down payment
Cash ................................................................................
10,000
Note receivable ...............................................................
40,000
Unearned franchise fee revenue .................................
50,000
Sept. 30, 2013
To recognize franchise fee revenue
Unearned franchise fee revenue .....................................
Franchise fee revenue .................................................
50,000
50,000
Continuing Franchise Fees
To recognize continuing franchise fee revenue
Cash (or accounts receivable) ........................................
1,000
Service revenue ..........................................................
1,000
Illustration 5-16
T5-19
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
5-29
ACTIVITY RATIOS

Activity ratios measure a company's efficiency in managing
its assets.
Asset turnover ratio
=
Net sales
Average total assets
Receivables turnover ratio
=
Net sales
Average accounts receivable (net)
=
365
Receivables turnover ratio
=
Cost of goods sold
Average Inventory
Average collection period
Inventory turnover ratio
Average days in inventory =
365
Inventory turnover ratio
T5-20
© The McGraw-Hill Companies, Inc. 2013
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Intermediate Accounting, 7/e
PROFITABILITY RATIOS

Profitability ratios assist in evaluating various aspects of a
company's profit-making activities.
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
T5-21
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
5-31
DUPONT FRAMEWORK

The DuPont Framework helps identify how profitability,
activity, and financial leverage trade off to determine return
to shareholders:
Return on
equity
Net income
Avg. total
equity

=
Profit
margin
X
Net income
= Total sales X
Asset
turnover
Total sales
Avg. total
assets
X
Equity
multiplier
Avg. total assets
X
Avg. total
equity
Because profit margin and asset turnover combine to equal
return on assets, the DuPont framework can also be written
as:
Return on
equity
Net income
Avg. total
equity
=
=
Return on
assets
Equity
multiplier
X
Net income
Avg. total
assets
Avg. total assets
X
Avg. total
equity
T5-22
© The McGraw-Hill Companies, Inc. 2013
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Intermediate Accounting, 7/e
THE NEW REVENUE RECOGNITION
FRAMEWORK
CORE REVENUE RECOGNITION PRINCIPLE
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.
KEY STEPS IN APPLYING THE PRINCIPLE
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.
T5-23
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© The McGraw-Hill Companies, Inc. 2013
5-33
STEP 1: IDENTIFY THE CONTRACT
For purposes of applying revenue recognition criteria, a contract
needs to have the following characteristics:
 Commercial substance. The contract is expected to affect the
seller’s future cash flows.
 Approval. Each party to the contract has approved the
contract and is committed to satisfying their respective
obligations.
 Rights. Each party’s rights are specified with regard to the
goods or services to be transferred.
 Payment terms. The terms and manner of payment are
specified.
 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.
T5-24
© The McGraw-Hill Companies, Inc. 2013
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Intermediate Accounting, 7/e
STEP 2: IDENTIFY SEPARATE
PERFORMANCE OBLIGATIONS
A performance obligation is accounted for as separate if it is
distinct, which is the case if either:
 The seller regularly sells the good or service separately, or
 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 a combined item(s) for the customer.
2. The bundle of goods or services is significantly modified or
customized to fulfill the contract.
Example: many construction contracts.
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:
 Options to receive additional goods or services that provide a
material right (but not a right of return).
 Extended Warranties (but not warranties for latent defects).
T5-25
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
5-35
STEP 2 EXAMPLE
TrueTech Industries manufactures the Tri-Box System, a
multiplayer gaming system allowing players to compete with each
other over the Internet.
The Tri-Box System has a wholesale price of $270 that
includes the physical Tri-Box module as well as a one-year
subscription to the Tri-Net of Internet-based games and other
applications.
TrueTech sells one-year subscriptions to the Tri-Net separately
for $50 to owners of Tri-Box modules as well as owners of
other gaming systems.
TrueTech does not sell a Tri-Box module without the initial
one-year Tri-Net subscription, but estimates that it would
charge $250 per module if modules were sold alone.
CompStores purchases 1,000 Tri-Box Systems at the normal
wholesale price of $270.
What separate performance obligations exist in the TrueTech
contract?
Illustration 5-21
T5-26
© The McGraw-Hill Companies, Inc. 2013
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Intermediate Accounting, 7/e
STEP 2 EXAMPLE (continued)
What separate performance obligations exist in the TrueTech
contract with CompStores?
Although TrueTech does not sell the module separately, the
module would have a function to the buyer in combination with
games and subscription services the buyer could obtain elsewhere.
The Tri-Net subscription is sold separately.
Therefore, the contract has two separate performance obligations:
(1) delivery of Tri-Box modules and (2) fulfillment of Tri-Net
subscriptions via access to the Tri-Net network over a one-year
period.
Illustration 5-21
T5-26 (continued)
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
5-37
STEP 3: DETERMINE
THE TRANSACTION PRICE
Include uncertain consideration, estimated as either
 most likely amount
 probability weighted amount
Uncollectible accounts:
 Ability to estimate bad debts does not figure into whether to
recognize revenue.
 Treat bad debts as a contra-revenue (like sales returns) rather
than as an expense.
Consider the time value of money if a contract has a significant
financing component.
 Assume not significant if payment within one year.
 Applies to prepayments (impute interest expense) and
receivables (impute interest revenue).
T5-27
© The McGraw-Hill Companies, Inc. 2013
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Intermediate Accounting, 7/e
STEP 3 EXAMPLE:
UNCERTAIN CONSIDERATION
TrueTech enters into a contract with ProSport Gaming to add
ProSport’s online games to the Tri-Net network. ProSport will pay
TrueTech an up-front $300,000 fixed fee for six months of
featured access, as well as a $200,000 bonus if Tri-Net users
access ProSport products for at least 15,000 hours during the six
month period. TrueTech estimates a 75% chance that it will
achieve the usage target and earn the $200,000 bonus.
TrueTech would make the following entry at contract inception to record receipt of
the cash:
Cash
300,000
Unearned Revenue
300,000
Two possibilities to estimate the uncertain consideration:
Probability-Weighted Amount
A probability-weighted transaction price would be calculated as follows:
Possible
Amounts
$500,000 ($300,000 + 200,000)
Prob.
X 75%
=
$300,000 ($300,000 + 0)
X 25%
=
Expected contract price at inception
Expected
Amounts
$375,000
75,000
$450,000
Most Likely Amount
The most likely amount of bonus is $200,000, so a transaction price based on the
most likely amount would be $300,000 + 200,000, or $500,000.
Illustration 5-22
T5-28
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
5-39
STEP 3 EXAMPLE:
UNCERTAIN CONSIDERATION (continued)
In this case, it is likely that TrueTech would use the estimate based
on the most likely amount, $500,000, because only two outcomes
are possible, and it is likely that the bonus will be received.
In each successive month, TrueTech would recognize one month’s
revenue based on a total transaction price of $500,000, reducing
unearned revenue and recognizing bonus receivable:
Unearned revenue($300,000 ÷ 6 months)
Bonus receivable (to balance)
Revenue ($500,000 ÷ 6 months)
50,000
33,333
83,333
After six months, TrueTech’s Unearned revenue account would be
reduced to a zero balance, and the Bonus receivable would have a
balance of $200,000 ($33,333 x 6). At that point TrueTech would
know if the usage of ProSport products had reached the bonus
threshold and would make one of the following two journal
entries:
If TrueTech receives the bonus:
Cash
If TrueTech does not receive the
bonus:
200,000
Revenue
200,000
Bonus receivable
200,000
Bonus receivable
200,000
T5-28 (continued)
© The McGraw-Hill Companies, Inc. 2013
5-40
Intermediate Accounting, 7/e
STEP 3 EXAMPLE:
TIME VALUE OF MONEY
On January 1, 2013, TrueTech enters into a contract with
GameStop Stores to deliver four Tri-Box modules that have a fair
value of $1,000.
 Prepayment Case: GameStop pays TrueTech $907 on
January 1, 2013 and TrueTech agrees to deliver the modules
on December 31, 2014. GameStop pays significantly in
advance of delivery, such that TrueTech is viewed as
borrowing money from GameStop and TrueTech incurs
interest expense.
 Receivable Case: TrueTech delivers the modules on January
1, 2013 and GameStop agrees to pay TrueTech $1,000 on
December 31, 2014. TrueTech delivers the modules
significantly in advance of payment, such that TrueTech is
viewed as loaning money to GameStop and TrueTech earns
interest revenue.
The fiscal year-end for both companies is December 31. The time
value of money in both cases is 5%.
Illustration 5-23
T5-29
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
5-41
STEP 3 EXAMPLE:
TIME VALUE OF MONEY (continued)
The following table compares TrueTech’s accounting for the
contract between the two cases (ignoring the entry for cost of
goods sold):
Prepayment
(payment before delivery)
January 1, 2013
When prepayment occurs:
Cash
Unearned revenue
Receivable
(payment after delivery)
907
December 31, 2013:
Accrual of year 1 interest expense:
Interest expense ($907 x 5%)
45
Unearned revenue
907
45
December 31, 2014
When subsequent delivery occurs:
Interest expense ($952 x 5%)
48
Unearned revenue
952
Revenue
1,000
January 1, 2013
When delivery occurs:
Accounts receivable
Revenue
1,000
1,000
December 31, 2013:
Accrual of year 1 interest revenue:
Accounts receivable
50
Interest revenue ($1000 x 5%)
50
December 31, 2014
When subsequent payment occurs:
Cash
1,103
Interest revenue ($1050 x 5%)
53
Accounts receivable
1,050
T5-29 (continued)
© The McGraw-Hill Companies, Inc. 2013
5-42
Intermediate Accounting, 7/e
STEP 4: ALLOCATE THE TRANSACTION
PRICE TO SEPARATE PERFORMANCE
OBLIGATIONS
Note: this approach is like current accounting for multipleelement arrangements.
 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.
 Can use estimated selling prices.
If contract gets modified subsequently, reallocate transaction price
to each separate performance obligation.
T5-30
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
5-43
STEP 4 EXAMPLE
Recall the initial data for the TrueTech example from Illustration 5-20:
 The Tri-Box System has a wholesale price of $270, which includes the
physical Tri-Box console as well as a one-year subscription to the TriNet of Internet-based games and other applications.
 Owners of Tri-Box modules as well as other game consoles can
purchase one-year subscriptions to the Tri-Net from TrueTech for $50.
 TrueTech does not sell a Tri-Box module without the initial one-year
Tri-Net subscription, but estimates that it would charge $250 per unit if
it chose to do so.
CompStores orders 1,000 Tri-Boxes at the normal wholesale price of $270.
Because the standalone price of the Tri-Box module ($250) represents 5/6
of the total fair values ($250 ÷ [$250 + 50]), and the Tri-Net subscription
comprises 1/6 of the total ($50 ÷ [$250 + 50]), we allocate 5/6 of the
transaction price to the Tri-Boxes and 1/6 of the transaction price to the TriNet subscriptions. Accordingly, TrueTech would recognize the following
journal entry (ignoring any entry to record the reduction in inventory and
the corresponding cost of goods sold):
Accounts receivable
Revenue ($270,000 x 5/6)
Unearned revenue ($270,000 x 1/6)
270,000
225,000
45,000
TrueTech then converts the unearned revenue to revenue over the one-year
term of the Tri-Net subscription as that revenue is earned.
Illustration 5-24
T5-31
© The McGraw-Hill Companies, Inc. 2013
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Intermediate Accounting, 7/e
STEP 4 EXAMPLE (continued)
Assume the same facts as Illustration 5-24, except that there is no basis on
which to estimate the value of the one-year Tri-Net subscription. In that
case, the value of the subscription would be estimated using the residual
method as follows:
Total price of Tri-Box with Tri-Net subscription
Estimated price of Tri-Box sold without subscription
Estimated price of Tri-Net subscription:
$270
250
$ 20
Based on these relative standalone selling prices, if CompStores orders
1000 Tri-Boxes at the normal wholesale price of $270, TrueTech would
recognize the following journal entry (ignoring any entry to record the
reduction in inventory and corresponding cost of goods sold):
Accounts receivable
Revenue (1,000 x $250)
Unearned revenue $1,000 x $20)
270,000
250,000
20,000
TrueTech would convert the unearned revenue to revenue over the oneyear term of the Tri-Net subscription.
Illustration 5-25
T5-31 (continued)
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
5-45
STEP 5: RECOGNIZE REVENUE AS
PERFORMANCE OBLIGATIONS ARE
SATISFIED
In general: Satisfy a performance obligation, and so recognize
revenue, when transfer control to the buyer.
Satisfy over time if either:
 The seller is creating or enhancing an asset that the buyer
controls as the service is performed, or
 The seller is not creating an asset that that the buyer controls
or that has alternative use to the seller, and either:
o The buyer simultaneously receives and consumes a
benefit as the seller performs the service.
o Another seller would not need to re-perform the
tasks performed to date if that other seller were to fulfill
the remaining obligation.
o The seller has the right to payment for performance
even if the buyer could cancel the contract.
 “Integrating products and services” with interrelated risks
and significant modification (as in long-term construction
contracts) are viewed as a performance obligation.
 Amount recognized is limited to amount reasonably assured
to be entitled to receive.
If don’t satisfy over time, satisfy at a point in time, when
transfer control.
T5-32
© The McGraw-Hill Companies, Inc. 2013
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Intermediate Accounting, 7/e
Suggestions for Class Activities
1.
Real World Scenario
The following is an excerpt from an article that appeared in the August 25, 2002 edition of The
Seattle Times:
When Cutter & Buck revealed two weeks ago that it padded sales figures in
2000 by recording $5.8 million in shipments that were mostly returned, the
news came as a surprise to many investors. But it wasn’t the first time the
Seattle sportswear retailer’s shipping and accounting practices have been
called into question. Shortly before co-founder Joey Rodolfo left in 1997, he
accused the company of shipping orders months before customers were
expecting them, a method of prematurely booking sales.
Some customers and former employees say early shipments persisted for years
after Rodolfo raised the issue. And late last week, Chief Executive Fran
Conley said an internal investigation has found that early shipments were
“more extensive than I had known” and may force the company to further
restate sales figures.
Shipping and booking orders ahead of schedule to meet short-term sales goals
— a practice sometimes called channel stuffing — is not, by definition, illegal.
But by essentially borrowing from future sales to claim bigger current sales
and profit, it can be used to boost a company’s bottom line and create a
misleading appearance of growth for investors.
Suggestions:
This article provides a good way to introduce the topic of channel stuffing. When a company
stuffs the channel, it ships inventory ahead of schedule filling its distribution channels with more
product than is needed. Since companies often record sales as soon as they ship products, channel
stuffing can make it appear that business is booming. Is this practice legal? Is it an acceptable
practice according to GAAP? Is it an ethical practice?
Points to note:
Channel stuffing is not an uncommon practice. There are many examples you can find for
your students. A text case references the Sunbeam incident that occurred in the late 90s. More
recent examples include Microsoft, Novell, Network Associates, and AOL.
GAAP do not address channel stuffing specifically. The key is whether or not the practice
leads to excessive future sales returns that are not adequately provided for by the seller. There may
be an issue with respect to the legality of the practice if it can be shown that the practice resulted
in misleading information to the investing public. And there are ethical dimensions to the practice
as well.
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
5-47
2.
Research Activity
Probably most of your students have purchased merchandise via the Internet. You can buy the
products of many companies on line. Some of these companies, such as Amazon.com, often act
merely as intermediaries between the manufacturer and the consumer. Revenue recognition for
this type of transaction has been controversial. If Amazon sells something to a customer for $100
that costs $80, the profit on the transaction is clearly $20. But should Amazon recognize $100 in
revenue and $80 in cost of goods sold (the gross method), or should it recognize only the $20 in
gross profit (the net method)?
Suggestions:
Discuss with your class the implications of one reporting method versus the other. Why should it
make a difference? What factors might dictate whether or not Amazon should recognize the
transaction gross versus net? Have them access Amazon’s most recent financial statements using
Edgar (at http://www.sec.gov/edgar.shtml). Or, you can show them Amazon’s disclosure note and
discuss the contents of the note. The following is a portion of the company’s revenue recognition
disclosure note that appeared in its 2010 financial statements:
We recognize revenue from product sales or services rendered when the following four criteria are
met: persuasive evidence of an arrangement exists, delivery has occurred or services have been
rendered, the selling price is fixed or determinable, and collectability is reasonably assured.
Revenue arrangements with multiple deliverables are divided into separate units and revenue is
allocated using estimated selling prices if we do not have vendorspecific objective evidence or
third-party evidence of the selling prices of the deliverables. ….
We evaluate whether it is appropriate to record the gross amount of product sales and related costs
or the net amount earned as commissions. Generally, when we are primarily obligated in a
transaction, are subject to inventory risk, have latitude in establishing prices and selecting
suppliers, or have several but not all of these indicators, revenue is recorded at the gross sales
price. If we are not primarily obligated, and do not have latitude in establishing prices, amounts
earned are determined using a fixed percentage, a fixed-payment schedule, or a combination of the
two, we generally record the net amounts as commissions earned.
© The McGraw-Hill Companies, Inc. 2013
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Intermediate Accounting, 7/e
3.
Google Analysis
Have students, individually or in groups, go to the most recent Google annual report using Edgar
which can be located at: http://www.sec.gov/edgar.shtml. Ask them to:
1. Compute the receivables turnover ratio, the profit margin on sales, the return on assets ratio,
and the return on shareholders' equity ratio for the most three years. Are there any discernible
trends? How might they be interpreted?
2. Read the "Revenues" section of "Management's Discussion and Analysis of Results of
Operations and Financial Condition." Has there been any significant shift over the last three
years in the company's service revenue mix?
3. Use Edgar to locate the most recent annual report information for Yahoo, Google’s competitor.
Using the most recent annual report information for both companies, compare the receivables
turnover ratio, the profit margin on sales, the return on assets ratio, and the return on
shareholders' equity ratio. Are there any differences in the way the companies recognize
revenue?
4. Note: another peer comparison of this nature is Federal Express vs. United Parcel Service.
4.
Professional Skills Development Activities
The following are suggested assignments from the end-of-chapter material that will help your
students develop their communication, research, analysis and judgment skills.
Communication Skills. In addition to Communication Case 5-15, Judgment Case 5-14 can be
adapted to ask students to choose one of the two alternatives and write a memo supporting their
position. Communication Case 5-5, Judgment Case 5-4, and IFRS Case 5-17 do well as group
assignments. Research Case 5-6 and Ethics Case 5-8 create good class discussions. Problem 512 and Analysis Case 5-21 are suitable for student presentation(s).
Research Skills. In their careers, our graduates will be required to locate and extract relevant
information from available resource material to determine the correct accounting practice,
perhaps identifying the appropriate authoritative literature to support a decision. Research
Cases 5-11, 5-12 and 5-13 and Real World Cast 5-21 provide an excellent opportunity to help
students develop this skill, as does the Air France-KLM case.
Analysis Skills. The “Broaden Your Perspective” section includes Analysis Cases that direct
students to gather, assemble, organize, process, or interpret data to provide options for making
business and investment decisions. In addition to Analysis Case 5-21; Exercises 5-23, 5-24, 525, and 5-26; Problems 5-11, 5-12, 5-13, and 5-14, and Judgment Case 5-17 also provide
opportunities to develop and sharpen analytical skills.
Judgment Skills. The “Broaden Your Perspective” section includes Judgment Cases that require
students to critically analyze issues to apply concepts learned to business situations in order to
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
5-49
evaluate options for decision-making and provide an appropriate conclusion. In addition to
Judgment Cases 5-2, 5-3, 5-4, 5-9, 5-10, 5-13, 5-14, and 5-22 Real World Case 5-1 also
requires students to exercise judgment.
5.
Ethical Dilemma
The chapter contains the following ethical dilemma:
ETHICAL DILEMMA
The Precision Parts Corporation manufactures automobile parts. The company has reported a
profit every year since the company’s inception in 1977. Management prides itself on this
accomplishment and believes one important contributing factor is the company’s incentive plan
that rewards top management a bonus equal to a percentage of operating income if the operating
income goal for the year is achieved. However, 2013 has been a tough year, and prospects for
attaining the income goal for the year are bleak.
Tony Smith, the company’s chief financial officer, has determined a way to increase December
sales by an amount sufficient to boost operating income over the goal for the year and earn bonuses
for all top management. A reputable customer ordered $120,000 of parts to be shipped on January
15, 2014. Tony told the rest of top management “I know we can get that order ready by December
31 even though it will require some production line overtime. We can then just leave the order on
the loading dock until shipment. I see nothing wrong with recognizing the sale in 2013, since the
parts will have been manufactured and we do have a firm order from a reputable customer.” The
company’s normal procedure is to ship goods f.o.b. destination and to recognize sales revenue
when the customer receives the parts.
You may wish to discuss this in class. If so, discussion should include these elements.
Step 1—The Facts:
Precision Parts Corporation has reported profits since its inception and given top management
bonuses when the operating income goal is achieved. In 2013, however, the company does not
expect to achieve its profit goal. Tony Smith, the CFO, wants to record a sale in 2013 that will not
be shipped until January 2014, so that management will receive bonuses for achieving the profit
goal. The CFO is attempting to manipulate the recognition of revenue. The company's normal
procedure is to recognize sales revenue when goods are shipped f.o.b. destination. Although sales
revenue may be recognized when production ends if certainty of collection exists, nothing in the case
indicates that there is reasonable certainty as to the collectibility of the revenue at the end of
production.
© The McGraw-Hill Companies, Inc. 2013
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Intermediate Accounting, 7/e
Step 2—The Ethical Issue and the Stakeholders:
The ethical issue or dilemma is whether Tony Smith's obligation to top management to show a
profit is greater than his obligation to provide information that is not misleading to users of financial
statements.
Stakeholders include Tony Smith, CFO, other corporate managers, auditors, present and future
creditors, and current and future investors.
Step 3—Values:
Values include competence, honesty, integrity, objectivity, loyalty to the company, and
responsibility to users of financial statements.
Step 4—Alternatives:
1. Record the parts sales revenue in 2013.
2. Record the parts sales revenue in 2014, when the goods are shipped.
Step 5—Evaluation of Alternatives in Terms of Values:
1. Alternative 1 illustrates loyalty to the company and other top managers.
2. Alternative 2 exhibits the values of competence, honesty, integrity, objectivity, and
responsibility to users of the financial statements.
Step 6—Consequences:
Alternative 1
Positive consequences: Tony would enable other top managers to receive bonuses and permit the
company to meet their operating income goal.
Negative consequences: Users of the financial statements would be misinformed. Users of
financial statements may sue the company upon learning the truth if the amount of revenue is
material and affects their financial decisions. Auditors may refuse to give a positive opinion on the
fair presentation of the financial statements. Tony may lose the respect of the rest of top
management and his job.
Alternative 2
Positive consequences: Users of financial statements would receive more relevant and reliable
reported revenue. Tony would maintain his integrity. He may receive praise for being honest and
keep his job.
Negative consequences: Tony may incur the disfavor of the rest of top management for not
enabling others to receive a bonus. He may lose the trust of other managers and lose his job.
Step 7—Decision:
Student(s) must decide their course of action.
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
5-51
Assignment Chart
Questions
5-1
5-2
5-3
5-4
5-5
5-6
5-7
5-8
5-9
5-10
5-11
5-12
5-13
5-14
5-15
5-16
5-17
5-18
5-19
5-20
5-21
Brief
Exercises
5-1
5-2
5-3
5-4
5-5
5-6
5-7
5-8
5-9
5-10
5-11
5-12
5-13
5-14
5-15
5-16
5-17
5-18
© The McGraw-Hill Companies, Inc. 2013
5-52
Learning
Objective(s)
1
1
2
3
3
3
4
1
5
5
5,8
5
5
6
6,8
6
7
7
7
1
8
Est. time
Topic
(min.)
Revenue recognition criteria
5
Revenue recognition at point of delivery
5
Principal or agent
Installment sales
5
Installment sales and cost recovery methods
5
Deferred gross profit—installment sales method
5
Right of return
5
Consignment sale
5
Service revenue
5
Percentage-of-completion and completed contract methods 5
IFRS; cost recovery method for long-term contracts
5
Billings on construction contract
5
Estimated loss on construction project
5
Software sales
5
IFRS; multiple-deliverable arrangements
5
Franchise fee revenue recognition
5
Activity ratios
5
Profitability ratios
5
DuPont framework
5
Interim reports [based on Appendix]
5
Interim reports [based on Appendix]
5
Learning
Objective(s)
1
2
3
3
3
4
5
5
5
5,8
5
6
6,8
6
7
7
7
7
Est. time
(min.)
5
10
10
10
10
5
10
10
5
10
10
10
10
5
5
10
10
10
Topic
Point of delivery recognition
Principal or agent
Installment sales method
Cost recovery method
Installment sales method
Right of return
Percentage-of-completion method; profit recognition
Percentage-of-completion method; balance sheet
Completed contract method
IFRS; cost recovery method for long-term contracts
Long-term contract accounting; loss on entire project
Multiple-deliverable contracts
IFRS; multiple deliverable contracts
Franchise sales
Turnover ratios
Profitability ratios
DuPont framework
Inventory turnover ratio
Intermediate Accounting, 7/e
5-1
5-2
5-3
5-4
5-5
Learning
Objective(s)
1
2
3
3
3
5-6
1,3
5-7
3
5-8
5-9
5-10
3
1,3
3,4,5
5-11
5
5-12
5,8
5-13
5
5-14
5
5-15
5
5-16
5-17
5-18
5-19
5-20
5-21
5-22
5-23
5-24
5-25
5-26
5
5
6
6
6,8
6
2,4,5,6,7
7
7
7
7
5-27
1
5-28
1
5-29
1
5-30
8
Exercises
Instructors Resource Manual
Est. time
(min.)
Service revenue
15
Principal or agent
10
Installment sales method
20
Installment sales method; journal entries
15
Installment sales; alternative recognition methods
15
Journal entries; point of delivery, installment sales, and cost
25
recovery methods
Installment sales and cost recovery methods; solve for
10
unknowns
Installment sales method and repossession.
20
Real estate sales; gain recognition
15
Percentage-of-completion, installment, and cost-recovery
methods, right of return, codification
Percentage-of-completion and completed contract methods 20
IFRS; long-term contract; percentage of completion and
30
completed contract methods
Percentage-of-completion method; loss projected on entire
30
project
Completed contract method; loss projected on entire
20
project
Income (loss) recognition; percentage-of-completion and
50
completed contract methods compared
Percentage-of-completion method; solve for unknowns
25
Percentage-of-completion, codification
10
Revenue recognition; software
10
Revenue recognition; Multiple-deliverable contracts
15
IFRS; multiple-deliverable contracts
15
Revenue recognition; franchise sales
10
Concepts; terminology
15
Inventory turnover; calculation and evaluation
10
Evaluating efficiency of asset management
10
Profitability ratios
10
DuPont framework
10
Interim financial statements; income tax expense [based on
10
Appendix]
Interim reporting; recognizing expenses [based on
10
Appendix]
Interim financial statements; reporting expenses [based on
10
Appendix]
Interim financial statements; reporting expenses under
IFRS [based on Appendix]
Topic
© The McGraw-Hill Companies, Inc. 2013
5-53
CPA
Review Questions
Learning
Objective(s)
1
3
3
5
5
5
1,8
5,8
6,8
1,8
5-1
5-2
5-3
5-4
5-5
5-6
5-7
5-8
5-9
5-10
Topic
Revenue recognition upon delivery
Installment sales method
Installment sales method
Percentage-of-completion method
Percentage-of-completion method
Percentage-of-completion method
Revenue recognition criteria under IFRS
Percentage-of-completion method under IFRS
Multiple-element contracts under IFRS
Interim financial statements under IFRS
Est. time
(min.)
3
3
3
2
3
3
3
3
3
3
CMA
Review Questions
Learning
Objective(s)
Topic
Est. time
(min.)
5-1
5-2
5-3
1
5
5
Revenue recognition upon delivery and bad debts
Percentage-of-completion method
Percentage-of-completion method
3
3
3
Problems
5-1



5-2
5-3
5-4
5-5
5-6
5-7
5-8
5-9
5-10
5-11
5-12

5-13
Learning
Objective(s)
2
2
2
2
5
5
5,8
5
5
2,6
7
7
7
5-14
7
5-15
1
Est. time
Topic
(min.)
Income statement presentation; installment sales method
25
[Chapters 4 and 5]
Installment sales and cost recovery methods
30
Installment sales; alternative recognition methods
30
Installment sales and cost recovery methods, multiple years 30
Percentage-of-completion method
45
Completed contract method
40
IFRS; Construction accounting
40
Construction accounting; loss projected on entire project
25
Percentage-of-completion and completed contract methods 45
Franchise sales, installment sales method
25
Calculating activity and profitability ratios
20
Use of ratios to compare two companies in the same
40
industry; Johnson and Johnson, Pfizer
Creating a balance sheet from ratios; chapters 3 and 5
50
Use of ratios to compare two companies in the same
40
industry; chapters 3 and 5
Interim financial reporting [based on Appendix]
15
 Star Problems
© The McGraw-Hill Companies, Inc. 2013
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Intermediate Accounting, 7/e
Cases
Real World Case 5-1
Judgment Case 5-2
Judgment Case 5-3
Judgment Case 5-4
Communication Case 5-5
Research Case 5-6
Research Case 5-7
Ethics Case 5-8
Judgment Case 5-9
Judgment Case 5-10
Research Case 5-11
Research Case 5-12
Judgment Case 5-13
Judgment Case 5-14
Communication Case 5-15
IFRS Case 5-16
Learning
Objective(s)
1
1
1
1
1
5
1
1
1,2
1
4
1
1,5
5
5
1,5,8
IFRS Case 5-17
Trueblood Accounting Case 5-18
5,8
6
Trueblood Accounting Case 5-19
Real World Case 5-20
Real World Case 5-21
Analysis Case 5-22
Judgment Case 5-23
Integrating Case 5-24
6
6
2
7
7
7
Air France-KLM Case
8
Instructors Resource Manual
Est. time
Topic
(min.)
Revenue recognition and earnings management; Sunbeam 20
Revenue recognition
15
Revenue recognition for initial and monthly fees
15
Revenue recognition; trade-ins
20
Revenue recognition
20
Long-term contract accounting
45
Earnings management techniques for revenues
30
Revenue recognition
15
Revenue recognition ; installment sales
20
Revenue recognition; SAB 101 questions, codification
20
45
Revenue recognition; right of return; Hewlett Packard,
Advanced Micro Devices, codification
Earnings management: gross vs. net and EITF 99-19;
30
Google, codification
Revenue recognition, service sales
15
Revenue recognition; long-term construction contracts
15
Percentage-of-completion and completed contract methods 50
IFRS; Comparison of revenue recognition in Sweden and
15
the U.S.A.; Vodafone
IFRS; Construction accounting
30
Revenue recognition for a multiple-element software
60
contract
Revenue recognition for multiple-element contracts
45
50
Revenue recognition; franchise sales; Jack in the Box
Principal or agent; Orbitz and priceline.com
60
Evaluating profitability and asset management
60
Relationships among ratios, chapters 3 and 5
30
Using ratios, chapters 3 and 5
45
IFRS, deferred revenue, multiple-element contracts; Air
France-KLM
45
© The McGraw-Hill Companies, Inc. 2013
5-55
Supplement
Est. time
Questions
5-22
5-23
5-24
5-25
5-26
5-27
Topic
Five steps to recognizing revenue
Characteristics of separate performance
obligations
Options as separate performance obligations
Allocating transaction price
Satisfying performance obligation for a good
Continuous revenue recognition
Brief
Exercises
5-19
5-20
5-21
5-22
5-23
5-24
5-25
(min.)
5
5
5
5
5
5
Est. time
Topic
(min.)
Difinition of a contract
Separate performance obligations
Separate performance obligations
Uncertain consideration
Allocating transaction price
Long-term contracts
Time value of money
5
5
5
5
5
5
5
Est. time
Exercises
5-31
5-32
5-33
5-34
5-35
5-36
5-37
5-38
Topic
Options
Separate performance obligation, option
Separate performance obligation, licensing
Uncertain consideration
Uncertain consideration
Satifying performance obligation
Satisfying performance obligation
Time value of money
(min.)
15
15
15
15
15
15
10
15
Est. time
Problems

Topic
5-16
Upfront fees, separate performance obligations
5-17
Satisfying performance obligations
5-18
Uncertain consideration
5-19
Uncertain consideration
 Star Problems
© The McGraw-Hill Companies, Inc. 2013
5-56
(min.)
45
45
30
45
Intermediate Accounting, 7/e