Income Measurement and Profitability Analysis
REVENUE RECOGNITION
Revenue Recognition Principle
Revenues are recognized when:
(1) It is realized or realizable
a) Revenue is realized when goods or services are exchanged for cash or receivables
b) Revenue is realizable when assets received are convertible to cash or receivable
(2) It is earned
a) Revenues are earned when the earnings process is complete
Quality of Earnings
Some publicly traded companies have had a tendency to recognize revenue prematurely.
This affects the quality of earnings and the transparency of overall financial reporting.
To combat this problem the SEC issued Staff Accounting Bulletin No. 101 that provides
additional criteria that must be followed in determining when revenue should be
recognized. The additional criteria are as follows:
1) Persuasive evidence of an arrangement exists.
2) Delivery has occurred or services have been rendered.
3) The seller’s price to the buyer is fixed or determinable.
4) Collectibility is reasonably assured.
REVENUE RECOGNITION AT A POINT IN TIME
The recognition of revenue depends of the type of business transaction involved. The
following is a table that lists the types of business transactions that might occur and the
timing of revenue recognition. This assumes that collectibility is reasonably certain.
Transaction
Source
Timing
Products
Sales
Date of sale
(date of delivery)
Services
Fees
Services
performed
Use of Assets
Interest, rents
Passage of time
Disposition of
Assets
Gain or loss
Date of sale or
trade-in
Completion of Production Basis
Under certain circumstances revenue is recognized at the completion of production even
though the product has not been sold. The circumstances that would make this possible
are:
1) The sales price is reasonably assured
2) The units of product are interchangeable
3) There are no significant costs involved in product distribution
Products that normally qualify for this type of accounting treatment are the harvesting of
agricultural crops and the mining of metals.
Revenue Recognition After Delivery
Installment Sales Accounting Method
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Income Measurement and Profitability Analysis
The recognition of revenue is based on the collection of cash rather than the completion
of the sale. It is used in industries where collection is relatively uncertain. To
accomplish this we use a separate set of accounts to record “Installment Receivables” and
“Deferred Gross Profit.”
Year of Installment Sale:
(1) Record all transactions as follows:
ACCOUNT
DEBIT
CREDIT
Installment receivables
$XX,XXX
Inventory
$XX,XXX
Deferred gross profit, (current year)
$X,XXX
To record installment sales and related deferred gross profit for the year.
(2) Calculate the gross profit percentage for all sales for the current year.
Amount
$100,000
60,000
$40,000
Installment sales
Cost of installment sales
Gross profit on installment sales
Percentage
100%
60%
40%
(3) Record the collection of installment receivables and the recognition of gross profit as
follows:
ACCOUNT
Cash
Installment receivables
To record cash collected on installment receivables
DEBIT
$XX,XXX
Deferred gross profit, (current year)
$X,XXX
Realized gross profit
To recognize gross profit on the collection of installment receivables
CREDIT
$XX,XXX
$X,XXX
Installment Collections on Prior Year Sales:
Apply each year’s gross profit percentage to the installment collections related to that
year’s sales as follows:
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Income Measurement and Profitability Analysis
ACCOUNT
Cash
Installment receivables, (year 1)
Installment receivables, (year 2)
To record cash collected on installment receivables
DEBIT
$XX,XXX
CREDIT
$XX,XXX
$XX,XXX
Deferred gross profit, (year 1)
$X,XXX
Deferred gross profit, (year 2)
$X,XXX
Realized gross profit
To recognize gross profit on the collection of installment receivables
$X,XXX
Financial Statement Presentation
The gross profit realized in the current year is reported as a separate component of gross
profit in the income statement. If a company has regular sales and installment sales the
income statement would be presented as follows.
Sales
Cost of goods sold
Gross profit on sales
Gross profit realized on installment sales
Total gross profit
$500,000
400,000
100,000
16,200
$116,200
Cost Recovery Method
The cost recovery method is use primarily in the real estate industry. It is used when the
collection of the selling price is uncertain. The same procedure is used as we
demonstrated in the installment method except that during the earlier periods no gross
profit is recognized. We do not recognize any gross profit until all of the costs have been
recovered.
Deposit Method
Under the deposit method the seller has not performed on the contract but has received
cash from the buyer. The seller records the cash deposit as a credit to a current liability
account. When the seller has completed the service or delivered the product then the
deposit will be reclassified to revenue and recognized in the income statement.
Buyback Agreements
There is no sale if a repurchase agreement is in place whereby the seller agrees to
repurchase the entire inventory at a set price which covers the holding costs. The
inventory remains on the seller’s books until the buyer resells the merchandise thus
completing the transaction.
Right of Return
In industries where there is a high rate of returns, there are three possible alternatives to
recording revenue.
(1) Delay recording the sale until the privilege for return has expired
(2) Recording the sale and an estimate of future returns
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Income Measurement and Profitability Analysis
(3) Recoding the sale and recording the returns as they occur
The following six conditions must be met to record the revenue from a sales transaction
recorded.
(1) Price must be determinable
(2) Buyer is obligated to pay seller with no contingencies
(3) Buyers obligation would not change because of changed conditions of inventory
(4) Buyer has economic substance in product
(5) Seller does not have significant obligations to effect the resale of the produce
(6) Amount of future returns can be reasonably estimated
If returned merchandise is a part of the normal business operations then an allowance
should be estimated for returns.
Trade Loading
In some industries, manufacturers will provide incentives to wholesalers to purchase
more product than can be resold. This overstates sales of the manufacturer.
Channel Stuffing
In order to inflate sales some manufacturers have offered deep discounts to distributors to
overbuy produce. The manufacturers then record the sale as complete as the product
leaves the sellers loading dock.
Consignment Sales
The consignor is the seller of the merchandise who ships the goods on consignment to the
consignee. The consignee is just an agent in the selling process and does not actually
own the goods. Therefore, at year-end the consignor (seller) should include the
consigned goods in its inventory even though it may still be in the physical possession of
the consignee. No sale takes place until the consignee sells the goods, deducts the
commission earned and remits the remainder of the selling price to the consignor.
REVENUE RECOGNITION OVER TIME
Service Revenue Earned over Time
When services are provided over an extended period of time, revenue is recognized in
each accounting period in which the services were provided and the revenue earned.
Long-Term Contracts
In construction-type contracts the builder (seller) will normally interim bill the customer
(buyer) as the contract progresses. There are two different methods of accounting for
long-term construction contracts.
(1) Percentage-of-Completion Method
At the end of each accounting period the contractor recognizes the percentage of
revenue earned on the contract. This requires the use of two new general ledger
accounts.
a) Construction in Process (Inventory Account - Debit Balance)
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Income Measurement and Profitability Analysis
This account reflects the accumulation of construction costs since the beginning
of the project and the periodic recognition of gross profit based on the percentage
of completion at the end of each accounting period.
b) Billings on Construction in Process (Contra-Inventory Account – Credit Balance)
(2) Completed-Contract Method
The contractor recognizes revenue earned on the contract at the end of the contract.
The general ledger accounts are used but there is no accumulation of gross profit
during the construction project. Gross profit is only recognized once the project is
completed.
Percentage-of-Completion Method
There are various methods of measuring progress on long-term contracts. The most
common method used in construction projects is the cost-to-cost basis. The costs
incurred to date are compared with the currently estimated total costs to derive a
percentage of completion as of the end of the accounting period. The formula for
determining the percentage completion is as follows:
Costs incurred to date
Current estimate of total costs
=
Percentage complete
The percentage complete as of the end of the accounting period is used to calculate the
revenue to be recognized to date. At the end of the accounting period the percentage
complete to date is multiplied by the total revenue associated with the long-term contract
to derive revenue recognized to date. The following formula determining the revenue
recognized to date is as follows:
Percentage complete
X Estimated total revenue =
Revenue recognized to date
Normally we are interested in preparing financial statements for an accounting period so
therefore we need to know the revenue earned in the current accounting period. To
derive this amount the revenue recognized in prior periods is subtracted from the revenue
recognized to date to derive the current period revenue earned on the long-term contract.
The following formula is used to do this caluculation.
Revenue recognized to date
-
Revenue recognized in prior periods =
Current period revenue
Example
The following fact pattern pertains to the long-term contract that Spencer Construction
Company has with Fido Chow, Inc.
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Income Measurement and Profitability Analysis
Costs to date
Estimated costs to complete
Progress billings during year
Cash collected during year
2000
100,000
400,000
120,000
90,000
2001
300,000
200,000
350,000
200,000
2002
550,000
130,000
250,000
At the beginning of the contract in 2000, the estimated costs are $500,000 and the
contract price is $600,000. Note that sometime in year 2002 it became clear that the total
costs on this contract were going to be more than originally estimated. The total
estimated costs are reevaluated at the end of each accounting period and adjusted based
on the currently available information. Also note, that the progress billings and the cash
collections are reported for the current year. Be sure you examine the fact pattern to
determine if the amounts are being presented as year to date or current year. It will effect
the way you prepare your analysis.
Now that we have the fact pattern we can determine the percentage completion on a costto-cost basis for each year. The following provides this analysis.
2000
Percentage complete
Costs incurred to date
Costs to complete
Total estimated costs
Percentage complete
2001
100,000
400,000
500,000
20%
300,000
200,000
500,000
60%
2002
550,000
0
550,000
100%
The revenue on this long-term contract is fixed as of the signing of the contract. We
know that the total revenue will be $600,000 so therefore using the above percentage
completion we can determine the amount of revenue that should be recognized.
2000
Revenue recognized
Contract price
Percentage complete
Revenue recognized to date
Revenue recognized in prior periods
Revenue recognized in current period
600,000
20%
120,000
0
120,000
2001
600,000
60%
360,000
120,000
240,000
2002
600,000
100%
600,000
360,000
240,000
To derive the gross profit to be recognized during the current accounting period we need
to convert the costs incurred to date to the current period costs. The following provides
this analysis.
2000
Current costs
Costs incurred to date
Costs recoginzed in prior period
Current costs
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100,000
0
100,000
6
2001
300,000
100,000
200,000
2002
550,000
300,000
250,000
Income Measurement and Profitability Analysis
Having determined the current period revenue and costs we can know calculate the gross
profit that should be recorded during each accounting period. The following provides
this analysis.
2000
Current period gross profit
Revenue recognized in current period
Current costs
Current period gross profit
2001
120,000
100,000
20,000
2002
240,000
200,000
40,000
240,000
250,000
(10,000)
Note that we were not aware of our higher construction costs until the last year.
Normally this would not be the case. At any time during the construction cycle estimated
total costs may be adjusted based on new information.
Now that we have completed the analysis we need to prepare the journal entries for each
year’s transactions. The following reflects the journal entries for 2000. During the year
the construction costs, billings and collections would be recorded as they take place. We
are going to record them as one general journal entry for the sake of simplicity.
DATE
2000
2000
2000
12/31/00
ACCOUNT
Construction in process
Accounts payable
To record construction costs during year
Accounts receivable
Billings on construction in process
To record progress billings
Cash
Accounts receivable
To record collections on account
DEBIT
100,000
CREDIT
100,000
120,000
120,000
90,000
90,000
Construction in process
Construction expenses
Revenue from long-term contract
20,000
100,000
120,000
To record current period expenses and revenue
on long-term contract that is 20% complete
Note that the “Construction expenses” and Revenue from long-term contract” accounts
are nominal accounts and will be closed out at the end of the accounting period.
The two accounts that we need to keep track of throughout the life of the long-term
contract are the “Construction in process” and “Billings on construction in process”
accounts. The following is the T-account analysis at the end of 2000.
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Income Measurement and Profitability Analysis
Construction in Process
DATE
DESCRIPTION
DEBIT
2000
Construction costs for 2000
100,000
12/31/00 Gross profit for 2000
20,000
DATE
2000
Billings on Construction in Process
DESCRIPTION
DEBIT
Progress billings for 2000
CREDIT
BALANCE
100,000
120,000
CREDIT
120,000
BALANCE
120,000
Now we will repeat this process for 2001. The following are the journal entries to record
the transactions and adjusting journal entries for 2001.
DATE
2001
2001
2001
12/31/01
ACCOUNT
Construction in process
Accounts payable
To record construction costs during year
DEBIT
200,000
CREDIT
200,000
Accounts receivable
Billings on construction in process
To record progress billings
350,000
Cash
Accounts receivable
To record collections on account
200,000
Construction in process
Construction expenses
Revenue from long-term contract
To record current period expenses and revenue
on long-term contract that is 60% complete
40,000
200,000
350,000
200,000
240,000
After these entries have been posted we should have the following balances in the Taccounts of the “Construction in process” and Billings on construction in process”
accounts.
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Income Measurement and Profitability Analysis
DATE
2000
12/31/00
2001
12/31/01
DATE
2000
2001
Construction in Process
DESCRIPTION
DEBIT
Construction costs for 2000
100,000
Gross profit for 2000
20,000
Construction costs for 2001
200,000
Gross profit for 2001
40,000
Billings on Construction in Process
DESCRIPTION
DEBIT
Progress billings for 2000
Progress billings for 2001
CREDIT
BALANCE
100,000
120,000
320,000
360,000
CREDIT
120,000
350,000
BALANCE
120,000
470,000
The activity for the final year of 2002 is listed below.
DATE
2002
2002
2002
12/31/02
ACCOUNT
Construction in process
Accounts payable
To record construction costs during year
DEBIT
250,000
CREDIT
250,000
Accounts receivable
Billings on construction in process
To record progress billings
130,000
Cash
Accounts receivable
To record collections on account
250,000
130,000
250,000
Construction in process
Construction expenses
Revenue from long-term contract
To record current period expenses and revenue
on long-term contract that is 100% complete
10,000
250,000
240,000
The following is the T-account analysis reflecting the accumulation of these entries to the
two accounts of which we have been keeping track.
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Income Measurement and Profitability Analysis
DATE
2000
12/31/00
2001
12/31/01
2002
12/31/02
DATE
2000
2001
2002
Construction in Process
DESCRIPTION
DEBIT
Construction costs for 2000
100,000
Gross profit for 2000
20,000
Construction costs for 2001
200,000
Gross profit for 2001
40,000
Construction costs for 2002
250,000
Gross profit for 2002
Billings on Construction in Process
DESCRIPTION
DEBIT
Progress billings for 2000
Progress billings for 2001
Progress billings for 2002
CREDIT
10,000
BALANCE
100,000
120,000
320,000
360,000
610,000
600,000
CREDIT
120,000
350,000
130,000
BALANCE
120,000
470,000
600,000
Please note that at the end of the long-term construction contract the balance in the
“Construction in Process” account is equal to the balance in the “Billings on Construction
in Process” account. The reason for this is that each year we recorded the gross profit in
the “Construction in Process” account and created two nominal accounts to reflect the
current period expenses and revenue. We are not ready to close the “Construction in
Process” and the Billings on Construction in Process” accounts. The final journal entry is
presented below.
DATE
12/31/02
ACCOUNT
Billings on construction in process
Construction in process
To close the long-term contract accounts
DEBIT
600,000
CREDIT
600,000
Financial Statement Presentation
The difference between the Construction in Process and the Billings on Construction in
Process accounts is presented in the balance sheet as either a current asset (net debit
balance) or a current liability (net credit balance). The following is a balance sheet
presentation at the end of each year that the contract is not complete.
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Income Measurement and Profitability Analysis
December 31, 2000
Current Asset
Construction in process
120,000
Less: progress billings
120,000
Costs and recognized profit in
excess of billings
0
December 31, 2002
Current Liability
Construction in process
Less: progress billings
Billings in excess of costs and
recognized profit
360,000
470,000
110,000
Completed-Contract Method
On rare occasions a company might use the completed-contract method. The same
balance sheet accounts will be used but there will be no adjusting journal entry at the end
of the accounting period. The company will accumulate costs and billings on the longterm contract until it is complete. Once the contract is complete and accepted by the
customer the balance sheet accounts are closed and revenue and expenses are recorded in
the income statement.
Losses on Long-Term Contracts
Overall Profitable Contracts: If the estimated costs increase resulting in less profit then
originally estimated, the loss in the current accounting period is recorded. This is a
change in accounting estimate.
Unprofitable Contracts: If the estimated costs increase resulting in a loss on the entire
long-term contract the entire loss is recorded in the period it is discovered.
SOFTWARE REVENUE RECOGNITION
Many computer companies sell hardware, software and support services under a single
contract. To the extent that the revenue has not been earned when received or billed the
computer company must defer the unearned revenue. The deferred revenue is recognized
in the accounting period(s) in which the services are performed or the revenue is earned.
FRANCHISE SALES
Franchises are a popular means of operating many retail business enterprises. The
franchise fee is normally comprised of two amounts. The franchisor receives an initial
franchise fee for the right to sell products or services under the franchisors name. This
fee may be earned over a period of months or years depending on the terms of the
contract. In addition, the franchisee is required to pay to the franchisor a periodic fee to
cover continuing services such as advertising and/or other continuing services provided
by the franchisor. These fees are normally based on the gross volume of the franchise
and are recognized by the franchisor as earned.
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