Additional Topics in
Income Determination
Revsine/Collins/Johnson: Chapter 3
Learning objectives
1. When is it appropriate to recognize revenue before or after the
point of sale?
2. Revenue recognition details for long-term construction contracts,
agricultural commodities, and installment sales.
3. Revenue principles for franchise sales, right of return, and
“bundled” software sales.
4. How GAAP income determination invites “earnings management”,
the various techniques used, and recent SEC guidance intended
to thwart such activities.
5. How error corrections and prior period restatements are reported.
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Recall the criteria for revenue
recognition
Time of sale is
used in most
industries
Condition 1: The critical event in the process of earning the
revenue has taken place.
Condition 2: The amount of revenue that will be collected is
reasonably assured and is measurable with a
reasonable degree of reliability.
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Revenue recognition prior to sale:
Long-term construction projects
 Before construction begins, a formal contract has been signed.

The buyer is assured and the contract price is specified.
 Consequently, both revenue recognition conditions are satisfied
prior to the time of sale.



Condition 1: The critical event is actual construction, thus revenue is
earned over time as the project progresses toward completion.
Condition 2: Measurability is satisfied because there’s a firm contract
with a known buyer at a set price.
In addition, construction costs can be estimated with reasonable
accuracy so that expenses can be matched with revenues.
 Percentage-of-completion method: revenue is recognized in
proportion to the “work done” each period.
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Example: Solid Construction Corp.
 Contract price is $1,000,000 and construction costs are estimated
to be $800,000.
Original estimate
was $800,000
Gross profit
2005
2006
2007
?
?
?
Total
$150,000
How much gross profit must be recognized each year?
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Percentage-of-completion for 2005
(Year 1)
Step 1:
Percentage of
completion ratio
Step 2:
Estimated total
contract profit
Step 3:
Estimated profit
earned to date
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30%
=
$240,000
=
$800,000
Cost incurred
Estimated total costs
$200,000 = $1,000,000 - $800,000
$60,000 = $200,000 x 30%
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Percentage-of-completion for 2006
(Year 2)
Step1: Percentage of
completion ratio
30%
Step2: Estimated total
contract profit
$200,000
Step3: Estimated profit
earned to date
$60,000
$60,000
=
$544,000
$850,000
Step4: Incremental profit
earned
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64%
$150,000 = $1,000,000 - $850,000
$96,000 = $150,000 x 64%
$36,000 = $96,000 - $60,000
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Percentage-of-completion for 2007
(Year 3)
Step1: Percentage of
completion ratio
Step2: Estimated total
contract profit
Step3: Estimated profit
earned to date
Step4: Incremental profit
earned
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30%
64%
100%
$200,000
$150,000
$150,000
$60,000
$96,000
$150,000
$36,000
$54,000
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Percentage-of-completion:
Journal entries
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Percentage-of-completion:
Alternative journal entries
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Percentage-of-completion:
Balance sheet presentation
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Completed-contract method:
Long-term construction projects
 Suppose it is not possible to determine expected costs with a high
degree of reliability.
 Percentage-of-completion then becomes inappropriate because
“matching” fails.
 Completed-contract method postpones all revenue recognition
(and expenses) until the period of project completion.
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Completed-contract method:
Journal entries
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Completed-contract method:
Journal entries concluded
 Entry for recognizing income in 2007 at project completion
DR Billings on construction in progress
$1,000,000
CR Construction in progress
$850,000
CR Income on long-term construction contract
150,000
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Revenue recognition prior to sale:
Commodities
 Revenue recognition conditions:


Condition 1: The critical event is extraction (mining) or harvesting
(agriculture), and occurs before the sale (i.e., formal transfer of title).
Condition 2: The precise time at which measurability is satisfied is
open to some dispute.
Critical Event
Time
of
Sale
 Revenue recognition could occur when the sales transaction is
completed, or earlier at extraction or harvest (i.e., when the critical
event is satisfied).
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Commodities:
Completed-transaction (sales) method
 Condition 2 is not satisfied until the eventual selling price is known.
 Accordingly, only the 100,000 bushels sold on Sept. 30, 2005 are
included in 2005 revenue.
Recognition
Matching
 Revenue (and related expenses) for the remaining 10,000
bushels is postponed to 2006 when those bushels are sold.
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Commodities:
Market-price (production) method
 Because producers face an established market price for the
commodity, Condition 2 is satisfied continuously.
 Accordingly, all 110,000 bushels produced in 2005 are included in
2005 revenue under the production method.
Recognition
Matching
Net realizable
value
 As a result, the inventory of 10,000 bushels is shown at market
value of $35,000.
DR Crop inventory
$15,000
CR Market gain on unsold inventory
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$15,000
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Commodities:
Market-price (production) method continued
 The farmer is engaging in two activities: corn production and
commodity speculation (10,000 bushels held in inventory).
 Subsequent changes in the market price give rise to speculative
gains and losses, called inventory holding gains and losses.
 At the start of 2006, the market price drops from $3.50 to $3.00.
The inventory is “marked-to-market” to reflect the loss:
DR Inventory (holding) loss on speculation
CR Crop inventory
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= 10,000 x
($3.50 - $3.00)
$5,000
$5,000
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Commodities:
Market-price (production) method continued
 Fearing a further market price decline, the farmer immediately
sells all 10,000 bushels at $3.00:
DR Cost of goods sold
CR Crop inventory
$30,000
$30,000
DR Cash
CR Crop revenue
$30,000
$30,000
The inventory book value is $30,000 at the time of sale:
Production cost (10,000 x $2.00)
$20,000
Market gain at harvest (10,000 x $1.50)
15,000
Inventory holding loss (10,000 x $0.50)
( 5,000)
$30,000
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Commodities:
Comparison of revenue recognition methods
 In practice, the completed-transaction method is more prevalent.
 However, the market price method conforms to GAAP when
readily determinable prices are continuously available.
 Dual advantages of the market price method:


Recognizes two income streams—one from farming and another
from commodity speculation.
Conforms more closely to the income recognition conditions (critical
event and measurability).
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Revenue recognition after the sale:
Installment sales method
 Sometimes revenue is not recognized at the point of sale even
though a valid sale has taken place.


High risk of not receiving cash from the buyer (Conditions 1 and 2 are
not met).
Or there is no reasonable basis for estimating uncollectible accounts
(Condition 2 is not met).
 Conditions 1 and 2 are both satisfied over time as cash
collections take place.
 So, revenue recognition occurs as cash is collected (i.e., as
installment payments are made).
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Revenue recognition after the sale:
Installment sales method example
 The amount of revenue recognized each period depends on two
things:


Installment-sales gross-profit percentage
Amount of cash collected on installment accounts receivable.
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Revenue recognition after the sale:
Installment sales calculations
Installment Sales Income:
Cash collections from 2005 sales
Gross-profit %
Income recognized
Cash collections from 2006 sales
Gross-profit %
Income recognized
$600,000
30%
$90,000
$180,000
$340,000
32%
$108,800
Total income recognized
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$300,000
30%
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$288,800
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Revenue recognition after the sale:
Installment sales income statement
$340,000 x 32%
$600,000 x 30%
$300,000 x 30%
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Revenue recognition after the sale:
Installment sales journal entries
Note: GAAP requires that the interest component of the periodic cash receipts must be
recorded separately.
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Revenue recognition after the sale:
Cost recovery method
 GAPP allows this approach when:


Collections on installment sales occur over an extended period.
There is no reasonable basis for estimating collectibility.
 Under the cost recovery method:


No profit is recognized until cash payments from the buyer exceed
the seller’s cost of goods sold.
After the seller’s cost has been recovered, any excess cash collected
is recorded as recognized gross profit.
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Revenue recognition after the sale:
Cost recovery example
$800,000
-600,000
$200,000
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Revenue recognition after the sale:
Cost recovery example
$1,200,000
-600,000
-200,000
$400,000
Note: The cost recovery method is very conservative because profit is recognized
only when the cumulative cash collections exceed the total cost of land sold.
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Specialized transactions:
Franchised sales
Exercise right to sell
product or service
Franchisor
Franchisee
Seller
Customer
Buyer
1. Initial franchisee fee
2. Continuing (periodic) fees
 Continuing franchise fees are recorded as revenue in the period they are
earned and received.
 The initial franchise fee is comprised of two elements:

Payment for the right to operate a franchise in a given area.

Payment for services to be performed later by the franchisor.
 The issue: How much of the initial franchise fee should be recognized as
revenue up front by the franchisor?
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Specialized transactions:
Franchise sales example
 SFAS No. 45 says:

recognize revenue for the initial franchise fee only when all material
services and conditions have been substantially performed by
franchisor.
 But, there is no “bright line” test.
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Specialized transactions:
Recording initial franchise fees
1/1/2005
Sell franchise
for $25,000
($10,000 cash)
3/1/2005
12/31/2005
Franchisor
provides
trainings, etc
Received installment
payment plus 8%
interests
January 1, 2005
DR Cash
DR Note receivable
CR Earned franchise fee revenue
CR Unearned franchise fees
$10,000
$15,000
Use of name
and right to sell
$10,000
$15,000
March 1, 2005
DR Unearned franchise fees
CR Earned franchise fees
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Training
$7,500
$7,500
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Specialized transactions:
Recording initial franchise fees (continued)
1/1/2005
Sell franchise
for $25,000
($10,000 cash)
3/1/2005
12/31/2005
Franchisor
provides
trainings, etc
Received installment
payment plus 8%
interests
December 31, 2005
DR Unearned franchise fees
CR Earned franchise fees
$2,500
$2,500
DR Cash
CR Notes receivable
$5,000
DR Cash
CR Interest revenue
$1,200
$5,000
$1,200
$15,000 x 8%
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Specialized transactions:
Recording continuing franchise fees
 Suppose franchise sales were $100,000 in 2005, and recall that
the continuing fee is 2% of sales. The entry for the continuing fee
is:
DR Cash
CR Earned franchise fee revenue
$2,000
$2,000
 Costs incurred by the franchisor for initial and continuing services
are expensed in the same period the franchise revenue is
recognized (matching principle).
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Specialized transactions:
Sales with right of return
Sell with right of return
Seller
Buyer
Customer
Resale
Cash payment or
obligation to pay
 SFAS No. 45 says the following six criteria must be met for a
seller to record revenue at the time of sale:






Seller’s price to buyer is substantially fixed at the date of sale.
Buyer has paid seller, or is obligated to pay and the obligation is not
contingent on resale.
Buyer’s obligation does not change in the event of theft, destruction, or
damage of the product.
The buyer has economic substance and is distinct from seller.
Seller does not have significant obligations for future performance to bring
about resale.
The amount of future returns can be reasonably estimated.
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Specialized transactions:
Bundled sales
 Oracle sells a database
software “bundle” for $1.5
million. The “bundle” includes:



Revenue recognized:
Customer support $150
Staff training
“Free” software upgrades
On-going customer support for
five years.
Upgrade $300
 How much revenue should
Oracle record up front?

Over 5-year
period
As installed
Training $450
When completed
Software $600
When delivered
and installed
SOP 97-2 provides guidance.
Oracle’s software
and services bundle
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Specialized transactions:
What Oracle says about bundled sales
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Earnings management
 Determining when revenue has been earned (critical event) and is
realized (measurability)—the two revenue recognition
conditions—often requires judgment.
 Managers can sometimes exploit the flexibility in GAAP to
manipulate reported earnings in ways that mask the company’s
underlying performance.
 Some managers have even resorted to outright financial fraud
(but that’s rare).
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Earnings management:
Avoiding a loss or earnings disappointment
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Popular earnings management
devices
 “Big bath” restructuring charges: Excessive restructuring write-offs that
overstate estimated charges for future expenditures.
 Creative acquisition accounting: Abuses linked to purchased “in-process
R&D” that SFAS No. 2 requires to be expensed at the date of acquisition.
 Miscellaneous “cookie jar reserves” for bad debts, loan losses, warranties
and other accruals: Reserve too much in good times and cut back on
estimated charges, or even reverse previous charges, in bad times. A
convenient income smoothing device.
 Intentional errors deemed to be “immaterial” and intentional bias in
estimates.
 Premature or aggressive revenue recognition (details to follow).
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Revenue recognition abuses
 The SEC says revenue is earned (critical event) and realized
(measurability) when all of the following are met:




Pervasive evidence of an exchange agreement exists.
Delivery has occurred or services have been rendered.
The seller’s price to the buyer is fixed or determinable.
Collectibility is reasonably assured.
 SEC Staff Accounting Bulletin (SAB) No. 104 illustrates
troublesome areas of revenue recognition.
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Revenue recognition abuses:
SAB No. 104 examples
Goods shipped
on consignment
No revenue can be
recognized at delivery.
Sales with
delayed delivery
Seller can’t recognize revenue until
delivery… except certain buy and hold
transactions.
Goods sold on
lay-away
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Postpone revenue recognition
until merchandise is delivered
to customer.
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Revenue recognition abuses:
SAB No. 104 examples
Non refundable
up-front fees
Earned as services are delivered over
the full term of service engagement.
Gross vs. net basis
for internet resellers
Revenue should be recognized on a
“net” basis as commission revenue.
Capacity
swaps
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Revenue should be recognized
over time as the capacity is
brought on line and used by
customers.
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Accounting errors
 Accounting errors and “irregularities” can occur for several reasons:




Simple oversight.
Unintentional misapplication of GAAP, especially where judgment is
required.
Intentional attempts to exploit the flexibility in GAAP.
Outright financial fraud.
 Parties charged with discovering accounting errors and irregularities:



The company’s internal audit staff and audit committee.
External auditors.
SEC staff surveillance of filings.
 Once discovered, accounting errors and irregularities must be
corrected and disclosed. Most are corrected through a prior period
adjustment.
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Accounting restatements:
GAO study of irregularities for 1997-2002
Total number of restatement announcements,
1997 - 2002
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Reasons for earnings restatements,
1997 - 2002
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Accounting restatements:
Share price reaction to announced restatements
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Accounting restatement disclosures:
An example
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Accounting restatement disclosures:
Footnote details
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Accounting restatement disclosures:
Footnote details
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Summary
 The “critical event” and “measurability” conditions for revenue
recognition are typically satisfied at the point of sale.
 There are circumstances—long-term construction contracts,
production of natural resources and agricultural commodities—
where it is appropriate to recognize revenue prior to the sale.
 There are also circumstances where revenue recognition may be
delayed until after the sale—installment sales and cost recovery
methods:


There is considerable uncertainty about collectibility.
There are significant costs that will be incurred after the sale that are
difficult to predict.
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Summary concluded
 Franchise sales, sales with right of return, and bundled sales
pose challenging revenue recognition issues.
 Management can sometimes exploit the flexibility in GAAP
revenue recognition rules to hide or misrepresent economic
performance.
 Once discovered, accounting errors and irregularities must be
corrected and disclosed. Most are corrected through a prior
period adjustment.
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