Chapter 5
INCOME MEASUREMENT
AND PROFITABLITY
ANALYSIS
© 2009 The McGraw-Hill Companies, Inc.
Slide 2
Realization Principle
Record revenue when:
the earnings
process is
complete or
virtually
complete.
McGraw-Hill /Irwin
AND
there is
reasonable
certainty as to the
collectibility of the
asset to be
received (usually
cash).
Slide 3
SEC Staff Accounting Bulletin No. 101
The SEC issued Staff Accounting Bulletin No.
101 to crackdown on earnings management.
The bulletin provides 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
performed.
3. The seller’s price to the buyer is fixed or
determinable.
4. Collectibility is reasonably assured.
McGraw-Hill /Irwin
Slide 4
Completion of the Earnings Process
within a Single Reporting Period
Recognize Revenue
When the product or service
has been delivered to the
customer and cash has been
received or a receivable has
been generated that has
reasonable assurance of
collectibility.
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Slide 5
Significant Uncertainty of Collectibility
When uncertainties about
collectibility exist, revenue
recognition is delayed.
1. Installment Sales Method
2. Cost Recovery Method
McGraw-Hill /Irwin
Slide 6
Installment Sales Method
On November 1, 2009, 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, 2009. The
land cost $560,000 to develop. The company’s fiscal
year ends on December 31.
Date
Nov. 1, 2009
Nov. 1, 2010
Nov. 1, 2011
Nov. 1, 2012
Totals
McGraw-Hill /Irwin
Cash
Cost
Collected
Recovery
$ 200,000 $ 140,000
200,000
140,000
200,000
140,000
200,000
140,000
$ 800,000 $ 560,000
Gross
Profit
$ 60,000
60,000
60,000
60,000
$ 240,000
Gross Profit
$240,000 ÷ $800,000 = 30%
Slide 7
Installment Sales Method
During 2009, Belmont Corporation collected
$200,000 on its installment sales.
General Journal
Description
Debit
Installment sales receivable
Credit
800,000
Inventory
560,000
Deferred gross profit
240,000
Cash
200,000
Installment sales receivable
Deferred gross profit
Realized gross profit
200,000
60,000
60,000
($200,000 collected x 30%)
This entry records the Realized Gross Profit by
adjusting the Deferred Gross Profit account.
McGraw-Hill /Irwin
Slide 8
Cost Recovery Method
On November 1, 2009, 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, 2009. The
land cost $560,000 to develop. The company’s fiscal
year ends on December 31.
Date
Nov. 1, 2009
Nov. 1, 2010
Nov. 1, 2011
Nov. 1, 2012
Totals
McGraw-Hill /Irwin
Cash
Cost
Collected
Recovery
$ 200,000 $ 200,000
200,000
200,000
200,000
160,000
200,000
$ 800,000 $ 560,000
Gross
Profit
$
40,000
200,000
$ 240,000
Slide 9
Cost Recovery Method
General Journal
Description
Debit
Credit
November 1, 2009
Installment sales receivable
800,000
Inventory
560,000
Deferred gross profit
240,000
November 1, 2009, 2010, 2011, & 2012
Cash
200,000
Installment sales receivable
200,000
November 1, 2011
Deferred gross profit
40,000
Realized gross profit
40,000
November 1, 2012
Deferred gross profit
Realized gross profit
McGraw-Hill /Irwin
200,000
200,000
Slide 10
Right of Return
In most situations, even though the right
to return merchandise exists, revenues
and expenses can be appropriately
recognized at point of delivery.
Estimate the
returns
Reduce both
Sales and Cost of
Goods Sold
McGraw-Hill /Irwin
Slide 11
Completion of the Earnings Process over
Multiple Reporting Periods
Completed
Contract Method
Long-term
Contracts
Percentage-ofCompletion
Method
McGraw-Hill /Irwin
Slide 12
Companies Engaged in Long-term
Contracts
COMPANIES ENGAGED IN LONG-TERM CONTRACTS
Company
Type of Industry or Product
Oracle Corp.
Computer software, license and consulting fees
Lockheed Martin Corporation
Aircraft, missiles and spacecraft
EDS
Information technology and outsourcing
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
McGraw-Hill /Irwin
Slide 13
Completed Contract Method
Geller Construction entered into a three-year
contract to build a containment vessel for
Southeast Power Company for a contract price of
$1,400,000. Presented below is information
about the contract:
Construction costs incurred during the year
Construction costs incurred in prior years
Cumulative construction costs
Estimated costs to complete at end of the year
Total estimated and actual construction costs
$
Billings made during the year
Cash collections during the year
$
$
2009
250,000
250,000
1,000,000
1,250,000
250,000
225,000
$
$
$
2010
550,000
250,000
800,000
425,000
1,225,000
525,000
470,000
$
$
$
Let’s see how Geller will account for
the revenues and cost of this project
using the completed contract method.
McGraw-Hill /Irwin
2011
400,000
800,000
1,200,000
1,200,000
625,000
405,000
Slide 14
Completed Contract Method
General Journal
Description
Debit
Construction in progress
Credit
250,000
Cash, materials, etc.
Accounts receivable
250,000
250,000
Billings on construction contract
Cash
250,000
225,000
Accounts receivable
Construction costs incurred during they 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
McGraw-Hill
/Irwin during year
225,000
2009
$ 250,000
250,000
1,000,000
$ 1,250,000
$
250,000
225,000
Gross
profit is
not
recognized
until
project is
complete.
Slide 15
Completed Contract Method
General Journal
Description
Debit
Construction in progress
Credit
250,000
Cash, materials, etc.
Accounts receivable
Billings on construction contract
Construction in Progress
- Billings on Construction Contract
Debit Balance (Unbilled Receivable)
Classified as
an asset
McGraw-Hill /Irwin
250,000
250,000
250,000
Construction in Progress
- Billings on Construction Contract
Credit Balance (Overbilled Receivable)
Classified as
a liability
Slide 16
Completed Contract Method
General Journal
Description
Debit
Construction in progress
Credit
550,000
Cash, materials, etc.
Accounts receivable
550,000
525,000
Billings on construction contract
Cash
525,000
470,000
Accounts receivable
Construction costs incurred during they 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
McGraw-Hill /Irwin
470,000
Gross
profit is
not
recognized
until
project is
complete.
2009
$ 250,000
250,000
1,000,000
$ 1,250,000
2010
$ 550,000
250,000
800,000
425,000
$ 1,225,000
$
$
250,000
225,000
525,000
470,000
Slide 17
Completed Contract Method
General Journal
Description
Debit
Construction in progress
Credit
400,000
Cash, materials, etc.
Accounts receivable
400,000
625,000
Billings on construction contract
Cash
625,000
405,000
Accounts receivable
Construction costs incurred during they 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
McGraw-Hill /Irwin
405,000
2009
$ 250,000
250,000
1,000,000
$ 1,250,000
2010
$ 550,000
250,000
800,000
425,000
$ 1,225,000
2011
$ 400,000
800,000
1,200,000
$ 1,200,000
$
$
$
250,000
225,000
525,000
470,000
625,000
405,000
Slide 18
Completed Contract Method
General Journal
Description
Debit
Construction in progress
Cash, materials,
Construction
costs incurred etc.
during they year
Construction costs incurred in prior years
Accountsconstruction
receivable
Cumulative
costs
Estimated costs to complete at end of year
Billings on construction contract
Total estimated and actual construction costs
Billings
Cash made during the year
Cash collections during year
400,000
2009
2010
$ 250,000
$ 550,000
250,000
625,000
250,000
800,000
1,000,000
425,000
$ 1,250,000
$ 1,225,000
$
250,000
$ 525,000
405,000
225,000
470,000
Accounts receivable
Cost of construction
Construction in progress
Cost of construction
Retained earnings
McGraw-Hill /Irwin
2011
$400,000
400,000
800,000
1,200,000
625,000
$ 1,200,000
$
625,000
405,000
405,000
1,200,000
200,000
Revenue from long-term contract
Revenue from long-term contract
Credit
Gross
profit is
recognized
in year 3
since
project is
complete.
1,400,000
1,400,000
1,200,000
200,000
Remember that
the contract price
was $1,400,000.
Slide 19
Completed Contract Method
2009
2010
2011
2011
Construction in Progress
250,000
550,000
400,000
200,000
1,400,000
Billings on Construction Contract
250,000
2009
525,000
2010
625,000
2011
1,400,000
Entry to transfer title to the customer.
General Journal
Description
Billings on construction contract
Construction in progress
McGraw-Hill /Irwin
Debit
1,400,000
Credit
1,400,000
Slide 20
Percentage-of-Completion Method
Geller Construction entered into a three-year
contract to build a containment vessel for
Southeast Power Company for a contract price of
$1,400,000. Presented below is information
about the contract:
Construction costs incurred during the year
Construction costs incurred in prior years
Cumulative construction costs
Estimated costs to complete at end of the year
Total estimated and actual construction costs
$
Billings made during the year
Cash collections during the year
$
$
2009
250,000
250,000
1,000,000
1,250,000
250,000
225,000
$
$
$
2010
550,000
250,000
800,000
425,000
1,225,000
525,000
470,000
$
$
$
2011
400,000
800,000
1,200,000
1,200,000
625,000
405,000
Let’s see how Geller will account for the
revenues and cost of this project using the
percentage-of-completion method.
McGraw-Hill /Irwin
Slide 21
Percentage-of-Completion Method
General Journal
Description
Debit
Construction in progress
Credit
250,000
Cash, materials, etc.
250,000
Cost of construction
250,000
Construction in progress
30,000
Revenue from long-term contract
280,000
2009
Contract price
$
Actual costs to date
$250,000
Estimated costs to complete
1,000,000
Total project cost
$1,250,000
Total gross profit (Contract price - total costs)
$
150,000
Percentage-of-completion (actual costs to date)
$
250,000
Divided by the estimated total project cost
$
1,250,000
Equals percentage complete to date
Total project gross profit
20.00%
$
150,000
$
30,000
$
30,000
Multiplied by the estimated % of completion
Gross profit earned to date
20.00%
Less gross profit recognized in previous periods
McGraw-Hill /Irwin
1,400,000
Gross profit recognized currently
-
Slide 22
Percentage-of-Completion Method
Measuring Progress Toward Completion
Cost incurred to date
Estimate of project’s total
cost
Gross profit estimate
Total costs incurred to date
Percent complete =
Most recent estimate of total
project cost
McGraw-Hill /Irwin
Slide 23
Percentage-of-Completion Method
2009
Contract price
$
Actual costs to date
1,400,000
$250,000
Estimated costs to complete
1,000,000
Total project cost
$1,250,000
Total gross profit (Contract price - total costs)
$
150,000
Percentage-of-completion (actual costs to date)
$
250,000
Divided by the estimated total project cost
$
1,250,000
Equals percentage complete to date
Total project gross profit
20.00%
$
Multiplied by the estimated % of completion
Gross profit earned to date
20.00%
$
Less gross profit recognized in previous periods
Gross profit recognized currently
McGraw-Hill /Irwin
150,000
30,000
-
$
30,000
Slide 24
Percentage-of-Completion Method
General Journal
Description
Debit
Construction in progress
Cash, materials, etc.
Cost of construction
250,000
Contra account
to CIP
250,000
Construction in progress
Accounts receivable
AccountsContract
receivable
- Billings on Construction
Debit Balance (Unbilled Receivable)
McGraw-Hill /Irwin
280,000
250,000
Billings on construction contract
Construction Cash
in Progress
250,000
30,000
Revenue from long-term contract
Classified as
an asset
Credit
250,000
Construction
in Progress
225,000
- Billings on Construction225,000
Contract
Credit Balance (Overbilled Receivable)
Classified as
a liability
Slide 25
Percentage-of-Completion Method
General Journal
Description
Debit
Construction in progress
250,000
Cash, materials, etc.
Cost of construction
Construction in progress
250,000
250,000
30,000
Revenue from long-term contract
Closing Entry
Accounts receivable
280,000
250,000
Billings on construction contract
Cash
250,000
225,000
Accounts receivable
Revenue from long-term contract
McGraw-Hill /Irwin
Credit
225,000
280,000
Cost of construction
250,000
Retained earnings
30,000
Slide 26
Percentage-of-Completion Method
General Journal
Description
Debit
Construction in progress
Credit
550,000
Cash, materials, etc.
Accounts receivable
550,000
525,000
Billings on construction contract
Cash
525,000
470,000
Accounts receivable
Construction costs incurred during they 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
McGraw-Hill
/Irwincollections during year
470,000
2009
$ 250,000
250,000
1,000,000
$ 1,250,000
2010
$ 550,000
250,000
800,000
425,000
$ 1,225,000
$
$
250,000
225,000
525,000
470,000
Slide 27
Percentage-of-Completion Method
2009
Contract price
$
Actual costs to date
Estimated costs to complete
Total project cost
2010
1,400,000
$
1,400,000
$250,000
$800,000
1,000,000
425,000
$1,250,000
$1,225,000
Total gross profit (Contract price - total costs)
$
150,000 $
175,000
Percentage-of-completion (actual costs to date)
$
250,000 $
800,000
Divided by the estimated total project cost
$
1,250,000 $
1,225,000
Equals percentage complete to date
Total project gross profit
20.00%
$
Multiplied by the estimated % of completion
Gross profit earned to date
20.00%
$
Less gross profit recognized in previous periods
Gross profit recognized currently
McGraw-Hill /Irwin
150,000 $
30,000 $
-
$
30,000 $
65.31%
175,000
65.31%
114,286
(30,000)
84,286
Slide 28
Percentage-of-Completion Method
2009
1,400,000 $
General $Journal
Actual costs to date
$250,000
Description
Debit
Estimated
costs to complete
1,000,000
Contract price
Total project cost
Construction
progress
Total grossin
profit
(Contract price - total costs)
$1,250,000
$
550,000
150,000 $
Cash, materials, etc.
Percentage-of-completion (actual costs to date)
Divided by the estimated total project cost
Accounts
receivable
Equals percentage complete to date
Gross profit earned to date
$1,225,000
175,000
800,000
$
1,250,000 $
1,225,000
525,000
20.00%
$
150,000 $
20.00%
470,000
$
30,000 $
$
30,000 $
-
Cost of construction
Construction in progress
65.31%
525,000
175,000
65.31%
114,286
(30,000)
470,000
84,286
550,000
84,286
Revenue from long-term contract
Revenue from long-term contract
Credit
425,000
250,000 $
Less gross profit recognized in previous periods
Accounts
receivable
Gross profit
recognized currently
$800,000
$
Multiplied by the estimated % of completion
Cash
1,400,000
550,000
Billings on construction contract
Total project gross profit
2010
634,286
634,286
Cost of construction
550,000
Retained earnings
84,286
McGraw-Hill /Irwin
Slide 29
Percentage-of-Completion Method
General Journal
Description
Debit
Construction in progress
Credit
400,000
Cash, materials, etc.
400,000
Accounts receivable
625,000
Billings on construction contract
625,000
Cash
405,000
Accounts receivable
405,000
Cost of construction
2009400,000
2010
2011
Construction costs
incurred during
they year
$ 250,000
$ 400,000
Construction
in progress
85,660$ 550,000
Construction costsRevenue
incurred from
in prior
years contract
250,000
long-term
485,660 800,000
Cumulative construction costs
250,000
800,000
1,200,000
Estimated costsRevenue
to complete
end of year
1,000,000
425,000
fromatlong-term
contract
485,660
Total estimated and actual construction costs
$ 1,250,000
$ 1,225,000
$ 1,200,000
Cost of construction
400,000
Retained
Billings made during
the yearearnings
Cash collections during year
McGraw-Hill /Irwin
$
250,000
225,000
$
85,660$
525,000
470,000
625,000
405,000
Slide 30
Percentage-of-Completion Method
2009
Contract price
$
2010
2011
1,400,000 $
1,400,000 $
Actual costs to date
$250,000
$800,000
$1,200,000
Estimated costs to complete
1,000,000
425,000
0
$1,250,000
$1,225,000
$1,200,000
Total project cost
Total gross profit (Contract price - total costs)
$
150,000 $
175,000 $
Percentage-of-completion (actual costs to date)
$
250,000 $
800,000
Divided by the estimated total project cost
$
1,250,000 $
1,225,000
Equals percentage complete to date
Total project gross profit
$
Multiplied by the estimated % of completion
Gross profit earned to date
$
Less gross profit recognized in previous periods
Gross profit recognized currently
McGraw-Hill /Irwin
200,000
(project is
complete)
20.00%
65.31%
100.00%
150,000 $
175,000 $
200,000
20.00%
65.31%
100.00%
30,000 $
-
$
1,400,000
30,000 $
114,286
200,000
(30,000)
(114,286)
84,286 $
85,714
Slide 31
Percentage-of-Completion Method
2009
2010
General Journal
Actual costs to date
$250,000
Description
Estimated costs to complete
1,000,000 Debit
Contract price
$
Total project cost
Construction in progress
Total gross profit (Contract price - total costs)
1,400,000
$
$1,250,000
$
150,000
2011
1,400,000
$800,000
425,000
$
Credit
$1,225,000
$
400,000 175,000
$
250,000
$
800,000
Divided by the estimated total project cost
$
1,250,000
$
1,225,000
Equals percentage complete to date
$
20.00%
$
Multiplied by the estimated % of completion
625,000
65.31%
100.00%
Accounts receivable
625,000
150,000
$
20.00%
$
Less gross profit recognized in previous periods
Gross profit recognized currently
30,000
$
175,000
$
Construction in progress
30,000
$
200,000
65.31%
100.00%
(30,000)
(114,286)
84,286
200,000
$
405,000
400,000
85,714
Revenue from long-term contract
Revenue from long-term contract
$
405,000 114,286
-
Cost of construction
McGraw-Hill /Irwin
200,000
(project is complete)
Billings on construction contract
Gross Cash
profit earned to date
0
400,000
Percentage-of-completion (actual costs to date)
Total project gross profit
$1,200,000
$1,200,000
Cash, materials, etc.
Accounts receivable
1,400,000
485,714
485,714
Cost of construction
400,000
Retained earnings
85,714
85,714
Slide 32
Percentage-of-Completion Method
Construction in Progress
2009
250,000
30,000
2010
550,000
84,286
2011
400,000
85,714
1,400,000
Billings on Construction Contract
250,000
2009
525,000
2010
625,000
2011
1,400,000
Entry to transfer title to the customer.
General Journal
Description
Billings on construction contract
Construction in progress
McGraw-Hill /Irwin
Debit
1,400,000
Credit
1,400,000
Slide 33
Long-term Contract Losses
Periodic Loss for
Profitable
Projects
Determine periodic
loss and record loss
as a credit to the
Construction in
Progress account.
McGraw-Hill /Irwin
Loss Projected
for Entire Project
Estimated loss is
fully recognized in
the first period the
loss is anticipated
and is recorded by a
credit to
Construction in
Progress account.
Slide 34
International Accounting Standards and
Long-term Contracts
Under the International Financial Reporting
Standards, International Accounting Standard
(IAS) No. 11 governs revenue recognition for
long-term construction contracts.
Like U.S. GAAP, IAS No. 11
requires use of percentage-ofcompletion accounting when
estimates can be made
precisely.
McGraw-Hill /Irwin
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.
Slide 35
Software and Other Multiple Deliverable
Arrangements
Statement of Position 97-2
If a sale includes multiple elements (software,
future upgrades, postcontract customer
support, etc.), the revenue should be allocated
to the various elements based on the relative
fair value of the individual elements.
This will likely result in a portion of the
proceeds received from the sale of software
being deferred and recognized as revenue in
future periods.
McGraw-Hill /Irwin
Slide 36
Other Multiple Deliverable Arrangements
For multiple-deliverable arrangements, revenue
should be allocated to individual deliverables
that qualify for separate revenue recognition.
Otherwise, revenue is delayed until completion
of later deliverables.
McGraw-Hill /Irwin
Slide 37
Franchise Sales
Initial Franchise
Fees
Continuing
Franchise Fees
Generally are
recognized at a
point in time when
the earnings
process is virtually
complete.
Recognized over
time as the services
are performed.
Source:
SFAS 45
McGraw-Hill /Irwin
Slide 38
Activity Ratios
Activity Ratios
Asset Turnover Ratio
Net Sales ÷ Average Total Assets
Receivables Turnover Ratio
Net Sales ÷ Average Accounts Receivable
Average Collection Period
365 ÷ Receivables Turnover Ratio
Inventory Turnover Ratio
Cost of Goods Sold ÷ Average Inventory
Average Days in Inventory
365 ÷ Inventory Turnover Ratio
Whenever a ratio divides an
income statement balance by a
balance sheet balance, the
average for the year is used in
the denominator.
McGraw-Hill /Irwin
Slide 39
Profitability Ratios
Profitability Ratios
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
Return on Equity Key Components
Profitability
Activity
Financial Leverage
McGraw-Hill /Irwin
Slide 40
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
This is called the DuPont
be written
as: because the DuPont
framework
Return on
equity
Net income
Avg. total
equity
McGraw-Hill /Irwin
=
ReturnCompany
on
Equity
was
a pioneer
X
assets
multiplier
in
emphasizng this relationship.
=
Net income
Avg. total
assets
Avg. total assets
X
Avg. total
equity
Slide 41
Appendix 5: Interim Reporting
Issued for periods of less than
a year, typically as quarterly
financial statements.
Serves to enhance the
timeliness of financial
information.
Fundamental debate centers
on the choice between the
discrete and integral part
approaches.
McGraw-Hill /Irwin
Slide 42
Interim Reporting
Reporting Revenues
and Expenses
With only a few exceptions, the
same accounting principles
applicable to annual reporting are
used for interim reporting.
Reporting Unusual
Items
Discontinued operations and
extraordinary items are reported
entirely within the interim period in
which they occur.
Earnings Per Share
Quarterly EPS calculations follow
the same procedures as annual
calculations.
Reporting Accounting
Changes
Accounting changes made in an
interim period are reported by
retrospectively applying the changes
to prior financial statements.
McGraw-Hill /Irwin
Slide 43
Minimum Disclosures
Sales, income taxes,
and net income
Discontinued operations,
extraordinary items, and
unusual or infrequent
items
Earnings per share
Contingencies
Seasonal revenues,
costs, and expenses
Changes in accounting
principles or estimates
Significant changes in
estimates for income
taxes
Significant changes in
financial position
McGraw-Hill /Irwin
End of Chapter 5
McGraw-Hill /Irwin
© 2008 The McGraw-Hill Companies, Inc.