© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 5 Income Measurement and Profitability Analysis

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Chapter 5

Income Measurement and Profitability

Analysis


Slide5-2

Revenue Recognition

Revenue should be recognized in the period or periods that the revenue-

generating activities of the company are performed.

Revenue should be recognized in the period or periods that the revenue-

generating activities of the company are performed.


Slide5-3

Realization Principle

Record revenue when:Record revenue when:

AND

There is reasonable

certainty as to the collectibility of the

asset to be received (usually

cash).

The earnings process is

complete or virtually

complete.


Slide5-4

SEC Staff Accounting Bulletin No. 101

The SEC issued Staff Accounting Bulletin No. 101 to crackdown on earnings

management. The bulletin provides additional guidance to determine if 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.

The SEC issued Staff Accounting Bulletin No. 101 to crackdown on earnings

management. The bulletin provides additional guidance to determine if 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.


Slide5-5

Revenue Recognition at Delivery

The product or service has been delivered to the

customer and cash has been received or

is receivable.

The product or service has been delivered to the

customer and cash has been received or

is receivable.

Revenue is earned and realized at the point of sale.

Revenue is earned and realized at the point of sale.


Slide5-6

Significant Uncertainty of Collectibility

1. Installment Sales Method

2. Cost Recovery

1. Installment Sales Method

2. Cost Recovery

When uncertainties about collectibility exist, revenue

recognition is delayed.

When uncertainties about collectibility exist, revenue

recognition is delayed.


Slide5-7

Sale and cost of sale recorded as usual.Compute gross margin rate on the

installment sales.Recognize gross margin as cash is received.Gross margin not realized is deferred until a

future period.

Installment Sales Method


Slide5-8

2003 2004 2005Installment sales $200,000 $250,000 $275,000Cost of sales 155,000 190,000 220,000Gross profit $45,000 $60,000 $55,000

Gross profit percentage 22.50% 24.00% 20.00%

Installment Sales MethodClarke, Inc. had the following installment

sales in addition to its regular sales.

$45,000 ÷ $200,000 = 22.50%$45,000 ÷ $200,000 = 22.50%


Slide5-9




Clarke, Inc. had the following installment sales in addition to its regular sales.

2003 2004 2005Installment sales 200,000$ 250,000$ 275,000$ Cash Collected:From 2003 Sales (100,000) (50,000) (50,000) From 2004 Sales (195,000) (25,000) From 2005 Sales (200,000)

Cash Collections At Dec. 31, 2005, Clarke, Inc. is still

owed $30,000 from the 2004

sales and $75,000 from the 2005

sales.


Slide5-10

Installment Sales MethodDuring 2003, Clarke collected $100,000

on its installment sales.During 2003, Clarke collected $100,000

on its installment sales.

Description Debit CreditInstallment sales receivable 2003 200,000

Inventory 155,000

Deferred gross profit 2003 45,000

Cash 100,000

Installment sales receivable 2003 100,000

General Journal

Deferred gross profit is the difference between the selling price and the cost of

the inventory.


Slide5-11



Inventory 155,000


Cash 100,000



Realized gross profit 22,500

($100,000 collected x 22.50%)

General Journal

This entry records the Realized Gross Profit by adjusting the Deferred Gross

Profit account.


Slide5-12



Inventory 190,000


Cash 245,000






General JournalDuring 2004, Clarke collected $50,000 on its 2003 installment sales and $195,000 on its 2004 installment sales.

During 2004, Clarke collected $50,000 on its 2003 installment sales and $195,000 on its 2004 installment sales.


Slide5-13



Inventory 190,000


Cash 245,000






General JournalDuring 2004, Clarke collected $50,000 on its 2003 installment sales and $195,000 on its 2004 installment sales.

During 2004, Clarke collected $50,000 on its 2003 installment sales and $195,000 on its 2004 installment sales.

Cash collections - 2003 50,000$ 22.50% 11,250$ Cash collections - 2004 195,000 24.00% 46,800

58,050$

Cash collections - 2003 50,000$ 22.50% 11,250$ Cash collections - 2004 195,000 24.00% 46,800

58,050$


Slide5-14


Inventory 220,000


Cash 275,000








General Journal

Cash Collection on Installment Sales in 2005

2003 50,000$ 22.50% 11,250$ 2004 25,000 24.00% 6,000 2005 200,000 20.00% 40,000

275,000$ 57,250$



Slide5-15



Slide5-16


Balance Sheet


Slide5-17

Cost Recovery Method



Clarke, Inc. had the following installment Clarke, Inc. had the following installment sales in addition to its regular sales. The sales in addition to its regular sales. The

company uses the company uses the cost recovery method to to account for installment sales.account for installment sales.

$45,000 ÷ $200,000 = 22.50%$45,000 ÷ $200,000 = 22.50%


Slide5-18


The following schedule shows the pattern of cash collections for the three year period.

Year of Sale 2003 2004 20052003 $100,000 $50,000 $50,0002004 195,000 25,0002005 200,000

COGS 155,000$ 190,000$ 220,000$

Year of CollectionYear of Sale 2003 2004 2005

2003 $100,000 $50,000 $50,0002004 195,000 25,0002005 200,000

COGS 155,000$ 190,000$ 220,000$

Year of Collection

Under the cost recovery method profit is not recognized until the

seller has recovered all of the cost of the goods sold.


Slide5-19


Description Debit CreditInstallment receivable 2003 200,000

Inventory 155,000


Cash 100,000

Installment receivable 2003 100,000

General Journal

The entries are exactly the same as under the Installment Method—EXCEPT that there is not an entry to realize gross profit. Since we have not

collected cash in excess of COGS, no gross profit is recognized in 2003.


Slide5-20

Cost Recovery MethodIn 2004, let’s concentrate on the

entries relating to 2003 sales only.

Description Debit CreditCash 50,000


General JournalDescription Debit Credit

Cash 50,000


General Journal

2003

Cost of goods sold 155,000$

Cash collections - 2003 (100,000)


Unrecovered cost 5,000

We have not fully recovered the

cost, so no profit is recognized in 2004.

2003

Cost of goods sold 155,000$



Unrecovered cost 5,000

We have not fully recovered the

cost, so no profit is recognized in 2004.

Now can we recognize some profit?


Slide5-21

Cost Recovery MethodHere are the entries we would make in

2005 relating to 2003 sales.

Description Debit CreditCash 50,000


Deferred gross profit 45,000


General Journal

We have fully recovered the $155,000 cost during 2005, so the entire deferred gross

profit will be recognized.


Slide5-22

Revenue Recognition Over Time

Completed Contract Method


Percentage-of-Completion

Method

Percentage-of-Completion

Method

Long-term Construction

Contracts

Long-term Construction

Contracts


Slide5-23

Percentage-of-Completion Method

Cost incurred to dateCost incurred to date

Gross profit estimateGross profit estimate

Measuring Progress Toward Completion

Estimate of project’s total cost

Estimate of project’s total cost


Slide5-24


Total costs incurred to date Percent complete = Most recent estimate of total project cost

Let’s look at an example.


Slide5-25 Percentage-of-Completion

Method

Year 1 Year 2 Year 3Cost incurred to date $250,000 $800,000 $1,200,000Estimated cost to complete 1,000,000 425,000 0Progress billing to date 250,000 775,000 1,400,000Cash collections to date 225,000 695,000 1,100,000Contract price $1,400,000


Geller Construction entered into a three-year contract to build a containment vessel for Southeast Power Company. Presented below is information about the contract.

Let’s see how Geller will account for the revenues and cost of this project using the percentage-of-completion

method.



Method

$250,000 ÷ $1,250,000 = 20%$250,000 ÷ $1,250,000 = 20%



Method


Slide5-28

Description Debit CreditConstruction in progress 250,000

Cash, materials, etc. 250,000

Accounts receivable 250,000

Billings on construction contract 250,000

Cash 225,000


General Journal


Contra account to CIP


Slide5-29





Cash 225,000


General Journal


Construction in Progress

- Billings on Construction ContractDebit Balance (Unbilled Receivable)

Classified as an asset

Construction in Progress

- Billings on Construction ContractCredit Balance (Overbilled Receivable)

Classified as a liability


Slide5-30





Cash 225,000


Cost of construction 250,000

Construction in progress 30,000

Revenue from long-term contract 280,000

General Journal




Method





Cash 225,000







Retained earnings 30,000

General Journal

Closing EntryClosing Entry



Method

$800,000 ÷ $1,225,000 = 65.31%$800,000 ÷ $1,225,000 = 65.31%



Method


Slide5-34



General Journal


$800,000 - $250,000 last year = $550,000


Slide5-35





General Journal


$775,000 - $250,000 last year = $525,000


Slide5-36





Cash 470,000


General Journal


$695,000 - $225,000 last year = $470,000


Slide5-37





Cash 470,000





General Journal




Method





Cash 470,000








General Journal

Closing EntryClosing Entry



MethodYear 1 Year 2 Year 3

Costs to date $250,000 $800,000 $1,200,000Cost to complete 1,000,000 425,000 0Estimated total cost $1,250,000 $1,225,000 $1,200,000Percent complete to date 20.00% 65.31% 100.00%

Percent completed earlier -20.00%Percent completed this year 45.31%

Total revenue 1,400,000$ 1,400,000$ Percent completed this year 20.00% 45.31%Revenue this year 280,000$ 634,340$ Revenue recorded earlierRevenue in last yearCosts this year 250,000 550,000 Gross profit 30,000$ 84,340$



MethodYear 1 Year 2 Year 3

Costs to date $250,000 $800,000 $1,200,000Cost to complete 1,000,000 425,000 0Estimated total cost $1,250,000 $1,225,000 $1,200,000Percent complete to date 20.00% 65.31% 100.00%

Percent completed earlier -20.00%Percent completed this year 45.31%

Total revenue 1,400,000$ 1,400,000$ 1,400,000$ Percent completed this year 20.00% 45.31%Revenue this year 280,000$ 634,340$ Revenue recorded earlier 914,340 Revenue in last year 485,660$ Costs this year 250,000 550,000 400,000 Gross profit 30,000$ 84,340$ 85,660$



Method





Cash 405,000








General Journal



Method

Description Debit CreditBillings on construction contract 1,400,000 Construction in progress 1,400,000

General JournalDescription Debit CreditBillings on construction contract 1,400,000 Construction in progress 1,400,000

General Journal

Entry to transfer title to the customer.

Year 1 250,000 30,000

Year 2 550,000 84,340

Year 3 400,000 85,660

1,400,000

Construction in Progress250,000 Year 1525,000 Year 2625,000 Year 3

1,400,000

Billings on Construction Contract


Slide5-43




Geller Construction entered into a three-year contract to build a containment vessel for Southeast Power Company. Presented below is information about the contract.

Let’s see how Geller will account for the revenues and cost of this project

using the completed contract method.


Slide5-44





Cash 225,000


General Journal


Entries are identical to the entries for

percentage of completion.

Gross profit is

not recognized

until project is complete.


Slide5-45





Cash 470,000


General Journal


Entries are identical to the

entries for percentage of completion.

Gross profit is

not recognized

until project is complete.


Slide5-46






Cash 405,000


Cost of construction 1,200,000


Revenue from long-term contract 1,400,000

Revenue from long-term contract 1,400,000

Cost of construction 1,200,000


General JournalGross

profit is recognized in year 3

since project is complete.


Slide5-47


Description Debit CreditBillings on construction contract 1,400,000 Construction in progress 1,400,000

General JournalDescription Debit CreditBillings on construction contract 1,400,000 Construction in progress 1,400,000

General Journal

Entry to transfer title to the customer.

Year 1 250,000 Year 2 550,000 Year 3 400,000 Year 3 200,000

1,400,000

Construction in Progress250,000 Year 1525,000 Year 2625,000 Year 3

1,400,000

Billings on Construction Contract


Slide5-48

Software Revenue Recognition

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 the recording of unearned revenue for future services.


Slide5-49

Franchise Sales

Initial franchise fees can be recognized as revenue only after the

Franchisor has substantially performed the initial services promised in the franchise agreement, and

Collectibility of the initial franchise fee is reasonable assured.

Initial franchise fees can be recognized as revenue only after the

Franchisor has substantially performed the initial services promised in the franchise agreement, and

Collectibility of the initial franchise fee is reasonable assured.

Source: SFAS 45


Slide5-50

Let’s look at some

activity ratios!


Slide5-51

Receivables 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.

Net Sales Average Accounts Receivable

ReceivablesTurnover

Ratio=

This ratio measures how many times a company converts its

receivables into cash each year.


Slide5-52

Average Collection Period

This ratio is an approximation of the number of days the average accounts

receivable balance is outstanding.

365 Receivables Turnover Ratio

Average Collection

Period=


Slide5-53

Inventory Turnover Ratio

This ratio measures the numberof times merchandise inventory

is sold and replaced during the year.

Cost of Goods Sold Average Inventory

InventoryTurnover

Ratio=


Slide5-54

Average Days in Inventory

This ratio indicates the numberof days it normally takes to sell inventory.

365 Inventory Turnover Ratio

Average Days in

Inventory=


Slide5-55

Asset Turnover Ratio

This ratio measures how efficiently a company utilizes all of its assets to

generate revenue.

Net Sales Average Total Assets

AssetTurnover

Ratio=


Slide5-56

Let’s look at some

profitability

ratios!


Slide5-57

Profit Margin on Sales

Profit Margin

on Sales

Net Income

Net Sales=

This ratio indicates the portion of each dollar of revenue that is available to cover expenses.


Slide5-58

Return on Total Assets

Return on

Total Assets

Net Income

Average Total Assets=

This ratio measures how well assets have been employed.


Slide5-59

Return on Equity

Return on

Equity

Net Income

Average Shareholders’ Equity=

This ratio measures the ability of management to generate net income from

the resources the owners provide.


Slide5-60

End of Chapter 5

Documents

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 5 Income Measurement and Profitability Analysis