Income Measurement and Profitability Analysis

Sid Glandon, DBA, CPA Associate Professor of Accounting 1

Guidelines for Revenue Recognition

Revenue is recognized when It is earned, and • When the earning process is substantially complete It is realized or realizable • When goods and services are exchanged for cash or claims to cash 2

Staff Accounting Bulletin No. 101

Persuasive evidence of an arrangement exists Delivery has occurred or services have been rendered The seller’s price to the buyer is fixed or determinable Collectibility is reasonably assured 3

Four Types of Transactions

Sale of products Recognized at date of sale (delivery) Provision of services Recognized when performed and billable Revenue from use of assets Recognized as time passes or assets used up Disposal of assets Recognized at point of sale 4

Revenue Recognition

Transfer of title, date of delivery Completion of production Revenue recognition after delivery if there is uncertainty of collectibility Installment sales Cost recovery Deposit method Buyback agreements Right of return Consignment sales 5

Installment Sales

Recognizes income in periods of collection instead of point of sale Title does not pass to buyer until after final payment Both sales and cost of sales are deferred Selling and administrative expenses are not deferred 6

Installment Sales Example

Installment sales Cost of sales Gross profit

Fact Pattern

Gross profit percentage

2004

$200,000 150,000 $50,000 25%

2005

$250,000 190,000 $60,000 24%

Cash received:

from 2004 sales from 2005 sales from 2006 sales Total cash received (by year)

2004

$60,000 $60,000

2005

$100,000 100,000 $200,000

2006

$240,000 168,000 $72,000 30%

2006

$40,000 125,000 80,000 $245,000 7

Installment Sales Example

Recognized gross profit: 2004

Collections, 2004 Gross profit percentage Gross profit recognized $60,000 25% $15,000 Collections, 2005 Gross profit percentage Gross profit recognized Collections, 2006 Gross profit percentage Gross profit recognized Total profit recognized (by year) $15,000

2005

$100,000 25% $25,000

2006

$40,000 25% $10,000 $100,000 24% $24,000 $125,000 24% $30,000 $49,000 $80,000 30% $24,000 $64,000 8

Date

2004

Account

Installment receivables Inventory Deferred gross profit, 2004 To record installment sales fo 2004

Debit

$200,000 2004 Cash Installment sales To record collections on installment sales for 2004 $60,000 12/31/04 Deferred gross profit, 2004 $15,000 Recognized gross profit from installment sales To recognize gross profit from 2004 installment sales

Analysis of realized gross profit:

Collections on installment sales, 2004 Gross profit percentage, 2004 Recognized gross profit on installment sales $60,000 25%

Credit

$150,000 50,000 $60,000 $15,000 $15,000 9

Date

2005

Account

Installment receivables Inventory Deferred gross profit, 2005 To record installment sales fo 2005

Debit

$250,000

Credit

$190,000 60,000 2005 Cash Installment sales To record collections on installment sales for 2005 $200,000 12/31/05 Deferred gross profit, 2004 Deferred gross profit, 2005 $25,000 $24,000 Recognized gross profit from installment sales To recognize gross profit from 2004 and 2005 installment sales $200,000 $49,000 10

Analysis of realized gross profit:

Collections on installment sales, 2004 Gross profit percentage, 2004 Recognized gross profit on installment sales Collections on installment sales, 2005 Gross profit percentage, 2005 Recognized gross profit on installment sales $100,000 25% $100,000 24% $25,000 $24,000 11

Date

2006

Account

Installment receivables Inventory Deferred gross profit, 2006 To record installment sales fo 2006

Debit

$240,000 2006 Cash Installment sales To record collections on installment sales for 2006 $245,000

Credit

$168,000 72,000 $245,000 12/31/06 Deferred gross profit, 2004 $10,000 Deferred gross profit, 2005 Deferred gross profit, 2006 Recognized gross profit from installment sales $30,000 $24,000 $64,000 To recognize gross profit from 2004, 2005 and 2006 installment sales 12

Analysis of realized gross profit:

Collections on installment sales, 2004 Gross profit percentage, 2004 Recognized gross profit on installment sales Collections on installment sales, 2005 Gross profit percentage, 2005 Recognized gross profit on installment sales Collections on installment sales, 2006 Gross profit percentage, 2006 Recognized gross profit on installment sales $40,000 25% $125,000 24% $80,000 30% $10,000 $30,000 $24,000 13

Cost Recovery Method

Seller recognizes no profit until cash receipts exceed seller’s cost of merchandise After recovering all costs, seller includes additional cash collections in income Used where there is no reasonable basis for estimating collectibility Franchises and real estate Income statement Report amount of gross profit recognized and deferred 14

Deposit Method

Seller receives cash before transfer Seller has no claim against purchaser Insufficient transfer of risks to buyer to warrant recording a sale Defers sale recognition until sale has occurred 15

Revenue Recognition Before Delivery

Long-term construction contracts Percentage of completion • Periodic billing Completed contract • Only used when percentage method is inapplicable 16

Long-Term Construction Contracts Accounting Methods

Percentage of completion Terms of contract must be certain and enforceable Certainty of performance Completed contract Uncertainty Short-term contracts 17

Percentage of Completion

Permits periodic billing Amount of gross profit recognized Normally based on percentage of work completed 18

Percentage Completion Steps

Step #1: Percentage Complete

Costs incurred to-date Estimated total costs $X,XXX $X,XXX = X %

Step #2: Current Period Revenue

Contract price Percentage complete to date Revenue recognized to date Revenue recognized in prior periods Current period revenue $X,XXX X % $X,XXX ($X,XXX) $X,XXX

Step #3: Current Period Costs

Costs incurred to date Costs incurred in prior period Current period costs

Step #4: Current Period Gross Profit

Current period revenue Current period costs Current period gross profit $X,XXX ($X,XXX) $X,XXX ($X,XXX) $X,XXX $X,XXX 19

Example: Percentage Completion

Fact Pattern:

Contract price Estimated cost Start date Finish date Balance sheet date $4,500,000 4,000,000 7/1/04 10/31/06 12/31

Annual Data:

Cost-to-date Estimated cost-to-complete Progress billings during the year Cash collected during the year

2004

$1,000,000 3,000,000 900,000 750,000

2005

$2,916,000 1,134,000 2,400,000 1,750,000

2006

$4,050,000 0 1,200,000 2,000,000 20

Step #1: Percentage Complete

Percentage Complete

Cost incurred to-date Cost to complete Estimated total cost

2004

$1,000,000 3,000,000 $4,000,000

2005

$2,916,000 1,134,000 $4,050,000

2006

$4,050,000 0 $4,050,000 Cost incurred to-date Estimated total cost Percentage complete $1,000,000 $4,000,000 $2,916,000 $4,050,000 $4,050,000 $4,050,000 25% 72% 100% 21

Step #2: Current Period Revenue

Current Period Revenue

Contract price Percentage complete to-date Revenue recognized to-date Revenue recognized in prior periods Current period revenue

2004

$4,500,000 25% 1,125,000 0 $1,125,000

2005

$4,500,000 72% 3,240,000 1,125,000 $2,115,000

2006

$4,500,000 100% 4,500,000 3,240,000 $1,260,000 22

Step #3: Current Period Costs

Current Period Cost

Cost incurred to-date Cost incurrent in prior period Current period cost

2004

$1,000,000 0 $1,000,000

2005

$2,916,000 1,000,000 $1,916,000

2006

$4,050,000 2,916,000 $1,134,000 23

Step #4: Current Period Gross Profit

Current Period Gross Profit

Current period reveune Current period cost Current period gross profit

2004

$1,125,000 1,000,000 $125,000

2005

$2,115,000 1,916,000 $199,000

2006

$1,260,000 1,134,000 $126,000 24

Long-Term Contract Losses

Loss in Current Period on a Profitable Contract Losses are recognized in current period under the percentage of completion method Loss on an Unprofitable Contract Expected contract loss is recognized in current period under either method 25

Activity Ratios

Receivables turnover ratio Inventory turnover ratio Asset turnover ratio 26

Activity Ratios

Receivables turnover ratio = Net sales Average accounts receivable (net) Inventory turnover ratio Asset turnover ratio = = Cost of goods sold Average inventory Net sales Average total assets 27

Profitability Ratios

Profit margin on sales Return on assets Return on shareholders’ equity 28

Profitability Ratios

Profit margin on sales = Return on assets = Return on shareholders' equity = Net income Net sales Net income Average total assets Net income Average shareholders' equity 29