additional topics in income determination revsine/collins/johnson: chapter 3
TRANSCRIPT
Additional Topics in Income
Determination
Revsine/Collins/Johnson: Chapter 3
2RCJ: Chapter 3 © 2005
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
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.
Time of sale is used in most industries
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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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Contract price is $1,000,000 and construction costs are estimated to be $800,000.
Example: Solid Construction Corp.
2005 2006 2007Gross profit ? ? ?
Total
$150,000
Original estimate was $800,000
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
30% =$240,000
$800,000=
Cost incurred
Estimated total costs
Step 2: Estimated totalcontract profit
$200,000 = $1,000,000 - $800,000
Step 3: Estimated profitearned to date
$60,000 = $200,000 x 30%
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30%
$200,000
$60,000
Percentage-of-completion for 2006 (Year 2)
Step1: Percentage ofcompletion ratio
Step2: Estimated totalcontract profit
Step3: Estimated profitearned to date
$150,000 = $1,000,000 - $850,000
$96,000 = $150,000 x 64%
Step4: Incremental profitearned
$36,000 = $96,000 - $60,000
30%
$200,000
$60,000
$544,000
$850,000=64%30%
$200,000
$60,000
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Percentage-of-completion for 2007 (Year 3)
Step1: Percentage ofcompletion ratio
100%
Step2: Estimated totalcontract profit
Step3: Estimated profitearned to date
Step4: Incremental profitearned
$150,000
$150,000
$54,000
30%
$200,000
$60,000
64%
$150,000
$96,000
$36,000
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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.
Revenue recognition could occur when the sales transaction is completed, or earlier at extraction or harvest (i.e., when the critical event is satisfied).
Time of
Sale
Critical Event
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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.
Revenue (and related expenses) for the remaining 10,000 bushels is postponed to 2006 when those bushels are sold.
Commodities:Completed-transaction (sales) method
Recognition
Matching
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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.
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 $15,000
Commodities:Market-price (production) method
Net realizable value
RecognitionMatching
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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 $5,000
CR Crop inventory $5,000
Commodities:Market-price (production) method continued
= 10,000 x ($3.50 - $3.00)
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Fearing a further market price decline, the farmer immediately sells all 10,000 bushels at $3.00:
DR Cost of goods sold $30,000
CR Crop inventory $30,000
DR Cash $30,000
CR Crop revenue $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)
Commodities:Market-price (production) method continued
$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
$300,000 30%
$90,000
Cash collections from 2006 sales
$300,000 30%
$90,000
Gross-profit %
Income recognized
Total income recognized
$600,000 30%
$180,000
$340,000 32%
$108,800
$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%
D
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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
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.
$1,200,000 -600,000 -200,000 $400,000
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Specialized transactions:Franchised sales
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?
Franchisor CustomerFranchisee
Seller Buyer
1. Initial franchisee fee2. Continuing (periodic) fees
Exercise right to sell product or service
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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
3/1/20051/1/2005 12/31/2005
Sell franchise for $25,000
($10,000 cash)
Franchisor provides trainings, etc
Received installment payment plus 8% interests
January 1, 2005
DR Cash $10,000 DR Note receivable $15,000 CR Earned franchise fee revenue $10,000 CR Unearned franchise fees $15,000
Use of name and right to sell
March 1, 2005
DR Unearned franchise fees $7,500 CR Earned franchise fees $7,500
Training
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Specialized transactions:Recording initial franchise fees (continued)
December 31, 2005 DR Unearned franchise fees $2,500 CR Earned franchise fees $2,500 DR Cash $5,000 CR Notes receivable $5,000
DR Cash $1,200 CR Interest revenue $1,200
$15,000 x 8%
3/1/20051/1/2005 12/31/2005
Sell franchise for $25,000
($10,000 cash)
Franchisor provides trainings, etc
Received installment payment plus 8% interests
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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:
Costs incurred by the franchisor for initial and continuing services are expensed in the same period the franchise revenue is recognized (matching principle).
DR Cash $2,000 CR Earned franchise fee revenue $2,000
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Specialized transactions:Sales with right of return
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.
Seller CustomerBuyer
Resale
Sell with right of return
Cash payment or obligation to pay
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Specialized transactions:Bundled sales
Oracle sells a database software “bundle” for $1.5 million. The “bundle” includes:
Staff training “Free” software upgrades On-going customer support for
five years.
How much revenue should Oracle record up front?
SOP 97-2 provides guidance.
Customer support $150
Upgrade $300
Training $450
Software $600
Revenue recognized:
Over 5-year period
As installed
When completed
When delivered and installed
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
Sales with delayed delivery
Goods sold on lay-away
No revenue can be recognized at delivery.
Seller can’t recognize revenue until delivery… except certain buy and hold transactions.
Postpone revenue recognitionuntil merchandise is delivered to customer.
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Revenue recognition abuses:SAB No. 104 examples
Gross vs. net basisfor internet resellers
Earned as services are delivered over the full term of service engagement.
Revenue should be recognized on a “net” basis as commission revenue.
Revenue should be recognized over time as the capacity is brought on line and used by customers.
Non refundable up-front fees
Capacityswaps
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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
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.