income measurement and profitablity analysis chapter 5 © 2009 the mcgraw-hill companies, inc

INCOME MEASUREMENT INCOME MEASUREMENT AND PROFITABLITY AND PROFITABLITY ANALYSISANALYSIS

Chapter 5

© 2009 The McGraw-Hill Companies, Inc.

McGraw-Hill /Irwin

Slide 2

Realization PrincipleRealization 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.

McGraw-Hill /Irwin

Slide 3

SEC Staff Accounting Bulletin No. 101SEC 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.

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 Completion of the Earnings Process within a Single Reporting Periodwithin a Single Reporting Period

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.

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.

Recognize RevenueRecognize Revenue

McGraw-Hill /Irwin

Slide 5

Significant Uncertainty of CollectibilitySignificant Uncertainty of Collectibility

1. Installment Sales Method

2. Cost Recovery Method

1. Installment Sales Method

2. Cost Recovery Method

When uncertainties about collectibility exist, revenue

recognition is delayed.

When uncertainties about collectibility exist, revenue

recognition is delayed.

McGraw-Hill /Irwin

Slide 6

Installment Sales MethodInstallment Sales MethodOn 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.

Gross Profit $240,000 ÷ $800,000 = 30%

Gross Profit $240,000 ÷ $800,000 = 30%

Date Cash

Collected Cost

RecoveryGross Profit

Nov. 1, 2009 $ 200,000 $ 140,000 $ 60,000 Nov. 1, 2010 200,000 140,000 60,000 Nov. 1, 2011 200,000 140,000 60,000 Nov. 1, 2012 200,000 140,000 60,000

Totals $ 800,000 $ 560,000 $ 240,000

McGraw-Hill /Irwin

Slide 7

Installment Sales MethodInstallment Sales Method

Description Debit CreditInstallment sales receivable 800,000

Inventory 560,000

Deferred gross profit 240,000

Cash 200,000

Installment sales receivable 200,000


Realized gross profit 60,000

($200,000 collected x 30%)

General Journal

During 2009, Belmont Corporation collected $200,000 on its installment sales.

During 2009, Belmont Corporation collected $200,000 on its installment sales.

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

McGraw-Hill /Irwin

Slide 8

Cost Recovery MethodCost Recovery MethodOn 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 Cash

Collected Cost

RecoveryGross Profit

Nov. 1, 2009 $ 200,000 $ 200,000 $ - Nov. 1, 2010 200,000 200,000 - Nov. 1, 2011 200,000 160,000 40,000 Nov. 1, 2012 200,000 - 200,000

Totals $ 800,000 $ 560,000 $ 240,000

McGraw-Hill /Irwin

Slide 9

Cost Recovery MethodCost Recovery Method

Description Debit CreditNovember 1, 2009


Inventory 560,000


November 1, 2009, 2010, 2011, & 2012

Cash 200,000


November 1, 2011



November 1, 2012



General Journal

McGraw-Hill /Irwin

Slide 10

Right of ReturnRight 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 Completion of the Earnings Process over Multiple Reporting PeriodsMultiple Reporting Periods

Completed Contract Method

Completed Contract Method

Percentage-of-Completion

Method

Percentage-of-Completion

Method

Long-term Contracts

Long-term Contracts

McGraw-Hill /Irwin

Slide 12

Companies Engaged in Long-term Companies Engaged in Long-term ContractsContracts

Company Type of Industry or Product Oracle Corp. Computer software, license and consulting feesLockheed Martin Corporation Aircraft, missiles and spacecraftEDS Information technology and outsourcingNorthrop Grumman Newport News ShipbuildingNortel Networks Corp Networking solutions and services to support the InternetSBA Communications Corp TelecommunicationsLayne Christensen Company Water supply services and geotechnical constructionKaufman & Broad Home Corp. Commercial and residential constructionRaytheon Company Defense electronicsFoster Wheeler Corp. Construction, petroleum and chemical facilitiesHalliburton Construction, energy servicesAllied Construction Products Corp. Large metal stamping presses

COMPANIES ENGAGED IN LONG-TERM CONTRACTS

McGraw-Hill /Irwin

Slide 13

Completed Contract MethodCompleted 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:

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

using the completed contract method.

2009 2010 2011Construction costs incurred during the year 250,000$ 550,000$ 400,000$ Construction costs incurred in prior years - 250,000 800,000 Cumulative construction costs 250,000 800,000 1,200,000 Estimated costs to complete at end of the year 1,000,000 425,000 - Total estimated and actual construction costs 1,250,000$ 1,225,000$ 1,200,000$

Billings made during the year 250,000$ 525,000$ 625,000$ Cash collections during the year 225,000 470,000 405,000

McGraw-Hill /Irwin

Slide 14

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


Gross profit is

not recognized

until project is complete.2009

Construction costs incurred during they year 250,000$

Construction costs incurred in prior years -

Cumulative construction costs 250,000

Estimated costs to complete at end of year 1,000,000

Total estimated and actual construction costs 1,250,000$

Billings made during the year 250,000$

Cash collections during year 225,000

McGraw-Hill /Irwin

Slide 15





General Journal


Construction in Progress

- Billings on Construction ContractDebit Balance (Unbilled Receivable)

Classified as an asset


- Billings on Construction ContractCredit Balance (Overbilled Receivable)

Classified as a liability

McGraw-Hill /Irwin

Slide 16





Cash 470,000


General Journal

Completed Contract MethodCompleted Contract MethodGross

profit is not

recognized until

project is complete.

2009 2010

Construction costs incurred during they year 250,000$ 550,000$

Construction costs incurred in prior years - 250,000

Cumulative construction costs 250,000 800,000

Estimated costs to complete at end of year 1,000,000 425,000

Total estimated and actual construction costs 1,250,000$ 1,225,000$

Billings made during the year 250,000$ 525,000$

Cash collections during year 225,000 470,000

McGraw-Hill /Irwin

Slide 17






Cash 405,000


General Journal

2009 2010 2011

Construction costs incurred during they year 250,000$ 550,000$ 400,000$

Construction costs incurred in prior years - 250,000 800,000

Cumulative construction costs 250,000 800,000 1,200,000

Estimated costs to complete at end of year 1,000,000 425,000 -

Total estimated and actual construction costs 1,250,000$ 1,225,000$ 1,200,000$

Billings made during the year 250,000$ 525,000$ 625,000$

Cash collections during year 225,000 470,000 405,000

McGraw-Hill /Irwin

Slide 18






Cash 405,000


Cost of construction 1,200,000

Construction in progress 200,000

Revenue from long-term contract 1,400,000

Revenue from long-term contract 1,400,000

Cost of construction 1,200,000

Retained earnings 200,000

General Journal Gross profit is

recognized in year 3

since project is complete.

Remember that the contract price was $1,400,000.

2009 2010 2011








McGraw-Hill /Irwin

Slide 19


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.

2009 250,000 2010 550,000 2011 400,000 2011 200,000

1,400,000

Construction in Progress250,000 2009525,000 2010625,000 2011

1,400,000

Billings on Construction Contract

McGraw-Hill /Irwin

Slide 20

Percentage-of-Completion MethodPercentage-of-Completion MethodGeller 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:

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

2009 2010 2011Construction costs incurred during the year 250,000$ 550,000$ 400,000$ Construction costs incurred in prior years - 250,000 800,000 Cumulative construction costs 250,000 800,000 1,200,000 Estimated costs to complete at end of the year 1,000,000 425,000 - Total estimated and actual construction costs 1,250,000$ 1,225,000$ 1,200,000$

Billings made during the year 250,000$ 525,000$ 625,000$ Cash collections during the year 225,000 470,000 405,000

McGraw-Hill /Irwin

Slide 21



Cost of construction 250,000


Revenue from long-term contract 280,000

General Journal

Percentage-of-Completion MethodPercentage-of-Completion Method

2009

Contract price 1,400,000$

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 20.00%

Total project gross profit 150,000$

Multiplied by the estimated % of completion 20.00%

Gross profit earned to date 30,000$

Less gross profit recognized in previous periods -

Gross profit recognized currently 30,000$

McGraw-Hill /Irwin

Slide 22


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

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

McGraw-Hill /Irwin

Slide 23

Percentage-of-Completion MethodPercentage-of-Completion Method2009

Contract price 1,400,000$

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 20.00%

Total project gross profit 150,000$

Multiplied by the estimated % of completion 20.00%

Gross profit earned to date 30,000$

Less gross profit recognized in previous periods -

Gross profit recognized currently 30,000$

McGraw-Hill /Irwin

Slide 24








Cash 225,000


General Journal



- Billings on Construction ContractDebit Balance (Unbilled Receivable)

Classified as an asset


- Billings on Construction ContractCredit Balance (Overbilled Receivable)

Classified as a liability

Contra account to CIP

McGraw-Hill /Irwin

Slide 25









Cash 225,000





General Journal

Closing EntryClosing Entry

McGraw-Hill /Irwin

Slide 26





Cash 470,000


General Journal


2009 2010

Construction costs incurred during they year 250,000$ 550,000$

Construction costs incurred in prior years - 250,000

Cumulative construction costs 250,000 800,000

Estimated costs to complete at end of year 1,000,000 425,000

Total estimated and actual construction costs 1,250,000$ 1,225,000$

Billings made during the year 250,000$ 525,000$

Cash collections during year 225,000 470,000

McGraw-Hill /Irwin

Slide 27

Percentage-of-Completion MethodPercentage-of-Completion Method2009 2010

Contract price 1,400,000$ 1,400,000$

Actual costs to date $250,000 $800,000

Estimated costs to complete 1,000,000 425,000

Total project cost $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 20.00% 65.31%

Total project gross profit 150,000$ 175,000$

Multiplied by the estimated % of completion 20.00% 65.31%

Gross profit earned to date 30,000$ 114,286$

Less gross profit recognized in previous periods - (30,000)

Gross profit recognized currently 30,000$ 84,286$

McGraw-Hill /Irwin

Slide 28






Cash 470,000








General Journal2009 2010

Contract price 1,400,000$ 1,400,000$

Actual costs to date $250,000 $800,000

Estimated costs to complete 1,000,000 425,000

Total project cost $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$


Equals percentage complete to date 20.00% 65.31%

Total project gross profit 150,000$ 175,000$

Multiplied by the estimated % of completion 20.00% 65.31%

Gross profit earned to date 30,000$ 114,286$

Less gross profit recognized in previous periods - (30,000)

Gross profit recognized currently 30,000$ 84,286$

McGraw-Hill /Irwin

Slide 29






Cash 405,000








General Journal

2009 2010 2011








McGraw-Hill /Irwin

Slide 30

Percentage-of-Completion MethodPercentage-of-Completion Method2009 2010 2011

Contract price 1,400,000$ 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

Total project cost $1,250,000 $1,225,000 $1,200,000

Total gross profit (Contract price - total costs) 150,000$ 175,000$ 200,000$

Percentage-of-completion (actual costs to date) 250,000$ 800,000$ (project is complete)


Equals percentage complete to date 20.00% 65.31% 100.00%

Total project gross profit 150,000$ 175,000$ 200,000$

Multiplied by the estimated % of completion 20.00% 65.31% 100.00%

Gross profit earned to date 30,000$ 114,286$ 200,000

Less gross profit recognized in previous periods - (30,000) (114,286)

Gross profit recognized currently 30,000$ 84,286$ 85,714$

McGraw-Hill /Irwin

Slide 31






Cash 405,000








General Journal2009 2010 2011

Contract price 1,400,000$ 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

Total project cost $1,250,000 $1,225,000 $1,200,000

Total gross profit (Contract price - total costs) 150,000$ 175,000$ 200,000$

Percentage-of-completion (actual costs to date) 250,000$ 800,000$ (project is complete)


Equals percentage complete to date 20.00% 65.31% 100.00%

Total project gross profit 150,000$ 175,000$ 200,000$

Multiplied by the estimated % of completion 20.00% 65.31% 100.00%

Gross profit earned to date 30,000$ 114,286$ 200,000

Less gross profit recognized in previous periods - (30,000) (114,286)

Gross profit recognized currently 30,000$ 84,286$ 85,714$

McGraw-Hill /Irwin

Slide 32


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 JournalEntry to transfer title to the customer.

2009 250,000 30,000

2010 550,000 84,286

2011 400,000 85,714

1,400,000

Construction in Progress250,000 2009525,000 2010625,000 2011

1,400,000

Billings on Construction Contract

McGraw-Hill /Irwin

Slide 33

Long-term Contract LossesLong-term Contract Losses

Periodic Loss for Profitable Projects

Determine periodic loss and record loss

as a credit to the Construction in

Progress account.

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.

McGraw-Hill /Irwin

Slide 34

International Accounting Standards and International Accounting Standards and Long-term Contracts 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-of-completion accounting when

estimates can be made precisely.

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.

McGraw-Hill /Irwin

Slide 35

Software and Other Multiple Deliverable Software and Other Multiple Deliverable ArrangementsArrangements

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 ArrangementsOther 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 SalesFranchise Sales

Source: SFAS 45

Initial Franchise Fees

Generally are recognized at a

point in time when the earnings

process is virtually complete.

Continuing Franchise Fees

Recognized over time as the services

are performed.

McGraw-Hill /Irwin

Slide 38

Activity RatiosActivity 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

Activity Ratios

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 RatiosProfitability 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

Profitability Ratios

Return on Equity Key ComponentsProfitability

ActivityFinancial Leverage

McGraw-Hill /Irwin

Slide 40

This is called the DuPont framework because the DuPont

Company was a pioneer in emphasizng this relationship.

Because profit margin and asset turnover combine to equal return on assets, the DuPont framework can also

be written as:

DuPont FrameworkDuPont Framework

Return on equity =

Profit margin X

Asset turnover X

Equity multiplier

Net incomeAvg. total

equity=

Net incomeTotal sales X

Total salesAvg. total

assetsX

Avg. total assetsAvg. total

equity

The DuPont Framework helps identify how profitability, activity, and financial leverage trade off to determine

return to shareholders:

Return on equity =

Return on assets X

Equity multiplier


equity=


assetsX

Avg. total assetsAvg. total

equity

McGraw-Hill /Irwin

Slide 41

Appendix 5: Interim ReportingAppendix 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 ReportingInterim 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 ShareQuarterly 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 DisclosuresMinimum Disclosures

Sales, income taxes, and net income

Earnings per share

Seasonal revenues, costs, and expenses

Significant changes in estimates for income

taxes

Discontinued operations, extraordinary items, and

unusual or infrequent items

Contingencies

Changes in accounting principles or estimates

Significant changes in financial position

income measurement and profitablity analysis chapter 5 © 2009 the mcgraw-hill companies, inc

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