5

Income Measurement and

Profitability Analysis

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
 Realization Principle
Revenues are inflows or other enhancements of assets of
an entity or settlements of its liabilities (or a combination of
both) from delivering or producing goods, rendering
services, or other activities that constitute the entity’s
ongoing major or central operations.

Record revenue when:

the earnings process is AND there is reasonable

complete or virtually certainty as to the
complete. collectibility of the asset
to be received (usually
cash).
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 SEC Staff Accounting Bulletin No. 101

Staff Accounting Bulletin No. 101 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.
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 Realization Principle

Revenue recognition is often tied to delivery

of the product from the seller to the buyer.

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 U. S. GAAP vs. IFRS

Revenue recognition criteria for U.S.

GAAP and IFRS include:

• Earnings process is complete • Revenue and costs can be

or virtually complete. measured reliably.
• Reasonable certainty as to the • Probable that economic
collectibility of the asset to be benefits will flow to the seller.
received. • Risk and rewards are
transferred to buyer and seller
does not manage or control the
goods.
• Stage of completion can be
measured reliably.
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 Revenue Recognition at Delivery

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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 Revenue Recognition After Delivery
When we are unable to make reasonable estimates of
uncollectible amounts or customer returns of products,
we delay recognizing revenue from the sale until the
uncertainty has been resolved.

1. Installment Sales Method

2. Cost Recovery Method

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 Installment Sales Method
On November 1, 2011, 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, 2011. The
land cost $560,000 to develop. The company’s fiscal
year ends on December 31.
Amount Allocated to:
Gross
Cash Cost Profit
Gross Profit Date Collected (70%) (30%)
$240,000 ÷ $800,000 Nov. 1, 2011 $ 200,000 $ 140,000 $ 60,000
= 30% Nov. 1, 2012 200,000 140,000 60,000
Nov. 1, 2013 200,000 140,000 60,000
Nov. 1, 2014 200,000 140,000 60,000
Totals $ 800,000 $ 560,000 $ 240,000
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 Installment Sales Method

During 2011, Belmont Corporation collected

$200,000 on its installment sales.

This entry records the Realized Gross Profit by

adjusting the Deferred Gross Profit account.
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 Cost Recovery Method
On November 1, 2011, 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, 2011. The
land cost $560,000 to develop. The company’s fiscal
year ends on December 31.
Cash Cost Gross Profit
Date Collected Recovery Recognized
Nov. 1, 2011 $ 200,000 $ 200,000 $ -
Nov. 1, 2012 200,000 200,000 -
Nov. 1, 2013 200,000 160,000 40,000
Nov. 1, 2014 200,000 - 200,000
Totals $ 800,000 $ 560,000 $ 240,000
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 Cost Recovery Method

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 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
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 Consignment Sales
Sometimes a company arranges for another
company to sell its product under consignment.

Because the consignor

retains the risks and
rewards of ownership of
the product and title does
not pass to the consignee,
the consignor does not
record a sale until the
consignee sells the goods
and title passes to the
eventual customer.
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 Revenue Recognition Prior to Delivery

Completed
Contract Method
Long-term
Contracts
Percentage-of-
Completion
Method

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 Completed Contract and Percentage-
of-Completion Methods Compared

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 Accounting for the Cost of Construction
and Accounts Receivable
With both the completed contract and percentage-of-
completion methods, all costs of construction are
recorded in an asset account called construction in
progress.

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 Gross Profit Recognition—General
Approach

In both methods the same In both methods we add

amounts of revenue, cost, gross profit to the
and gross profit are construction in progress
recognized. asset.
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 Gross Profit Recognition—General
Approach
The same journal entry is recorded to close out the billings
on construction contract and construction in progress
accounts under the completed contract and percentage-of-
completion methods.

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 Timing of Gross Profit Recognition
Under the Completed Contract Method
Under the completed contract method, all
revenues and expenses related to the project are
recognized when the contract is completed.

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 Timing of Gross Profit Recognition Under
the Percentage-of-Completion Method

Using the percentage-of-completion method, we

recognize a portion of the estimated gross profit
each period based on progress to date.

We determine the amount of gross profit recognized in each

period using the following logic:

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 Percentage-of-Completion Method
Allocation of Gross Profit

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 Percentage-of-Completion Method
Allocation of Gross Profit
Notice that the gross profit recognized in each period is
added to the construction in progress account.

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 Percentage-of-Completion Method
Allocation of Gross Profit
The income statement for each year will report
the appropriate revenue and cost of
construction amounts.

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 Income Recognition

The same total amount of profit or loss is recognized

under both the completed contract and the percentage-of-
completion methods, but the timing of recognition differs.

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 Balance Sheet Recognition
Billings on construction contract are subtracted
from construction in progress to determine
balance sheet presentation.

CIP > Billings Asset

Billings > CIP Liability

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 Balance Sheet Recognition
The balance in the construction in progress
account differs between methods because of the
earlier gross profit recognition that occurs under
the percentage-of-completion method.

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 Long-term Contract Losses
Periodic Loss for Loss Projected
Profitable for Entire Project
Projects

Estimated loss is
Determine periodic fully recognized in
loss and record loss the first period the
as a credit to the loss is anticipated
Construction in and is recorded by a
Progress account. credit to
Construction in
Progress account.
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 U. S. GAAP vs. IFRS

There are similarities and differences between

IFRS and U.S. GAAP when considering revenue
recognition for long-term construction
contracts.

• Requires percentage-of- • Requires percentage-of-

completion when reliable completion when reliable
estimates can be made. estimates can be made.
• Requires completed contract • Requires cost recovery method
method when reliable when reliable estimates can’t
estimates can’t be made. be made.

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 U. S. GAAP vs. IFRS
Notice that revenue recognition occurs earlier under the
cost recovery method than under the completed contract
method, but gross profit recognition occurs at the end of
the contract for both methods.

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 Software and Other Multiple-
Deliverable Arrangements
If a sale includes multiple elements (software,
future upgrades, postcontract customer
support, etc.), the revenue should be allocated
to the elements that have stand-alone value
(e.g., aren’t contingent). Otherwise, defer
revenue recognition until the last item delivered.
•Software: base allocation on VSOE
•Other: can use estimated selling prices. This
includes tangible products that contain
essential software.
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 U. S. GAAP vs. IFRS

IFRS contains very little guidance about

multiple-deliverable arrangements.

• Revenue should be allocated • May be necessary to apply the

to the various elements based recognition criteria to the
on the stand-alone selling separately identifiable
prices of the individual components of a single
elements. These can be transaction.
estimated for non-software • Allocation of total revenue to
arrangements if VSOE is not individual components are
available, but have to use based on fair value.
VSOE for software
arrangements.
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 Franchise Sales
Initial Franchise Continuing
Fees Franchise Fees

Generally are
recognized at a
Recognized over
point in time when
time as the services
the earnings
are performed.
process is virtually
complete.

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 U. S. GAAP vs. IFRS
The FASB and IASB are currently working on a
new, comprehensive approach to revenue
recognition.

• Has over 100 revenue-related • Has two primary standards that

standards that sometimes also sometimes contradict
contradict each other. each other and that don’t offer
guidance in some important
areas (like multiple
deliverables).

The Boards appear committed to improving

accounting in this area.
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 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.

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 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

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 DuPont Framework
The DuPont Framework helps identify how profitability,
activity, and financial leverage trade off to determine
return to shareholders:
Return on Profit Asset Equity
equity = margin X turnover X multiplier

Net income Net income Total sales Avg. total assets

Avg. total = Total sales X Avg. total X Avg. total equity
equity assets

Because profit margin and asset turnover combine to

equal return on assets, the DuPont framework can also be
This is called the DuPont
written as: because the DuPont
framework
Return on Return on
Company was a Equity
pioneer in
equity = assets X multiplier
emphasizing this relationship.
Net income Net income Avg. total assets
Avg. total = Avg. total X Avg. total equity
equity assets

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 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.
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 Interim Reporting
With only a few exceptions, the
Reporting Revenues same accounting principles
and Expenses applicable to annual reporting are
used for interim reporting.

Discontinued operations and

Reporting Unusual extraordinary items are reported
Items entirely within the interim period in
which they occur.

Quarterly EPS calculations follow

Earnings Per Share the same procedures as annual
calculations.

Accounting changes made in an

Reporting Accounting interim period are reported by
Changes retrospectively applying the changes
to prior financial statements.
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 Minimum Disclosures
1. Sales, income taxes, and net income
2. Earnings per share
3. Seasonal revenues, costs, and expenses
4. Significant changes in estimates for income
taxes
5. Discontinued operations, extraordinary items,
and unusual or infrequent items
6. Contingencies
7. Changes in accounting principles or estimates
8. Information about fair value of financial
instruments and the methods and assumptions
used to estimate fair values
9. Significant changes in financial position
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End of Chapter 5