Income Measurement and Profitability Analysis
Chapter
5
Income Measurement and Profitability Analysis
Learning Objectives
After studying this chapter, you should be able to:
LO5-1Discuss the timing of revenue recognition, list the two general criteria that must be satisfied before revenue can be recognized, and explain why these criteria usually are satisfied when products or services are delivered.
LO5-2Discuss the principal/agent distinction that determines the amount of revenue to record.
LO5-3Describe the installment sales and cost recovery methods of recognizing revenue and explain the unusual conditions under which these methods might be used.
LO5-4Discuss the implications for revenue recognition of allowing customers the right of return.
LO5-5Identify situations requiring recognition of revenue over time and demonstrate the percentage-of-completion and completed contract methods of recognizing revenue for long-term contracts.
LO5-6Discuss the revenue recognition issues involving multiple-deliverable contracts, software, and franchise sales.
LO5-7Identify and calculate the common ratios used to assess profitability.
LO5-8Discuss the primary differences between U.S. GAAP and IFRS with respect to revenue recognition.
Chapter Highlights
Part A: Revenue Recognition
According to the FASB, “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.” In other words, revenue tracks the inflow of net assets that occurs when a business provides goods or services to its customers.
Our objective is to recognize revenue in the period or periods that the revenue-generating activities of the company are performed. But we also must consider that recognizing revenue presumes that an asset (usually cash) has been received or will be received in exchange for the goods or services sold. Our judgment as to the collectibility of the cash from the sale of a product or service will, therefore, impact the timing of revenue recognition. These two concepts of performance and collectibility are captured by the general guidelines for revenue recognition in the realization principle.
The realization principle requires that two criteria be satisfied before revenue can be recognized:
1.The earnings process is judged to be complete or virtually complete, (the earnings process refers to the activity or activities performed by the company to generate revenue).
2.There is reasonable certainty as to the collectibility of the asset to be received (usually cash).
Revenue often is recognized at a point in time at or near the end of the earnings process. In other situations, revenue is recognized over time.
Premature revenue recognition reduces the quality of reported earnings, particularly if those revenues never materialize. As part of its crackdown on earnings management, the SEC issued Staff Accounting Bulletin No. 101 summarizing the SEC’s views on revenue recognition. The Bulletin provides additional criteria for judging whether or not the realization principle is satisfied:
- 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.
Soon after SAB No. 101 was issued, many companies changed their revenue recognition methods. In most cases, the changes resulted in a deferral of revenue recognition.
IFRS revenue recognition concepts focus on transfer of economic benefits. IFRS allows revenue to be recognized when the following conditions have been satisfied:
- The amount of revenue and costs associated with the transaction can be measured reliably,
- It is probable that the economic benefits associated with the transaction will flow to the seller,
- (for sales of goods) the seller has transferred to the buyer the risks and rewards of ownership, and doesn’t effectively manage or control the goods,
- (for sales of services) the stage of completion can be measured reliably.
These requirements are similar to U.S. GAAP, and revenue typically is recognized at a similar point under IFRS and U.S. GAAP.
Revenue Recognition at Delivery
For product sales, the product delivery date refers to the date legal title to the product passes from seller to buyer. In most cases, the realization principle criteria are satisfied at this point. The earnings process is virtually complete and the only remaining uncertainty involves the ultimate cash collection. This remaining uncertainty can be accounted for by estimating and recording allowances for possible product returns and for potential bad debts.
Service revenue, too, often is recognized at a point in time if there is one final activity that is deemed critical to the earnings process. In this case, all revenue and costs are deferred until this final activity has been performed. For example, a moving company will pack, load, transport, and deliver household goods for a fixed fee. Although packing, loading, and transporting all are important to the earning process, delivery is the culminating event of the earnings process. So, the entire service fee is recognized as revenue after the goods have been delivered. However, in many instances, service revenue activities occur over extended periods and recognizing revenue at any single date within that period would be inappropriate. Instead, it’s more meaningful to recognize revenue over time in proportion to the performance of the activity. Rent revenue is an example.
It is important to determine whether a seller is a principal of an agent. A principal has primary responsibility for delivering a product or service, and typically is vulnerable to risks associated with delivering the product or service and collecting payment from the customer. An agent does not have primary responsibility for delivering a product or service, and typically is not vulnerable to risks associated with delivering the product or service and collecting payment from the customer. If the seller is a principal, it should recognize as revenue the gross (total) amount received from a customer. If the seller is an agent, it should recognize as revenue only the commission it receives for facilitating the sale.
Revenue Recognition after Delivery
Recognizing revenue at a specific point in time assumes we are able to make reasonable estimates of amounts due from customers that potentially might be uncollectible. For product sales, this also includes amounts not collectible due to customers returning the products they purchased. Otherwise, we would violate one of the requirements of the revenue realization principle we discussed earlier that there must be reasonable certainty as to the collectibility of cash from the customer. There are a few situations when uncertainties could cause a delay in recognizing revenue from a sale of a product or service. One such situation occasionally occurs when products (or services) are sold on an installment basis.
Installment Sales
Revenue recognition for most installment sales takes place at point of delivery, because accurate estimates can be made of potential uncollectible amounts. Two accounting methods, the installment sales method and the cost recovery method are available for situations where there is significant uncertainty concerning cash collection making it impossible to reasonably estimate bad debts. The installment sales method recognizes revenue and costs only when cash payments are made. The amount of gross profit recognized is determined by multiplying the gross profit percentage (gross profit ÷ by sales price) by the cash collected. The cost recovery method defers all gross profit until cash equal to the cost of the item sold has been received. These methods are sometimes used for real estate sales.
Illustration
On April 16, 2013, the Aspen Real Estate Company sold land to a developer for $2,000,000. The buyer will make five annual payments of $400,000 plus interest on each April 16, beginning in 2014. Aspen's cost of the land is $800,000. Let's ignore interest charges and concentrate on the recognition of the $1,200,000 gross profit on the sale of land ($2,000,000 - 800,000).
Using point of delivery revenue recognition, all of the $1,200,000 in gross profit is recognized in 2013.
Using the installment sales method, the gross profit of $1,200,000 represents 60% of the sales price ($1,200,000 ÷ $2,000,000). Therefore, as $400,000 of cash is collected each year beginning in 2014, $240,000 of gross profit is recognized.
Using the cost recovery method, no gross profit is recognized until the $800,000 in cost is collected. Therefore, no gross profit is recognized in 2013, 2014 and 2015. Beginning in 2016, 100% of the cash collected is recognized as income.
The following table summarizes gross profit recognition for the three alternatives:
Installment Sales MethodPoint of delivery / (60% x cash collection) / Cost Recovery Method
2013 / $1,200,000 / $ - 0 - / $ - 0 -
2014 / - 0 - / 240,000 / - 0 -
2015 / - 0 - / 240,000 / - 0 -
2016 / - 0 - / 240,000 / 400,000
2017 / - 0 - / 240,000 / 400,000
2018 / - 0 - / 240,000 / 400,000
Totals / $1,200,000 / $1,200,000 / $1,200,000
Right of Return
When the right of returnexists, revenue cannot be recognized at the point of delivery unless the seller is able to make reliable estimates of future returns. In most retail situations, even though the right to return merchandise exists, reliable estimates can be made and revenue and costs are recognized at point of delivery. Otherwise, revenue and cost recognition is delayed until such time the uncertainty is resolved. For example, many semiconductor companies delay recognition of revenue until the product is sold by their customer (the distributor) to an end-user.
Consignment Sales
Sometimes a company arranges for another company to sell its product under consignment. The “consignor” physically transfers the goods to the other company (the consignee), but the consignor retains legal title. If the consignee can’t find a buyer within an agreed-upon time, the consignee returns the goods to the consignor. However, if a buyer is found, the consignee remits the selling price (less commission and approved expenses) to the consignor. 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 (revenue and related costs) until the consignee sells the goods and title passes to the eventual customer.
Revenue Recognition Prior to Delivery
Long-Term Contracts
For long-term contracts, it usually is not appropriate to recognize revenue at the delivery point (that is, when the project is completed). This is known as the completed contract method of revenue recognition. The problem with this method is that all revenues, expenses, and resulting income from the project are recognized in the period in which the project is completed; no revenues or expenses are reported in the income statements of earlier reporting periods in which much of the work may have been performed.
A more appropriate method of recognizing revenue is the percentage-of-completion method which allocates a share of a project's revenue and expenses (revenues less project expenses = gross profit) to each reporting period during the contract period. The allocation is based on progress to date which can be estimated as the proportion of the project's cost incurred to date divided by total estimated costs (cost-to-cost), or by relying on an engineer's or architect's estimate.
For long-term construction contracts, under both methods, the costs of construction are debited to an inventory account, construction in progress. Using the percentage-of-completion method, this account also includes gross profit recognized to date. Also under both methods, progress billings are recorded with a debit to accounts receivable and a credit to billings on construction contract. This account is a contra account to construction in progress, and serves to reduce the carrying value of construction in progress by amounts billed to the customer to avoid simultaneously including both the receivable and the inventory on the balance sheet. At the end of each period, the balances in these two accounts are compared. If the net amount is a debit, it is reported in the balance sheet as an asset. Conversely, if the net amount is a credit, it is reported as a liability.
By waiting until the contract is complete, the completed contract method does not properly portray a company’s performance over the construction period. The percentage-of-completion method is preferable, and the completed contract method should be used in unusual situations when forecasts of future costs are not dependable.
Illustration
In 2013, the Calahan Construction Company contracted to build an office building for $3,000,000. Construction was completed in 2015. Data relating to the contract are as follows ($ in thousands):
2013 2014 2015
Costs incurred during the year...... $ 500 $1,000 $1,050
Estimated costs to complete as of year-end..... 2,000 1,000 -
Billings during the year ...... 400 1,500 1,100
Cash collections during the year...... 350 1,050 1,600
Calculation of estimated gross profit:
2013 2014 2015
Contract price $3,000 $3,000 $3,000
Actual costs to date $ 500 $1,500 $2,550
Estimated costs to complete 2,000 1,000 - 0 -
Total estimated costs (2,500) (2,500)
Estimated gross profit $ 500 $ 500
Total actual costs (2,550)
Actual gross profit $ 450
Gross profit recognition:
Completed contract method:
2013: $ - 0 -
2014: $ - 0 -
2015: $ 450
Percentage-of-completion method (using cost-to-cost to estimate progress):
2013: $ 500
= 20% x $500 = $100 gross profit to be recognized in 2013.
$2,500
2014: $1,500
= 60% x $500 = $300 - 100 (2013 gross profit already recognized) = $2,500 $200 gross profit to be recognized in 2014.
2015: $450 - 300 (2013 and 2014 gross profit) = $150 gross profit to be recognized in
2015.
The journal entries to record Calahan's construction project are as follows
($ in thousands):
Percentage-of- Completed
2013:Completion Method Contract Method
Construction in progress 500 500
Cash, materials, etc. 500 500
To record construction costs.
Accounts receivable 400 400
Billings on construction contract 400 400
To record progress billings.
(note: journal entries continued on next page)
Percentage-of- Completed
2013 (continued):Completion Method Contract Method
Cash 350 350
Accounts receivable 350 350
To record cash collection.
Construction in progress (gross profit) 100 No income recognition
Cost of construction (expense) 500 until project completion
Revenue from long-term contracts 600
To record gross profit.
(revenue = 20% x $3 million; expense = cost incurred)
2014:
Construction in progress 1,000 1,000
Cash, materials, etc. 1,000 1,000
To record construction costs.
Accounts receivable 1,500 1,500
Billings on construction contract 1,500 1,500
To record progress billings.
Cash 1,050 1,050
Accounts receivable 1,050 1,050
To record cash collection.
Construction in progress (gross profit) 200 No income recognition
Cost of construction (expense) 1,000 until project completion
Revenue from long-term contracts 1,200
To record gross profit.
(revenue = 60% x $3 million less 2013 revenue;
expense = cost incurred)
2015:
Construction in progress 1,050 1,050
Cash, materials, etc. 1,050 1,050
To record construction costs.
Accounts receivable 1,100 1,100
Billings on construction contract 1,100 1,100
To record progress billings.
Cash 1,600 1,600
Accounts receivable 1,600 1,600
To record cash collection.
(note: journal entries continued on next page)
Percentage-of- Completed
2015 (continued):Completion Method Contract Method
Construction in progress (gross profit) 150 450
Cost of construction (expense) 1,050 2,550
Revenue from long-term contracts 1,200 3,000
To record gross profit.
(revenue = $3 million less 2013 and 2014 revenue; (All revenue and
expense = cost incurred) cost recognized)
Billings on construction contract 3,000 3,000
Construction in progress 3,000 3,000
To close accounts once title transfers to the customer.
The balance sheet presentation for the construction-related accounts for 2013 and 2014 by both methods is as follows:
Completed contract method: 2013 2014
Current assets:
Accounts receivable $ 50 $500
Costs ($500) in excess of billings ($400) 100
Current liabilities:
Billings ($1,900) in excess of costs
($1,500) 400
Percentage-of-completion: 2013 2014
Current assets:
Accounts receivable $ 50 $500
Costs and profit ($600) in excess of billings ($400) 200
Current liabilities:
Billings ($1,900) in excess of costs
and profit ($1,800) 100
An estimated loss on a long-term contract is fully recognized in the first period the loss is anticipated regardless of the revenue recognition method used. In addition, under the percentage-of-completion method, a loss is recognized for profitable contracts whenever previously recognized gross profit exceeds the cumulative gross profit to date.
IFRS’ accounting for long-term contracts is similar to U.S. GAAP, except that IFRS requires use of the cost recovery method rather than the completed contract method in circumstances where the percentage-of-completion method would not be appropriate. Under the cost recovery method, contract costs are expensed as incurred, and an offsetting amount of contract revenue is recognized to the extent that it is probable that costs will be recoverable from the customer. No gross profit is recognized until all costs have been recovered, which is why this method is also sometimes called the “zero-profit method.”
The FASB and IASB are working together on a revenue recognition project designed to provide a single overall standard for revenue recognition. That project is discussed further in the Addendum to Chapter 5.
Industry-Specific Revenue Issues
Software Revenue Recognition and Multiple-Element Contracts
It is not unusual for software companies to sell multiple software elements in a bundle for a lump-sum contract price. The bundle often includes product, upgrades, postcontract customer support and other services. The critical accounting question concerns the timing of revenue recognition. Current GAAP indicates that if an arrangement includes multiple elements, the revenue from the arrangement should be allocated to the various elements based on the relative fair values of the individual elements, regardless of any separate prices stated within the contract for each element.
More recently, the FASB’s Emerging Issues Task Force (EITF) issued guidance to broaden the application of this basic perspective to other arrangements that involve “multiple deliverables.” In such arrangements, sellers must separately record revenue for parts of the arrangement in proportion to those parts’ selling priceswhen sold separately. However, if part of an arrangement does not qualify for separate accounting, recognition of the revenue from that part is delayed until revenue associated with the other parts is recognized. For example, if the usability of Product A is contingent on the delivery of Product B, Product A does not qualify for separate revenue recognition. This results in deferring revenue recognition unless parts of an arrangement clearly qualify for separate revenue recognition. IFRS does not provide much guidance concerning revenue recognition with respect to multiple-element contracts.
Franchise Sales
The fees to be paid by the franchisee to the franchisor usually comprise: (1) the initial franchise fee and (2) continuing franchise fees. The services to be performed by the franchisor in exchange for the initial franchise fee include the right to use its name and sell its products. The continuing franchise fees are paid to the franchisor for continuing rights as well as for advertising and promotion and other services provided over the life of the franchise agreement.