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Chapter 5. Income Measurement and Profitablity Analysis. the earnings process is complete or virtually complete. there is reasonable certainty as to the collectibility of the asset to be received (usually cash). AND. Realization Principle. Record revenue when:.
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Chapter 5 Income Measurement and Profitablity Analysis
the earnings process is complete or virtually complete. there is reasonable certainty as to the collectibility of the asset to be received (usually cash). AND Realization Principle Record revenue when:
SEC 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: • Persuasive evidence of an arrangement exists. • Delivery has occurred or services have been performed. • The seller’s price to the buyer is fixed or determinable. • Collectibility is reasonably assured.
Completion of the Earnings Process within a Single Reporting Period 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.
Significant Uncertainty of Collectibility When uncertainties about collectibility exist, revenue recognition is delayed. • Installment Sales Method • Cost Recovery Method
Installment Sales Method On 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%
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. Installment Sales Method
Cost Recovery Method On 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.
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
Completion of the Earnings Process over Multiple Reporting Periods Completed Contract Method Long-term Contracts Percentage-of-Completion Method
Completed 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.
Completed Contract Method Gross profit is not recognized until project is complete.
Classified as an asset Classified as a liability Completed Contract Method
Completed Contract Method Gross profit is not recognized until project is complete.
Completed Contract Method Gross profit is recognized in year 3 since project is complete. Remember that the contract price was $1,400,000.
Completed Contract Method Entry to transfer title to the customer.
Percentage-of-Completion 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 percentage-of-completion method.
Total costs incurred to date Percent complete = Most recent estimate of total project cost Percentage-of-Completion Method Measuring Progress Toward Completion Cost incurred to date Estimate of project’s total cost Gross profit estimate
Classified as an asset Classified as a liability Percentage-of-Completion Method Contra account to CIP
Closing Entry Percentage-of-Completion Method
Percentage-of-Completion Method Entry to transfer title to the customer.
Loss Projected for Entire Project Periodic Loss for Profitable Projects Estimated loss is fully recognized in the first period the loss is anticipated and is recorded by a credit to Construction in Progress account. Determine periodic loss and record loss as a credit to the Construction in Progress account. Long-term Contract Losses
International Accounting Standards and 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.
Software and Other Multiple Deliverable Arrangements Statement of Position 97-2 If a sale includes multiple elements (software, future upgrades, postcontract customer support, etc.), therevenueshould be allocated to the various elements based on therelative fair valueof 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.
Other 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.
Continuing Franchise Fees Initial Franchise Fees Recognized over time as the services are performed. Generally are recognized at a point in time when the earnings process is virtually complete. Franchise Sales Source: SFAS 45
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.
Profitability Ratios Return on Equity Key Components Profitability Activity Financial Leverage
DuPont Framework The DuPont Framework helps identify how profitability, activity, and financial leverage trade off to determine return to shareholders: Because profit margin and asset turnover combine to equal return on assets, the DuPont framework can also be written as: This is called the DuPont framework because the DuPont Company was a pioneer in emphasizng this relationship.
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.
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 Share Quarterly 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. Interim Reporting
Minimum Disclosures Sales, income taxes, and net income Discontinued operations, extraordinary items, and unusual or infrequent items Earnings per share Contingencies Seasonal revenues, costs, and expenses Changes in accounting principles or estimates Significant changes in estimates for income taxes Significant changes in financial position
