1

Income Measurement and Profitability Analysis

Sid Glandon, DBA, CPAAssociate Professor of Accounting

2

Guidelines for Revenue Recognition

Revenue is recognized whenIt is earned, and• When the earning process is substantially

complete

It is realized or realizable• When goods and services are exchanged

for cash or claims to cash

3

Staff Accounting Bulletin No. 101

Persuasive evidence of an arrangement existsDelivery has occurred or services have been renderedThe seller’s price to the buyer is fixed or determinableCollectibility is reasonably assured

4

Four Types of Transactions

Sale of productsRecognized at date of sale (delivery)

Provision of servicesRecognized when performed and billable

Revenue from use of assetsRecognized as time passes or assets used up

Disposal of assetsRecognized at point of sale

5

Revenue RecognitionTransfer of title, date of deliveryCompletion of productionRevenue recognition after delivery if there is uncertainty of collectibility

Installment salesCost recoveryDeposit methodBuyback agreementsRight of returnConsignment sales

6

Installment Sales

Recognizes income in periods of collection instead of point of saleTitle does not pass to buyer until after final paymentBoth sales and cost of sales are deferredSelling and administrative expenses are not deferred

7

Installment Sales ExampleFact Pattern 2004 2005 2006

Installment sales $200,000 $250,000 $240,000Cost of sales 150,000 190,000 168,000Gross profit $50,000 $60,000 $72,000

Gross profit percentage 25% 24% 30%

Cash received: 2004 2005 2006 from 2004 sales $60,000 $100,000 $40,000 from 2005 sales 100,000 125,000 from 2006 sales 80,000 Total cash received (by year) $60,000 $200,000 $245,000

8

Installment Sales ExampleRecognized gross profit: 2004 2005 2006Collections, 2004 $60,000 $100,000 $40,000 Gross profit percentage 25% 25% 25% Gross profit recognized $15,000 $25,000 $10,000

Collections, 2005 $100,000 $125,000 Gross profit percentage 24% 24% Gross profit recognized $24,000 $30,000

Collections, 2006 $80,000 Gross profit percentage 30% Gross profit recognized $24,000

Total profit recognized (by year) $15,000 $49,000 $64,000

9

Date Account Debit Credit2004 Installment receivables $200,000

Inventory $150,000 Deferred gross profit, 2004 50,000

2004 Cash $60,000 Installment sales $60,000

12/31/04 Deferred gross profit, 2004 $15,000 Recognized gross profit from installment sales $15,000

Analysis of realized gross profit:Collections on installment sales, 2004 $60,000Gross profit percentage, 2004 25% Recognized gross profit on installment sales $15,000

To record installment sales fo 2004

To record collections on installment sales for 2004

To recognize gross profit from 2004 installment sales

10

Date Account Debit Credit2005 Installment receivables $250,000

Inventory $190,000 Deferred gross profit, 2005 60,000

2005 Cash $200,000 Installment sales $200,000

12/31/05 Deferred gross profit, 2004 $25,000Deferred gross profit, 2005 $24,000 Recognized gross profit from installment sales $49,000

To record installment sales fo 2005

To record collections on installment sales for 2005

To recognize gross profit from 2004 and 2005 installment sales

11

Analysis of realized gross profit:Collections on installment sales, 2004 $100,000Gross profit percentage, 2004 25% Recognized gross profit on installment sales $25,000

Collections on installment sales, 2005 $100,000Gross profit percentage, 2005 24% Recognized gross profit on installment sales $24,000

12

Date Account Debit Credit2006 Installment receivables $240,000

Inventory $168,000 Deferred gross profit, 2006 72,000

2006 Cash $245,000 Installment sales $245,000

12/31/06 Deferred gross profit, 2004 $10,000Deferred gross profit, 2005 $30,000Deferred gross profit, 2006 $24,000 Recognized gross profit from installment sales $64,000

To record installment sales fo 2006

To record collections on installment sales for 2006

To recognize gross profit from 2004, 2005 and 2006 installment sales

13

Analysis of realized gross profit:Collections on installment sales, 2004 $40,000Gross profit percentage, 2004 25% Recognized gross profit on installment sales $10,000

Collections on installment sales, 2005 $125,000Gross profit percentage, 2005 24% Recognized gross profit on installment sales $30,000

Collections on installment sales, 2006 $80,000Gross profit percentage, 2006 30% Recognized gross profit on installment sales $24,000

14

Cost Recovery MethodSeller recognizes no profit until cash receipts exceed seller’s cost of merchandiseAfter recovering all costs, seller includes additional cash collections in incomeUsed where there is no reasonable basis for estimating collectibility

Franchises and real estate

Income statementReport amount of gross profit recognized and deferred

15

Deposit Method

Seller receives cash before transferSeller has no claim against purchaserInsufficient transfer of risks to buyer to warrant recording a saleDefers sale recognition until sale has occurred

16

Revenue Recognition Before Delivery

Long-term construction contractsPercentage of completion• Periodic billing

Completed contract• Only used when percentage method is

inapplicable

17

Long-Term Construction Contracts Accounting Methods

Percentage of completionTerms of contract must be certain and enforceableCertainty of performance

Completed contractUncertaintyShort-term contracts

18

Percentage of Completion

Permits periodic billingAmount of gross profit recognized

Normally based on percentage of work completed

19

Percentage Completion StepsStep #1: Percentage Complete

Costs incurred to-date $X,XXXEstimated total costs $X,XXX

Step #2: Current Period Revenue Contract price $X,XXX Percentage complete to date X % Revenue recognized to date $X,XXX Revenue recognized in prior periods ($X,XXX) Current period revenue $X,XXX

Step #3: Current Period Costs Costs incurred to date $X,XXX Costs incurred in prior period ($X,XXX) Current period costs $X,XXX

Step #4: Current Period Gross Profit Current period revenue $X,XXX Current period costs ($X,XXX) Current period gross profit $X,XXX

= X %

20

Example: Percentage CompletionFact Pattern:Contract price $4,500,000Estimated cost 4,000,000Start date 7/1/04Finish date 10/31/06Balance sheet date 12/31

Annual Data: 2004 2005 2006Cost-to-date $1,000,000 $2,916,000 $4,050,000Estimated cost-to-complete 3,000,000 1,134,000 0Progress billings during the year 900,000 2,400,000 1,200,000Cash collected during the year 750,000 1,750,000 2,000,000

21

Step #1: Percentage CompletePercentage Complete 2004 2005 2006

Cost incurred to-date $1,000,000 $2,916,000 $4,050,000Cost to complete 3,000,000 1,134,000 0 Estimated total cost $4,000,000 $4,050,000 $4,050,000

Cost incurred to-date $1,000,000 $2,916,000 $4,050,000Estimated total cost $4,000,000 $4,050,000 $4,050,000

Percentage complete 25% 72% 100%

22

Step #2: Current Period RevenueCurrent Period Revenue 2004 2005 2006

Contract price $4,500,000 $4,500,000 $4,500,000Percentage complete to-date 25% 72% 100% Revenue recognized to-date 1,125,000 3,240,000 4,500,000Revenue recognized in prior periods 0 1,125,000 3,240,000 Current period revenue $1,125,000 $2,115,000 $1,260,000

23

Step #3: Current Period CostsCurrent Period Cost 2004 2005 2006

Cost incurred to-date $1,000,000 $2,916,000 $4,050,000Cost incurrent in prior period 0 1,000,000 2,916,000 Current period cost $1,000,000 $1,916,000 $1,134,000

24

Step #4: Current Period Gross ProfitCurrent Period Gross Profit 2004 2005 2006

Current period reveune $1,125,000 $2,115,000 $1,260,000Current period cost 1,000,000 1,916,000 1,134,000 Current period gross profit $125,000 $199,000 $126,000

25

Long-Term Contract Losses

Loss in Current Period on a Profitable Contract

Losses are recognized in current period under the percentage of completion method

Loss on an Unprofitable ContractExpected contract loss is recognized in current period under either method

26

Activity Ratios

Receivables turnover ratioInventory turnover ratioAsset turnover ratio

27

Activity RatiosNet sales

Average accounts receivable (net)

Cost of goods soldAverage inventory

Net salesAverage total assets

Asset turnover ratio =

=Receivables turnover ratio

Inventory turnover ratio =

28

Profitability Ratios

Profit margin on salesReturn on assetsReturn on shareholders’ equity

29

Profitability RatiosNet income

Net sales

Net incomeAverage total assets

Net incomeAverage shareholders' equity

Return on shareholders' equity =

=Profit margin on sales

Return on assets =