Income Measurement and Profitability Analysis

Sid Glandon, DBA, CPAAssistant Professor of Accounting

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

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

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

Revenue Recognition

Completion of productionRevenue recognition after delivery if there is uncertainty of collectibility

Installment salesCost recoveryDeposit methodBuyback agreementsRight of returnConsignment sales

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

Installment Sales ExampleFACT PATTERN: 2001 2002 2003Installment sales 200,000 250,000 240,000Cost of sales 150,000 190,000 168,000Gross profit 50,000 60,000 72,000Gross profit percentage 25% 24% 30%

Cash received: 2001 2002 2003 from 2001 sales 60,000 100,000 40,000 from 2002 sales 0 100,000 125,000 from 2003 sales 0 0 80,000

Installment Sales ExampleRealized Gross Profit: 2001 2002 2003Collections, 2001 sales 60,000 100,000 40,000 Gross profit percentage 25% 25% 25% Gross profit realized 15,000 25,000 10,000

Collections, 2002 sales 100,000 125,000 Gross profit percentage 24% 24% Gross profit realized 24,000 30,000

Collections, 2003 sales 80,000 Gross profit percentage 30% Gross profit realized 24,000

Total recognized 15,000 49,000 64,000

DATE ACCOUNT DEBIT CREDIT2001 Installment receivables 200,000

Inventory 150,000 Deferred gross profit, 2001 50,000To record installment sales for 2001

2001 Cash 60,000 Installment receivables 60,000To record collections on installment sales for 2001

12/31/01 Deferred gross profit, 2001 15,000 Realized gross profit on installment sales 15,000To recognize gross profit from installment collections

Analysis of realized gross profitCollections on installment sales, 2001 60,000Gross profit percentage 25% Realized gross profit on installment collections 15,000

DATE ACCOUNT DEBIT CREDIT2002 Installment receivables 250,000

Inventory 190,000 Deferred gross profit, 2002 60,000To record installment sales for 2002

2002 Cash 200,000 Installment receivables 200,000To record collections on installment sales for 2002

12/31/02 Deferred gross profit, 2001 25,000Deferred gross profit, 2002 24,000 Realized gross profit on installment sales 49,000To recognize gross profit from installment collections

Analysis of realized gross profitCollections on installment sales, 2001 100,000Gross profit percentage 25% Realized gross profit on installment collections 25,000

Analysis of realized gross profitCollections on installment sales, 2002 100,000Gross profit percentage 24% Realized gross profit on installment collections 24,000

DATE ACCOUNT DEBIT CREDIT2003 Installment receivables 250,000

Inventory 190,000 Deferred gross profit, 2003 60,000To record installment sales for 2003

2003 Cash 200,000 Installment receivables 200,000To record collections on installment sales for 2003

12/31/01 Deferred gross profit, 2001 10,000Deferred gross profit, 2002 30,000Deferred gross profit, 2003 24,000 Realized gross profit on installment sales 64,000To recognize gross profit from installment collections

Analysis of realized gross profitCollections on installment sales, 2001 40,000Gross profit percentage 25% Realized gross profit on installment collections 10,000

Analysis of realized gross profitCollections on installment sales, 2002 125,000Gross profit percentage 24% Realized gross profit on installment collections 30,000

Analysis of realized gross profitCollections on installment sales, 2003 80,000Gross profit percentage 30% Realized gross profit on installment collections 24,000

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

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

Revenue Recognition Before Delivery

Long-term construction contractsPercentage of completion• Periodic billing

Completed contract• Only used when percentage method is

inapplicable

Long-Term Construction Contracts Accounting Methods

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

Completed contractUncertaintyShort-term contracts

Percentage of Completion

Permits periodic billingAmount of gross profit recognized

Normally based on percentage of work completed

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 %

Example: Percentage Completion

FACT PATTERN:Contract price: 4,500,000Estimated cost: 4,000,000Start date: July, 2001Finaish date: October, 2003Balance sheet date: December 31

Given: 2001 2002 2003Costs to-date 1,000,000 2,916,000 4,050,000Estimated costs to-complete 3,000,000 1,134,000 0Progress billings during year 900,000 2,400,000 1,200,000Cash collected during year 750,000 1,750,000 2,000,000

Step #1: Percentage CompletePercentage Complete 2001 2002 2003

Costs incurred to-date 1,000,000 2,916,000 4,050,000Costs to complete 3,000,000 1,134,000 0Estimated total costs 4,000,000 4,050,000 4,050,000

Costs incurred to-date 1,000,000 2,916,000 4,050,000Estimated total costs 4,000,000 4,050,000 4,050,000

Percentage complete 25% 72% 100%

Step #2: Current Period RevenueCurrent Period Revenue 2001 2002 2003

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 3,240,000Current period revenue 1,125,000 2,115,000 1,260,000

Step #3: Current Period CostsCurrent Period Costs 2001 2002 2003

Costs incurred to date 1,000,000 2,916,000 4,050,000Costs incurred in prior period 0 1,000,000 2,916,000Current period costs 1,000,000 1,916,000 1,134,000

Step #4: Current Period Gross Profit

Current gross profit 2001 2002 2003Current period revenue 1,125,000 2,115,000 1,260,000Current period costs 1,000,000 1,916,000 1,134,000 Current period gross profit 125,000 199,000 126,000

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

Activity Ratios

Receivables turnover ratioInventory turnover ratioAsset turnover ratio

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 =

Profitability Ratios

Profit margin on salesReturn on assetsReturn on shareholders’ equity

Profitability RatiosNet income

Net sales

Net incomeAverage total assets

Net incomeAverage shareholders' equity

Return on shareholders' equity =

=Profit margin on sales

Return on assets =