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Chapter 3: Additional Topics in Income Determination (Source: ACCT303 Textbook). When can revenue be recognized before or after the point of sale? Revenue recognition for long-term construction contracts, agricultural commodities, and installment sales.

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Chapter 3 additional topics in income determination source acct303 textbook
Chapter 3: Additional Topics in Income Determination (Source: ACCT303 Textbook)

  • When can revenue be recognized before or after the point of sale?

  • Revenue recognition for long-term construction contracts, agricultural commodities, and installment sales.

  • Revenue principles for franchise sales, sales with right of return, and “bundled” software sales with multiple deliverables..

3-1


Chapter 3 additional topics in income determination
Chapter 3: Additional Topics in Income Determination

  • How GAAP income determination invites “earnings management”.

  • The various techniques used to manage earnings.

  • The SEC guidance intended to curtail earnings management.

  • Key differences between IFRS and U.S. GAAP rules for revenue recognition.

3-2


The criteria for revenue recognition
The criteria for revenue recognition

Time of sale is used in most industries

Condition 1: The critical event in the process of earning the

revenue has taken place. (Earned)

Condition 2: The amount of revenue that will be collected is

reasonably assured and is measurable with a

reasonable degree of reliability. (Measurability)


Timing of revenue recognition
Timing of Revenue Recognition

  • Time of sale

  • During production

    • Percentage of completion Method

    • Completed contract Method

  • On completion of production ( Prior to the sale)

  • After sale


  • Learning objective
    Learning Objective :

    Time of sale


    1 revenue recognition time of sale

    May 1

    June 1

    July 1

    Buy 3 TV sets ($160 each)

    Sells and delivers 2 sets ($200 each) One customer pays cash

    The other customer pays

    1. Revenue Recognition: Time of sale

    • Time of sale is the dominant practice in most industries.

    • Revenue is recognized at the time of sale (June 1) because that’s when the two critical conditions are met.

    • Example: Howard’s TV and Appliance Store


    Example accounting for howard s tv and appliance store
    Example: Accounting for Howard’s TV and Appliance Store

    • May 1

      Inventory ($160*3) 480

      Cash 480

    • June 1 ( Time of Sale)

      Cash 200

      Account Receivable 200

      Sales 400

    • July 1

      Cash 200

      Account Receivable 200


    Learning objective1
    Learning Objective :

    During the production phase


    Revenue recognition during production
    Revenue Recognition: during production

    Criteria for recognizing revenue during production:

    • A customer must be identified and an exchange price agrees upon (i.e., a contract signed).

    • A significant portion of the agreed services has been performed ,and the expected costs of future services can be reliably estimated.

    • Future payments from customers are expected (i.e., reasonably assured).


    Revenue recognition during production contd
    Revenue Recognition: during production (contd.)

    • In addition:

    • The contract clearly specifies the enforceable rights regarding goods or services by the parties, the consideration to be exchanged, and the manner and terms of settlement.

    • The buyer can be expected to satisfy all obligations.

    • The contractor can be expected to perform under the contract.


    Revenues recognize during production phase case study long term construction projects
    Revenues recognize during production phase Case Study:Long-term Construction Projects

    • Two Methods:

      • 1. Percentage-of-completion method

      • 2. Completed contract method ( Not allowed for IFRS)

      • If all the criteria listed above are met, the Percentage-of-completion method must be applied; otherwise the Completed contract method would be used.


    Method 1 percentage of completion
    Method 1: Percentage-of-completion

    • Percentage-of-completion method: revenue is recognized in proportion to the “work done” each period.

    • What journal entries are needed to record?

      • 1. Gross profit.

      • 2. Inventory costs.

      • 3. Billings.

      • 4. Cash collections.


    Example solid construction corp
    Example: Solid Construction Corp.

    • Contract price is $1,000,000 and construction costs are estimated to be $800,000.

    Actual Experience on the Project as of December 31

    Original estimate was $800,000

    How much gross profit must be recognized each year?


    Percentage of completion for 2011 year 1

    Estimated total

    contract profit

    Step 2:

    $200,000 = $1,000,000 - $800,000

    Estimated profit

    earned to date

    Step 3:

    $60,000 = $200,000 x 30%

    Percentage-of-completion for 2011 (Year 1)

    Actual Experience on the Project as of December 31

    $240,000

    Cost incurred

    Percentage of

    completion ratio

    Step 1:

    30% =

    =

    $800,000

    Estimated total costs


    Percentage of completion for 2012 year 2

    $544,000

    64%

    =

    30%

    $850,000

    $200,000

    $60,000

    Incremental profit

    earned

    Step 4:

    $36,000 = $96,000 - $60,000

    Percentage-of-completion for 2012 (Year 2)

    Actual Experience on the Project as of December 31

    Percentage of

    completion ratio

    Step 1:

    30%

    30%

    Estimated total

    contract profit

    Step 2:

    $150,000 = $1,000,000 - $850,000

    $200,000

    $200,000

    Estimated profit

    earned to date

    Step 3:

    $60,000

    $60,000

    $96,000 = $150,000 x 64%


    Percentage of completion for 2013 year 3
    Percentage-of-completion for 2013 (Year 3)

    Actual Experience on the Project as of December 31

    Percentage of

    completion ratio

    Step 1:

    100%

    30%

    64%

    Estimated total

    contract profit

    Step 2:

    $200,000

    $150,000

    $150,000

    Estimated profit

    earned to date

    $60,000

    Step 3:

    $96,000

    $150,000

    Incremental profit

    earned

    Step 4:

    $54,000

    $36,000


    Percentage of completion balance sheet presentation
    Percentage-of-completion:Balance sheet presentation

    Construction in progress > Billings on construction in progress - record -- Current Assets

    Construction in progress < Billings on construction in progress - record -- Current Liabilities


    Journal entries for 2011 percentage of completion method
    Journal Entries for 2011:Percentage-of-completion method

    • 1. To record costs incurred:

      Inventory: Construction in progress $240,000

      Account payable, cash, etc. 240,000

    • 2. To record net profit:

      Inventory: Construction in progress $60,000

      Income on L-term construction contract $60,000

    • 2. To record customer billings

      Accounts receivable $280,000

      Billings on construction in progress $280,000

    • 4. To record cash received

      Cash $210,000

      Account receivable $210,000


    An alternative to record 2 percentage of completion method
    An Alternative to record 2Percentage-of-completion method

    • 2. To record construction revenue, expense and net profit:

      Construction Expense $240,000

      Inventory: Construction in progress $60,000

      Construction Revenue $300,000



    Method 2 completed contract method long term construction projects
    Method 2: Completed-contract method:Long-term construction projects

    • Suppose it is not possible to determine expected costs with a high degree of reliability.

    • Percentage-of-completion then becomes inappropriate because “matching” fails.

    • Completed-contract method postpones all revenue recognition (and expenses) until the period of project completion.


    Completed contract method journal entries
    Completed-contract Method: Journal entries

    2011

    2012

    2013

    No entry needed for completed contract method

    a. Construction in Progress 150,000 b. Billing on construction in progress 1,000,000

    Income on L-T Cons. Contract 150,000 Construction in progress 1,000,000


    Loss on an unprofitable contract
    Loss on an Unprofitable Contract

    Under both percentage-of-completion and completed-contract methods, the company must recognize in the current period the entire expected contract loss.


    Learning objective2
    Learning Objective :

    On completion of production

    Prior to Sale:

    Revenue recognition on Commodities


    3 revenue recognition on completion of production prior to sale
    3. Revenue Recognition on Completion of Production (Prior to Sale)

    Criteria for recognizing revenue on completion of production or prior to sale:

    The product is immediately saleable at quoted market prices.

    Units are homogeneous.

    No significant uncertainty exists regarding the cost of distributing the product.


    Revenue recognition prior to sale
    Revenue recognition prior to sale:

    • Both revenue recognition conditions need to be met to recognize revenues. Take “commodities” for instance:

      • Condition 1 :The critical event is extraction (mining) or harvesting (agriculture).

      • Condition 2:Open to some dispute.

    • Thus, revenue recognition could occur when the sales transaction is completed, or earlier at extraction or harvest (i.e., when the critical event is satisfied).


    Revenue recognition prior to sale case study commodities
    Revenue recognition prior to sale: Case study: Commodities

    • Two Methods for Commodities revenue recognition:

      • 1.Completed-transaction (sales) method

      • 2. Market-price (production) method

    Critical Event

    A farmer harvests 110,000 bushels of corn on September 30, 2011. On this date, the posted market price per bushel was $3.50. The total cost of growing the crop was $220,000 or $2.00 per bushel. The farmer decides to sell 100,000 bushels for cash on September at the posted price of $3.50 and stores the remaining 10,000 bushels. On January 2, 2012 the market price drops to $3.00. Fearing further price declines, the farmer immediately sells the bushels in storage at a price of $3.00 per bushel.

    Time of Sale


    Commodities 1 completed transaction sales method
    Commodities:1. Completed-transaction (sales) method

    • Condition 2 is not satisfied until the eventual selling price is known.

    • Accordingly, only the 100,000 bushels sold on Sept. 30, 2011 are included in 2011 revenue.

    • Revenue (and related expenses) for the remaining 10,000 bushels is postponed to 2012 when those bushels are sold.


    Commodities 2 market price production method
    Commodities:2. Market-price (production) method

    • Because producers face an established market price for the commodity, Condition 2 is satisfied continuously.

    • Accordingly, all 110,000 bushels produced in 2011 are included in 2011 revenue under the production method.

    • As a result, the inventory of 10,000 bushels is shown at market value of $35,000.

      DR Crop inventory $15,000

      CR Market gain on unsold inventory $15,000

    Recognition

    Matching

    Net realizable value


    Method 2 market price production method
    Method 2 - Market-price (production) method

    • Assumption:

      The farmer is engaging in two activities: corn production and commodity speculation (10,000 bushels held in inventory).

    • Subsequent changes in the market price give rise to speculative gains and losses, called inventory holding gains and losses.

    • At the start of 2012, the market price drops from $3.50 to $3.00. The inventory is “marked-to-market” to reflect the loss:

      DR Inventory (holding) loss on speculation $5,000

      CR Crop inventory $5,000

    = 10,000 x ($3.50 - $3.00)


    Commodities market price production method continued
    Commodities:Market-price (production) method (continued)

    • Fearing a further market price decline, the farmer immediately sells all 10,000 bushels at $3.00:

      DR Cost of goods sold $30,000

      CR Crop inventory $30,000

      DR Cash $30,000

      CR Crop revenue $30,000

      The inventory book value is $30,000 at the time of sale:

      Production cost (10,000 x $2.00) $20,000

      Market gain at harvest (10,000 x $1.50) 15,000

      Inventory holding loss (10,000 x $0.50) ( 5,000)

    $30,000


    Commodities comparison of revenue recognition methods
    Commodities:Comparison of revenue recognition methods


    Commodities comparison of revenue recognition methods1
    Commodities:Comparison of revenue recognition methods

    • In practice, the sales method is more prevalent.

    • However, the production conforms to GAAP when readily determinable prices are continuously available.

    • Two advantages of the production method:

      • Recognizes two income streams—one from farming and another from commodity speculation.

      • Conforms more closely to the income recognition conditions (critical event and measurability).


    Learning objective3
    Learning Objective :

    Revenue Recognition After the Sale


    Revenue recognition after the sale method 1 installment sales method
    Revenue recognition after the sale:Method 1: Installment sales method

    • Sometimes revenue is not recognized at the point of sale even though a valid sale has taken place, because.

      • Cash collection extends to a long period of time,

      • High risk of not receiving cash from the buyer.

      • No reasonable basis for estimating uncollectible accounts.

    • Conditions 1 and 2 are both satisfied over time as cash collections take place and revenue is recognized as cash is collected.


    Revenue recognition after the sale installment sales method example
    Revenue recognition after the sale:Installment sales method example

    • The amount of revenue recognized each period depends on two things:

      • Installment-sales gross-profit percentage

      • Amount of cash collected on installment accounts receivable.

    3-36


    Revenue recognition after the sale installment sales calculations

    $600,000

    30%

    $180,000

    $340,000

    Gross-profit %

    32%

    Income recognized

    $108,800

    Total income recognized

    $288,800

    Revenue recognition after the sale:Installment sales calculations

    Cash collections from 2011 sales

    $300,000

    $300,000

    Gross-profit %

    30%

    30%

    Income recognized

    $90,000

    Cash collections from 2012 sales

    3-37


    Revenue recognition after the sale installment sales income statement
    Revenue recognition after the sale:Installment sales income statement

    3-38


    Revenue recognition after the sale installment sales journal entries
    Revenue recognition afterthe sale: Installment sales journal entries

    2011

    2012

    Note: GAAP requires that the interest component of the periodic cash receipts must be recorded separately.


    Revenue recognition after the sale method 2 cost recovery method
    Revenue recognition after the sale:Method 2: Cost recovery method

    • GAAP allows this approach when:

      • Collections on installment sales occur over an extended period.

      • Highly unlikely the collection will be realized (i.e., with high default rate).

      • There is no reasonable basis for estimating collectability.

    • Under the cost recovery method:

      • No profit is recognized until cash payments from the buyer exceed the seller’s cost of goods sold.

      • After the seller’s cost has been recovered, any excess cash collected is recorded as recognized gross profit.


    Revenue recognition after the sale method 2 cost recovery method skip

    $800,000

    -600,000

    $200,000

    Revenue recognition after the sale:Method 2: Cost recovery method (skip)


    Revenue recognition after the sale method 2 cost recovery method skip1
    Revenue recognition after the sale:Method 2: Cost recovery method (skip)

    $1,200,000

    -600,000

    -200,000

    $400,000

    Note: The cost recovery method is very conservative because profit is recognized only when the cumulativecash collections exceed the total cost of land sold.


    Learning objective4
    Learning Objective :

    Specialized transactions

    1. Franchise sales

    2. Sales with Significant Return

    3. “bundled” software sales with

    multiple deliverables


    Specialized transactions franchised sales
    Specialized transactions:Franchised sales

    Exercise right to sell

    product or service

    • Continuing franchise fees are recorded as revenue in the period they are earned and received.

    • The initial franchise fee is comprised of two elements:

      • Payment for the right to operate a franchise in a given area.

      • Payment for services to be performed later by the franchisor.

    • The issue: How much of the initial franchise fee should be recognized as revenue up front by the franchisor?

    Franchisor

    Franchisee

    Customer

    Seller

    Buyer

    1. Initial franchisee fee

    2. Continuing fees

    3-44


    Specialized transactions franchise sales example
    Specialized transactions:Franchise sales example

    • GAAP specifies:

      • recognize revenue for the initial franchise fee only when all material services and conditions have been substantially performed by franchisor.

    On January 1, 2011, Diet Right sells a dieting/weight loss franchise for an initial fee of $25,000 with $10,000 due at the signing of the franchise agreement and the remainder due in three annual installments (due December 31) of $5,000 each plus interest at 8% on the unpaid balance. The $10,000 up-front payment gives the franchisee the right to use Diet Right’s name and sell prepackaged healthy meals prepared at Diet Right’s corporate headquarters. In return for the initial franchise fee, Diet Right agrees to train employees, set up a recordkeeping system, maintain a Web site with online dietary counseling by a registered dietician, and provide advertising and various promotional materials. In addition to the initial franchise fee, Diet Right will receive 2% of the franchise’s annual sales for allowing the franchisee to purchase prepackaged meals at below market prices.

    3-45


    Franchise sales contd
    Franchise Sales (contd.)

    • 1/1/2011 (when contract is signed)

    • Cash 10,000

    • Note receivable 15,000*

    • Earned franchise Fees 10,000**

    • Unearned franchise fees 15,000

    • *payments for the service to be performed later.

    • ** amount received for right to use Diet Right name and to sell Diet Right’s prepackaged meals.

    • Assuming half of the deferred payment ($7,500)is for employee training and recordkeeping system installation and both tasks have been completed by Diet Right on 3/1/2011, the following entry will be recorded on 3/1/2011:

    • Unearned franchise fees 7,500

    • Earned franchise Fees 7,500


    Franchise sales contd1
    Franchise Sales (contd.)

    • The remaining $7,500 initial franchise fees will be recognized as earned fees when services are performed.

    • Recording Continuing Franchise Fees:

    • Assuming franchisee sales were $100,000 in 2011, the following entry will be recorded for the franchisor:

    • Cash (2% x 100,000) 2,000

    • Earned franchise fees 2,000


    Specialized transactions sales with significant return
    Specialized transactions:Sales with Significant Return

    Sell with significant return

    • SFAS No. 45 says the following six criteria must be met for a seller to record revenue at the time of sale:

      • Seller’s price to buyer is substantially fixed at the date of sale.

      • Buyer has paid seller, or is obligated to pay and the obligation is not contingent on resale.

      • Buyer’s obligation does not change in the event of theft, destruction, or damage of the product.

      • Buyers and sellers are two separate economic entities;

      • Seller does not have significant obligations for future performance to directly bring about resale of the product to the buyer.

      • The amount of future returns can be reasonably estimated.

    Seller

    Buyer

    Customer

    Resale

    Cash payment or obligation to pay


    Specialized transactions sales with significant return contd
    Specialized transactions:Sales with Significant Return (contd.)

    • If all six conditions are met, revenue can be recognized at time of sale.

    • However, the amount of potential returns need to be estimated and recognized at the end of a period.

    • If conditions are not met, revenue cannot be recognized until the return period expired.


    Specialized transactions:Bundled (Multi-element) sales –Software only and it does not require any modification or additional development

    • Oracle sells a database software “bundle” for $1 million. The “bundle” includes:

      • Customer support for five years.

      • Software upgrades

      • Staff training

      • Software

    • Revenue recognition for each element is based on the relative selling price of each element:

    • Cus. Support: $150/1,500=10%

    • Upgrades: $300/1,500=20%

    • Training:$450/1,500=30%

    • Software: $600/1,500=40%

    VSOE of selling price

    Revenue recognized:

    Over 5-year period

    Customer support $150

    Upgrades $300

    As installed

    Training $450

    When completed

    Software $600

    When delivered and installed

    Oracle’s software and services bundle

    3-50


    Bundled multi element sales hardware and software i e iphone of apple inc
    Bundled (Multi-element) sales – Hardware and Software (i.e., iPhone of Apple Inc.)

    • Old guidance (prior to June 2010):

    • If the hardware and software were not sold separately and therefore, did not have VSOE for each separate deliverable, a significant portion of the revenue had to be deferred until all elements had been delivered.

    • Example: In Sep. 27, 2008 balance sheet, Apple reported $4.8 billion of deferred revenue on multiple-element arrangement, mostly from iPhone sales.


    Bundled multi element sales hardware and software i e iphone of apple inc1
    Bundled (Multi-element) sales – Hardware and Software (i.e., iPhone of Apple Inc.)

    • New guidance (effective for arrangements entered into in fiscal years beginning on or after June 15, 2010):

    • Allows companies to estimate the VSOE for the elements in the multiple element arrangement involving software and hardware (ASU2009-13 and ASU2009-14).

    • Therefore, the overall revenue for the multiple-element sales involving both hardware and software can be allocated to each element based on their estimated selling prices.

    • Potential earnings management?


    Learning objective5
    Learning Objective : (i.e., iPhone of Apple Inc.)

    Earnings Mangement


    Earnings management
    Earnings management (i.e., iPhone of Apple Inc.)

    • Earnings management is:

      “earnings reported reflect the desires of management rather than the underlying financial performance of the firm”.

      - Arthur Levitt, the former SEC chairman


    Income statement
    Income Statement (i.e., iPhone of Apple Inc.)

    Limitations

    • Companies omit items that cannot be measured reliably.

    • Income is affected by the accounting methods employed.

    • Income measurement involves judgment.

    LO 1 Understand the uses and limitations of an income statement.


    Why can earnings be managed
    Why Can Earnings be Managed? (i.e., iPhone of Apple Inc.)

    • Determining when revenue has been earned (critical event) and is realized (measurability)—the two revenue recognition conditions—often requires management judgment.

    • Managers can sometimes exploit the flexibility in GAAP to manipulate reported earnings in ways that mask the company’s underlying economic performance.

    • Some managers have achieved earnings management by financial frauds (that’s illegal).


    Earnings management avoiding a loss or earnings disappointment
    Earnings management: (i.e., iPhone of Apple Inc.)Avoiding a loss or earnings disappointment

    Figure 3.1

    Figure 3.2

    3-57


    Popular earnings management devices
    Popular Earnings Management Devices (i.e., iPhone of Apple Inc.)

    • “Big bath” restructuring charges: Excessive restructuring write-offs that overstate estimated charges for future expenditures. - Why are companies tempted to overstate restructuring charges?

    • Creative acquisition accounting: Abuses linked to purchased “in-process R&D” that SFAS No. 2 requires to be expensed at the date of acquisition.


    Popular earnings management devices1
    Popular Earnings Management Devices (i.e., iPhone of Apple Inc.)

    • “Cookie jar reserves” for bad debts, loan losses, warranties and other accruals:

      • Reserve more in good times and cut reverse previous charges, in bad times.

      • A convenient income smoothing device.

    • Intentional errors deemed to be “immaterial” and intentional bias in estimates.


    Popular earnings management devices contd
    Popular Earnings Management Devices (contd.) (i.e., iPhone of Apple Inc.)

    • Income shifting including:

      • Premature or aggressive revenue recognition (i.e., Delphi, General Mills, and Lucent Technology)

      • Delay recognition of expenses (i.e., WorldCom and AOL).


    Premature recognition of revenue
    Premature Recognition of Revenue (i.e., iPhone of Apple Inc.)

    • Delphi(WSJ, 3/7/2005): 1)Prematurely recognized revenue for tech contracts; 2) boosted cash flows and earnings by selling assets and inventory with buy back agreements.

    • General Mills (WSJ 2/18/04): Parking transactions.

    • Lucent Technology (Spiceland, etc. 5th edition): Improperly recognized sales of $1.15 billion in 2000 with false documents..


    Premature recognition of revenue contd
    Premature Recognition of Revenue (contd.) (i.e., iPhone of Apple Inc.)

    • Bristal-Myers Squibb (WSJ 6/6/2005):

      • Sales was inflated by $2.5 billion from 1999-2001.

      • Wholesalers of Bristal-Myers Squibb were offered incentive to buy more products than needed at the end of fiscal quarters (this practice is referred as parking transaction).


    Revenue recognition abuses
    Revenue recognition abuses (i.e., iPhone of Apple Inc.)

    • The SEC Staff Accounting Bulletin 104 indicates revenue is earned (critical event) and realized (measurability) when all of the following are met:

      • Pervasive evidence of an exchange agreement exists.

      • Delivery has occurred or services have been rendered.

      • The seller’s price to the buyer is fixed or determinable.

      • Collectibility is reasonably assured.


    Revenue recognition abuses sab no 104 examples
    Revenue recognition abuses: (i.e., iPhone of Apple Inc.)SAB No. 104 examples

    SEC SAB No.104 illustrates troublesome areas of revenue recognition.:

    1.Goods shipped on consignment:

    No revenue can be recognized at delivery.

    2. Sales with delayed delivery:

    Seller can not recognize revenue

    until delivery.

    3. Goods sold on layaway:

    Postpone revenue recognition

    until merchandise is delivered to customer.


    Revenue recognition abuses sab no 104 examples1
    Revenue recognition abuses: (i.e., iPhone of Apple Inc.)SAB No. 104 examples

    4. Non refundable up-front fees:

    Earned as services are delivered over

    the full term of service engagement.

    5. Gross vs. net basis for internet resellers:Revenue should be recognized on a “ net” basis as commission revenue.

    6. Capacity swaps:

    Revenue should be recognized over time as the capacity is brought on line and used by customers.


    Accounting errors
    Accounting errors (i.e., iPhone of Apple Inc.)

    • Accounting errors and “irregularities” can occur for several reasons:

      • Simple oversight.

      • Unintentional misapplication of GAAP, especially where judgment is required.

      • Intentional attempts to exploit the flexibility in GAAP.

      • Outright financial fraud.


    Accounting errors contd
    Accounting errors (Contd.) (i.e., iPhone of Apple Inc.)

    • Parties charged with discovering accounting errors and irregularities:

      • The company’s internal audit staff and audit committee.

      • External auditors.

      • SEC staff surveillance of filings.

    • Once discovered, accounting errors and irregularities must be corrected and disclosed.

    • Most are corrected through a prior period adjustment.


    Accounting restatements gao study of irregularities for 1997 2002
    Accounting restatements: (i.e., iPhone of Apple Inc.)GAO study of irregularities for 1997-2002

    Reasons for earnings restatements, 1997 - 2002

    Total number of restatement announcements, 1997 - 2002


    Accounting restatements share price reaction to announced restatements
    Accounting restatements: (i.e., iPhone of Apple Inc.)Share price reaction to announced restatements

    When restatements are announced, the abnormal returns drop tremendously.


    Accounting restatement disclosures an example
    Accounting restatement disclosures: (i.e., iPhone of Apple Inc.)An example


    Global vantage point
    Global Vantage Point (i.e., iPhone of Apple Inc.)

    • IFRS and U.S. GAAP rules for revenue recognition and measurement largely overlap, although the U.S. GAAP standards are much more detailed.


    Ifrs revenue recognition and measurement
    IFRS Revenue Recognition and Measurement (i.e., iPhone of Apple Inc.)

    • International Accounting Standard (IAS) 18 requires that the following two conditions be met before an entity can recognize revenue on the sale of goods:

      • The seller has transferred significant risks and rewards of ownership of the goods to the buyer

      • The seller retains neither continuing management involvement associated with ownership nor effective control of the goods being sold


    Global vantage point1
    Global Vantage Point (i.e., iPhone of Apple Inc.)

    • Differences between IFRS and U.S. GAAP are in two areas

      • Long-term construction contracts

      • Installment sales method of accounting


    Global vantage point long term construction accounting
    Global Vantage Point (i.e., iPhone of Apple Inc.)Long-Term Construction Accounting

    • IFRS rules distinguish two types of contracts:

      • Cost-plus contract – the contractor is reimbursed for allowable costs plus a profit mark-up

      • Fixed-price contract – one in which the contractor agrees to a fixed contract price

      • Applicable treatments:

        - Percentage of completion – if outcome can be

        reliably estimated, or

        - Cost recovery method – if outcome cannot be

        reliably estimated (i.e., the cost occurred will be recognized as expense and the same amount of revenue will also be recognized in the construction period.)

        Note: The completed contract method is not allowed by IFRS.


    Global vantage point installment sales method
    Global Vantage Point (i.e., iPhone of Apple Inc.)Installment Sales Method

    • IRFS rules do not permit entities to use the installment sales method, the cost recovery method is required.

    • As installment receivables are collected, cost recovery takes place equal to the amount of cash collected that period.

    • Revenues and expenses would be recognized equal to the amount of cash collected each period up to the point where costs have been fully recovered.

    • Only after the cumulative amount of cash collected exceeds the cost of the installment sale will the entity recognize any profits.


    Summary
    Summary (i.e., iPhone of Apple Inc.)

    • The “critical event” and “measurability” conditions for revenue recognition are typically satisfied at the point of sale.

    • There are circumstances—long-term construction contracts, production of natural resources and agricultural commodities—where it is appropriate to recognize revenue prior to the sale.

    • There are also circumstances where revenue recognition may be delayed until after the sale—installment sales and cost recovery methods:

      • There is considerable uncertainty about collectibility.

      • There are significant costs that will be incurred after the sale that are difficult to predict.


    Summary concluded
    Summary concluded (i.e., iPhone of Apple Inc.)

    • Franchise sales, sales with right of return, and bundled (multi-element) sales pose challenging revenue recognition issues.

    • Management can sometimes exploit the flexibility in GAAP revenue recognition rules to hide or misrepresent economic performance.

    • Once discovered, accounting errors and irregularities must be corrected and disclosed. Most are corrected through a prior period adjustment.

    • IFRS and U.S. GAAP rules for revenue recognition largely overlap but important differences exist for long-term construction contracts and installment sales.

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