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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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realization principle

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
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
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
Significant Uncertainty of Collectibility

When uncertainties about collectibility exist, revenue recognition is delayed.

  • Installment Sales Method
  • Cost Recovery Method
installment sales 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%

installment sales method1

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
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
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
Completion of the Earnings Process over Multiple Reporting Periods

Completed Contract Method

Long-term Contracts

Percentage-of-Completion Method

completed contract 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 method1
Completed Contract Method

Gross profit is not recognized until project is complete.

completed contract method3
Completed Contract Method

Gross profit is not recognized until project is complete.

completed contract method5
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 method6
Completed Contract Method

Entry to transfer title to the customer.

percentage of completion method
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.

percentage of completion method2

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

percentage of completion method4

Classified as an asset

Classified as a liability

Percentage-of-Completion Method

Contra account to CIP

percentage of completion method12
Percentage-of-Completion Method

Entry to transfer title to the customer.

long term contract losses

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
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
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
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.

franchise sales

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
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
Profitability Ratios

Return on Equity Key Components

Profitability

Activity

Financial Leverage

dupont framework
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
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.

interim reporting

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
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