Chapter 5: Income Measurement and Profitability Analysis
The focus of this chapter is revenue recognition. We first discuss the general circumstance in which revenue is recognized when a good or service is delivered. Then we discuss circumstances in which revenue should be deferred until after delivery or should be recognized prior to delivery. The chapter also includes an appendix describing requirements for interim financial reporting and a Where We’re Headed Supplement explaining in detail a proposed Accounting Standards Update (hereafter, “proposed ASU”) that the FASB and IASB plan to issue in 2012 that substantially changes how we account for revenue recognition.
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Income Measurement and Profitability AnalysisChapter 5Realization PrincipleRecord revenue when: ANDthere is reasonable certainty as to the collectibility of the asset to be received (usually cash).the earnings process is complete or virtually complete.Revenues are inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.SEC Staff Accounting Bulletin No. 101 and 104Additional 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. In addition to these four criteria, the SABs also pose a number of revenue recognition questions relating to each of the criteria.Realization PrincipleRevenue recognition is often tied to delivery of the product from the seller to the buyer. Revenue Recognition at DeliveryWhen 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.Recognize RevenueIs the Seller a Principal or Agent?PrincipalHas primary responsibility for delivering product or service and is vulnerable to risks associated with delivery and collection.AgentDoes not have primary responsibility for delivering product or service but acts as a facilitator that earns a commissionRecognizes as revenue the gross (total) amount received from a customer.Recognizes as revenue the net commission it receives for facilitating the sale.Revenue Recognition after DeliveryInstallment Sales MethodCost Recovery MethodRecognizing revenue at delivery of the product or service assumes we are able to make reasonable estimates of amounts due from customers that potentially might be uncollectible and amounts not collectible due to customers returning the products they purchased. Right of ReturnIn most situations, even though the right to return merchandise exists, revenues and expenses can be appropriately recognized at point of delivery.Estimate the returnsReduce both sales and cost of goods soldConsignment SalesSometimes a company arranges for another company to sell its product under consignment. Because the consignor retains the risks and rewards of ownership of the product and title does not pass to the consignee, the consignor does not record a sale until the consignee sells the goods and title passes to the eventual customer.Revenue Recognition Prior to DeliveryCompleted Contract MethodPercentage-of-Completion MethodLong-term ContractsLong-term Contract LossesPeriodic Loss for Profitable ProjectsDetermine periodic loss and record loss as a credit to the construction in progress account.Software and Other Multiple Deliverable ArrangementsIf a sale includes multiple elements (software, future upgrades, post contract customer support, etc.), the revenue should be allocated to the various elements based on ‘vendor-specific objective evidence’ (VSOE) of fair values of the individual elements. Software and Other Multiple Deliverable ArrangementsSellers offering other multiple-deliverable contracts now are allowed to estimate selling prices when they lack VSOE from stand-alone sales prices. Using estimated selling prices allows earlier revenue recognition than would be allowed if sellers had to have VSOE in order to recognize revenue. The FASB’s Emerging Issues Task Force (EITF) issued guidance to broaden the application of this basic perspective to other arrangements that involve “multiple deliverables,” such as sales of appliances with maintenance contracts, cellular phone contracts that come with a “free phone,” and even painting services that include sales of paint as well as labor. Franchise SalesInitial Franchise FeesGenerally are recognized at a point in time when the earnings process is virtually complete.Activity RatiosWhenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator.Profitability RatiosReturn on Equity Key ComponentsProfitabilityActivityFinancial LeverageThis is called the DuPont framework because the DuPont Company was a pioneer in emphasizing this relationship.DuPont FrameworkReturn on equity=Profit marginXAsset turnoverXEquity multiplierNet incomeAvg. total equity=Net incomeTotal salesXTotal salesAvg. total assetsXAvg. total assetsAvg. total equityThe DuPont framework helps identify how profitability, activity, and financial leverage trade off to determine return to shareholders:Return on equity=Return on assetsXEquity multiplierNet incomeAvg. total equity=Net incomeAvg. total assetsXAvg. total assetsAvg. total equityAppendix 5: Interim ReportingIssued 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 ReportingReporting Revenues and ExpensesWith only a few exceptions, the same accounting principles applicable to annual reporting are used for interim reporting. Reporting Unusual ItemsDiscontinued operations and extraordinary items are reported entirely within the interim period in which they occur. Earnings Per ShareQuarterly EPS calculations follow the same procedures as annual calculations. Reporting Accounting ChangesAccounting changes made in an interim period are reported by retrospectively applying the changes to prior financial statements. Appendix 5: Interim ReportingMinimum DisclosuresSales, income taxes, and net incomeEarnings per shareSeasonal revenues, costs, and expensesSignificant changes in estimates for income taxesDiscontinued operations, extraordinary items, and unusual or infrequent itemsContingenciesChanges in accounting principles or estimatesInformation about fair value of financial instruments and the methods and assumptions used to estimate fair values Significant changes in financial positionRevenue Recognition: A Chapter SupplementCore Revenue Recognition PrincipleA company must recognize revenue when goods or services are transferred to customers in an amount that reflects the consideration the company expects to receive in exchange for those goods or services. Key Steps in Applying the PrincipleIdentify a contract with a customer.Identify the performance obligation(s) in the contract.Determine the transaction price.Allocate the transaction price to the performance obligations.Recognize revenue when each performance obligation is satisfied. End of Chapter 5