Tài chính doanh nghiệp - Chapter 3: Additional topics in income determination

Additional Topics in Income DeterminationRevsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 3Learning objectivesWhen is it appropriate to recognize revenue before or after the point of sale?Revenue recognition details for long-term construction contracts, agricultural commodities, and installment sales.Revenue principles for franchise sales, right of return, and “bundled” software sales.How the flexibility in GAAP for income determination invites managers to manipulate or manage earnings.The various techniques used to manage earnings.SEC guidance on revenue recognition designed to curb earnings managementHow error corrections and prior period restatements are reported.Key differences between IFRS and U.S. GAAP rules for revenue recognition.Proposed changes that IASB and FASB are considering for contract-based revenue recognition.3-*Recall the criteria for revenue recognitionCondition 1: The critical event in the process of earning the revenue has taken place.Condition 2: The amount of revenue that will be collected is reasonably assured and is measurable with a reasonable degree of reliability.Time of sale is used in most industries3-*Figure 2.2Revenue recognition prior to sale:Long-term construction projectsBefore construction begins, a formal contract has been signed.The buyer is assured and the contract price is specified.Consequently, both revenue recognition conditions are satisfied prior to the time of sale.Condition 1: The critical event is actual construction, thus revenue is earned over time as the project progresses toward completion.Condition 2: Measurability is satisfied because there’s a firm contract with a known buyer at a set price. In addition, construction costs can be estimated with reasonable accuracy so that expenses can be matched with revenues.Percentage-of-completion method: revenue is recognized in proportion to the “work done” each period.3-*Example: Solid Construction Corp. Contract price is $1,000,000 and construction costs are estimated to be $800,000.Original estimate was $800,000 How much gross profit must be recognized each year?201420152016TotalGross Profit???$200,0003-*Percentage-of-completion for 2014 (Year 1)Step 1:Percentage of completion ratio30% =$240,000$800,000=Cost incurredEstimated total costsStep 2:Estimated totalcontract profit$200,000 = $1,000,000 - $800,000Step 3:Estimated profitearned to date $60,000 = $200,000 x 30%3-*30%$200,000$60,000Percentage-of-completion for 2015 (Year 2)Step 1:Percentage ofcompletion ratioStep 2:Estimated totalcontract profitStep 3:Estimated profitearned to date$150,000 = $1,000,000 - $850,000$96,000 = $150,000 x 64%Step 4:Incremental profitearned$36,000 = $96,000 - $60,00030%$200,000$60,000$544,000$850,000=64%30%$200,000$60,0003-*Percentage-of-completion for 2016 (Year 3)Step 1:Percentage ofcompletion ratio100%Step 2:Estimated totalcontract profitStep 3:Estimated profitearned to dateStep 4:Incremental profitearned$150,000$150,000$54,00030%$200,000$60,00064%$150,000$96,000$36,0003-*Percentage-of-completion:Balance sheet presentation3-*Completed-contract method:Long-term construction projectsSuppose 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.3-*Revenue recognition on CommoditiesRevenue recognition conditions:Condition 1: The critical event is extraction (mining) or harvesting (agriculture), and occurs before the sale (i.e., formal transfer of title).Condition 2: The precise time at which measurability is satisfied is open to some dispute. Revenue recognition could occur when the sales transaction is completed, or earlier at extraction or harvest (i.e., when the critical event is satisfied).3-*Commodities:Completed-transaction (sales) methodCondition 2 is not satisfied until the eventual selling price is known.3-*Revenue (and related expenses) for the remaining 10,000 bushels is postponed to 2015 when those bushels are sold.Accordingly, only the 100,000 bushels sold on Sept. 30, 2014 are included in 2014 revenue.Because producers face an established market price for the commodity, Condition 2 is satisfied continuously.Accordingly, all 110,000 bushels produced in 2014 are included in 2014 revenue under the production method.Commodities:Market-price (production) methodRecognitionMatchingNet realizable value3-*As a result, the inventory of 10,000 bushels is shown at market value of $35,000. The additional entry required is: DR Crop inventory $15,000 CR Market gain on unsold inventory $15,000The 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 2015, 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 $5,000Commodities:Market-price (production) method (continued)3-*= 10,000 x ($3.50 - $3.00)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)Commodities:Market-price (production) method (continued)$30,0003-*Commodities:Comparison of revenue recognition methodsIn practice, the completed-transaction method is more prevalent.However, the market price method conforms to GAAP when readily determinable prices are continuously available.Dual advantages of the market price 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).3-*Revenue recognition after the sale:Installment sales methodSometimes revenue is not recognized at the point of sale even though a valid sale has taken place.High risk of not receiving cash from the buyer (Conditions 1 and 2 are not met).Or there is no reasonable basis for estimating uncollectible accounts (Condition 2 is not met).Conditions 1 and 2 are both satisfied over time as cash collections take place.So, revenue recognition occurs as cash is collected (i.e., as installment payments are made).3-*Revenue recognition after the sale:Installment sales method exampleThe amount of revenue recognized each period depends on two things:Installment-sales gross-profit percentageAmount of cash collected on installment accounts receivable.3-*Revenue recognition after the sale:Installment sales calculations3-*Revenue recognition after the sale:Installment sales income statement3-*Revenue recognition after the sale:Cost recovery methodGAPP allows this approach when:Collections on installment sales occur over an extended period.There is no reasonable basis for estimating collectibility.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.3-*Specialized transactions:Franchised salesContinuing 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?FranchisorCustomerFranchiseeSellerBuyer1. Initial franchisee fee2. Continuing (periodic) feesExercise right to sell product or service3-*Specialized transactions:Franchise sales exampleGAAP specifies:recognize revenue for the initial franchise fee only when all material services and conditions have been substantially performed by franchisor.But, there is no “bright line” test.3-*Specialized transactions:Sales with right of returnGAAP specifies that 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.The buyer has economic substance and is distinct from seller.Seller does not have significant obligations for future performance to bring about resale.The amount of future returns can be reasonably estimated.SellerCustomerBuyerResaleSell with right of returnCash payment or obligation to pay3-*Specialized transactions:Bundled (Multi-element) salesOracle sells a database software “bundle” for $1 million. The “bundle” includes staff training, “free” software upgrades, and on-going customer support for five years. If sold separately, the fair values would be as shown.3-*Revenue is recognized as calculated for each componentEarnings managementDetermining when revenue has been earned (critical event) and is realized (measurability)—the two revenue recognition conditions—often requires judgment.Managers can sometimes exploit the flexibility in GAAP to manipulate reported earnings in ways that mask the company’s underlying performance.Some managers have even resorted to outright financial fraud (but that’s rare).3-*Earnings management:Avoiding a loss or earnings disappointment3-*Figure 3.1Figure 3.2Popular earnings management devices“Big bath” restructuring charges: Excessive restructuring write-offs that overstate estimated charges for future expenditures.Miscellaneous “cookie jar reserves” for bad debts, loan losses, warranties and other accruals: Reserve too much in good times and cut back on estimated charges, or even reverse previous charges, in bad times. A convenient income smoothing device.Intentional errors deemed to be “immaterial” and intentional bias in estimates.Premature or aggressive revenue recognition.3-*Revenue recognition abusesThe SEC says 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.SEC Staff Accounting Bulletin (SAB) No. 104 illustrates troublesome areas of revenue recognition.3-*Revenue recognition abuses:SAB No. 104 examplesGoods shipped on consignmentNo revenue can be recognized at delivery.Sales with delayed deliverySeller can’t recognize revenue until delivery except certain buy and hold transactions.Goods sold on lay-awayPostpone revenue recognitionuntil merchandise is delivered to customer.3-*Revenue recognition abuses:SAB No. 104 examplesEarned as services are delivered over the full term of service engagement.Gross vs. net basisfor internet resellersRevenue should be recognized on a “net” basis as commission revenue.Non refundable up-front feesRevenue should be recognized over time as the capacity is brought on line and used by customers.Capacityswaps3-*Accounting errorsAccounting 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.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.3-*Accounting restatements:GAO study of irregularities for 1997-2006Figure 3.3Figure 3.43-*Accounting restatements:Share price reaction to announced restatementsFigure 3.53-*Accounting restatement disclosures:An example3-*Global Vantage PointIFRS and U.S. GAAP rules for revenue recognition and measurement largely overlap, although the U.S. GAAP standards are much more detailed.Differences between IFRS and U.S. GAAP are in two areasLong-term construction contractsInstallment sales method of accounting3-*IFRS Revenue Recognition and MeasurementInternational Accounting Standard (IAS) 18 requires that the following five 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 buyerThe seller retains neither continuing management involvement associated with ownership nor effective control of the goods being soldThe amount of revenue can be measured reliablyIt is probable that the entity will obtain economic benefits as a result.The costs incurred can be measured reliably3-*Global Vantage PointLong-Term Construction AccountingIFRS rules for revenue recognition on long-term construction contracts distinguish two types of contracts:Cost-plus contracts – those for which the contractor is reimbursed for allowable costs plus a profit mark-upFixed-price contract – one in which the contractor agrees to a fixed contract price or fixed rate per unit of output3-*Global Vantage PointInstallment Sales MethodIRFS 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.3-*SummaryThe “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.3-*Summary concludedFranchise 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.The IASB and FASB have recently issued an exposure draft on revenue recognition.3-*