additional topics in income determination revsine/collins/johnson: chapter 3

Additional Topics in Income

Determination

Revsine/Collins/Johnson: Chapter 3

2RCJ: Chapter 3 © 2005

Learning objectives

1. When is it appropriate to recognize revenue before or after the point of sale?

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

3. Revenue principles for franchise sales, right of return, and “bundled” software sales.

4. How GAAP income determination invites “earnings management”, the various techniques used, and recent SEC guidance intended to thwart such activities.

5. How error corrections and prior period restatements are reported.


Recall the criteria for revenue recognition

Condition 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 industries


Revenue recognition prior to sale:Long-term construction projects

Before 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.


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

Example: Solid Construction Corp.

2005 2006 2007Gross profit ? ? ?

Total

$150,000

Original estimate was $800,000

How much gross profit must be recognized each year?


Percentage-of-completion for 2005 (Year 1)

Step 1: Percentage of completion ratio

30% =$240,000

$800,000=

Cost incurred

Estimated total costs

Step 2: Estimated totalcontract profit

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

Step 3: Estimated profitearned to date

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


30%

$200,000

$60,000


Step1: Percentage ofcompletion ratio

Step2: Estimated totalcontract profit

Step3: Estimated profitearned to date

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

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

Step4: Incremental profitearned

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

30%

$200,000

$60,000

$544,000

$850,000=64%30%

$200,000

$60,000



Step1: Percentage ofcompletion ratio

100%

Step2: Estimated totalcontract profit

Step3: Estimated profitearned to date

Step4: Incremental profitearned

$150,000

$150,000

$54,000

30%

$200,000

$60,000

64%

$150,000

$96,000

$36,000


Percentage-of-completion:Journal entries


Percentage-of-completion:Alternative journal entries


Percentage-of-completion:Balance sheet presentation


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 concluded

Entry for recognizing income in 2007 at project completion

DR Billings on construction in progress $1,000,000

CR Construction in progress $850,000

CR Income on long-term construction contract 150,000


Revenue recognition prior to sale:Commodities

Revenue 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).

Time of

Sale

Critical Event


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

Accordingly, only the 100,000 bushels sold on Sept. 30, 2005 are included in 2005 revenue.

Revenue (and related expenses) for the remaining 10,000 bushels is postponed to 2006 when those bushels are sold.

Commodities:Completed-transaction (sales) method

Recognition

Matching


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

Accordingly, all 110,000 bushels produced in 2005 are included in 2005 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

Commodities:Market-price (production) method

Net realizable value

RecognitionMatching


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 2006, 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

Commodities:Market-price (production) method continued

= 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

$30,000


Commodities:Comparison of revenue recognition methods

In 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).


Revenue recognition after the sale:Installment sales method

Sometimes 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).


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.


Revenue recognition after the sale:Installment sales calculations

Installment Sales Income:Cash collections from 2005 sales Gross-profit %

Income recognized

$300,000 30%

$90,000

Cash collections from 2006 sales

$300,000 30%

$90,000

Gross-profit %

Income recognized

Total income recognized

$600,000 30%

$180,000

$340,000 32%

$108,800

$288,800


Revenue recognition after the sale:Installment sales income statement

$340,000 x 32%

$600,000 x 30%

$300,000 x 30%

D


Revenue recognition after the sale:Installment sales journal entries

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


Revenue recognition after the sale:Cost recovery method

GAPP 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.


Revenue recognition after the sale:Cost recovery example

$800,000-600,000$200,000


Revenue recognition after the sale:Cost recovery example

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

$1,200,000 -600,000 -200,000 $400,000


Specialized transactions:Franchised sales

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 CustomerFranchisee

Seller Buyer

1. Initial franchisee fee2. Continuing (periodic) fees

Exercise right to sell product or service


Specialized transactions:Franchise sales example

SFAS No. 45 says: 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.


Specialized transactions:Recording initial franchise fees

3/1/20051/1/2005 12/31/2005

Sell franchise for $25,000

($10,000 cash)

Franchisor provides trainings, etc

Received installment payment plus 8% interests

January 1, 2005

DR Cash $10,000 DR Note receivable $15,000 CR Earned franchise fee revenue $10,000 CR Unearned franchise fees $15,000

Use of name and right to sell

March 1, 2005

DR Unearned franchise fees $7,500 CR Earned franchise fees $7,500

Training


Specialized transactions:Recording initial franchise fees (continued)

December 31, 2005 DR Unearned franchise fees $2,500 CR Earned franchise fees $2,500 DR Cash $5,000 CR Notes receivable $5,000

DR Cash $1,200 CR Interest revenue $1,200

$15,000 x 8%

3/1/20051/1/2005 12/31/2005

Sell franchise for $25,000

($10,000 cash)

Franchisor provides trainings, etc

Received installment payment plus 8% interests


Specialized transactions:Recording continuing franchise fees

Suppose franchise sales were $100,000 in 2005, and recall that the continuing fee is 2% of sales. The entry for the continuing fee is:

Costs incurred by the franchisor for initial and continuing services are expensed in the same period the franchise revenue is recognized (matching principle).

DR Cash $2,000 CR Earned franchise fee revenue $2,000


Specialized transactions:Sales with right of 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. 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.

Seller CustomerBuyer

Resale

Sell with right of return

Cash payment or obligation to pay


Specialized transactions:Bundled sales

Oracle sells a database software “bundle” for $1.5 million. The “bundle” includes:

Staff training “Free” software upgrades On-going customer support for

five years.

How much revenue should Oracle record up front?

SOP 97-2 provides guidance.

Customer support $150

Upgrade $300

Training $450

Software $600

Revenue recognized:

Over 5-year period

As installed

When completed

When delivered and installed

Oracle’s software and services bundle


Specialized transactions:What Oracle says about bundled sales


Earnings management

Determining 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).


Earnings management:Avoiding a loss or earnings disappointment


Popular earnings management devices

“Big bath” restructuring charges: Excessive restructuring write-offs that overstate estimated charges for future expenditures.

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

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 (details to follow).


Revenue recognition abuses

The 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.


Revenue recognition abuses:SAB No. 104 examples

Goods shipped on consignment

Sales with delayed delivery

Goods sold on lay-away

No revenue can be recognized at delivery.

Seller can’t recognize revenue until delivery… except certain buy and hold transactions.

Postpone revenue recognitionuntil merchandise is delivered to customer.


Revenue recognition abuses:SAB No. 104 examples

Gross vs. net basisfor internet resellers

Earned as services are delivered over the full term of service engagement.

Revenue should be recognized on a “net” basis as commission revenue.

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

Non refundable up-front fees

Capacityswaps


Accounting errors

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.

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

Total number of restatement announcements, 1997 - 2002

Reasons for earnings restatements, 1997 - 2002


Accounting restatements:Share price reaction to announced restatements


Accounting restatement disclosures:An example


Accounting restatement disclosures:Footnote details


Summary

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

Franchise sales, sales with right of return, and bundled 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.

additional topics in income determination revsine/collins/johnson: chapter 3

Documents

completion method

revenue principles

revenue recognitioncondition

construction costs

contract method

revenue recognition

revenue recognition

contract price