chapter 3: additional topics in income determination (source: acct303 textbook) 1. when can revenue...

Chapter 3: Additional Topics in Income Determination (Source: ACCT303 Textbook)1. When can revenue be recognized before or

after the point of sale?

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

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

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Chapter 3: Additional Topics in Income Determination

4. How GAAP income determination invites “earnings management”.

5. The various techniques used to manage earnings.

6. The SEC guidance intended to curtail earnings management.

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

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The criteria for revenue recognition

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)

Time of sale is used in most industries

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Timing of Revenue Recognition1. Time of sale

2. During productiona) Percentage of completion Method

b) Completed contract Method

3. On completion of production ( Prior to the sale)

4. After sale

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Learning Objective :

Time of sale

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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 StoreMay 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

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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

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During the production phase

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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).

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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.

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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.

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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.

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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?

2011 2012 2013Costs incurred to date $240,000 $544,000 $850,000

Estimated future costs 560,000 306,000 0

Billings to date 280,000 650,000 1,000,000

Cash collections to date 210,000 600,000 1,000,000

Actual Experience on the Project as of December 31

2011 2012 2013 Total

Gross Profit ? ? ? $150,000

Percentage-of-completion for 2011 (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%

2011 2012 2013

Costs incurred to date $240,000 $544,000 $850,000


Billings to date 280,000 650,000 1,000,000



30%

$200,000

$60,000


Step 1: Percentage ofcompletion ratio



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

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

Step 4: Incremental profitearned

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

30%

$200,000

$60,000

$544,000

$850,000=64%30%

$200,000

$60,000

2011 2012 2013



Billings to date 280,000 650,000 1,000,000




Step 1: Percentage ofcompletion ratio

100%



Step 4: Incremental profitearned

$150,000

$150,000

$54,000

30%

$200,000

$60,000

64%

$150,000

$96,000

$36,000

2011 2012 2013



Billings to date 280,000 650,000 1,000,000



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

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

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An Alternative to record 2 Percentage-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

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Percentage-of-completion: Journal entries2011 2012 2013

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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

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

No entry needed for completed contract method

2011 2012 2013

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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.

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On completion of production

Prior to Sale:

Revenue recognition on Commodities

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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.

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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).

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Revenue recognition prior to sale: Case study: Commodities

Critical Event

Time of

Sale

Two Methods for Commodities revenue recognition:1. Completed-transaction (sales) method2. Market-price (production) method

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.

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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.

2011 Income Statement

Revenues (sale of 100,000 bushels at a market price of $3.50 per bushel)

$350,000

Expenses (costs of $2.00 per bushel for 100,000 bushels sold) (200,000)

Income from sale $150,000

2012 Income Statement

Revenues (sale of 10,000 bushels at a market price of $3.00 per bushel)

$30,000

Expenses (costs of $2.00 per bushel for 10,000 bushels sold) (20,000)

Income from sale $10,000

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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

Commodities:2. Market-price (production) method

Net realizable value

Recognition

Matching

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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

Method 2 - Market-price (production) method

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

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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

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Commodities:Comparison of revenue recognition methods

Completed-Transaction (Sales) Method

Market Price (Production) Method

Income from sales $150,000 2011 Income from farming activities

$165,000

Income from sales 10,000 2012 Holding loss on speculation

(5,000)

Total Income $160,000 Total Income $160,000

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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).

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Revenue Recognition After the Sale

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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.

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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.

2011 2012

Installment sales $1,200,000 $1,300,000

Cost of installment goods sold 840,000 884,000

Gross profit $360,000 $416,000

Gross-profit percentage 30% 32%

Cash collections

On 2011 installment sales $300,000 $600,000

On 2012 installment sales $340,000

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Revenue recognition after the sale:Installment sales calculations

Cash collections from 2011 sales Gross-profit %

Income recognized

$300,000 30%

$90,000

Cash collections from 2012 sales

$300,000 30%

Gross-profit %

Income recognized

Total income recognized

$600,000 30%

$180,000

$340,000 32%

$108,800

$288,800

2011 2012



Gross profit $360,000 $416,000

Gross-profit percentage 30% 32%

Cash collections

On 2011 installment sales $300,000 $600,000

On 2012 installment sales $340,000

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Revenue recognition after the sale:Installment sales income statement2011 2012



Gross profit 360,000 416,000

Less: Deferred gross profit on installment sales of current year

(270,000) (307,200)

Gross profit recognized on current year’s sales

90,000 108,800

Plus: Gross profit recognized on installment sales of prior years

0 180,000

Total gross profit recognized this year $90,000 $288,800

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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.

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2011 2012

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.

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Method 2: Cost recovery method (skip)

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

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Method 2: Cost recovery method (skip)

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

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Specialized transactions

1. Franchise sales

2. Sales with Significant Return

3. “bundled” software sales with

multiple deliverables

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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 fees

Exercise right to sell product or service

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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.

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Franchise Sales (contd.)1/1/2011 (when contract is signed)Cash 10,000Note 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

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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

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 CustomerBuyer

Resale

Sell with significant return

Cash payment or obligation to pay

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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.

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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%

Customer support $150

Upgrades $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

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VSOE of selling price

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.

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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?

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Earnings Mangement

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Earnings management 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

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Companies omit items that cannot be measured reliably.

Income Statement

Limitations

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

Income measurement involves judgment.

Income is affected by the accounting methods employed.

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Why Can Earnings be Managed? 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).

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Earnings management:Avoiding a loss or earnings disappointment

Figure 3.2

Figure 3.1

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Popular Earnings Management Devices “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.

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Popular Earnings Management Devices “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.

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Popular Earnings Management Devices (contd.) 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).

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Premature Recognition of Revenue

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..

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Premature Recognition of Revenue (contd.)

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 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.

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Revenue recognition abuses:SAB No. 104 examplesSEC 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.

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Revenue recognition abuses:SAB No. 104 examples4. 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.

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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.

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Accounting errors (Contd.)

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.

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Accounting restatements:GAO study of irregularities for 1997-2002

Total number of restatement announcements, 1997 - 2002

Reasons for earnings restatements, 1997 - 2002

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Accounting restatements:Share price reaction to announced restatements

When restatements are announced, the abnormal returns drop tremendously.69

Accounting restatement disclosures:An example

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Global Vantage Point

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 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

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Global Vantage Point

Differences between IFRS and U.S. GAAP are in two areas Long-term construction contracts Installment sales method of accounting

Global Vantage PointLong-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. 74

Global Vantage PointInstallment 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. 75

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.76

Summary concluded 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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chapter 3: additional topics in income determination (source: acct303 textbook) 1. when can revenue...

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time of sale time of

revenue recognition

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revenue principles

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