Chapter 5

INCOME MEASUREMENT
AND PROFITABILITY
ANALYSIS

2013 The McGraw-Hill Companies, Inc.

Revenue Recognition

IFRS

Revenue is the gross inflow of economic benefits during

the period arising in the course of the ordinary activities of
an entity when those inflows result in increases in equity,
other than increases relating to contributions from equity
participants
Record
Record revenue
revenue when:
when:
1. Revenue and costs can be measured reliably
2. Probable that economic benefits will flow to seller
3. Seller has transferred the risks and rewards of ownership
and doesnt effectively manage or control the goods
4. The stage of completion can be measured reliably (for
services)
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U.S. GAAP

Realization Principle

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 entitys
ongoing major or central operations.
Record
Record revenue
revenue when:
when:
the earnings process is
complete or virtually
complete.

AND

there is reasonable
certainty as to the
collectibility of the asset
to be received (usually
cash).
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SEC Staff Accounting Bulletin No. 101

and 104
Additional
Additionalcriteria
criteria for
for judging
judgingwhether
whether or
or not
not the
the
realization
realization principle
principle is
issatisfied:
satisfied:
1.
1. Persuasive
Persuasiveevidence
evidence of
of an
anarrangement
arrangement exists.
exists.
2.
2. Delivery
Deliveryhas
hasoccurred
occurred or
or services
serviceshave
havebeen
been
performed.
performed.
3.
3. The
Thesellers
sellersprice
priceto
to the
the buyer
buyer is
isfixed
fixed or
or
determinable.
determinable.
4.
4. Collectibility
Collectibilityis
is reasonably
reasonablyassured.
assured.
In addition to these four criteria, the SABs also pose
a number of revenue recognition questions relating
to each of the criteria.
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Revenue Recognition
Revenue recognition is often tied to delivery
of the product from the seller to the buyer.

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Revenue Recognition at Delivery

Recognize
Recognize Revenue
Revenue
Revenue
Revenue is
is recognized
recognized at
at one
one
specific
specific point
point in
in time
time when
when
all
all the
the revenue
revenue recognition
recognition
criteria
criteria are
are satisfied.
satisfied.

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Is the Seller a Principal or Agent?

Principal

Agent

Has primary responsibility

for delivering product or
service and is vulnerable
to risks associated with
delivery and collection.

Does not have primary

responsibility for
delivering product or
service but acts as a
facilitator that earns a
commission

Recognizes as revenue
the gross (total) amount
received from a customer.

Recognizes as revenue
the net commission it
receives for facilitating the
sale.
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Revenue Recognition after Delivery

Recognizing
Recognizing revenue
revenue when
when goods
goods and
and services
services are
are
delivered
delivered as
as described
described in
in the
the previous
previous section
section assumes
assumes
we
we are
are able
able to
to make
make reliable
reliable estimates
estimates of
of amounts
amounts due
due
from
from customers
customers that
that might
might potentially
potentially be
be uncollectible.
uncollectible.
Under
UnderIFRS,
IFRS,when
whenthere
thereis
issignificant
significant
uncertainty
uncertaintyregarding
regardingcollectibility,
collectibility,revenue
revenue
and
andexpense
expenserecognition
recognitionshould
shouldbe
bedelayed
delayed
until
untilthe
therecognition
recognitioncriteria
criteriacan
canbe
besatisfied.
satisfied.
Under
UnderU.S.
U.S.GAAP,
GAAP,when
whenthere
thereis
isexceptional
exceptional
uncertainty:
uncertainty:
1.
1. Installment
InstallmentSales
SalesMethod
Method
2.
2. Profit
ProfitDeferral
DeferralMethod
Method
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Installment Sales
On November 1, 2013, 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, 2013. The
land cost $560,000 to develop. The companys financial
year ends on December 31.

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Installment Sales

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IFRS Method for Significant Uncertainty

in Collectibility

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Installment Sales Method

Gross Profit
$240,000
$240,000
$800,000
$800,000
=
= 30%
30%

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Installment Sales Method

During 2013, Belmont Corporation collected

$200,000 on its installment sales.

This entry records the realized gross profit by

adjusting the deferred gross profit account.
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Profit Deferral Method

On November 1, 2013, 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, 2013. The
land cost $560,000 to develop. The companys fiscal
year ends on December 31.

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Profit Deferral Method

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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
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Consignment Sales
Sometimes 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.
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Revenue Recognition Prior to Delivery

Long-term
Long-term
Contracts
Contracts

Percentage-ofPercentage-ofCompletion
Completion
Method
Method
Completed
Completed
Contract
Contract Method
Method
(under
(under U.S.
U.S. GAAP)
GAAP)

Cost
Cost Recovery
Recovery
Method
Method
(under
(under IFRS)
IFRS)

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Percentage-of-Completion, Cost Recovery, and

Completed Contract Methods Compared
At the beginning of 2013, the Harding Construction Company received a
contract to build an office building for $5 million. The project is estimated to
take three years to complete. According to the contract, Harding will bill the
buyer in installments over the construction period according to a
prearranged schedule. Information related to the contract is as follows:

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Accounting for the Cost of Construction

and Accounts Receivable
Under the percentage-of-completion, cost recovery, and
completed contract methods, all costs of construction are
recorded in an asset account called
construction in progress.

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Gross Profit RecognitionGeneral

Approach

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Gross Profit RecognitionGeneral

Approach
The same journal entry is recorded to close out the billings
on construction contract and construction in progress
accounts under the percentage-of-completion, cost
recovery, and completed contract methods.

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Timing of Gross Profit Recognition Under

the Percentage-of-Completion Method
Under the percentage-of-completion method, profit
is recognized over the life of the project as the
project is completed.

We determine the amount of gross profit recognized in each

period using the following logic:

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Percentage-of-Completion Method
Allocation of Gross Profit

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Percentage-of-Completion Method
Allocation of Gross Profit
Notice that the gross profit recognized in each period is
added to the construction in progress account.

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Percentage-of-Completion Method
Allocation of Gross Profit
The income statement for each year will report
the appropriate revenue and cost of
construction amounts.

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Timing of Gross Profit Recognition

Under the Completed Contract Method
Under the completed contract method, all revenues
and expenses related to the project are recognized
when the contract is completed.

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Income Recognition
The same total amount of profit or loss is recognized under
the percentage-of-completion, cost recovery, and
completed contract methods, but the timing of recognition
differs.

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Statement of Financial Position

Recognition
The balance in the construction in progress
account differs among the methods because of the
earlier gross profit recognition that occurs under
the percentage-of-completion method.

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Statement of Financial Position

Recognition
Billings on construction contract are subtracted
from construction in progress to determine balance
sheet presentation.

CIP >
Billings

Asset

Billings >
CIP

Liability
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Long-term Contract Losses

Periodic Loss for
Profitable
Projects

Determine periodic
loss and record loss
as a credit to the
construction in
progress account.

Loss Projected
for Entire Project

Estimated loss is
fully recognized in
the first period the
loss is anticipated
and is recorded by a
credit to
construction in
progress account.
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Software and Other Multiple Deliverable

Arrangements
Under IFRS, if a sale includes multiple
elements (software, future upgrades,
post contract customer support, etc.),
the revenue should be allocated to the
various elements based on the fair
values of the individual elements.
Under U.S. GAAP, multiple-deliverable software arrangements
had to have vendor-specific objective evidence (VSOE) of
fair values of the individual elements in order to recognize
revenue. Revenue is deferred until VSOE is available or until
all elements of the arrangement are delivered.
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Software and Other Multiple Deliverable

Arrangements
The FASBs 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.
Sellers 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.
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Franchise Sales
Initial Franchise
Fees

Generally recognized at
a point in time when the
franchisor has
substantially performed
all of the initial services
required by the franchise
agreement.

Continuing
Franchise Fees

Recognized over
time as the services
are performed.

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U. S. GAAP vs. IFRS

The IASB and FASB are working together on a
comprehensive revenue-recognition standard.

Has over 100 revenuerelated standards that

sometimes contradict each
other.

Has two primary standards

that also sometimes
contradict each other and
that dont offer guidance in
some important areas (like
multiple deliverables).

The Boards appear committed to improving

accounting in this area.
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Activity Ratios

Whenever a ratio divides an

income statement balance by a
statement of financial position
balance, the average for the
year is used in the denominator.
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Profitability Ratios

Return on Equity Key

Components
Profitability
Activity
Financial Leverage

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DuPont Framework
The DuPont framework helps identify how profitability,
activity, and financial leverage trade off to determine
return to shareholders:
Return on
equity
Net income
Avg. total
equity

Profit
margin

Net income
Net sales

Asset
turnover
Net sales
Avg. total
assets

Equity
multiplier

Avg. total assets

Avg. total equity

Because profit margin and asset turnover combine to

equal return on assets, the DuPont framework can also be
This is called the DuPont
written
as: because the DuPont
framework
Return on
equity

Net income
Avg. total equity

Return on
Equity
Company
was
amultiplier
pioneer in
assets
X
emphasizing this relationship.
Net income
Avg. total
assets

Avg. total assets

Avg. total equity

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Appendix 5A: 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.
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Interim Reporting
Reporting Revenues
and Expenses

IAS No. 14 requires companies to

apply the same accounting policies
in its interim financial statements as
its annual financial statements

Reporting Unusual
Items

Major events such as discontinued

operations 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.
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Appendix 5A: Interim Reporting

Disclosures
Recognition and reversal of impairment loss and write-downs.
Purchase and disposal of property, plant, and equipment.
Litigation settlements.
Changes in accounting policies, accounting estimates, and
correction of errors.
Related party transactions.
Changes in the classification of financial assets.
Changes in contingent liabilities or contingent assets.
Seasonal revenues, costs, and expenses.
Issuance of debt and equity securities.
Dividends paid.
Changes in corporate structure such as business
combinations, gain or loss of control of investments,
restructurings, and discontinued operations.
Unusual or infrequent items.
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Revenue Recognition: A Chapter

Supplement
Core Revenue Recognition Principle
A 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 Principle
1.Identify a contract with a customer.
2.Identify the performance obligation(s) in the contract.
3.Determine the transaction price.
4.Allocate the transaction price to the performance obligations.
5.Recognize revenue when each performance obligation is
satisfied.
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Step 1: Identify the Contract

Under the proposed standard,
we recognize revenue
associated with contracts that
are legally enforceable.

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Step 2: Identify the Performance

Obligation(s)
Performance obligations are promises to
transfer goods or services to the buyer and are
accounted for separately if they are distinct.
A performance obligation is accounted for separately from
other performance obligations if it is distinct, which is the
case if either:
1.The seller regularly sells the good or service separately, or
2.A buyer could use the good or service on its own or in
combination with goods or services the buyer could obtain
elsewhere

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Step 2: Identify the Performance

Obligation(s)
If a seller integrates goods and services into one asset,
they are viewed as providing an integration service that
qualifies as a single performance obligation.
A bundle of goods or services is viewed as
a single performance obligation if both of the
following are true:
1.The goods or services in the bundle are
highly interrelated and the seller provides a
significant service of integrating them into a
combined item.
2.The bundle is significantly modified or
customized for the customer.
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Step 3: Determine the Transaction Price

Determining the transaction price is simple if the buyer
Variable
Consideration
pays
a fixed
amount immediately or in the near future.
Complications in Determining Transaction Price

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Accounting for Variable Consideration

When it Can be Reasonably Estimated

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Accounting for Variable Consideration

When it Can be Reasonably Estimated

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The Time Value of Money

If the time value of money is significant, a sales transaction is
viewed as including two parts: a delivery component and a
financing component.

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The Time Value of Money

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Step 4: Allocate the Transaction Price to

the Performance Obligations
If an arrangement has
more than one distinct
performance obligation,
the seller allocates the
transaction price to the
separate performance
obligations in proportion
to the standalone selling
price of the goods or
services underlying those
performance obligations.

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Step 4: Allocate the Transaction Price to

the Performance Obligations

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Step 5: Recognize Revenue When Each

Performance Obligation Is Satisfied
In general, a seller recognizes revenue allocated to each performance
obligation when it satisfies the performance obligation.

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Step 5: Recognize Revenue When Each

Performance Obligation Is Satisfied
If a performance obligation is not satisfied over time, it is
satisfied at a single point in time, when the seller transfers
control of goods to the buyer. Often transfer of control is
obvious and coincides with delivery. In other circumstances,
though, transfer of control is not as clear.

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End of Chapter 5

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