Intermetdiate accounting 4e spiceland sepe tomasssi chap005

Income
Measurement
and Profitability
Analysis
5

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.


5-2

Learning Objectives
Discuss the general objective of the timing of
revenue recognition, list the two general
criteria that must be satisfied before revenue
can be recognized, and explain why these
criteria usually are satisfied at a specific point
in time.


5-3

Revenue Recognition
Revenue
Revenue should
should be
be recognized
recognized in
in the
the
period

period or
or periods
periods that
that the
the revenuerevenuegenerating
generating activities
activities of
of the
the company
company are
are
performed.
performed.


5-4

Realization Principle
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).


5-5

SEC Staff Accounting Bulletin No. 101
The
The SEC
SEC issued
issued Staff
Staff Accounting
Accounting Bulletin
Bulletin
No.
No. 101
101 to
to crackdown
crackdown on
on earnings
earnings
management.
management. The
The bulletin
bulletin provides

provides
additional
additional guidance
guidance to
to determine
determine ifif the
the
realization
realization principle
principle is
is satisfied:
satisfied:
1.
1.
2.
2.
3.
3.
4.
4.

Persuasive
Persuasiveevidence
evidenceof
ofan
anarrangement
arrangementexists.
exists.
Delivery
Deliveryhas

hasoccurred
occurredor
or services
serviceshave
have been
been
performed.
performed.
The
Theseller’s
seller’sprice
priceto
tothe
thebuyer
buyerisisfixed
fixedor
or
determinable.
determinable.
Collectibility
Collectibilityisisreasonably
reasonably assured.
assured.


Completion of the Earnings Process Within
a Single Reporting Period

Recognize
Recognize Revenue

Revenue
When
When the
the product
product or
or
service
service has
has been
been
delivered
delivered to
to the
the customer
customer
and
and cash
cash has
has been
been
received
received or
or aa receivable
receivable
has
has been
been generated
generated that
that
has

has reasonable
reasonable
assurance
assurance of
of
collectibility.
collectibility.

5-6


5-7

Learning Objectives
Describe the installment sales and cost
recovery methods of recognizing revenues for
certain installment sales and explain the
unusual conditions under which these methods
might be used.


5-8

Significant Uncertainty of Collectibility

When
When uncertainties
uncertainties about
about
collectibility

collectibility exist,
exist, revenue
revenue
recognition
recognition is
is delayed.
delayed.
1.
1. Installment
Installment Sales
Sales Method
Method
2.
2. Cost
Cost Recovery
Recovery Method
Method


5-9

Installment Sales Method
The installment sales method
recognizes the gross profit by
applying the gross profit
percentage on the sale to the
amount of cash actually collected.


5-10

Installment Sales Method
Clarke, Inc. had the following installment
sales in addition to its regular sales.
Installment sales
Cost of sales
Gross profit
Gross profit percentage

2005
$200,000
155,000
$45,000
22.50%

2006
$250,000
190,000
$60,000
24.00%

$45,000 ÷ $200,000 = 22.50%

2007
$275,000
220,000
$55,000
20.00%

5-11

Installment Sales Method
Clarke, Inc. had the following installment
sales in addition to its regular sales.
2005
$200,000
155,000
$45,000
22.50%

Installment sales
Cost of sales
Gross profit
Gross profit percentage
Cash Collections
Installment sales
Cash Collected:
From 2005 Sales
From 2006 Sales
From 2007 Sales

2005
$ 200,000
(100,000)

2006
$ 250,000
(50,000)
(195,000)

2007
$ 275,000
(50,000)
(25,000)
(200,000)

2006
$250,000
190,000
$60,000
24.00%

2007
$275,000
220,000
$55,000
20.00%

At Dec. 31, 2007,
Clarke, Inc. is still
owed $30,000 from
the 2006 sales and
$75,000 from the
2007 sales.


5-12

Installment Sales Method

General Journal
Description
Debit
Installment sales receivable 2005
Inventory
Deferred gross profit 2005

Credit

200,000
155,000
45,000

Deferred gross profit is the difference
between the selling price and the cost of the
inventory.


5-13

Installment Sales Method
During 2005, Clarke collected $100,000
on its installment sales.
General Journal
Description
Debit
Installment sales receivable 2005

200,000

Inventory

155,000

Deferred gross profit 2005
Cash

45,000
100,000

Installment sales receivable 2005
Deferred gross profit 2005
Realized gross profit

Credit

100,000
22,500
22,500

($100,000 collected x 22.50%)

This entry records the Realized Gross Profit by
adjusting the Deferred Gross Profit account.


5-14

Installment Sales Method

During 2006, Clarke sold $250,000 on installments and
collected $50,000 on its 2005 installment sales and $195,000
on its 2006
installment
General
Journal sales.
Description
Installment sales receivable 2006

Debit
250,000

Inventory

190,000

Deferred gross profit 2006
Cash

Credit

60,000
245,000

Installment sales receivable 2005

50,000

Installment sales receivable 2006

195,000

Deferred gross profit 2005

11,250

Deferred gross profit 2006

46,800

Realized gross profit

58,050


5-15

Installment Sales Method
General Journal
Description
Debit
Installment sales receivable 2007

Credit

275,000

Inventory

220,000

Deferred gross profit 2007

55,000

Cash

275,000

Installment sales receivable 2005

50,000

Installment sales receivable 2006

25,000

Installment sales receivable 2007

200,000

Deferred gross profit 2005

11,250

Deferred gross profit 2006

6,000

Deferred gross profit 2007

40,000

Realized gross profit

57,250

Cash Collection on Installment Sales in 2007

2005
2006
2007

$ 50,000
25,000
200,000
$ 275,000

×
×
×

22.50%
24.00%
20.00%

=
=
=

$

$

11,250
6,000
40,000
57,250


5-16

Installment Sales Method


5-17

Installment Sales Method
Balance Sheet


5-18

Cost Recovery Method
Clarke, Inc. had the following installment
sales in addition to its regular sales. The
company uses the cost recovery method to
account for installment sales.
Installment sales
Cost of sales

Gross profit
Gross profit percentage

2005
$200,000
155,000
$45,000
22.50%

2006
$250,000
190,000
$60,000
24.00%

$45,000 ÷ $200,000 = 22.50%

2007
$275,000
220,000
$55,000
20.00%


5-19

Cost Recovery Method
The following schedule shows the pattern of
cash collections for the three year period.
Year of Sale

2005
2006
2007
COGS

Year of Collection
2005
2006
2007
$100,000

$50,000
195,000

$ 155,000

$ 190,000

$50,000
25,000
200,000
$ 220,000

Under the cost recovery method
profit is not recognized until the
seller has recovered all of the cost of
the goods sold.

5-20

Cost Recovery Method
General Journal
Description
Debit
Installment receivable 2005

200,000

Inventory

155,000

Deferred gross profit 2005
Cash
Installment receivable 2005

Credit

45,000
100,000
100,000

The entries are exactly the same as under the Installment
Method—EXCEPT that there is not an entry to realize gross
profit. Since we have not collected cash in excess of COGS,
no gross profit is recognized in 2005.

5-21

Cost Recovery Method
In 2006, let’s concentrate on the
entries relating to 2005 sales only.
General Journal
Description
Debit
Cash

Credit

50,000

Installment receivable 2005

50,000

Now can we recognize some profit?
2005 Installment Sale
Cost of goods sold

$

155,000

Cash collections - 2005

(100,000)

Cash collections - 2006

(50,000)

Unrecovered cost

5,000

We have not fully recovered the
cost, so no profit is recognized in 2006.


5-22

Cost Recovery Method
Here are the entries we would make in
2007 relating to 2005 sales.
General Journal
Description
Debit
Cash

50,000

Installment receivable 2005
Deferred gross profit
Realized gross profit

Credit
50,000

45,000
45,000

We have fully recovered the $155,000 cost
during 2007, so the entire deferred gross
profit will be recognized.


5-23

Learning Objectives
Discuss the implications for revenue
recognition of allowing customers the right of
return.


5-24

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.

5-25

Learning Objectives
Identify situations that call for the recognition of
revenue over time and distinguish between the
percentage-of-completion and completed
contract methods of recognizing revenue for
long-term contracts.