Additional Topics in Income Determination

Revsine/Collins/Johnson/Mittelstaedt: Chapter 3

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, All

Learning objectives1. 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.

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Recall the criteria for revenue recognition

Time of sale is used in most industries

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.RCJM: Chapter 3 2009 3-3

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 theres 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.RCJM: Chapter 3 2009 3-4

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?

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Percentage-of-completion for 2008 (Year 1)

Step 1:

Percentage of completion ratio Estimated total contract profit Estimated profit earned to date

30%

=

$240,000 $800,000

=

Cost incurred Estimated total costs

Step 2:

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

Step 3:

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

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Percentage-of-completion for 2009 (Year 2)

Step1: Percentage of completion ratio Step2: Estimated total contract profit Step3: Estimated profit earned to date Step4: Incremental profit earned

30%

64%

=

$544,000 $850,000

$200,000 $60,000 $60,000

$150,000 = $1,000,000 - $850,000 $96,000 = $150,000 x 64% $36,000 = $96,000 - $60,000

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Percentage-of-completion for 2010 (Year 3)

Step1: Percentage of completion ratio Step2: Estimated total contract profit Step3: Estimated profit earned to date Step4: Incremental profit earned

30% $200,000 $60,000

64% $150,000 $96,000 $36,000

100% $150,000 $150,000 $54,000

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Percentage-of-completion:Balance sheet presentation

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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.

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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).

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Commodities:

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, 2008 are included in 2008 revenue.

Revenue (and related expenses) for the remaining 10,000 bushels is postponed to 2009 when those bushels are sold.

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Commodities:

Market-price (production) method Because producers face an established market price for the commodity, Condition 2 is satisfied continuously. Accordingly, all 110,000 bushels produced in 2008 are included in 2008 revenue under the production method.Recognition Matching

Net realizable value

As a result, the inventory of 10,000 bushels is shown at market value of $35,000.DR Crop inventory CR Market gain on unsold inventory $15,000 $15,000

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Commodities:

Market-price (production) method continued 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 2009, 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 CR Crop inventory $5,000 $5,000= 10,000 x ($3.50 - $3.00)

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Commodities:

Market-price (production) method continued Fearing a further market price decline, the farmer immediately sells all 10,000 bushels at $3.00:DR Cost of goods sold CR Crop inventory DR Cash CR Crop revenue $30,000 $30,000 $30,000 $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) $30,000

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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 streamsone 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: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).

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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.

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Revenue recognition after the sale:Installment sales calculations

Installment Sales Income: Cash collections from 2008 sales Gross-profit % Income recognized Cash collections from 2009 sales Gross-profit % Income recognized Total income recognizedRCJM: Chapter 3 2009

$300,000 30% $90,000

$600,000 30% $180,000 $340,000 32% $108,800 $288,8003-19

Revenue recognition after the sale:Installment sales income statement

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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 sellers cost of goods sold. After the sellers cost has been recovered, any excess cash collected is recorded as recognized gross profit.

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Specialized transactions:Franchised salesExercise right to sell product or service

FranchisorSeller

FranchiseeBuyer

Customer

1. Initial franchisee fee 2. Continuing (periodic) fees

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?

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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.

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Specialized transactions:Sales with right of returnSell with right of return

SellerCash payment or obligation to pay

BuyerResale

Customer

SFAS No. 45 says the following six criteria must be met for a seller to record revenue at the time of sale:

Sellers 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. Buyers 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. 2009 3-24

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Specialized transactions:Bundled sales Oracle sells a database software bundle for $1.5 million. The bundle includes:

Revenue recognized:Customer support $150 Upgrade $300

Staff training Free software upgrades On-going customer support for five years.

Over 5-year period

As installed

Training $450

When completed

How much revenue should Oracle record up front?

Software $600

When delivered and installed

SOP 97-2 provides guidance. Oracles software and services bundle

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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 companys underlying performance. Some managers have even resorted to outright financial fraud (but thats rare).

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Earnings management:Avoiding a loss or earnings disappointment

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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).RCJM: Chapter 3 2009 3-28

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 sellers 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.

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Revenue recognition abuses:SAB No. 104 examples

Goods shipped on consignment

No revenue can be recognized at delivery. Seller cant recognize revenue until delivery except certain buy and hold transactions. Postpone revenue recognition until merchandise is delivered to customer.

Sales with delayed delivery

Goods sold on lay-away

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Revenue recognition abuses:SAB No. 104 examples

Non refundable up-front fees

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.

Gross vs. net basis for internet resellers

Capacity swaps

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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.

Parties charged with discovering accounting errors and irregularities:

The companys 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

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Accounting restatement disclosures:An example

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Summary The critical event and measurability conditions for revenue recognition are typically satisfied at the point of sale. There are circumstanceslong-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 saleinstallment 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.

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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.

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