Ch05 Income.Measurement and Profitability.Analysis

5-1 Chapter Income Measurement and Profitability Analysis 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 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 2 3 4 Persuasive Persuasiveevidence evidenceof of an an arrangement arrangementexists exists Delivery Deliveryhas has occurred occurredor or services serviceshave have been been performed performed The Theseller’s seller’sprice priceto tothe thebuyer buyer isisfixed fixedor or determinable determinable Collectibility Collectibilityisisreasonably reasonablyassured assured 5-4 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 5-5 Significant Uncertainty of Collectibility When When uncertainties uncertainties about about collectibility collectibility exist, exist, revenue revenue recognition recognition is is delayed delayed 1 Installment Installment Sales Sales Method Method 2 Cost Cost Recovery Recovery Method Method 5-6 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 5-7 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% 5-8 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 5-9 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 5-10 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 5-44 Completed Contract Method General Journal Description Debit Construction in progress Credit 400,000 Cash, materials, etc Accounts receivable 400,000 625,000 Billings on construction contract Cash 625,000 405,000 Accounts receivable 405,000 Construction costs incurred during they year Construction costs incurred in prior years Cumulative construction costs Estimated costs to complete at end of year Total estimated and actual construction costs 2006 $ 250,000 250,000 1,000,000 $ 1,250,000 2007 $ 550,000 250,000 800,000 425,000 $ 1,225,000 2008 $ 400,000 800,000 1,200,000 $ 1,200,000 Billings made during the year Cash collections during year $ 250,000 225,000 $ 525,000 470,000 $ 625,000 405,000 5-45 Completed Contract Method General Journal Description Debit Construction in progress Cash, materials, etc Construction costs incurred during they year Construction costs incurred in prior years Accountsconstruction receivable Cumulative costs Estimated costson to complete at end of year Billings construction contract Total estimated and actual construction costs Cash Billings made during the year receivable CashAccounts collections during year Cost of construction Construction in progress Credit 400,000 2006 2007 $ 250,000 $ 550,000 250,000 625,000 250,000 800,000 1,000,000 425,000 $ 1,250,000 $ 1,225,000 $ 405,000 250,000 225,000 $ Cost of construction Retained earnings $ 625,000 405,000 405,000 1,200,000 200,000 Revenue from long-term contract Revenue from long-term contract 525,000 470,000 2008 $ 400,000 800,000 1,200,000 625,000 $ 1,200,000 400,000 Gross profit is recognized in year since project is complete 1,400,000 1,400,000 1,200,000 200,000 Remember that the contract price was $1,400,000 5-46 Completed Contract Method Construction in Progress 2006 250,000 2007 550,000 2008 400,000 2008 200,000 1,400,000 Billings on Construction Contract 250,000 2006 525,000 2007 625,000 2008 1,400,000 Entry to transfer title to the customer General Journal Description Billings on construction contract Construction in progress Debit 1,400,000 Credit 1,400,000 5-47 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 5-48 Learning Objectives Identify and calculate the common ratios used to assess profitability 5-49 Receivables Turnover Ratio Receivables Turnover = Ratio Net Sales Average Accounts Receivable Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator This ratio measures how many times a company converts its receivables into cash each year 5-50 Average Collection Period Average Collection Period = 365 Receivables Turnover Ratio This ratio is an approximation of the number of days the average accounts receivable balance is outstanding 5-51 Inventory Turnover Ratio Inventory Turnover Ratio = Cost of Goods Sold Average Inventory This ratio measures the number of times merchandise inventory is sold and replaced during the year 5-52 Average Days in Inventory Average 365 = Days in Inventory Turnover Ratio Inventory This ratio indicates the number of days it normally takes to sell inventory 5-53 Asset Turnover Ratio Asset Turnover Ratio = Net Sales Average Total Assets This ratio measures how efficiently a company utilizes all of its assets to generate revenue 5-54 Profit Margin on Sales Profit Margin = on Sales Net Income Net Sales This ratio indicates the portion of each dollar of revenue that is available to cover expenses 5-55 Return on Total Assets Return on = Total Assets Net Income Average Total Assets This ratio measures how well assets have been employed 5-56 Return on Equity Return on Equity = Net Income Average Shareholders’ Equity This ratio measures the ability of management to generate net income from the resources the owners provide 5-57 Remember     Read the text book Do all examples in text book Do Review Exercise Do homework 5-58 End of Chapter ... 5-4 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... 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... 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