Income Measurement and Profitability Analysis 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 2 3 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 Installment Installment Sales Sales Method Method 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% 5-53 Franchise Sales Initial Franchise Fees Continuing Franchise Fees Generally are recognized at a point in time when the earnings process is virtually complete Recognized over time as the services are performed Source: SFAS 45 5-54 Learning Objectives Identify and calculate the common ratios used to assess profitability 5-55 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 5-56 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 5-57 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 5-58 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 5-59 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 5-60 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 5-61 Return on Total Assets Return on = Total Assets Net Income Average Total Assets This ratio measures how well assets have been employed 5-62 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 5-63 Interim Reporting Appendix 5-64 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 5-65 Interim Reporting Reporting Revenues and Expenses With only a few exceptions, the same accounting principles applicable to annual reporting are used for interim reporting Reporting Unusual Items Discontinued operations and extraordinary items 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 5-66 Minimum Disclosures Sales, income taxes, and net income Discontinued operations, extraordinary items, and unusual or infrequent items Earnings per share Contingencies Seasonal revenues, costs, and expenses Changes in accounting principles or estimates Significant changes in estimates for income taxes Significant changes in financial position 5-67 End of Chapter ... 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