978-0078025679 Chapter 3 Lecture Note

Financial Reporting and Analysis 6e Additional Topics in Income Determination

CHAPTER 3

ADDITIONAL TOPICS IN INCOME DETERMINATION

Chapter Overview

This chapter emphasizes the special accounting procedures used when revenue recognition

doesn’t occur at the point of sale. The “critical event” and “measurability” conditions for revenue

recognition are typically satisfied at the point of sale. However, there are circumstances—long–

term construction contracts, production of natural resources, and agricultural commodities—

where it is appropriate to recognize revenue prior to sale. Alternatively, revenue (and profit)

recognition may be delayed until after the sale—specifically, when cash is collected. This

approach is used in instances where there is considerable uncertainty as to the collectability of the

sales price or where there are significant costs or uncertainties that may occur following the sale

that are difficult to predict. Franchise sales, sales with a right of return, and bundled sales

(especially technology sales that bundle software and hardware products along with technical

support) pose particularly challenging revenue recognition issues and statement users need to be

aware of the potential accounting abuses. The financial reporting must reflect the revenue when

it is earned. This earnings process may be as early as technological certainty or as late as when

the support for the product expires. The broad criteria for revenue and expense recognition leave

room for considerable latitude and judgment. Management can sometimes exploit this flexibility

in GAAP to hide or misrepresent the underlying economic performance of a company.

Companies sometimes fail to adjust their revenue and expense recognition policies when

economic conditions change. In addition, management of an organization may try to reach short-

term earnings projections by manipulating the flexibility of income and expense recognition under

generally accepted accounting principles. This chapter outlines some of the more common ways of

managing earnings that have come under SEC scrutiny.

Auditors and financial statement users must be aware of management’s incentives to manage

earnings and the various ways it can be accomplished. Once discovered, errors and irregularities

must be corrected and disclosed. The errors and irregularities discovered in subsequent periods are

corrected through a prior period adjustment to retained earnings.

While IFRS and U.S. GAAP rules for revenue recognition and measurement largely overlap,

important differences exist for long-term construction contracts and for installment sales contracts.

A current Exposure Draft, if adopted, would substantially change current revenue recognition

practices, particularly percentage-of-completion for long-term construction contracts and multiple-

element sales contracts.

CHAPTER OUTLINE

I. REVENUE RECOGNITION PRIOR TO SALE

A. Revenue recognition prior to sale—Condition 1 (the “critical event”) and Condition 2

(“measurability”) from Chapter 2 are both satisfied prior to the time of the sale.

1. Percentage-of–completion method recognizes revenue, cost, and gross profit as

progress toward completion is made and is used primarily for long-term

construction contracts.

a. This method requires fairly good estimates of progress.

b. Cost–to–cost ratio: % complete = costs incurred to date ÷ estimate of total costs.

c. Current revenue (gross profit) = % complete x estimated total revenue (gross

Financial Reporting and Analysis 6e Additional Topics in Income Determination

profit) – revenue (gross profit) recognized in previous years.

d. A change in cost estimate is accounted for in a cumulative catch-up manner,

i.e., accounted for such that the balance sheet is as it would have been if the

revised estimate had been the original estimate.

e. A current asset results when total costs and recognized profit exceed billings.

f. A current liability results when billings exceed total costs and recognized

profit.

g. Estimated losses on a contract are recognized in their entirety as soon as it

becomes known that a loss will ensue.

Teaching Tip: Consulting firms use the percentage-of-completion method for fixed price,

fixed period contracts. The Information Technology Professional Services sector, for

example, uses this method to record approximately 30 % of its revenues.

2. Completed Contract Method is used when it is not possible to determine

expected costs with a high degree of reliability. It is not a method that recognizes

revenue and profits prior to sale.

a. Therefore, no interim revenue, costs, or gross profit are recorded.

b. These items are accumulated on the balance sheet, but not reflected on the

income statement until the project is completed.

3. Long-term contract losses (regardless of the revenue recognition method):

a. Cost increases require current period adjustment of excess gross profit

recognized in earlier periods.

b. With unprofitable contracts, the entire expected loss must be recognized in the

current period (as well as the recovery of previously recognized revenue and

gross profit).

4. Revenue Recognition on Commodities:

a. The Completed–Transaction (Sales) Method recognizes income when the

commodities are sold.

b. The Market Price (Production) Method recognizes income when the

agricultural commodities are harvested or when the natural resources are

extracted.

i. This alternative assumes that well-organized liquid markets exist for the

commodities.

ii. Changes in the market value of the commodities while they are held in

storage are reflected on both the balance sheet and income statement.

c. Comparisons of these two methods:

i. The completed transaction (sales) method merges the results of

speculative and operating activity and does not reflect the separate

results of either.

ii. The market price (production) method has the advantage of explicitly

recognizing the separate results arising from operating and

speculative activities.

II. REVENUE RECOGNITION SUBSEQUENT TO SALE

—Conditions 1 and 2 are both satisfied subsequent to the time of the sale.

1. This treatment is acceptable only under highly unusual circumstances. For

example, when the risk of noncollection is unusually high and when there is

Financial Reporting and Analysis 6e Additional Topics in Income Determination

no reasonable basis for estimating the proportion of installment accounts likely

to prove uncollectible, then the revenue recognition is deferred.

2. Installment Sales Method recognizes revenue and income proportionately as cash

is collected based on the installment sales gross profit percentage and the amount of

cash collected.

a. Installment accounts receivable are typically shown on the balance sheet as a

current asset, even amounts that will be collected beyond the next 12 months.

b. Extant practice typically classifies the deferred gross profit account as a

contra-asset reported as a reduction to accounts receivable.

c. Selling, general, and administrative costs of installment sales are treated as

period costs.

d. Interest on Installment Contracts is normally charged by sellers. GAAP

requires that the interest component of the periodic cash proceeds must be

recorded separately as interest revenue.

3. Cost Recovery Method recognizes revenue only when the cash payments received

from the buyer exceed the seller’s cost of goods sold. It is used when collections

on installment sales occur over an extended period and there is no reasonable basis

for estimating collectability.

III. REVENUE RECOGNITION FOR SPECIALIZED SALES TRANSACTIONS

1. Franchise Sales

a. The franchisor recognizes sales revenues based on the initial franchise fee,

which includes the payment for the right to operate in a given area and

payment for services to be performed by the franchise.

b. The franchisee recognizes expenses based on receiving the intangible asset

based on the name recognition of the franchise and tangible assets

including property, plant, and equipment and inventory.

2. Sales with Right of Return exists when the buyer has the right to return a product

until a specific date and past results indicate a significant return of products within

this timeframe. GAAP specifies criteria requiring the conditions to be met prior to

revenue recognition at time of sale when a right of return exists.

3. Bundled (Multi–Element) Sales result when a company sells multiple products

and services for a single price.

a. The timing of the revenue recognition varies among the products and

services.

b. Financial statement users need to exercise care based on the allocation of

the sales revenue to the various goods and services provided since the

determination of relative fair values of multiple deliverables (multi-

element sales) requires considerable judgment.

IV. EARNINGS MANAGEMENT

A. Managers sometimes exploit the flexibility in GAAP to manipulate reported earnings in

ways that mask the underlying performance of the company.

1. Arthur Levitt, former SEC Chairman warned in a 1998 speech delivered at the

NYU Center for Law and Business: “As a result, I fear that we are witnessing an

erosion in the quality of earnings, and therefore the quality of financial reporting.

Managing may be giving way to manipulation; integrity may be losing to illusion.”

2. The American Accounting Association completed a “Quality of Earnings” project

where they studied and provided guidance to accounting educators on the issues

Financial Reporting and Analysis 6e Additional Topics in Income Determination

and concerns of earnings management. The Issues in Accounting Education

Journal devoted a special issue to this topic in November of 2002.

3. Figure 3.1 shows the discontinuity in the number of firms reporting slightly

negative earnings versus slightly positive earnings.

a. This suggests that managers try to avoid reporting losses, since investors

often penalize companies that fail to meet analysts’ earnings

expectations.

b. One way of avoiding the reporting of small losses and to push earnings

into the positive range is to exploit the flexibility in GAAP.

c. There are a large number of forecast errors (i.e., actual earnings minus

analysts’ consensus earnings) clustered around zero, with a disproportionate

number of small negative forecast errors.

d. One explanation is that some companies manage earnings upward to meet or

beat analysts’ earnings projections, and not just when there are losses instead

of profits.

B. Popular Earnings Management Devices:

1. “Big bath” restructuring charges may be used to boost earnings in future years.

a. Restructurings include the consolidation of operations through plant closures,

labor force reductions, and the sale of noncore business units.

b. The associated estimated costs are charged to expenses and are offset by a

liability.

c. Managers may have an incentive to overstate the charges by including

recurring future operating expenses. The boost to income results when the

operating expenses are charged against the reserve, bypassing the income

statement.

d. There is a prevailing belief that investors look beyond one-time special charges

and write-offs, and instead focus on sustainable operating earnings.

2. Miscellaneous “cookie jar reserves” are a convenient income smoothing device.

a. Accrual accounting allows companies to estimate and accrue for obligations

that will be paid in future periods as a result of transactions or events in the

current period.

b. Some companies over-reserve in good times and cut back on estimated

charges, or even reverse previous charges, in bad times.

3. Intentional errors deemed to be “immaterial” and intentional bias in estimates

might be used to inflate earnings.

a. Companies may intentionally misapply GAAP, arguing that the incorrect

treatment has an immaterial effect on earnings.

b. The cumulative total of these items may have a material effect on bottom

line earnings.

4. Premature or aggressive revenue recognition may also lead to the overstatement

of earnings.

a. Revenue Recognition Abuses – Revenue is recognized when it is earned

(critical event criterion) and realized or realizable (measurability criterion).

This occurs when the following criteria are met:

i. Persuasive evidence of an arrangement exists,

ii. Delivery has occurred or services have been rendered,

iii. The seller’s price to the buyer is fixed or determinable, and

iv. Collectability is reasonably assured.

b. SEC Staff Accounting Bulletin illustrates several troublesome areas of

revenue recognition as well as the SEC’s recommendations for the

Financial Reporting and Analysis 6e Additional Topics in Income Determination

appropriate treatment.

V. ACCOUNTING ERRORS, EARNINGS RESTATEMENTS, AND PRIOR

PERIOD ADJUSTMENTS

A. Accounting errors or irregularities can occur for various reasons including

oversight, disagreements on how to account for a given transaction, and/or because

management attempts to exploit the flexibility in GAAP or commits outright

financial fraud by inflating earnings ad overstating net assets.

a. Internal audit staff and audit committee evaluate internal controls and

oversee the preparation of financial statements to ensure they represent the

company’s financial condition and performance. These staff provides the

first-line defense against accounting errors and/or irregularities.

b. External auditors provide an additional safeguard in indentifying and

correcting accounting errors and/or irregularities even though management

is responsible for the preparation and content of the published financial

statements.

c. The SEC also reviews selected issuers’ filings to ensure compliance with

SEC accounting and disclosure requirements. This review sometimes

uncovers accounting errors and/or irregularities.

B. Accounting errors and irregularities discovered after the year in which the error is

made are corrected through prior-period adjustments. The adjustments are made

to the beginning balance of retained earnings account and if comparative statements

are presented, then retroactive adjustments are made to the prior statements in order

to enhance comparability.

VI. GLOBAL VANTAGE POINT

IFRS and U.S. GAAP rules for revenue recognition and measurement largely overlap

although the U.S. GAAP standards are much more voluminous and detailed. Some

important areas of differences still exist. IFRS requires that five conditions be met for

revenue recognition on the sale of goods;

1. Seller has transferred significant risks and rewards to the buyer.

2. Seller retains neither continuing management nor effective control over the goods.

3. The amount of revenue can be measured reliably.

4. It is probable that the entity will obtain economic benefits from the transaction.

5. The costs incurred for the transaction can be measured reliably.

A. IFRS rules for revenue recognition on long-term construction contracts distinguish two

types of contracts:

1. Cost-plus contracts are those for which the contractor is reimbursed for allowable

or defined costs plus a profit mark-up.

2. Fixed-price contracts have a fixed contract price or rate per unit of output.

B. Like U.S. GAAP, IFRS the percentage-of–completion method is allowed although if a

contract outcome cannot be reliably estimated, IFRS rules do not permit firms to use the

completed contract method.

C. While U.S. GAAP allows the use of installment sales method when the risk of non-

collection of installment payments is high, IFRS rules do not. The cost recovery

method is required, instead.

D. Both U.S. GAAP and IFRS prescribe to measuring revenue at the fair value of the

consideration received or receivable.

Financial Reporting and Analysis 6e Additional Topics in Income Determination

E. IASB and FASB have an ongoing project with the purpose to clarify principles for

recognizing revenue consistently across industries and various transactions rather than

the piecemeal and disjointed rules that currently apply.

F. An Exposure Draft has been issued that addresses when and how much revenue should

be recognized in contracts to provide goods or services.

G. If adopted, the exposure draft would substantially change current revenue recognition

principles especially for long-term construction contracts and multiple-element sales

contracts.

Financial Reporting and Analysis 6e Additional Topics in Income Determination

CHAPTER QUIZ

Consider the following information in answering questions 1 and 2.

Riverton Construction contracted to build an addition for $500,000. Construction started in

January 2015 and was completed in November 2016. Data relating to the contract are

summarized below: 2015 2016

Costs incurred during the year $290,500 $120,000

Estimated additional costs to complete 124,500 —

Cash collections 250,000 250,000

1. Calculate the gross profit that Riverton reports in 2016 under the percentage–of–

completion method.

a. $85,000

b. $59,500

c. $30,000

d. $130,000

2. (Refer to the data in question 1) The change in gross profit percentage under the

percentage-of-completion method from 2015 to 2016 reflects:

a. A real increase in operating performance.

b. A real decrease in operating performance.

c. A change in accounting estimates since total actual costs were greater than

original estimates.

d. A change in accounting estimates since total actual costs were less than original

estimates.

3. Which of the following is true of the percentage-of-completion method?

a. Revenue recognition is not affected by changes in estimates during the course of

the contract.

b. Revenue recognition drives the financial reporting process.

c. Costs drive the financial reporting process.

d. The actual gross profit on any contract is easily determinable for the financial

statements.

4. Twist Real Estate began operations on January 2, 2015, and uses the installment sales

method of accounting for revenue recognition. The following information is available for

2015: Installment accounts receivable, December 31, 2015 $400,000

Gross profit on total 2015 sales (i.e., total of realized and

unrealized gross profit on 2015 sales) $280,000

Gross profit percentage on 2015 sales 30%

For the year ended December 31, 2015, calculate the amount of realized gross profit.

a. $ 72,000

b. $120,000

c. $160,000

d. $400,000

Financial Reporting and Analysis 6e Additional Topics in Income Determination

5. Why is revenue recognized in each year of a long-term contract even though delivery cannot

occur until the contract is completed?

a. Revenue can be recognized even when collectability cannot be reasonable assured.

b. Revenue can be recognized since the seller’s price is always fixed.

c. Revenue can be recognized since services have been rendered.

d. Revenue can be immediately recognized whenever persuasive evidence of an

arrangement exists.

6. Alma Autos sells automobiles on the installment basis of accounting to customers with the

motto, “no credit rating will be refused”. A customer takes delivery of a Sports Utility

Vehicle with a sales price of $30,000 and a 40% gross profit on sales. The customer makes

payments of $9,000 for the fiscal period ending December 31, 2015. What amount of profit

will Alma realize under the installment method of accounting?

a. $ 3,600

b. $18,000

c. $12,000

d. $ 5,400

7. A telecommunications company enters into a “capacity swap” transaction. On January 1,

2016 Atlantic Telecom agrees to exchange $100 million worth of capacity for a fiber optic

cable from New York to Europe for $150 million worth of capacity from San Francisco to

Australia. Under Staff Accounting Bulletin number 101, when is the technology access fee

recognized as revenue?

a. When the contract is signed.

b. When the capacity exchanged is brought on line and used by the acquiring firm’s

customers.

c. When the contract expires.

d. Systematically on a straight line basis over the estimated life of the asset.

8. Priceline.com operates an Internet site where customers may bid on discounted airline tickets.

Customers place their orders for a ticket and provide a credit card number for the payment.

Priceline receives the order and authorization from the credit card company, and passes the

order on to various airlines. If an airline accepts a bid, Priceline notifies the customer of the

itinerary and ticket number. Priceline does not take ownership of the ticket and has no risk of

loss or other responsibility for the product. Assume a customer bids $275 for a ticket that

“costs” $250. Priceline gets to keep the $25 difference. How should Priceline report this

transaction?

a. Record revenue of $275 and cost of goods sold of $250 since it assumes risk of

ownership.

b. Record revenue of $25 on a net basis since it only acts as an agent or broker.

c. Record revenue of $275 and cost of goods sold of $250 since it assumes risk of loss

for collection.

d. Record revenue of $275 and cost of goods sold of $250 since it takes title to the

tickets momentarily during the transaction.

Financial Reporting and Analysis 6e Additional Topics in Income Determination

9. In January 1997, Raytheon acquired the defense systems and electronics business (DSE) of

Texas Instruments. The current liabilities of DSE had a book value of $460 million at the

end of 1996. Raytheon recorded these liabilities at their fair value of $745 million as part of

the acquisition. This difference may be an example of what earnings management method?

a. Big bath.

b. Creative acquisition accounting.

c. Cookie jar reserves.

d. Purchased R&D.

10. Research and development costs are generally expensed as incurred in the U.S. Which of the

following captures the controversy surrounding purchased R&D?

a. Internally generated intangible assets are generally expensed whereas externally acquired

intangible assets are generally capitalized.

b. Internally generated intangible assets are more difficult to value than externally acquired

intangible assets.

c. R&D expenditures made prior to the determination of technological feasibility have no

value.

d. Purchased R&D has the effect of increasing earnings in the year of the acquisition.

Essay question

Technology companies sell software, hardware, and support in a bundled (multi-element

sales) transaction. Describe the various methods of earnings management possible for

technology companies.

QUIZ ANSWERS:

1. c. 2015 2016

Percent complete 290,500 ÷ 415,000 = 70% 100%

Revenue 70% x 500,000 = 350,000 150,000 (500,000 – 350,000)

Costs 290,500 120,000

Gross Profit 59,500 30,000

Gross Profit % 17.0% 20%

Financial Reporting and Analysis 6e Additional Topics in Income Determination

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estimated. Revenues are then allocated to accounting periods based on the cost structure.

4. c. Installment A/R $400,000

GP rate 30%

Deferred GP $120,000

Realized GP = $280,000 – $120,000 = $160,000

5. c. Provided that the other criteria for revenue recognition are met, revenue can be recognized

since services have been rendered.

6. a. Alma Auto should record $3,600 of realized profit for the fiscal year ending December

31, 2015. The amount of gross profit for the transaction would be calculated by taking the

cash collections of $9,000 times the gross profit of 40%.

7. b. Staff Accounting Bulletin (SAB) 101 states, “revenues should be deferred and recognized

over the term of the swap agreement as the capacity is brought on line and used by the

acquiring firm’s customers”.

8. b. Priceline should report revenue on a net basis as $25, similar to a commission. Since

Priceline performs as an agent or broker without assuming the risks and rewards of ownership

of the goods, sales should be reported on a net basis.

9. b. This may be representative of an excess reserve against which future operating expenses

can be charged. It is interesting to note that the fair value of these current liabilities is

substantially higher than their book values. Raytheon did not comment on the valuation of

these liabilities. However, note that this example is offered for illustrative purposes only and

that no charges of impropriety have ever been leveled against Raytheon.

10. a. R&D is expensed as incurred because of the uncertain future benefits it provides.

However, if a firm were able to “value” purchased R&D, it would make sense to capitalize

the amount and amortize it to expense during the periods benefited. Other externally

purchased intangible assets are capitalized even though internally generated intangibles are

expensed. In addition, this may be an attempt at goodwill avoidance where amortization (old

rules) or impairment (new rules) will reduce future earnings streams.