Additional Topics in

Income Determination

Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 3
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 Learning objectives
1. 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 the flexibility in GAAP for income determination invites
managers to manipulate or manage earnings.
5. The various techniques used to manage earnings.
6. SEC guidance on revenue recognition designed to curb earnings
management
7. How error corrections and prior period restatements are reported.
8. Key differences between IFRS and U.S. GAAP rules for revenue
recognition.
9. Proposed changes that IASB and FASB are considering for contract-
based revenue recognition.

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 Recall the criteria for revenue
recognition

Figure 2.2

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.

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 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 there’s 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.

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 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?

2014 2015 2016 Total

Gross Profit ? ? ? $200,000

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 Percentage-of-completion for 2014
(Year 1)

Percentage of $240,000 Cost incurred

Step 1: 30% = =
completion ratio $800,000 Estimated total costs

Step 2: Estimated total $200,000 = $1,000,000 - $800,000

contract profit

Step 3: Estimated profit $60,000 = $200,000 x 30%

earned to date

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 Percentage-of-completion for 2015
(Year 2)

$544,000
Step 1: Percentage of 30% 64% =
completion ratio $850,000

Step 2: Estimated total $200,000 $150,000 = $1,000,000 - $850,000

contract profit

Step 3: Estimated profit $60,000

$60,000 $96,000 = $150,000 x 64%
earned to date

Step 4: Incremental profit $36,000 = $96,000 - $60,000

earned

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 Percentage-of-completion for 2016
(Year 3)

Step 1: Percentage of 30% 64% 100%

completion ratio
Step 2: Estimated total $200,000 $150,000 $150,000
contract profit
Step 3: Estimated profit $60,000 $96,000 $150,000
earned to date
Step 4: Incremental profit $36,000 $54,000
earned

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 Percentage-of-completion:
Balance sheet presentation

given

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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.

kh xac dinh dc reliable measurement

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 Revenue recognition on
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.

contract

 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, 2014 are
included in 2014 revenue.

 Revenue (and related expenses) for the remaining 10,000 bushels is

postponed to 2015 when those bushels are sold.

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 Commodities:
Market-price (production) method
rice, gold, silver fluctuate based on market price => recognize unsold int
 Because producers face an established market price for the
commodity, Condition 2 is satisfied continuously.
 Accordingly, all 110,000 bushels produced in 2014 are included in
2014 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. The additional entry required is:
DR Crop inventory $15,000
CR Market gain on unsold inventory $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 2015, the market price drops from $3.50 to $3.00.
The inventory is “marked-to-market” to reflect the loss:

= 10,000 x
DR Inventory (holding) loss on speculation $5,000 ($3.50 - $3.00)
CR Crop inventory $5,000

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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 $30,000

CR Crop inventory $30,000

DR Cash $30,000
CR Crop revenue $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

cho toi khi ban that su moi ghi nhanh rev cap nhat rev hang nam theo market price

 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 streams—one 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

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

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 Specialized transactions:
Franchised sales
Exercise right to sell
product or service

Franchisor Franchisee Customer

Seller Buyer

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
 GAAP specifies:
◼ 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 return
Sell with right of return

Seller Buyer Customer

Resale
Cash payment or
obligation to pay

 GAAP specifies that the following six criteria must be met for a
seller to record revenue at the time of sale:
◼ Seller’s 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.
◼ Buyer’s 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.

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 Specialized transactions:
Bundled (Multi-element) sales
Oracle sells a database software “bundle” for $1 million. The “bundle”
includes staff training, “free” software upgrades, and on-going
customer support for five years. If sold separately, the fair values
would be as shown.
Revenue is recognized as calculated for each component

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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 company’s
underlying performance.

 Some managers have even resorted to outright financial fraud

(but that’s rare).

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 Earnings management:
Avoiding a loss or earnings disappointment

Figure 3.1

Figure 3.2

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 Popular earnings management
devices
 “Big bath” restructuring charges: Excessive restructuring write-offs that
overstate estimated charges for future expenditures.

 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.

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 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 seller’s 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 No revenue can be

on consignment recognized at delivery.

Seller can’t recognize revenue until

Sales with
delivery… except certain buy and hold
delayed delivery transactions.

Postpone revenue recognition

Goods sold on
until merchandise is delivered
lay-away to customer.

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 Revenue recognition abuses:
SAB No. 104 examples

Non refundable Earned as services are delivered over

up-front fees the full term of service engagement.

Gross vs. net basis Revenue should be recognized on a

for internet resellers “net” basis as commission revenue.

Revenue should be recognized

Capacity over time as the capacity is
swaps brought on line and used by
customers.

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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 company’s 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 1997-2006

Figure 3.3 Figure 3.4

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Accounting restatements:
Share price reaction to announced restatements
Figure 3.5

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Accounting restatement disclosures:
An example

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 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 detailed.

 Differences between IFRS and U.S. GAAP are in two areas

◼ Long-term construction contracts
◼ Installment sales method of accounting

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 IFRS Revenue Recognition and
Measurement
 International Accounting Standard (IAS) 18 requires that the
following five conditions be met before an entity can recognize
revenue on the sale of goods:
1. The seller has transferred significant risks and rewards of ownership of
the goods to the buyer
2. The seller retains neither continuing management involvement
associated with ownership nor effective control of the goods being sold
3. The amount of revenue can be measured reliably
4. It is probable that the entity will obtain economic benefits as a result.
5. The costs incurred can be measured reliably

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 Global Vantage Point
Long-Term Construction Accounting

 IFRS rules for revenue recognition on long-term

construction contracts distinguish two types of
contracts:
◼ Cost-plus contracts – those for which the contractor is
reimbursed for allowable costs plus a profit mark-up
◼ Fixed-price contract – one in which the contractor
agrees to a fixed contract price or fixed rate per unit of
output

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 Global Vantage Point
Installment Sales Method

 IRFS rules do not permit entities to use the installment sales

method, the cost recovery method is required.

 As installment receivables are collected, cost recovery takes

place equal to the amount of cash collected that period.

 Revenues and expenses would be recognized equal to the

amount of cash collected each period up to the point where costs
have been fully recovered.

 Only after the cumulative amount of cash collected exceeds the

cost of the installment sale will the entity recognize any profits.

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 Summary
 The “critical event” and “measurability” conditions for revenue
recognition are typically satisfied at the point of sale.

 There are circumstances—long-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 sale—installment 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 (multi-
element) 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.
 IFRS and U.S. GAAP rules for revenue recognition largely overlap
but important differences exist for long-term construction contracts
and installment sales.
 The IASB and FASB have recently issued an exposure draft on
revenue recognition.

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