Part A: Revenue Recognition

1. Revenue Recognition in General
   1. The  realization principle requires that two criteria be satisfied before revenue can be recognized:
      1. The earnings process is judged to be complete or virtually complete.
      2. There is reasonable certainty as to the collectibility of the asset to be received.
   2.  Staff Accounting Bulletin No. 101summarized the SEC's views on revenue recognition. The bulletin provides additional criteria for judging whether or not the realization principle is satisfied:
      1. Persuasive evidence of an arrangement exists.
      2. Delivery has occurred or services have been rendered.
      3. The seller's price to the buyer is fixed or determinable.
      4. Collectibility is reasonably assured.
   3. Revenue is either recognized at one particular point in time or over time.
   
   
2. Completion of the Earnings Process Within a Single Reporting Period
   1. While revenue usually is earned during a period of time, revenue often is recognized at one specific point in time when both revenue recognition criteria are satisfied.
   2. Revenue from the sale of products usually is recognized at the  point of product delivery.
   3. For service revenue, if there is one final service that is critical to the earnings process, revenues and costs are deferred and recognized after this service has been performed.
   4. Significant uncertainties about cash collection could cause a delay in recognizing revenue from the sale of a product or a service.
   5. Installment sales
      1. Revenue recognition for most installment sales takes place at the point of delivery, and estimates are made of potential uncollectible amounts.
      2. When exceptional uncertainty exists, two accounting methods are available:
         1. The installment sales method.
         2. The cost recovery method.
      3. The  installment sales method recognizes gross profit by applying the gross profit percentage on the sale to the amount of cash actually received.
      4. The cost recovery method defers all gross profit recognition until cash equal to the cost of the item sold has been received.
          Illustration
   6. Right of Return
      1. When the  right of return exists, revenue cannot be recognized at the point of delivery unless the seller is able to make reliable estimates of future returns. In most retail situations, reliable estimates can be made and revenue and costs are recognized at point of delivery.
      2. Otherwise, revenue and cost recognition is delayed until the uncertainty is resolved.
   7. Here is an interesting article that addresses the problems experienced by  Bausch and Lomb related to the right of return.
   
   
3. Completion of the Earnings Process Over Multiple Reporting Periods
   1. Service revenue often is recognized over time, in proportion to the amount of service performed
   2. Another activity in which it is desirable to recognize revenue over time is one involving a long–term contract. The  types of companies that make use of long-term contracts are many and varied, although they are most prevalent in the construction industry. (T5-7) In these situations, there are two methods of accounting for revenue and expense recognition:
      1. The completed contract method.
      2. The percentage-of-completion method.
   3. The completed contract method is equivalent to recognizing revenue at the point of delivery, that is, when the project is complete.
      1. No revenues or expenses are recognized until the project is complete.
      2. The completed contract method does not properly portray a company's performance over the construction period and should only be used in unusual situations when forecasts of costs to complete the project are highly uncertain.
   4. The percentage-of-completion method allocates a fair share of a project's revenues and expenses to each reporting period during construction.
      1. The allocation of project profit is accomplished by estimating progress to date.
      2.  Progress to date (the percentage of completion) can be estimated as the proportion of the project's cost incurred to date divided by total estimated costs, or by relying on an engineer's or architect's estimate.
      3. To determine periodic gross profit (revenues less expenses), the percentage of completion is multiplied by estimated gross profit to determine gross profit earned to date, and then the current period's gross profit is determined by subtracting from this amount the gross profit recognized in previous periods.
      4. Periodic revenues are determined by multiplying the percentage of completion by the total contract price and then subtracting revenue recognized in prior periods. In most cases, the cost of construction equals the construction costs incurred during the period.

5. Balance sheet effects
   1. All costs of construction are recorded in an asset (inventory) account called construction in progress.
   2. Period billings are credited to billings on construction contract, a contra account to the construction in progress account.
   3. Construction in progress is debited for the amount of gross profit recognized.
   4. Construction in progress is compared to billings on construction contract.
      1. A debit balance indicates costs (plus profits for the percentage-of-completion method) in excess of billings and is reported as an asset.
      2. A credit balance indicates billings in excess of costs (plus profits for the percentage-of-completion method) and is reported as a liability.
       Illustration
6.  Long-term contract losses
   1. A loss could occur on a profitable project if the estimated costs to complete were underestimated in prior periods.
   2. An estimated loss on a long-term contract is fully recognized in the first period the loss is anticipated, regardless of the revenue recognition method used.
   3. Recognized losses on long-term contracts reduce the construction in progress account.


4. Industry-Specific Revenue Issues
   1. If a  software arrangement (sale) includes multiple elements, the revenue from the arrangement should be allocated to the various elements based on the relative fair values of the individual elements. Take a look at Microsoft's disclosure note describing its software revenue recognition policy.
   2. In a franchise sale, the fees to be paid by the franchisee to the franchisor usually comprise (1) the  initial franchise fee, and (2) continuing franchise fees.
      1. GAAP require that the franchisor has substantially performed the services promised in the franchise agreement and that the collectibility of the initial franchise fee is reasonably assured before the fee can be recognized.
      2. Continuing franchise fees are paid to the franchisor for continuing rights as well as for advertising and promotion and other services over the life of the agreement and are recognized by the franchisor as revenue in the period received, which corresponds to the periods the services are performed.

Part B: Profitability Analysis

1. Activity Ratios
   1. Activity ratios measure a company's efficiency in managing its assets.
   2. The  receivables turnover ratio offers an indication of how quickly a company is able to collect its accounts receivable.
      1. The ratio is calculated by dividing a period's net credit sales by the average net accounts receivable.
      2. An extension of this ratio is the  average collection period, which is computed by dividing 365 days by the receivable turnover ratio.
   3. The  inventory turnover ratio measures a company's efficiency in managing its investment in inventory.
      1. The ratio is calculated by dividing the period's cost of goods sold by the average inventory balance.
      2. An extension of this ratio is the  average days in inventory, which is computed by dividing 365 days by the inventory turnover ratio.
   4. The  asset turnover ratio measures a company's efficiency in using assets to generate revenue and is calculated by dividing a company's net sales or revenues by the average total assets available for use during the period.
   
   
2. Profitability Ratios
   1. Profitability ratios assist in evaluating various aspects of a company's profit-making activities.
   2. The  profit margin on sales measures the amount of net income achieved per sales dollar and is computed by dividing net income by net sales.
   3. The  return on assets (ROA) indicates a company's overall profitability.
      1. It is calculated by dividing net income by average total assets.
      2. The return on assets can also be computed by multiplying the profit margin on sales by the asset turnover.
   4. The  return on shareholders' equity measures the return to suppliers of equity capital. It is calculated by dividing net income by average shareholders' equity. This Real-World, Real-Time Electronic Case describes and illustrates the DuPont formula for calculating the return on shareholders' equity ratio.
       Illustration

 Here is a quiz to test your understanding of this chapter.