ACCT 301
Profitability Analysis and Revenue Recognition
Ethan Bohannon
Liberty University
ACCT 301-D02
ACCT 301 2
Profitability Analysis and Revenue Recognition
Profitability and Revenue Recognition are some of the biggest essentials within a
company in order to track performance and financial transactions. These two concepts can
determine the success, failure, and future of a company. This paper is formatted to discuss the
definitions of each term and how they relate to the accounting world. Topics such as deffered
revenue, accured revenue, cash based accounting, accrual based accounting, profitability
analysis, and how revenue recognition and profitability analysis relate to each other will be
discussed.
To kick things off, let’s define revenue. Revenue is the income earned from the sale of
goods or the provision of services. The sale of goods could relate to a baking business, selling a
cake, and the provision of services could be a car wash, washing your car. The revenue
recognition principle states that revenue is recognised when it’s earned, not when cash is
received. An example of this is a baking company receiving a prepaid advancement for a cake in
november, and the cake is completed and delivered in december, rather than recognizing the
revenue in november, the cake company recognizes the revenue in december, once the order has
been fulfilled. This is known as deferred revenue, since the payment is made in advance for
goods or services that are delivered in the future. The same principles can be applied in past
tense as well, with a car wash washing a car in december, and then receiving payment for it in
january. This is known as accrued revenue, as the payment is received in the future for a service
completed in the past. For clarity, accrued and deferred revenue do not exist under the cash basis
of accounting, as in that method, revenue is recognized when the cash payment is received,
deferred and accrued revenue only exists in the accrual accounting method.
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There are five steps to the model of preforming revenue recognition. The first step is to
identify the contract with a customer. This process includes the agreement of both parties under a
legally binding contract. The next step is to identify the performance obligations that have been
stated in the contract. In this stage, companies determine how they are going to preform based on
the agreements made under the contract. The third step is to determine the transaction price. The
company must list all streams of revenue and how their revenue is received from which stream.
How payments are made and when must be in detail as well. The fourth stage to revenue
recognition is to allocate the prices to the performance obligations. In this step, the company
must take each good or service that they provided in stage two. This can be achieved through
market assessments, evaluating expected costs and margins, and / or a residual approach. Then,
each product or service must be valued on their one and sold separately in order to have accurate
and detailed results. The final and fifth stage is to recognize the revenue and when each
performance obligation is satisfied. Things like royalties, sales, and expenses are recognized as
incurred and accounted for, then the transaction is completed. (The Five-Step Method, 2020)
Both cash based accounting and accrual based accounting are methods used in the
accounting world to record financial transactions within a company. The key difference between
the cash based accounting and accrual based accounting is how the money transactions are
accounted for. In cash based accounting, the recognition of a transcation occurs whenever money
is spent or received. Examples of cash based accounting in action include cashing in a check,
paying for your items in the checkout line at the store, and paying for a car wash once the service
provided by the company is completed. Accrual based accounting recognizes a transaction once
the money is earned, not whenever it is exchanged, an example of this is whenever a hospital
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sends a patient an invoice. An invoice is a payment request that has been sent by the supplier of
goods or services to a buyer.
Each of these accounting methods have their own pro’s and con’s. cash based accounting
has the advantage of knowing how much money is available to spend at all times, since with cash
based accounting, it is primarily watching the transaction of money, rather than when the money
is earned. An additional benefit is that the income generated is not taxed until it is in the bank.
This allows a company to have more control over their money. Accrual based accounting has the
benefit of better financial insights, and has more accurate reportings due to the accounting firm
reporting cash whenever it is earned, allowing for better monitoring of fianaces within a
company. One of the biggest disadvantages to cash based accounting is the lack of knowledge on
how much account receivables a company using this method would have. Since the company is
following the transation of money rather than the earning on money, there are no accounts
reciable or accounts payable to record on the balance sheet, since they are not noticed until such
time as they are paid by customers or paid by the company, respectively. (QuickBooks, 2019) In
accrual accounting, one of the biggest con’s to using this method is that a companys bank
account will not match it’s accounting information/ books. This is because while your bank
account is counting the transation of money, the accrual accounting method is counting the
earning of money. Another downside to the accrual method is the possibility of taxation on
money that has not been received yet. This is because when using the accrual method, the firm
would report income in the tax year that it is earned, even if the payment is received in the next
year, due to the decuction of expenses in the tax year a company incurs them, rather than when
the payment is made. (Kenton W, 2020)
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Cash based and accrual are both valid forms of accounting, however each one produces
more accurate results based on a company and how they operate. The cash based method is best
if a company has a lot of transations and deals directly with consumers. A good example of a
company that would use the cash based method rather than the accrual based method would be
Walmart. Walmart is a great example due to the high volume of customers that visit a wallmart
store within a day and because wallmart will be doing hundreds of cash transations per day with
customers. The accrual method is best if you deal with large businesses and don’t get paid
quickly. A prime example of a company that would be more likely to use the accrual method over
the cash method would be a construction company or general contractor such as Bechtel. These
companies would most likely use the accrual method because of the type of customers and
transactions the company will be dealing with. A majority of the time, a construction company
will get paid in a lump sum for the job, in this type of situation, recording the generation of
revenue is best once the money is earned, as other factors might play a role in the payment of a
construction company. Because work accidents, project delays, or weather can affect how much
or when such construction company gets paid, accounting for the money once it is earned is
much more practical for an accounting firm rather than accounting for the money whenever a
transaction occurs.
Profitability analysis is known as the analysis of profitability based on the output of the
company. Output can be grouped into products, customers, locations, channels, and/or
transations. In order to preform a profitability analysis, all costs of an organization have to be
allocated to output units by using intermediate drivers. This process is called costing. When the
costs have been allocated, they can be deducted from the revenues per output unit. The
reamainder shows the margin of a product, client, location, channel, and/ or transations. After
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calculating the profit per unit, the managers or decision makers can use the outcome to
substanciate management decisions. Managers can decide to stop selling loss generating
products, to reduce costs for loss making customers, or to increase sales in profitable locations.
Profitability analysis provides an opportunity for both business owners and managers to evaluate
the ability of a business to generate profit in the future. By doing preforming a profitability
analysis, it is possible to then find the “whale curve” for the data provided from the calculation
preformed above. Whale curves are graphical representation of the firms’ profits, usually plotting
cumulative profits against cumulative products ranked by profitability. The whale curve is used
to graphically show the potential margine for an organization.
Some of the most common profitability measures include asset turnover ratio, return on
total assets (ROA), return on stockholders’ equity (ROE), earnings per share (EPS), price-
earnings ratio (P/E) and dividends per share. The asset turnover ratio can be found by dividing
net sales by average total assets. Return on total assets can be computed by dividing net income
by the average total assets. Return on stockholders equity ratio measures the amount of income a
company can generate using the funds stockholders have invested. Earnings per share is the
amount of net income that is allocated to each outstanding share of common stock. This can be
found by subtracting net income by dividends on preferred stock, then divided by average
outstanding shares. The price-earnings ratio measures the market price of a common stock on a
given date compared to the earnings per share. It can be found by dividing market price per share
by earnings per share. Dividends per share looks at how much dividend is available to each
share. This can be found by dividing dividends by the number of shares outstanding. Profitability
analysis is highly critical to a company or organization, as a profit analysis can help shape the
future direction of a company.
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In profitability analysis, it is possible to preform a pareto analysis by ranking units from
most profitable to least possible. The patero principle uses the idea of the 80/20 rule (also known
as the law of the vital few). The 80/20 rule is the idea that by doing 20% of the work, imput, or
activities the company can generate 80% of the benefit or output of doing the entire job. The
pareto principle was named after the Italian economist, Vilfredo Pareto. Pareto discovered this
law in action in his very own garden during the 1800’s. One day, Pareto was in his garden and he
noticed that 20% of the pea pods generated 80% of the healthy peas. This discovery lead him
discover that in Italy, 80% of the land was owned by 20% of italy’s population. (Brooks C, 2014)
This concept of the 80/20 can be seen everywhere in our daily lives. For example you most likely
only wear 20% of your clothes 80% of the time. A great example of this rule being applied in the
business world is home depot. At home depot, these customers are known as pro customers. For
home depot, these customers can be contractors, landscaping, or construction companies that are
in need of a large quantity of supplies for a project. Home depot does an excellent job of
capitalizing on these pro customers and giving them special benefits to keep their business.
Home depot achieves this goal with benefits such as their own personal checkout line, special
rates on bulk deals, reserved parking for pro customers, expanded assortment, project pricing,
and rewards in the form of points for pro customers, which they can redeem for futher discounts
and free products. (Cochrane, M, 2017) Something to keep in mind is that it will not always be
80/20, however most of the time it is. It can be 70/30, 90/10, or any percentage. The point of the
80/20 philosophy is to show the fact that a majority of your results will most likely come from a
minimum amount of causes, and the minority of results come from a majority of causes.
Another method a company could use to help with a profitability analysis is by using the
DuPont framework (also known as the Dupont equation, DuPont model, or the DuPont method)
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The DuPont framework is an equation that allows the company’s stakeholders to understand the
return on equity through multiplying three parts. The DuPont method is the concept that a
companies return on equity is equal to the return on assets (profit margin asset turn). The
calculation of the DuPont formula is completed as so: net income/ sales X sales / total assets X
total assets / Average shareholder’s equity. By splitting the return on equity into three parts,
companies can more easily understand changes in their returns on equity over time. Return on
equity can help identify how a company uses their investment funds to aid in the generation of
earnings growth. As profit margin increases, each sale that is made will generate more money to
a company’s bottom line. This results in a higher overall return on equity. Additionally, the
increase of financial leverage from generating more money will result in an increase on return on
equity, due to using more debt financing that causes higher interest payments. This is a positive
because the higher interests payments can be written off as a tax deductible. (Pinset W, 2020)
Revenue recognition and profitiability analysis both correlate with one another. As the
both can have an impact on each other. The way that revenue is recognized within a company,
wether it be through cash or accrual, can affect the results of a profitability analysis. An example
of this today would be if a company used the accrual method of accounting and received
payment in December, but didn’t earn the money until January. This could affect an annual
profitiability analysis by not showing the profits made from the work yet, as the payment will not
be received until January, therefore the profits made from the work would not be included in the
profitability analysis for that year. Profitability analysis can also affect revenue recognition.
Based on a companies profitability results, it could impact their decision on wether or not the
company will continue to use their method of revenue recognition, or change it in order to help
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increase their profits. This can affect the way a company is perceived by the government,
investors, and customers.
In conclusion, Profitability analysis and Revenue Recognition can be a company’s
biggest tool in identifying performance issues, find solutions to such company’s problems, and
help determine how a company should run and operate in the future. They are common business
practices that help enable and advance a company futher in output, and being able to extent their
reach to more customers, therefore generating more revenue. These methods can also help a
business stay afloat during financial issues that a company may be facing. By analyzing the
companies profitability, it will help a company to see what sections of their company need more
attention than others.
Revenue recognition is used as a method to help manage a companies books and to
account for money whenever it is earned, rather than whenever it is received. This method is best
used by companies that interact with larger companies and have large scale operations, or as an
altnerative to cash based accounting.
Profitability analysis is the analysis of a companies output based on their imputs.
Accounting formulas can be used to help with this analysis such as asset turnover ratio, return on
total assets (ROA), return on stockholders’ equity (ROE), earnings per share (EPS), price-
earnings ratio (P/E) and dividends per share. A company uses a profit analysis to help identify a
multitude of things. Profit margins, what products are not preforming up to standard, and how a
company can improve their outputs are all things a company can identity in order to improve
their numbers.
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Citations:
Brooks, C. (2014, March 29). What Is a Pareto Analysis? Retrieved from
https://www.businessnewsdaily.com/6154-pareto-analysis.html
Cochrane, M. (2017, November 24). Home Depot Gets With the PROgram. Retrieved from
https://www.fool.com/investing/2017/11/24/home-depot-gets-with-the-program.aspx
Kenton, W. (2020, January 29). What Is Accrual Accounting and Who Uses It? Retrieved from
https://www.investopedia.com/terms/a/accrualaccounting.asp
Pinsent, W. (2020, January 29). Decoding DuPont Analysis. Retrieved from
https://www.investopedia.com/articles/fundamental-analysis/08/dupont-analysis.asp
QuickBooks. (2019, May 3). Cash vs. accrual accounting: What's best for your small business?
Retrieved from https://quickbooks.intuit.com/r/bookkeeping/cash-vs-accrual-accounting-whats-
best-small-business/
The Five-Step Method. (2020, May 2). Retrieved from https://www.revenuehub.org/the-five-step-
approach/
