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©Cambridge Business Publishers, 2011

Solutions Manual, Chapter 6 6-1

Chapter 6

Reporting and Analyzing Revenues and Receivables

Learning Objectives – coverage by question Mini-

exercises Exercises Problems Cases

LO1 – Describe and apply the criteria for determining when revenue is recognized.

14, 15, 17 26, 27, 32,

39

47, 48, 49

LO2 – Illustrate revenue and expense recognition when the transaction involves future deliverables.

17, 24, 25 39 46 48

LO3 – Illustrate revenue and expense recognition for long-term projects.

13, 16 28, 29, 30 41

LO4 – Estimate and account for uncollectible accounts receivable.

18, 19, 20,

21, 23

33, 34, 35,

36, 37

43, 44, 45 49

LO5 – Calculate return on capital employed, net operating profit after taxes, net operating profit margin, accounts receivable turnover, and average collection period.

22 34, 38 44 49

LO6 –Discuss earnings management and explain how it affects analysis and interpretation of financial statements.

27, 32, 34 42, 43, 44 47, 48

LO7 Appendix 6A – Describe and illustrate the reporting for nonrecurring items.

31 40 47


Financial Accounting, 3rd Edition 6-2

QUESTIONS

Q6-1. Revenue must be realized or realizable and earned before it can be reported in the income statement. Realized or realizable means that the company’s net assets have increased, that is, the company has received an asset (for example, cash or accounts receivable) or satisfied a liability as a result of the transaction. Earned means that the company has done everything it must do under the terms of the sale.

For retailers, like Abercrombie & Fitch, revenue is generally earned when title to the merchandise passes to the buyer (e.g., when the buyer takes possession of the merchandise), because returns can be estimated. For companies operating under long-term contracts, the earning process is typically measured using the percentage-of-completion method, that is, by the percentage of costs incurred relative to total expected costs.

Q6-2. Financial statement analysis is usually conducted for purposes of forecasting future financial performance of the company. Discontinued operations are, by definition, not expected to continue to affect the profits and cash flows of the company. Accordingly, the financial statements separately report discontinued operations from continuing operations to provide more useful measures of financial performance and financial income. For example, yielding an income measure that is more likely to persist into the future, and a net assets measure absent discontinued items.

Q6-3. In order for an event to be classified as an extraordinary item, its occurrence must be both unusual and infrequent. Items that are considered to be both unusual and infrequent might be the destruction of property by natural disaster or the expropriation of assets by a foreign government in which the company operates. Gains and losses on early retirement of long-term bonds, once comprising the majority of extraordinary items, are no longer considered as such unless they meet the tests outlined above. Other events not likely to be included as extraordinary items include asset write-downs, gains and losses on the sales of assets, and costs related to an employee strike.

Q6-4. Restructuring costs typically consist of two general categories: asset write-downs and accruals of liabilities. Asset write-downs reduce assets and are recognized in the income statement as an expense that reduces income and, thus, equity. Liability accruals create a liability, such as for anticipated severance costs and exit costs, and yield a corresponding expense that reduces income and equity.

Big bath refers to an event in which companies are perceived as overestimating the amount of asset write-downs or liability accruals to deliberately reduce current period earnings so as to remove future costs from the balance sheet or to create ‘reserves’ that can be used to increase future period earnings.



Q6-5. Earnings management may be motivated by a desire to reach or exceed previously stated earnings targets, to meet analysts’ expectations, or to maintain steady growth in earnings from year to year. This desire to achieve income goals may be motivated by the need to avoid violating covenants in loan indentures or to maximize incentive-based compensation.

The tactics used to manage income involve transaction timing (recognizing a gain or loss) and estimations that increase (or decrease) income to achieve a target.

Q6-6. Pro forma income adjusts GAAP income to eliminate (and sometimes add) various items that the company believes do not reflect its core operations. Such pro forma disclosures are only reported in earnings and press releases and are not part of the published 10-Ks or other annual reports provided for shareholders. The SEC requires that GAAP income be reported together with pro forma income. Yet, companies often report their GAAP income at the very end of the earnings or press release, thus obfuscating their comparison and focusing attention on the pro forma income.

It is because of this potential to confuse the reader about the true financial performance of the company that the SEC has become concerned. Also, pro forma numbers are not subject to accepted standards (and, thus, we observe differing definitions across companies), are not subject to usual audit tests, and are subject to considerable management latitude in what is and is not included and how items are measured.

Q6-7. Estimates are necessary in order to accurately measure and report income on a timely basis. For example, in order to record periodic depreciation of long-lived assets, one must estimate the useful life of the asset. Estimates allow accountants to match revenues and expenses incurred in different periods. For example, accountants estimate warranty costs so that the warranty expense is matched against the corresponding sales revenue. If the accounting process waited until no estimates were necessary, there would be a significant delay in the reporting of financial results.

Q6-8. When analysts publish earnings forecasts, these forecasts become a benchmark against which some investors evaluate the company’s performance. A company that fails to meet analysts’ forecasts may suffer a stock price decline, even though earnings are higher than previous years’ earnings and overall performance is good. Consequently, management may feel pressure to meet or slightly exceed analysts’ forecasts of earnings.



Q6-9. Bad debts expense is recorded in the income statement when the allowance for uncollectible accounts is increased. If a company overestimates the allowance account, net income will be understated on the income statement and accounts receivable (net of the allowance account) will be underestimated on the balance sheet. In future periods, such a company will not need to add as much to its allowance account since it is already overestimated from that prior period (or, it can reverse the existing excess allowance balance). As a result, future net income will be higher.

On the other hand, if a company underestimates its allowance account, then current net income will be overstated. In future periods, however, net income will be understated as the company must add to the allowance account and report higher bad debts expense.

Q6-10. There are several possible explanations for a decrease in the allowance account. First, after an aging of accounts receivable, Wallace Company may have determined that a smaller percentage of its receivables are past due. Wallace Company may have changed its credit policy such that it is attracting lower-risk customers than in the past. Second, experience may have indicated that the percentages used to estimate uncollectibles was too high in previous years. By correcting the estimated percentage of defaults, the estimated uncollectibles would end up lower than in past years. Third, Wallace Company may be managing earnings. By lowering estimated uncollectibles, the company can increase current earnings, but may end up reporting a loss in a future year when write-offs exceed the balance in the allowance account.

Q6-11. Minimizing uncollectible accounts is not necessarily the best objective for managing accounts receivable. That objective could be accomplished by not offering to sell to customers on credit. The purpose of offering credit to customers is to increase sales and profits. Losses from uncollectible accounts are a cost of doing business. As long as the benefit (greater contribution to profits due to increased sales) exceeds the cost (increased losses due to uncollectibles) then a higher-risk credit policy which increases the amount of uncollectible accounts would be a more profitable policy.

Q6-12. The number of defaults tends to rise and fall with the economy. For example, in a recession, customers are more likely to default and companies take longer, on average, to pay their bills than during a healthy economy. This would result in higher estimated uncollectibles if the estimates are based on an aging of accounts receivable.

For many companies, sales revenue also tends to decline during a recession. If estimated uncollectibles are estimated as a percentage of sales, then the estimate would tend to fall in a recession. This is contrary to the increase in the number of defaults that occurs during a recession. Therefore, the percentage of sales approach is not as sensitive to changing economic conditions as is accounts receivable aging.



MINI EXERCISES M6-13 (15 minutes) Note: The completed contract method is not required but is presented for the purpose of comparison.

Percentage-of-Completion Method Completed Contract

Year

Costs incurred

Percent of total

expected costs

(rounded)

Revenue recognized

(percentage of

costs incurred total contract

amount)

Income (revenue – costs

incurred)

Revenue recognized

Income

2009 $ 400,000 21%a $ 525,000 $125,000 0 0

2010 1,000,000 53%b 1,325,000 325,000 0 0

2011 500,000 26%c 650,000 150,000 $2,500,000 $600,000

Total $1,900,000 $2,500,000 $600,000 $2,500,000 $600,000

a $400,000 / $1,900,000 b $1,000,000/ $1,900,000 c $500,000 / $1,900,000 M6-14 (20 minutes)

Company Revenue recognition

GAP When merchandise is given to the customer and returns can be estimated (or the right of return period has expired).

Merck When merchandise is given to the customer and returns can be estimated (or the right of return period has expired). The company will also establish a reserve and recognize expense relating to uncollectible accounts receivable at the time the sale is recorded.

Deere When merchandise is given to the customer and the right of return period, if any, has expired. The company will also establish a reserve and recognize expense for uncollectible accounts receivable and anticipated warranty costs at the time the sale is recorded.

Bank of America

Interest is earned by the passage of time. Each period, Bank of America accrues income on each of its loans and establishes a receivable on its balance sheet.

Johnson Controls

Revenue is recognized under long-term contracts under the percentage-of-completion method.



M6-15 (15 minutes) The Unlimited can only recognize revenues once they have been earned and the amount of returns can be estimated with sufficient accuracy. Assuming that happens at the time of sale, it must estimate the proportion of product that is likely to be returned and deduct that amount from gross sales for the period. In this case, it would report $4.9 million in net revenue (98% of $5 million) for the period. If The Unlimited does not have sufficient experience to estimate returns, then it should wait to recognize revenue until the right of return period has elapsed. M6-16 (20 minutes)

a. Percentage-of-completion method:

Year 2009 2010 2011 Total

Percent completed 30% 50% 20%

Revenue $12,000,000 $20,000,000 $8,000,000 $40,000,000

Construction costs 9,000,000 15,000,000 6,000,000 30,000,000

Gross profit $3,000,000 $5,000,000 $2,000,000 $10,000,000

b. Completed contract method:

Year 2009 2010 2011 Total

Revenue $40,000,000 $40,000,000

Construction costs 30,000,000 30,000,000

Gross profit $10,000,000 $10,000,000

M6-17 (20 minutes) a. A.J. Smith should recognize the warranty revenue as it is earned. Since the

warranties provide coverage for three years beginning in 2010, one-third of the revenue should be recognized in 2010, one-third in 2011, and the remaining third in 2012.

b. Year 2010 2011 2012 Total Revenue $566,666 $566,667 $566,667 $1,700,000 Warranty expenses 166,666 166,667 166,667 500,000 Gross profit $400,000 $400,000 $400,000 $1,200,000



M6-17—continued c. Total revenue from sales of the camera packages is $79,800 ($399 x 200). The

revenue is allocated among the three elements of the sale (camera, printer and warranty) as follows:

Element Retail price Proportion of total Camera $300 60% ($300/$500) Printer 125 25% ($125/$500) Warranty 75 15% ($75/$500) Total $500 100%

Using these proportions, the revenue is allocated among the three elements and recognized for each element as it is earned. In this case, the portion of the revenue allocated to the camera and printer are recognized immediately, while the revenue allocated to the warranty is deferred and recognized over the three-year warranty coverage period.

Year Revenue 2010 $67,830 ($79,800 x .6 + $79,800 x .25) 2011 3,990 ($79,800 x .15 / 3) 2012 3,990 2013 3,990 Total $79,800

M6-18 (15 minutes) a. To bring the allowance to the desired balance of $2,100, the company will need

to increase the allowance account by $1,600, resulting in bad debt expense of that same amount.

b. The net amount of Accounts Receivable is calculated as follows: $98,000 $2,100 = $95,900.

c.

- Allowance for Doubtful Accounts (XA) + + Bad Debt Expense (E) -

500 Balance (a) 1,600 1,600 (a)

2,100 Balance Balance 1,600



M6-19 (15 minutes) a. Credit losses are incurred in the process of generating sales revenue. Specific

losses may not be known until many months after the sale. A company sets up an allowance for uncollectible accounts to place the expense of uncollectible accounts in the same accounting period as the sale and to report accounts receivable at its estimated realizable value at the end of the accounting period.

b. The balance sheet presentation shows the gross amount of accounts

receivable, the allowance amount, and the difference between the two, the estimated net realizable value. The balance sheet, thus, reports the net amount that we expect to collect. That is the amount that is the most relevant to financial statement users.

c. The matching concept requires that expenses (credit losses) related to a given

revenue be matched with, and deducted from, the revenue in the determination of net income. This dictates the use of the allowance method. Recognition of expense only upon the write-off of the account would delay the reporting of our knowledge that losses are likely and, thereby, reduce the informativeness of the income statement. Accountants believe that providing more timely information justifies the use of estimates that may not be as precise as we would like.

M6-20 (20 minutes) a.

($ millions) 2008 2007

Accounts receivable (net) .......................................... $4,704 $5,197

Allowance for uncollectible accounts ...................... 129 94

Gross accounts receivable ........................................ $4,833 $5,291

Percentage of uncollectible accounts to gross accounts receivable .....................................

2.67% ($129/$4,833)

1.78% ($94/$5,291)

b. The increase in the allowance for uncollectible accounts as a percentage of

gross accounts receivable may indicate that the quality of the accounts receivable has declined, perhaps because the economy has deteriorated, the company is selling to a less creditworthy class of customers, or the company’s management of accounts receivable is less effective. It may also indicate, however, that the receivables were under-reserved (e.g., allowance account was too low last year). This would result in lower reported profits in the current year because past profits were too high.



M6-21 (10 minutes) Bad debt expense of $2,400 ($120,000 × 0.02) would cause the allowance for

uncollectibles to increase by the same amount. If the allowance increased by only $2,100 for the period, Sloan Company must have written off accounts totaling $300. Under accounts receivable, sales revenue increased the account by $120,000, and the write offs would decrease it by $300. If there was a net increase of $15,000 for the period, Sloan Company must have collected $104,700 in cash. ($104,700 = $120,000 - $300 - $15,000.)


Accounts Receivable Turnover rates for 2009

Procter & Gamble $76,029 / [($5,836+$6,761)/2] = 12.07

Colgate-Palmolive $15,330 / [($1,592+$1,681)/2] = 9.37

b. P&G turns its accounts receivable much faster than Colgate-Palmolive.

Receivable turns typically evolve to an equilibrium level for each industry that arises from the general business models used by industry competitors. Differences can arise due to variations in the product mix of competitors, the types of customers they sell to, their willingness to offer discounts for early payment, and their relative strength vis-à-vis the companies or individuals owing them money. Both of these companies sell a significant amount of their product to Wal-Mart. P&G is a sizable company, and may have greater bargaining power over Wal-Mart than does the smaller Colgate-Palmolive.

One other possibility is that the difference is due to the companies’

differing fiscal year-ends. If the receivable balance is not constant during the year due to some seasonality, then the receivable turnover ratio will depend on the choice of fiscal year.



M6-23 (20 minutes)

a. i. Accounts receivable (+A) ……………………………………… 3,200,000 Sales revenue (+R, +SE) ………………………………… 3,200,000 ii. Bad debts expense (+E, -SE) ………………………………… 42,000 Allowance for uncollectible accounts (+XA, -A)… 42,000 iii. Allowance for uncollectible accounts (-XA, +A) …… 39,000 Accounts receivable (-A) ………………………………… 39,000 iv. Accounts receivable (+A) ……………………………………… 12,000 Allowance for uncollectible accounts (+XA, -A) 12,000 Cash (+A) ……………………………………………………… 12,000 Accounts receivable (-A) ………………………………… 12,000

The recovered receivable is reinstated, so that its payment may be properly

recorded. b. Besides the $12,000 in recovery, the collections from customers can be

summarized in the following entry:

v. Cash (+A) 2,926,000 Accounts receivable (-A) 2,926,000

(This amount includes payment of the recovered receivable for $12,000. The

allowance increases by $15,000 over the period, so the fact that net receivables increased by $220,000 means that gross receivables must have increased by $235,000. That fact allows us to “back out” the cash received.)

c.

+ Cash (A) - - Sales Revenue (R) +

(iv) 12,000 3,200,000 (i)

(v) 2,926,000

2,938,000

+ Accounts Receivable (A) - + Bad Debts Expense (E) -

(i) 3,200,000 (ii) 42,000

(iv) 12,000 39,000 (iii) 12,000 (iv) 2,926,000 (v)

235,000

- Allowance for Uncollectibles (XA) +

42,000 (ii) (iii) 39,000 12,000 (iv)

15,000



d.

Balance Sheet Income Statement

Transaction Cash Asset

+

Noncash Assets -

Contra Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital

Revenues - Expenses = Net Income

i. Sales on account.

+3,200,000 Accounts

Receivable -

=

+3,200,000 Retained Earnings

+3,200,000 Sales

Revenue -

=

+3,200,000

ii. Bad debt expense.

-

+42,000

Allowance for Uncollectible

Accounts

=

-42,000

Retained Earnings

-

+42,000

Bad Debt Expense

=

-42,000

iii. Write-off of uncollectible accounts.

-39,000

Accounts Receivable

-

-39,000


Accounts

=

-

=

iv. Reinstate account previously written off.

+12,000 Accounts

Receivable -

+12,000


Accounts

-

=

Collect reinstated account.

+12,000 Cash

-12,000

Accounts Receivable

- - =

v. Collect cash on sales.

+2,926,000

Cash

-2,926,000 Accounts

Receivable -

=

-

=




Fiscal year Revenue Revenue growth

2007 48,000

2008 55,000 14.6%

2009 62,000 12.7%

2010 62,000 0.0%

b.

Fiscal year

Revenue Unearned revenue liability (end of

year)

Purchases = Revenue + Change in Unearned revenue liability

Growth in purchases

2007 48,000 20,000

2008 55,000 24,000 55,000 + 4,000 = 59,000

2009 62,000 26,000 62,000 + 2,000 = 64,000 8.5%

2010 62,000 25,000 62,000 - 1,000 = 61,000 -4.7%

c. In both fiscal year 2009 and 2010, the growth in customer purchases is lower than the growth in reported revenues. The practice of deferring revenue recognition implies that reported revenues in a given period are the result of customer purchases over many periods, resulting in a smoothing of revenues. In the case of Finn Publishing, revenues in any given year are the result of newsstand and bookstore purchases during that year, plus part of the subscriptions from that year, plus part of the subscriptions from the previous year. That means that growth in annual revenues is a composite of growth in customer purchases over an even longer period of time. For 2009 and 2010, Finn’s growth in revenues exceeds the growth in purchases because the revenues are still reflecting growth from prior periods. Purchases are a “leading indicator” of revenues, and calculating purchase behavior can be useful in forecasting future revenue and identifying changes in customers’ attitudes about a company’s current offerings.

M6-25 (20 minutes) This question is based on an actual situation, in which the accounting rules were influencing the product decisions. The rules for revenue deferral when there are multiple deliverables deterred the company from providing enhancements and upgrades that were available. If Commtech’s customers (the wireless companies) had been willing to pay for the upgrades to its customer’s phones, that would have been allowed. (It’s not clear what the wireless companies’ incentives would be, because they may want to encourage users to purchase new phones – with a new service contract – rather than improving their existing phones.)



M6-25—continued. The question can generate a discussion about whether accounting should drive decisions. Whether it should or not, it does, so the question should evolve into what top management should do about this type of situation. Does the situation described in the problem require some managerial action, or not. Is the company foregoing sales because of its accounting? Within Commtech, the finance staff was skeptical of marketing’s predictions that the upgrades and enhancements would increase the sales of existing phone models. If the upgrades and enhancements are delivered, Commtech will have to change its accounting for revenue, with a resulting decrease in near-term profitability. How might the company communicate that change in a way that the investing public will understand as a net benefit to the company?



EXERCISES E6-26 (20 minutes) Company Revenue recognition

The Limited When merchandise is given to the customer and returns can be estimated (or the right of return period has expired).

Boeing Corporation

Revenue is recognized under long-term contracts under the percentage-of-completion method.

SUPERVALU When merchandise is given to the customer and cash is received.

MTV When the content is aired by the TV stations.

Real estate developer

When title to the houses is transferred to the buyers.

Wells Fargo Interest is earned by the passage of time. Each period, Wells Fargo accrues income on each of its loans and establishes an account receivable on its balance sheet.

Harley-Davidson

When title to the motorcycles is transferred to the buyer. Harley will also set up a reserve for anticipated warranty costs and recognize the expected warranty cost expense when it recognizes the sales revenue.

Time-Warner When the magazines are sent to subscribers.

E6-27 (20 minutes) Company Revenue recognition

Real Money Recognize revenue ratably over the period of time that customers can access its Web site, not when the cash is received. The recognition of revenue is dependent upon Real Money providing updates.

Oracle The fee to purchase the right to use the software can be recorded as revenue when the software is installed, unless that fee includes future deliverables like upgrades and support. (If such post-sale services are included in the fee, some portion must be deferred and recognized over the appropriate period.) Service revenue can only be recognized ratably over the period of time covered by the service contract.

Intuit Recognize revenue when the software is sent to customers. The company must estimate potential warranty claims and establish a reserve for them when revenue is recorded.

Computer game developer

Record revenue after the 10-day right of return period has elapsed.



E6-28 (20 minutes) a.

($ millions) Percentage-of-Completion Method Completed Contract

Year

Costs incurred

Percent of total

expected costs

Revenue recognized (percentage of costs

incurred total

contract amount)


incurred)

Revenue recognized

Income

2010 $100 25% $125 $ 25 $ 0 $ 0

2011 300 75% 375 75 500 100

$400 $500 $100 $500 $100

b. ($ millions) Installment Method

Year

Cash

collected

Revenue

recognized

Expense recognized

[Revenue 1- gross profit margin (20%)]

Income

(Revenue 20%)

2010 $300 $300 $240 $ 60

2011 200 200 160 40

$500 $500 $400 $100

c. The percentage-of-completion method normally provides a reasonable

estimate of the revenues, expenses, and income earned for each period. A key is obtaining good estimates of expected costs and costs to date. This method is also acceptable under GAAP for contracts spanning more than one accounting period, such as in the consulting and transportation industries.




($ millions) Percentage-of-Completion Method Completed Contract

Year

Costs incurred

Percent of total

expected costs

(rounded)

Revenue recognized (percentage of costs

incurred total

contract amount)


incurred)

Revenue recognized

Income

2010 $15 18% ($15/$85)

$ 21.6 $ 6.6 $ 0 $ 0

2011 40 47% ($40/$85)

56.4 16.4 0 0

2012 30 35% ($30/$85)

42.0 12.0 120 35

$85 $120.0 $35.0 $120 $ 35

($ millions) Installment Method

Year

Cash

collected

Revenue recognized

Expense recognized

[Revenue 1- gross

profit margin (29.17%)]

Income

(Revenue 29.17%)

2010 $30 $30 $21.25 $ 8.75

2011 50 50 35.42 14.58

2012 40 40 28.33 11.67

$120 $120 $85.00 $35.00

b. The percentage-of-completion method provides a good estimate of the

revenue and income earned in each period. This method is also acceptable under GAAP for contracts spanning more than one accounting period. Recognition of revenue and income is not affected by the cash received, except under the installment method.

E6-30 (15 minutes) a. Year 2010 2011 2012 2013 Total Revenue $1,000,000 $750,000 $500,000 $250,000 $2,500,000 Cost of software* 180,000 135,000 90,000 45,000 450,000 Gross profit $820,000 $615,000 $410,000 $205,000 $2,050,000

* $180,000 = $450,000 x $1,000,000/$2,500,000 $135,000 = $450,000 x $750,000/$2,500,000 $90,000 = $450,000 x $500,000/$2,500,000 $45,000 = $450,000 x $250,000/$2,500,000



E6-30—continued. b. By 2012, Bryant had recognized gross profit of $1,435,000 ($820,000 +

$615,000). However, only $315,000 ($180,000 + $135,000) of the software cost had been recognized. If none of the remaining cost was recoverable after the default, Bryant would recognize a loss equal to the remaining cost in 2012. Hence, Bryant would record a loss in 2012 of $135,000 ($90,000 + $45,000).


Balance Sheet Income Statement

Transaction Cash Asset

+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital

Revenues - Expenses = Net

Income

a. To record restructuring loss

-159

-186 Plant

Assets, etc. =

+198 Liability

for Restruct-

uring

-543 Retained Earnings

-

+ 543 Loss due to

Restruct- uring =

-543

Loss due to restructuring 543 Plant assets, etc.*

Cash 186

159 Liability for restructuring 198

* The credit to plant assets would most likely be recorded in a contra asset account.

+ Cash (A) - + Plant Assets (A) -

159 (a) 186 (a)

+ Loss Due to Restructuring (E) - - Liability for Restructuring (L) +

(a) 543 198 (a)

b. Restructuring charges should not be classified as discontinued operations.

The term discontinued operations refers to discontinuing a component of the company with separately identifiable operations and cash flows. Restructuring charges generally do not meet this definition. However, restructuring charges are a transitory component of income and, if material, should be reported separately in the income statement (which PepsiCo does not).



E6-32 (15 minutes)

In none of these cases should Simpyl Technologies recognize revenue. Each of the four settings touches on one of the four conditions for revenue recognition listed by the SEC. In part a, “persuasive evidence of an exchange agreement” does not yet exist, because the company’s policies have defined a contract with authorized signatures to constitute persuasive evidence. In part b, delivery has not occurred. The product has been shipped, but not to the customer and not with the specified customizations that are required by the customer. In part c, the price is not yet fixed or determinable, because the negotiations over volume discounts have not been concluded. Finally, the distributor in part d does not have the means to pay for the items delivered, so collectibility cannot be reasonably assured (until the distributor sells the product to an end customer). The delivery should be viewed as a consignment arrangement, in which Simpyl recognizes revenue when the distributor sells the items to a third party.

This problem is based on the restatements of Symbol Technologies, Inc.’s 10-K filing for fiscal year 2002, in which they detail the errors and irregularities in financial statements dating back to 1998. Symbol had made accounting entries that violated each of the SEC’s four criteria for revenue recognition. An article by Steve Lohr describing the incoming CEO’s experiences at Symbol Technologies can be found in the New York Times, June 21, 2004. The title of the article is “Day 2: I Learn the Books are Cooked.” (Motorola, Inc., acquired Symbol Technologies in January 2007 for a price of $3.9 billion.)

E6-33 (20 minutes) a. Prior to the aging of accounts, the balance in the Allowance for Uncollectible

Accounts would be a credit of $520 (the opening balance of $4,350 less the amounts written off of $3,830).

2010 bad debt expense computation

$250,000 × 0.5% = $1,250

$90,000 1% = 900

20,000 2% = 400

11,000 5% = 550

6,000 10% = 600

4,000 25% = 1,000 4,700

Less: Unused balance before adjustment 520 Bad debt expense for 2010 $4,180 b. Accounts receivable, net = $381,000 - $4,700 = $376,300

Reported in the balance sheet as follows: Accounts receivable, net of $4,700 in allowances .............................. $376,300



c. + Bad Debts Expense (E) - - Allowance for Uncollectible Accounts (XA)

+

(a) 4,180 4,350 Balance Write-offs 3,830 4,180 (a)

4,700 Balance

E6-34 (35 minutes) a. Allowance for doubtful accounts (-XA) 400 Accounts receivable (-A) 400 Allowance for doubtful accounts (-XA) 773 Provision for doubtful accounts (-E,+SE) 773 The latter entry is the reverse of the normal one (and reversed from previous

years). The provision for doubtful accounts (bad debt expense) has a credit entry that has the effect of increasing Ethan Allen’s reported income by $773 (thousand) for the year.

b. and c.

2009 2008 2007

From the income statement:

Net sales $674,277 $980,045 $1,005,312

From the balance sheet:

Accounts receivable, net 13,086 12,672 14,602

From the disclosure on Allowance for doubtful accounts:

Balance at beginning of period 2,535 2,042 2,074

Additions (reductions) charged to income (773) 493 10

Adjustments or deductions (400) – (42)

Balance at end of period 1,362 2,535 2,042

Gross receivables (net plus allowance) 14,448 15,207 16,644

Allowance as a % of gross receivables 9.4% 16.7% 12.3%

Accounts receivable turnover (Sales ÷ Average AR, net)

52.4 71.9



Ethan Allen’s allowance was 16.7% of its gross receivables at the end of 2008. If that percentage were applied to the 2009 gross receivables, it would produce an allowance of $2,408 (14,448×16.7%) which is $1,046 higher than the amount in Ethan Allen’s allowance at the end of 2009. Bad debt expense (provision for doubtful accounts) would have been higher by this amount if the same percentage were applied.

d. Accounts receivable started with a balance of $15,207 and was increased by $674,277 in net sales. The account was decreased by write-offs of $400, and ended with a balance of $14,448. Therefore, the amount collected must have been $674,636 ($15,207 + $674,277 - $400 - $14,448).

e. The patterns in Ethan Allen’s allowance account are unusual. In 2008, the company recorded a large bad debt expense relative to previous years, but wrote off no accounts. In 2009, the company wrote off some accounts (less than 3% of the opening balance), and then reduced its allowance by debiting it and crediting income. Perhaps the company was overly pessimistic about its collections in 2008 and became much more optimistic in 2009. That is not the experience of many companies in this time period.

The very fast ART is probably due to the custom furniture aspect of Ethan

Allen’s business. Many of their products are not produced until a customer places an order, so payment occurs very soon after delivery.

E6-35 (20 minutes) Accounts receivable $138,100 Less Allowance for uncollectible accounts 10,384 $127,716 Computations

Accounts Allowance for Receivable Uncollectible Accounts

Beginning balance $ 122,000 $ 7,900 Sales 1,173,000 Collections (1,150,000) Write-offs ($3,600 + $2,400 +$900) (6,900) (6,900)

Provision for uncollectibles ($1,173,000 0.8%) _________ 9,384 $ 138,100 $ 10,384



E6-36 (20 minutes) a. Aging schedule at December 31, 2010

Current $304,000 1% = $ 3,040

0–60 days past due 44,000 5% = 2,200

61–180 days past due 18,000 15% = 2,700

Over 180 days past due 9,000 40% = 3,600 Amount required 11,540 Balance of allowance 4,200 Provision $ 7,340 = 2010 bad debt expense b. Current Assets Accounts receivable $375,000 Less: Allowance for uncollectible accounts 11,540 $363,460 c.

+ Bad Debts Expense (E) - - Allowance for Uncollectible Accounts (XA) +

(a) 7,340 4,200 Balance 7,340 (a)

11,540 Balance


Year Sales Collections Accounts Written Off

2009 $ 751,000 $ 733,000 $ 5,300 2010 876,000 864,000 5,800 2011 972,000 938,000 6,500 Total $2,599,000 $2,535,000 $17,600

Accounts Receivable at the end of 2011 is:

$46,400, computed as ($2,599,000 - $2,535,000 - $17,600). Bad Debts Expense is:

2009 $ 7,510 computed as 1% $751,000

2010 8,760 computed as 1% $876,000

2011 9,720 computed as 1% $972,000

2009-2011 $25,990 computed as 1% $2,599,000 Allowance for Uncollectible Accounts is:

$8,390, computed as $25,990 total bad debts expense less $17,600 in total write-offs.



E6-37—continued. b.

Accounts Receivable (A) Allowance for Uncollectibles (XA)

Beg Bal 0 0 Beg Bal

Sales 751,000 5,300 Write offs

Write offs 5,300 7,510 Bad debts expense

733,000 Collections

2009 Bal 12,700 2,210 2009 Bal



864,000 Collections

2010 Bal 18,900 5,170 2010 Bal



938,000 Collections

2011 Bal 46,400 8,390 2011 Bal

There isn’t any indication that the 1% rate is incorrect. If the rate is too high, we would expect the allowance to grow at a faster rate than receivables. If the rate is too low, the opposite would occur. In this case, the allowance percentage of receivables is 17%, 27% and 18% at the end of 2009, 2010 and 2011, respectively. So, there is no clear direction that would indicate an inappropriate estimate.


Earnings from

operations

End. Assets

Beg. Assets

Avg. Assets

ROCE

Technology Solutions Group $ 5,529 $ 63,008 $ 39,116 $ 51,062

10.8%

Personal Systems Group 2,375

16,451 14,153

15,302

15.5%

Imaging and Printing Group 4,590

14,203

14,573

14,388

31.9%

HP Financial Services 192

9,174

9,001

9,088

2.1%



b.

Earnings from

operations

NOPAT=(1-0.2)×Earnings

from Opns

Revenues NOPM

Technology Solutions Group $5,529 $4,423 $44,826 9.9%

Personal Systems Group 2,375 1,900 42,295 4.5%

Imaging and Printing Group 4,590 3,672 29,385 12.5%

HP Financial Services

192 154 2,698 5.7%

c. The most profitable group seems to be the Imaging and Printing Group,

which represent’s HP’s traditional strength. However, it is not growing very quickly (sales percentage increases in the single digits). The Personal Systems Group (commercial and personal PCs, workstations, etc.) has good ROCE, even though its NOPM is not high, because it has high asset turnover. The Technology Solutions Group (including the newly-acquired EDS consulting business) has substantial assets, which reduce the ROCE, but it is the area of highest growth.

E6-39 (20 minutes) a. Just like for-profit organizations, not-for-profit organizations cannot

recognize revenue until it has been earned. In the case of The Lyric Opera, it cannot recognize the ticket revenue until the performances occur. (The Lyric does not issue quarterly reports, so we cannot observe how much of the revenue has been earned by six months through its fiscal year.)

b. This entry is simplified by the fact the fiscal year-end is after the end of the current season and by assuming that all of The Lyric’s deferred revenue relates to the following season (and none to any years after the following season).

To record revenue for the fiscal year 2009 season: Deferred ticket and other revenue (-L) 17,246 Cash or Accounts receivable (+A) 10,805 Ticket sales (+R, +NA) 28,051 (As a not-for-profit, The Lyric Opera does not have shareholders’ equity,

but rather “net assets.” Therefore, the recognition of revenue increases net assets (NA) on the balance sheet.)

To record advance purchases for the fiscal year 2010 season: Cash or Accounts receivable (+A) 13,103 Deferred ticket and other revenue (+L) 13,103



c. It’s likely that the downturn in the economy caused some subscribers not

to renew (or to wait until after April 30 to renew). It’s possible that the decline in advance purchases is a statement about the opera selections for the 2009-10 season. However, the loyal subscriber base (and the desire to keep one’s assigned seating) makes the economy a more likely cause.

d. The Lyric Opera usually operates at close to seating capacity. And, in a typical year, approximately 60% of its seats are sold by the April 30th preceding the season. So, the quantity of unsold seats will affect The Lyric’s marketing efforts for subscribers who have not yet renewed, outreach to new potential subscribers and promotions for individual tickets which go on sale shortly before the season. Those efforts can be scaled up or down depending on the experience with advance sales.



PROBLEMS P6-40A (20 minutes) a. The following items might be considered to be operating: 1. Net Sales, cost of sales, R&D expenses, and SG&A expenses are typically

designated as operating. 2. Amortization of intangible assets and restructuring charges would usually be

considered to be operating under the assumptions that the acquisition that gave rise to the intangible assets is included as part of operations, and that the restructuring did not involve discontinuation of distinct parts of the business.

3. The asbestos-related credit would be considered to be operating since it is related to Dow Chemical’s operating activities. The same is true of the goodwill impairment losses. (These items are both operating and transitory – see b.)

4. Purchased in-process research and development charges and Acquisition-related expenses are caused by the company’s investing activities, and would be considered nonoperating.

5. Equity in earnings of nonconsolidated affiliates would be considered operating under the assumption that the affiliates are related to Dow’s core operations, which is typically the case.

6. Sundry income would generally be considered nonoperating in the absence of a footnote clearly indicating its connection to the operating activities of the company.

7. Interest income (expense) is considered nonoperating 8. Minority interests’ share in income is nonoperating as it relates to equity that

is nonoperating. Due to changes discussed in Chapter 12, Dow’s 2009 income statement will not show Minority interest in the determination of net income.

b. The following items might be identified as transitory items:

1. Purchased in-process research and development and Acquisition-related expenses – these are one-time (e.g., transitory) costs incurred in connection with the acquisition of another company and can properly be expensed under GAAP.

2. Asbestos-related credit – this is a reversal of a previous accrual for litigation in connection with asbestos-related lawsuits. GAAP requires such an accrual if the loss is probable and can be reasonably estimated. Since it is a one-time occurrence, it can be considered to be a transitory item.

3. Goodwill impairment losses – this loss results from changes in expectations of the performance of past acquisitions. It would be considered operating, but transitory.

4. Restructuring charges – these relate to the company’s actions due to the economic decline in 2008 and the expectations that future performance will



not meet prior expectations. Restructuring costs are considered “special items,” meaning that individually they are transitory, but as a category, they happen frequently. (Dow had restructuring charges – from other causes – of $578 million and $591 million in 2007 and 2006, respectively.)

We would need to examine prior years’ income statements to discern if the other categories in Dow’s income statement are to be considered transitory. P6-41 (20 minutes) a. 1. Percentage-of-completion based on number of employees trained

Year 2010 2011 2012 Total Number of employees trained 125 200 75 400 Revenues (# trained x $1,200) $150,000.00 $240,000.00 $90,000.00 $480,000.00 Expenses (# trained x $437.50)* 54,687.50 87,500.00 32,812.50 175,000.00 Gross Profit $95,312.50 $152,500.00 $57,187.50 $305,000.00

* $437.50 = $175,000 / 400 2. Percentage-of-completion based on costs incurred

Year 2010 2011 2012 Total Costs incurred $60,000 $75,000 $40,000 $175,000 Percentage completed 34.29% 42.86% 22.86% 100.00% Revenues (% x $480,000) $164,571.43 $205,714.29 $109,714.29 $480,000.00 Expenses 60,000.00 75,000.00 40,000.00 175,000.00 Gross Profit $104,571.43 $130,714.29 $69,714.29 $305,000.00

3. Completed contract method

Year 2010 2011 2012 Total Revenues $0 $0 $480,000 $480,000 Expenses 0 0 175,000 175,000 Gross Profit $0 $0 $305,000 $305,000

b. Assuming that (1) Philbrick has a noncancelable contract that specifies the

price at $1,200 per employee, (2) the number of employees and the costs of training can be estimated with a reasonable degree of accuracy, and (3) Elliot Company is a reasonable credit risk, the best method would be to recognize revenues using the percentage-of-completion method based on the number of employees trained. The completed contract method should only be used if either of the first two conditions is not met.



P6-42 (15 minutes) a. Management would have an incentive to shift $1 million of income from the

current period into next. This might be accomplished by delaying revenue recognition or accelerating expenses. This would increase their bonus by $100,000 next year without decreasing the current bonus.

b. Management would have an incentive to shift $3 million of income from next

year into income reported this year. This would increase the current year bonus by $300,000 without reducing next year’s bonus.

c. Management would have an incentive to shift income from the current year

into next year. Even though this would reduce earnings this year, earnings are already so low that management does not expect to receive a bonus. Shifting earnings into a future period increases the bonus in that period.

d. These incentives for earnings management would be mitigated if the “kinks”

in the bonus formula were removed. Alternatively, some companies pay bonuses based on a three-year moving average of earnings to minimize the impact of earnings management.

This problem can provide an opportunity to discuss the “slippery slope” of earnings management. For example, management’s optimism about next year in part b may not turn out to be warranted. Suppose next year’s “natural” earnings turns out to be $20 million instead of $24 million. Management’s action in the first year will have reduced next year’s $20 million to $17 million, and earnings management would again be required to meet the target. And, if meeting the target in one year causes the next year’s target to increase, things can get out of control very quickly.



P6-43 (30 minutes) a. 2007: $61,471 million ÷ $7,275 million = 8.45. 2006: $57,878 million ÷ $6,161 million = 9.39. Customers appear to be paying more slowly in 2007 than in 2006. In 2007,

the average customer is taking about a month and a half to pay (and about 4 days longer than in 2006).

b. Accounts receivable, net, is $8,054 million (=$8,624 million - $570 million). c. To record the bad debt provision: Bad debt provision (+E, -SE) 481 Allowance for doubtful accounts (+XA, -A) 481 To record write-offs of receivables: Allowance for doubtful accounts (-XA, +A) 428 Accounts receivable (-A) 428 d. There are two items of information that conflict with the drop from 7.7% to

6.6%. First, the write-offs as a percentage of average receivables is going up from 5.1% to 5.9%. Second, the information on past due accounts (basically an aging analysis) indicates that the percentage of Target’s receivables that are significantly past due has been increasing. In any normal aging of accounts analysis, that would lead to an increased allowance as a percentage of the receivables balance.

e. There are quite a few reasons that might account of the disparity in part d.

For example, it could be that Target has changed its credit policies in the middle of 2007. So, there is a “holdover” of late accounts, but Target expects that the remainder of the accounts will have a better rate of collection than they have experienced in the past.

However, one must consider the possibility of earnings management. Target’s pretax earnings were $4,625 million in 2007 and $4,497 million in 2006, an increase of $128 million. If Target had kept its allowance at 7.7% of gross accounts receivables, it would have needed an allowance of $664 million and an increase in its bad debt provision (and a decrease in pretax income) of $94 million ($664 million - $570 million), reducing the already modest increase in income. In fact, if the allowance were anything over about 8.1% of receivables, the change in pretax income would have been negative.

Postscript: In fiscal year 2008, the estimates used for uncollectible accounts changed

significantly. The 2008 bad debt provision was $1,251 million (a 160% increase over 2007), and the ending allowance for doubtful accounts was $1,010 (11.1% of ending accounts receivable).



P6-44 (40 minutes)

(all in $ millions)

a. Gross receivables as of 2002 are $5,667 + $2,379 = $8,046.

Gross receivables as of 2001 are $6,054 + $1,889 = $7,943. b. Estimated uncollectible accounts to gross accounts receivable are:

30% ($2,379/$8,046) in 2002 24% ($1,889/$7,943) in 2001

Gross receivables to sales are:

19.6% ($8,046/$40,961) in 2002 21.4% ($7,943/$37,166) in 2001

Although receivables are a lower percentage of sales in 2002, it appears that their collectibility is less certain.

c. The receivables turnover rate is $40,961 / [($5,667 + $6,054)/2] = 6.99

Days sales in accounts receivable is $5,667/ ($40,961/365) = 50.5 days The AOL part of the business is mainly a cash basis operation and we would expect relatively minor receivables. The Time, Inc., portion of the business contains publishing, cable, film and music. Although the magazine publishing business does not carry significant receivables, the other lines of business do.

On the whole, 50.5 days sales on average in accounts receivable for this type of business seems high, and our concern is increased by the relatively high levels of estimated uncollectible accounts.

d. Time-Warner significantly increased its allowance for uncollectible accounts

as a percentage of gross accounts receivable. There are two possible reasons for this, neither of which are particularly good for AOL: 1. The financial condition of its customers has deteriorated significantly, thus

warranting a higher reserve, or 2. Time-Warner arbitrarily increased its allowance account. The second alternative would be consistent with the “big bath” theory. By increasing its allowance account more than necessary, it might have recorded more expense in 2002 than was warranted and created an allowance account that was higher than warranted. In future years, then, Time-Warner might have the ability to reverse this allowance account to immediately improve earnings, or it might just allow the allowance account to decline gradually as credit losses are recognized. In either case, future profits would be higher as Time-Warner would not have the current period expense to increase the allowance account.



A careful reader of the financial statements would keep an eye on these accounts in future years. Allowances as a percentage of gross receivables remained at 30% in 2003 and went to 28% in 2004, so there does not seem to be any significant reversal of the provisions taken in 2002. In retrospect, it appears that the first possible reason (deteriorating receivables) is the more likely of the two.

P6-45 (25 minutes)

For the instructor:

This problem covers the accounting for product returns, which is not covered in the chapter. The description of The Gap’s practices should allow students to answer parts a and b. Part c is a bit of a stretch, because it requires that the allowance for returns, which is in gross profit terms, be “grossed-up” to revenue terms.

a. Beginning balance + $700 million - $701 million = $21 million, so Beginning

balance = $22 million. b. Sale and expected returns: (1) Record revenue. Cash (+A) 5,000 Revenue (+R,+SE) 5,000 (2) Record COGS. Cost of goods sold (+E,-SE) 3,000 Inventory (-A) 3,000 (3) Recognize expected returns.

Revenue contra, returns (+XR, -SE) 500 COGS contra, returns (+XE, +SE) 300

Sales returns allowance (+L) 200 The sales returns allowance is equal to Gross sales ($5,000) times the probability of return (10%) times the gross profit margin (40%), or $200. For these ten units, the cost of goods was $300. Returns: (4) Process return transactions.

DR Inventory (+A) 300 DR Sales returns allowance (-L) 200

CR Cash (-A) 500 At the conclusion of this transaction, the customers have their cash, the

inventory costs have been adjusted to include the returned items, and the sales returns allowance liability has a balance of zero because the actual returns coincided with the expected returns.

c. The Gap’s reported gross profit is 37.5% of its net sales ($5,447million/$14,526

million). So, if The Gap expects returns of items with gross profit of $700 million, those items must have had sales prices of $1,867 million ($700 million/0.375) and cost of goods sold of $1,167 million ($1,867 million - $700



million). The entry that would have reflected The Gap’s accounting for these expected returns is the following:

Recognize expected returns.

Revenue contra, returns (+XR, -SE) 1,867 COGS contra, returns (+XE, +SE) 1,167

Sales returns allowance (+L) 700 The Gap’s gross sales revenue would have been $16,393 million ($14,526

million + $1,867 million), and its expected returns as a percentage of sales would be 11.4% ($1,867 million/$16,393 million).

The size of the allowance for 2008 ($700 million) relative to the end-of-year

return liability ($21 million) means that the vast majority of these product returns occurred during the 2008 fiscal year, so it is more a reflection of actual experience than of management’s estimates of future events.

d. Under these circumstances, The Gap doesn’t have to worry about accounting

for expected returns, because it has not satisfied the requirements for revenue recognition. If the amount to be received (or in this case, the amount to be kept) is not yet “fixed or determinable,” the revenue should not be recognized until it is.

P6-46 (25 minutes)

a.

Fiscal year ending March

31

Net revenue Growth rate

2005 3,129 –

2006 2,951 -5.7%

2007 3,091 4.7%

2008 3,665 18.6%

2009 4,212 14.9%

b.

Fiscal year ending

March 31

Net revenue

Deferred net revenue (liability)

Purchases = Net revenue + Change in Deferred net revenue

Growth rate

2005 3,129 0 3,129 –

2006 2,951 9 2,960 -5.4%

2007 3,091 32 3,114 5.2%

2008 3,665 387 4,020 29.1%

2009 4,212 261 4,086 1.6%



When companies defer revenue, there is a lag between customers’ purchases and the recognition of revenue on the income statement. In 2006, 2007 and 2008, a growing portion of EA’s sales to customers were deferred, as there was an increase in the rate of growth in purchases. So the growth in revenues was less than the growth in customer purchases. However, the growth in customer purchases for 2009 was not large – only 1.6%. The substantial growth in revenue for 2009 is a vestige of the higher growth rates in previous years (particularly 2008).

c. If customer purchases in 2009 are a leading indicator of customer purchases

in 2010, we would predict a substantial drop in revenue growth for 2010 over 2009.



CASES C6-47A (60 minutes) a. i. SALES – revenue is normally earned when title to the product passes to the

customer who either purchases the product for cash or on credit terms. ii. SERVICES, OUTSOURCING AND RENTALS – revenue from services is normally

earned as the service is performed, usually ratably over the period of the service contract. The same applies to outsourcing and rentals.

iii. FINANCE INCOME – revenue from finance income (normally interest) is earned

with the passage of time. For example, each period, Xerox accrues interest on its loans and leases.

b. i. Restructuring costs typically fall within two general categories. (1) The

write-off of assets, such as plant assets and goodwill, and (2) the accrual of liabilities for items, such as employee severance payments and exit costs.

ii. These restructuring costs result in expenses that are recorded in their

respective current periods despite the fact that the corresponding impaired assets may not be formerly written off and the employees not paid their severance until future periods. In any event, most analysts treat restructuring costs as transitory (one-time occurrences). Accordingly, they should impact the analysis, but are unlikely to impact the analysis to the degree of more persistent items such as recurring revenues and expenses.

iii. Some companies report regularly recurring restructuring costs. In such

cases, many analysts treat these recurring costs as operating expenses and do not consider them to be transitory items. This treatment implies that these costs are less transitory and more persistent in nature.

In 2007, Xerox had a net credit on restructuring – the result of a restructuring provision of $35 million and a reversal of prior restructuring accruals of $41 million.

c. Companies are not required to separately disclose revenue and expense items

unless they are deemed to be material. If not separately disclosed, these items are aggregated with other items that are also deemed not to be material. Such aggregation generally reduces the informativeness of income statements. More problematic is that revenues and expenses can be commingled in this “Other” category to yield a small number that further obscures the importance of the individual items comprising this category.



In Xerox’s case, the significantly higher amount in Other expenses, net, is due to a $774 million pretax charge for litigation losses. These would not be expected to recur in future years.

d. The following items might be considered to be operating:

Sales and service, outsourcing and rental revenue would be considered operating; cost of sales, cost of service, outsourcing and rentals, R&D and engineering expenses, and SG&A expenses are typically designated as operating. Restructuring and asset impairment charges would usually be considered to be operating. Equity in earnings of unconsolidated affiliates would be considered operating under the assumption that the affiliates are related to Xerox’s core operations, which is typically the case. Finance income and equipment financing interest expense would be classified as operating, because financing customers’ purchases is one of Xerox’s lines of business. However, it would be useful to consider it as a separate line of business for forecasting purposes. Other expenses would generally be considered nonoperating in the absence of a footnote clearly indicating its connection to the operating activities of the company (such as the litigation losses described above).

The following items might be identified as transitory items:

If Xerox had income from discontinued operations or extraordinary items, those would be considered transitory. Those items did not appear in its 2006, 2007 or 2008 income statement. The restructuring and impairment charges appear regularly, but in varying amounts, and the MD&A reports that a significant share of the Other expenses, net is due to litigation charges that are probably transitory (but related to operations).

One other item that has transitory factors is the company’s income tax expenses for the year. For reasons that will be discussed in Chapter 10, Xerox’s tax expense as a percentage of pretax income was (35.6%), 27.8% and 202.6% in 2006, 2007 and 2008, respectively. Given that the U.S corporate tax rate is 35%, it is clear that there are some transitory effects going on in this line item.



C6-48 (30 minutes) a. When Dell sells other companies’ software products, it is often as part of a

multiple-element sales agreement. For example, the customer may purchase hardware, software, and customer support for one price. This is an example of a bundled sale. Dell must allocate the sales price based on the relative fair market value of each element. Revenue is recognized for each specific element when it is clear that the element has been delivered and the revenue is earned.

There are at least two possibilities for earnings management here. First, Dell

could misallocate the sales price. By allocating more of the price to hardware and less to software, Dell may be able to manage when earnings are reported. Second, Dell may be aggressive in applying the “earned and realizable” criteria to each element, thereby prematurely recognizing revenue.

From the information provided, it appears that Dell was recognizing revenue

on software “resales” at the time of sale. However, most software is not truly sold. Instead, the customer purchases a license to use the software. As a result, Dell should have deferred part of the revenue and recognized it ratably over the license period.

b. Extended warranties are typically sold separately from other products.

Therefore, the revenue should be deferred and recognized ratably over the warranty contract period. Dell employees were apparently recording revenue at the time of sale, or were recognizing the revenue over a shorter time period than the contract period. As a result, revenues and income were overstated.

c. It is common for managers to have performance targets based on revenues

and earnings. This provides an incentive for these employees to take actions to accelerate revenue recognition when it appears that targets may not be met. On the other hand, in periods when revenues and earnings exceed the targets, managers may delay revenue recognition until a future period. In this way, they can “store up” revenues and earnings to meet future targets.

The key to preventing this type of abuse is the periodic audit of divisional

revenues and earnings. In addition, businesses spend a large amount of resources trying to design incentive compensation plans that do not encourage this type of abuse.



C6-49 (45 minutes) a. i. Bad debt expense (+E, -SE) 2,095,000 Allowance for doubtful accounts (+XA, -A) 2,095,000 ii. Allowance for doubtful accounts (-XA, +A) 1,562,000 Accounts receivable (-A) 1,562,000

+ Accounts Receivable (A) ($000) - - Allowance for Doubtful Accounts (XA) ($000) +

Balance 110,069 3,609 Balance Sales 761,865 2,095 (i) 1,562 (ii) (ii) 1,562

Balance*

124,430 4,142 Balance

*This accounts receivable T-account above is incomplete; it is missing a credit for sales returns and a credit for cash collections. Both are discussed and illustrated below.)

b. If sales returns are material in amount and can be estimated with a reasonable

degree of accuracy, they should be estimated just as bad debts are estimated. Sales revenue is debited for the estimated returns while an allowance for returns is credited. One important difference is that with sales returns (unlike bad debts) the customer returns the product to the company and it is often returned to inventory. Hence, the amount of estimated returns is equal to the estimated gross profit on expected returns. Using Oakley’s gross profit margin of 54.2% (= $412,751 / $761,865) the following entries would be required in 2006:

iii. Sales revenue (est. sales returns) (-R, -SE) 7,547,000 Allowance for returns (+XA, -A) 7,547,000 iv. Allowance for returns (-XA, +A) 6,993,000 Inventory (+A) 5,909,000 Accounts receivable* (-A) 12,902,000

+ Accounts Receivable (A) ($000) - - Allowance for Returns (XA) ($000) +

Balance 110,069 6,683 Balance Sales 761,865 1,562 (ii) 7,547 (iii) 12,902 (iv) (iv) 6,993 733,040 Collections

Balance 124,430 7,237 Balance

* $6,993,000 / 0.542 = $12,902,000



Note that an alternative entry for b(iii) would be the following, where the income statement adjustment for estimated returns affects both revenue and cost of gods sold. The T-accounts just above would not be affected.

iii. Sales revenue (est. sales returns) (-R, -SE) 13,924,000 Allowance for returns (+XA, -A) 7,547,000 Cost of goods sold (-E, +SE) 6,377,000

($13,924,000 = $7,547,000/0.542.) However, if the sales returns cannot be resold, then the amount of estimated returns is equal to the estimated expected returned sales (not the gross profit on sales). This would be the case if sales returns were primarily returns of defective merchandise. If this is the case for Oakley, the appropriate journal entries and T-accounts would be as follows: iii. Sales revenue (est. sales returns) (-R, -SE) 7,547,000 Allowance for returns (+XA, -A) 7,547,000 iv. Allowance for returns (-XA, +A) 6,993,000 Accounts receivable (-A) 6,993,000

+ Accounts Receivable (A) ($000) - - Allowance for Returns (XA) ($000) +

Balance 110,069 6,683 Balance Sales 761,865 1,562 (ii) 7,547 (iii) 6,993 (iv) (iv) 6,993 738,949 Collections

Balance 124,430 7,237 Balance

Note that our calculation of the amount of cash collections on account (calculated as a “plug” amount) is contingent upon what assumption we make about Oakley’s returns. If returned merchandise is returned to inventory and resold, then cash collections are approximately $733,040,000. On the other hand, if sales returns are not returned to inventory for resale (i.e., because the merchandise is defective) the cash collections are calculated as $738,949,000. These different scenarios represent not just different accounting, but substantively different situations. If Oakley can return the items to inventory, their reporting implies that customers will return (and not pay for) items totaling almost $13 million in sales. If returned products are always defective, then Oakley’s reporting implies that customers will return items totaling about $7.5 million in sales. Obviously, only one of these amounts is correct, but it is impossible to tell from Oakley’s financial statements. (The authors believe that Oakley’s returns are largely related to performance warranties and returned goods are deemed “defective” and not returned to inventory. Hence the second set of journal



entries would be correct.) The amount of cash collected is included in the accounts receivable T-accounts above to be complete. c. Accounts receivable turnover: $761,865 / [($109,168 + $99,430)/2] = 7.3 times.

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