CH6

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©Cambridge Business Publishers, 2014

Chapter 6

Reporting and Analyzing Revenuesand Receivables

Learning Objectives – coverage by questionMini-

ExercisesExercises Problems

Cases andProjects

LO1 – Describe and apply the criteriafor determining when revenue isrecognized.

14, 15, 17 26, 27,

32, 39

47 - 49

LO2 – Illustrate revenue and expenserecognition when the transactioninvolves future deliverables.

17, 24, 25 30, 39, 40 46 47, 48

LO3 – Illustrate revenue and expenserecognition for long-term projects.

13, 16 28 - 30 42

LO4 – Estimate and account foruncollectible accounts receivable.

18 - 21, 23 33 - 37 45 49

LO5 – Calculate return on capitalemployed, net operating profit aftertaxes, net operating profit margin,accounts receivable turnover, andaverage collection period.

22 31, 34, 38 44 49

LO6 –Discuss earnings management

and explain how it affects analysisand interpretation of financialstatements.

27, 32, 34 43, 44 48

LO7 Appendix 6A – Describe andillustrate the reporting for nonrecurringitems.

41

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DISCUSSION 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 netassets have increased, that is, the company has received an asset (forexample, cash or accounts receivable) or satisfied a liability as a result of thetransaction. Earned means that the company has done everything it must dounder the terms of the sale.

For retailers, like Abercrombie & Fitch, revenue is generally earned when titleto the merchandise passes to the buyer (e.g., when the buyer takes possessionof the merchandise), because returns can be estimated. For companiesoperating under long-term contracts, the earning process is typically measuredusing the percentage-of-completion method , that is, by the percentage of costsincurred relative to total expected costs.

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

Q6-3. In order for an event to be classified as an extraordinary item, its occurrencemust be both unusual and infrequent . Items that are considered to be both

unusual and infrequent might be the destruction of property by natural disasteror the expropriation of assets by a foreign government in which the companyoperates. Gains and losses on early retirement of long-term bonds, oncecomprising the majority of extraordinary items, are no longer considered assuch unless they meet the tests outlined above. Other events not likely to beincluded as extraordinary items include asset write-downs, gains and losses onthe 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 arerecognized 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 thatreduces income and equity.

Big bath refers to an event in which a company records a nonrecurring loss in aperiod of already depressed income. By deliberately reducing current periodearnings, the company removes future costs from the balance sheet or creates‘reserves’ that can be used to increase future period earnings.

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

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

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. Suchpro forma disclosures are only reported in earnings and press releases and arenot part of the published 10-Ks or other annual reports provided forshareholders. The SEC requires that GAAP income be reported together withpro forma income. Yet, companies often report their GAAP income at the veryend 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 financialperformance of the company that the SEC has become concerned. Also, proforma numbers are not subject to accepted standards (and, thus, we observediffering definitions across companies), are not subject to usual audit tests, andare subject to considerable management latitude in what is and is not includedand how items are measured.

Q6-7. Estimates are necessary in order to accurately measure and report income ona 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. Forexample, accountants estimate warranty costs so that the warranty expense ismatched against the corresponding sales revenue. If the accounting processwaited until no estimates were necessary, there would be a significant delay inthe reporting of financial results.

Q6-8. When analysts publish earnings forecasts, these forecasts become abenchmark against which some investors evaluate the company’sperformance. A company that fails to meet analysts’ forecasts may suffer astock 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.

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Q6-9. Bad debts expense is recorded in the income statement when the allowance foruncollectible accounts is increased. If a company overestimates the allowanceaccount, net income will be understated on the income statement and accountsreceivable (net of the allowance account) will be underestimated on thebalance 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, futurenet income will be higher.

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

Q6-10. There are several possible explanations for a decrease in the allowanceaccount. First, after an aging of accounts receivable, Wallace Company mayhave determined that a smaller percentage of its receivables are past due.

Wallace Company may have changed its credit policy such that it is attractinglower-risk customers than in the past. Second, experience may have indicatedthat the percentages used to estimate uncollectibles was too high in previousyears. By correcting the estimated percentage of defaults, the estimateduncollectibles would end up lower than in past years. Third, Wallace Companymay be managing earnings. By lowering estimated uncollectibles, thecompany can increase current earnings, but may end up reporting a loss in afuture year when write-offs exceed the balance in the allowance account.

Q6-11. Minimizing uncollectible accounts is not necessarily the best objective formanaging accounts receivable. That objective could be accomplished by notoffering to sell to customers on credit. The purpose of offering credit to

customers is to increase sales and profits. Losses from uncollectible accountsare a cost of doing business. As long as the benefit (greater contribution toprofits due to increased sales) exceeds the cost (increased losses due touncollectibles) then a higher-risk credit policy which increases the amount ofuncollectible 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 resultin higher estimated uncollectibles if the estimates are based on an aging ofaccounts receivable.

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

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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

YearCosts

incurred

Percentof total

expectedcosts

(rounded)

Revenuerecognized

(percentage ofcosts incurred

total contractamount)

Income(revenue – costsincurred)

Revenuerecognized Income

2013 $ 400,000 21%a $ 525,000 $125,000 0 0

2014 1,000,000 53%b 1,325,000 325,000 0 0

2015 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 / $1,900,000b $1,000,000/ $1,900,000c $500,000 / $1,900,000

M6-14. (20 minutes)

Company Revenue recognition

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

Merck When merchandise is given to the customer and returns can beestimated (or the right of return period has expired). The companywill also establish a reserve and recognize expense relating touncollectible 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 reserveand recognize expense for uncollectible accounts receivable andanticipated 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 areceivable on its balance sheet.

Johnson Controls Revenue is recognized under long-term contracts under thepercentage-of-completion method.

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M6-15. (15 minutes)

The Unlimited can only recognize revenues once they have been earned and theamount of returns can be estimated with sufficient accuracy. Assuming that happens atthe 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 $4.9million in net revenue (98% of $5 million) for the period. If The Unlimited does not havesufficient experience to estimate returns, then it should wait to recognize revenue untilthe right of return period has elapsed.

M6-16. (20 minutes)

a. Percentage-of-completion method:

Year 2013 2014 2015 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 2013 2014 2015 Total

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

Construction costs 30,000,000 30,000,000Gross 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 thewarranties provide coverage for three years beginning in 2014, one-third of therevenue should be recognized in 2014, one-third in 2015, and the remaining third in2016.

b.Year 2014 2015 2016 TotalRevenue $566,666 $566,667 $566,667 $1,700,000Warranty expenses 166,666 166,667 166,667 500,000Gross profit $400,000 $400,000 $400,000 $1,200,000

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M6-17. concluded

c. Total revenue from sales of the camera packages is $79,800 ($399 x 200). Therevenue is allocated among the three elements of the sale (camera, printer andwarranty) as follows:

Element Retail Price Proportion of TotalCamera $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 andrecognized for each element as it is earned. In this case, the portion of the revenueallocated to the camera and printer are recognized immediately, while the revenueallocated to the warranty is deferred and recognized over the three-year warranty

coverage period.

Year Revenue2014 $67,830 ($79,800 x .6 + $79,800 x .25)2015 3,990 ($79,800 x .15 / 3)2016 3,9902017 3,990Total $79,800

M6-18. (15 minutes)

a. To bring the allowance to the desired balance of $2,100, the company will need toincrease the allowance account by $1,600, resulting in bad debt expense of thatsame 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) 1,6001,600 (a)

2,100 Balance Balance 1,600

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M6-19. (15 minutes)

a. Credit losses are incurred in the process of generating sales revenue. Specificlosses may not be known until many months after the sale. A company sets up anallowance for uncollectible accounts to place the expense of uncollectible accounts

in the same accounting period as the sale and to report accounts receivable at itsestimated realizable value at the end of the accounting period.

b. The balance sheet presentation shows the gross amount of accounts receivable, theallowance amount, and the difference between the two, the estimated net realizablevalue. 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 givenrevenue be matched with, and deducted from, the revenue in the determination ofnet 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 knowledgethat losses are likely and, thereby, reduce the informativeness of the incomestatement. Accountants believe that providing more timely information justifies theuse of estimates that may not be as precise as we would like.

M6-20. (20 minutes)

a.($ millions) 2011 2010

Accounts receivable (net) ................................... $6,361 $6,539

Allowance for uncollectible accounts .................. 143 246

Gross accounts receivable ................................. $6,504 $6,785

Percentage of uncollectible accounts to grossaccounts receivable .........................................

2.2%($143/$6,504)

3.6%($246/$6,785)

b. The decrease in the allowance for uncollectible accounts as a percentage of grossaccounts receivable may indicate that the quality of the accounts receivable hasimproved, perhaps because the economy has improved, the company is selling to amore creditworthy class of customers, or the company’s management of accounts

receivable is more effective. It may also indicate, however, that the receivables wereover-reserved (e.g., allowance account was too high in 2010). This would result inhigher reported profits in 2011 because past profits were too low.

c. $54,365/[($6,361+$6,539)/2] = 8.43 times

365/8.43 = 43.3 days

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M6-21. (10 minutes)

Bad debt expense of $2,400 ($120,000 ! 0.02) would cause the allowance foruncollectibles 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 thewrite offs would decrease it by $300. If there was a net increase of $15,000 for theperiod, Sloan Company must have collected $104,700 in cash. ($104,700 = $120,000 -$300 - $15,000.)

M6-22. (20 minutes)

a.Accounts Receivable Turnover rates for 2011

Procter & Gamble $83,680 / [($6,068+$6,275)/2] = 13.6 times

365 / 13.6 = 26.8 days

Colgate-Palmolive $16,734 / [($1,675+$1,610)/2] = 10.2 times

365 / 10.2 = 35.8 days

b. P&G turns its accounts receivable faster than Colgate-Palmolive. Receivable turnstypically evolve to an equilibrium level for each industry that arises from the generalbusiness models used by industry competitors. Differences can arise due tovariations in the product mix of competitors, the types of customers they sell to, theirwillingness to offer discounts for early payment, and their relative strength vis-à-vis

the companies or individuals owing them money.

Also, the size of the firm may affect the ability of a company to exert bargainingpower over major suppliers or customers. For instance, both of these companies sella significant amount of their product to Wal-Mart. P&G is a sizable company, andmay 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 fiscalyear-ends. If the receivable balance is not constant during the year due to someseasonality, then the receivable turnover ratio will depend on the choice of fiscal

year.

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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 properlyrecorded.

b. Besides the $12,000 in recovery, the collections from customers can be summarizedin 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 receivablesincreased 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)

15,000continued next page

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M6-23. concluded

d.Balance Sheet Income Statement

TransactionCashAsset +

NoncashAssets -

ContraAssets

=Liabil-ities

+Contrib.Capital

+EarnedCapital

Revenues - Expenses = Net Incom

i. Sales onaccount. +3,200,000 AccountsReceivable

- =+3,200,000RetainedEarnings

+3,200,000SalesRevenue

- = +3,200,00

ii. Bad debtexpense.

-

+42,000 Allowance forUncollectible Accounts

=

-42,000RetainedEarnings

-

+42,000Bad DebtExpense

= -42,000

iii. Write-off ofuncollectibleaccounts.

-39,000 AccountsReceivable

-

-39,000 Allowance forUncollectible Accounts

= - =

iv. Reinstateaccountpreviouslywritten off.

+12,000

AccountsReceivable -

+12,000 Allowance forUncollectible Accounts

- =

Collectreinstatedaccount.

+12,000Cash

-12,000 AccountsReceivable

- - =

v. Collect cashon sales. +2,926,000

Cash

-2,926,000 AccountsReceivable

- = - =

M6-24. (20 minutes)

a.Fiscal Year Revenue Revenue Growth2012 48,0002013 55,000 14.6%2014 62,000 12.7%20150 62,000 0.0%

b.

Fiscal

Year Revenue

UnearnedRevenue Liability

(end of year)

Customer Purchases =Revenue + Change in Unearned

Revenue Liability

Growth inCustomer

Purchases2012 48,000 20,0002013 55,000 24,000 55,000 + 4,000 = 59,0002014 62,000 26,000 62,000 + 2,000 = 64,000 8.5%2015 62,000 25,000 62,000 - 1,000 = 61,000 -4.7%

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M6-24. concluded

c. In both fiscal year 2014 and 2015, the growth in customer purchases is lower thanthe growth in reported revenues. The practice of deferring revenue recognitionimplies 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 ofFinn Publishing, revenues in any given year are the result of newsstand andbookstore 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 inannual revenues is a composite of growth in customer purchases over an evenlonger period of time.

For 2014 and 2015, Finn’s growth in revenues exceeds the gr owth in customerpurchases because the revenues are still reflecting growth from prior periods.Purchases are a “leading indicator” of revenues, and thus, calculating customerpurchase behavior can be useful in forecasting future revenue and identifying

changes in customers’ attitudes about a company’s current offerings.

M6-25. (15 minutes)

This question is based on an actual situation, in which the accounting rules wereinfluencing the product decisions. The rules for revenue deferral when there aremultiple deliverables deterred the company from providing enhancements and upgradesthat were available. If Commtech’s customers (the wireless companies) had beenwilling 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 maywant to encourage users to purchase new phones – with a new service contract – ratherthan improving their existing phones.)

The question can generate a discussion about whether accounting should drivedecisions. Whether it should or not, it does, so the question should evolve into what topmanagement should do about this type of situation. Does the situation described in theproblem require some managerial action, or not. Is the company foregoing salesbecause of its accounting? Within Commtech, the finance staff was skeptical ofmarketing’s predictions that the upgrades and enhancements would increase the salesof existing phone models. If the upgrades and enhancements are delivered, Commtechwill have to change its accounting for revenue, with a resulting decrease in near-termprofitability. How might the company communicate that change in a way that theinvesting public will understand as a net benefit to the company?

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EXERCISES

E6-26. (20 minutes)

Company Revenue RecognitionThe Limited When merchandise is given to the customer and returns can be

estimated (or the right of return period has expired).

BoeingCorporation

Revenue is recognized under long-term contracts under thepercentage-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 estatedeveloper

When title to the houses is transferred to the buyers.

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

Harley-Davidson When title to the motorcycles is transferred to the buyer. Harley willalso set up a reserve for anticipated warranty costs and recognizethe expected warranty cost expense when it recognizes the salesrevenue.

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 customerscan access its Web site, not when the cash is received. Therecognition of revenue is dependent upon Real Money providingupdates.

Oracle The fee to purchase the right to use the software can be recordedas revenue when the software is installed, unless that fee includesfuture deliverables like upgrades and support. (If such post-saleservices are included in the fee, some portion must be deferred andrecognized over the appropriate period.) Service revenue can only

be recognized ratably over the period of time covered by the servicecontract.

Intuit Recognize revenue when the software is sent to customers. Thecompany must estimate potential warranty claims and establish areserve for them when revenue is recorded.

Computer gamedeveloper

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

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E6-28. (20 minutes)

($ millions) a. Percentage-of-Completion Method b. Completed Contract

Year Costsincurred

Percent oftotal

expectedcosts

Revenue recognized(percentage of costs

incurred totalcontract amount)

Income(revenue –

costsincurred) Revenuerecognized Income

2013 $100 25% $125 $ 25 $ 0 $ 0

2014 300 75% 375 75 500 100

$400 $500 $100 $500 $100

c. The percentage-of-completion method normally provides a reasonable estimate ofthe revenues, expenses, and income earned for each period based on the amount ofwork completed. A key assumption underlying the use of this method is that thecontract price is fixed and it is possible to obtain reliable estimates of expected costsand costs to date. When such estimates are not available, the completed contract

method should be used.

The percentage-of-completion method is acceptable under GAAP for a variety ofcontracts spanning more than one accounting period, such as in the consulting andtransportation industries.

E6-29. (20 minutes)

a.

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

YearCosts

incurred

Percent oftotal

expectedcosts

(rounded)

Revenue recognized(percentage of costs

incurred totalcontract amount)

Income(revenue –

costsincurred)

Revenuerecognized Income

2014 $15 18%($15/$85)

$ 21.6 $ 6.6 $ 0 $ 0

2015 40 47%($40/$85)

56.4 16.4 0 0

2016 30 35%($30/$85)

42.0 12.0 120 35

$85 $120.0 $35.0 $120 $ 35

b. The percentage-of-completion method provides a good estimate of the revenue andincome earned in each period. This method is also acceptable under GAAP forcontracts spanning more than one accounting period. Recognition of revenue andincome is not affected by the cash received, but the percentage-of-completionmethod more closely approximates cash flows than the completed contract method.

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E6-30. (15 minutes)

a. Multiple element arrangements are sales transactions in which two or moredeliverables are “bundled” together and sold for one price. The revenue should berecognized on each deliverable element when it is earned. This involves first

assigning a portion of the sales revenue to each element and then recognizing eachportion of the revenue only when that element has been delivered to the customer.

b. The total revenue for the “bundle” is $190. However the Kindle, if sold alone sells for$170 and the wireless and upgrades sell for $30, which brings the total “value” to$200. Thus, the Kindle device represents 85% of the total value of the bundle($170/$200). Amazon should recognize $161.50 at the time of the sale (85% of the$190 sale price) and defer the remaining $28.50.

c.Balance Sheet Income Statement

TransactionCashAsset +

NoncashAssets = iabil-ities +

Contrib.Capital +

EarnedCapital Revenues - Expenses =

NetIncome

To record bundled saletransaction

+190

=

+28.50Unearnedrevenue

+161.50

RetainedEarnings

+161.50Sales

revenue - =

+161.50

Cash (+A) 190.00Sales revenue (+R, +SE) 161.50Unearned revenue (+L) 28.50

E6-31. (15 minutes)

a. 2010: €4,674 + €497 x (1-.35) = €4,997 2011: €6,029 + €514 x (1-.35) = €6,363

b. 2010: €4,997 / €97,761 = .0511 or 5.11% 2011: €6,363 / €106,540 = .0597 or 5.97%

c. €6,363 / [(€143,844 - €23,571 + €131,487 - €21,191) / 2] = .0552 or 5.52%

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E6-32. (15 minutes)

In none of these cases should Simpyl Technologies recognize revenue. Each of thefour settings touches on one of the four conditions for revenue recognition listed by theSEC. 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 toconstitute persuasive evidence. In part b, delivery has not occurred. The product hasbeen shipped, but not to the customer and not with the specified customizations that arerequired by the customer. In part c, the price is not yet fixed or determinable, becausethe negotiations over volume discounts have not been concluded. Finally, thedistributor in part d does not have the means to pay for the items delivered, socollectibility cannot be reasonably assured (until the distributor sells the product to anend customer). The delivery should be viewed as a consignment arrangement, in whichSimpyl 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 statementsdating back to 1998. Symbol had made accounting entries that violated each of theSEC’s four criteria for revenue recognition. An article by Steve Lohr describing theincoming CEO’s experiences at Symbol Technologies can be found in the New YorkTimes, 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 $3.9billion.)

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 amountswritten off of $3,830).

2013 bad debt expense computation$250,000 0.5% = $1,250$ 90,000 1% = 900

20,000 2% = 40011,000 5% = 5506,000 10% = 6004,000 25% = 1,000

4,700

Less: Unused balance before adjustment 520Bad debt expense for 2013 $4,180

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E6-33. concluded

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 ................................... $376,300c.+ Bad Debts Expense (E) - - Allowance for Uncollectible Accounts (XA) +

(a) 4,180 4,350 BalanceWrite-offs 3,830

4,180 (a)

4,700 Balance

E6-34. (25 minutes)

a. Allowance for doubtful accounts (-XA) 70 Accounts receivable (-A) 70

Provision for doubtful accounts (+E,-SE) 9 Allowance for doubtful accounts (+XA) 9

The provision for doubtful accounts (bad debt expense) has a credit entry that hasthe effect of decreasing Ethan Allen’s reported income by $9 thousand for the year.The write-off of $70 thousand of uncollectible accounts has no effect on income.

b. 2012 2011 Accounts receivable, net 14,919 15,036 Allowance for doubtful accounts 1,250 1,171

Gross receivables (net plus allowance) $16,169 $16,207

Allowance as a % of gross receivables 7.7% 7.2%

c. $729,373 / [($14,919 + $15,036) / 2] = 48.7 times. The very fast ART is probablydue to the custom furniture aspect of Ethan Allen’s business. Many of their products

are not produced until a customer places an order and payment occurs upondelivery or very soon thereafter.

d. $729,373 + ($65,465 - $62,649) – ($14,919 - $15,036) – $9 = $723,297.

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E6-35. (15 minutes)

Accounts receivable $138,100Less Allowance for uncollectible accounts 10,384 $127,716

Computations Accounts Allowance forReceivable Uncollectible Accounts

Beginning balance $ 122,000 $ 7,900Sales 1,173,000Collections (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, 2013Current $304,000 1% = $ 3,0400 –60 days past due 44,000 5% = 2,20061 –180 days past due 18,000 15% = 2,700Over 180 days past due 9,000 40% = 3,600

Amount required 11,540Balance of allowance 4,200Provision $ 7,340 = 2010 bad debt expense

b. Current Assets Accounts receivable $375,000Less: Allowance for uncollectible accounts 11,540 $363,460

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

(a) 7,340 4,200 Balance7,340 (a)

11,540 Balance

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E6-37. (30 minutes)

a.

Year Sales Collections Accounts Written Off

2012 $ 751,000 $ 733,000 $ 5,3002013 876,000 864,000 5,8002014 972,000 938,000 6,500Total $2,599,000 $2,535,000 $17,600

Accounts Receivable at the end of 2014 is $46,400, computed as:($2,599,000 - $2,535,000 - $17,600).

Bad Debts Expense is:2012 $ 7,510 computed as 1% $751,0002013 8,760 computed as 1% $876,0002014 9,720 computed as 1% $972,000

2012-2014 $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.

b.Accounts Receivable (A) Allowance for Uncollectibles (XA)

Beg Bal 0 0 Beg BalSales 751,000 5,300 Write offs Write offs 5,300 7,510 Bad debts exp.

733,000 Collections

2012 Bal 12,700 2,210 2012 Bal

Sales 876,000 5,800 Write offs Write offs 5,800 8,760 Bad debts exp.864,000 Collections

2013 Bal 18,900 5,170 2013 Bal

Sales 972,000 6,500 Write offs Write offs 6,500 9,720 Bad debts exp.938,000 Collections

2014 Bal 46,400 8,390 2014 Bal

There isn’t any indication that the 1% rate is incorrect. If the rate is too high, wewould expect the allowance to grow at a faster rate than receivables. If the rate istoo low, the opposite would occur. In this case, the allowance percentage ofreceivables is 17%, 27% and 18% at the end of 2012, 2013 and 2014, respectively.So, there is no clear direction that would indicate an inappropriate estimate.

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E6-38. (20 minutes)

a.Earnings

fromOperations

End.Assets

Beg.Assets

Avg.Assets

Return onCapital

Employed

Personal Systems Group $ 2,350 $ 15,781 $ 16,548 $16,164.5 14.5%

Services 5,149 40,614 41,989 41,301.5 12.5%

Imaging and Printing Group 3,973 11,939 12,514 12,226.5 32.5%

Enterprise Servers, Storageand Network

3,026 17,539 18,262 17,900.5 16.9%

HP Software 698 21,028 9,979 15,503.5 4.5%

HP Financial Services 348 13,543 12,123 12,833.0 2.7%

b. The most profitable group seems to be the Imaging and Printing Group, whichrepresents HP’s traditional strength. However, it is not growing very quickly (basedon sales percentage increases). The Enterprise Servers, Storage and NetworkingGroup and the Personal Systems Group (commercial and personal PCs,workstations, etc.) also have good return on capital employed. The HP SoftwareGroup has a low return on capital employed but that group appears to have had amajor investment in assets during the year, which can distort this measure,depending on the timing of the capital expenditures.

c. Restructuring charges are reported “above the line,” as part of income fromcontinuing operations before income taxes. They are listed as a charge againstoperating income in the income statement, and thus would reduce our calculation ofreturn on capital employed. Restructuring charges are nonrecurring, however, andshould be considered separately when evaluating profitability of a businesssegment.

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E6-39. (20 minutes)

a. Just like for-profit organizations, not-for-profit organizations cannot recognizerevenue until it has been earned. In the case of The Lyric Opera, it cannotrecognize 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 earnedby six months through its fiscal year.)

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

To record revenue for the fiscal year 2012 season:

Deferred ticket and other revenue (-L) 12,711Cash or Accounts receivable (+A) 12,319

Ticket sales (+R, +NA) 25,030

(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 thebalance sheet.)

To record advance purchases for the fiscal year 2012 season:Cash or Accounts receivable (+A) 12,638

Deferred ticket and other revenue (+L) 12,638

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) in 2009 and it would appear that three yearslater, the advanced ticket sales have not recovered from the 2009 decline. It’spossible that the decline in advance purchases is a statement about the operaselections. However, the loyal subscriber base (and the desire to keep one’sassigned 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 more than one-half of its seats are sold by the April 30th precedingthe season. So, the quantity of unsold seats will affect The Lyric’s marketing effortsfor subscribers who have not yet renewed, outreach to new potential subscribersand 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 advancesales.

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E6-40. (20 minutes)

a. Membership fees are initially recorded as a liability (deferred membership feerevenue) and recognized over a period of one year. Member rewards are similarlydeferred, but the offsetting debit is recorded as a reduction to sales revenue.

b.Cash (+A) 2.203

Deferred membership fees (+L) 2,203

Deferred membership fees (-L) 2,075Membership fee revenue (+R, +SE) 2,075

c.Sales revenue (-R, -SE) 900

Accrued member rewards (+L) 900

Accrued member rewards (-L) 841Merchandise inventory (-A)* 841

*The Costco note does not say how the membership rewards are redeemed. Theentry above assumes that the rewards are redeemed for merchandise, as is thecase in many such situations. If, instead, the rewards are redeemed for cash, thecredit entry would be to cash and not merchandise inventory.

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PROBLEMS

P6-41.A (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 typicallydesignated as operating.

2. Amortization of intangible assets and restructuring charges would usually beconsidered to be operating under the assumptions that the acquisition that gaverise to the intangible assets is included as part of operations, and that therestructuring did not involve discontinuation of distinct parts of the business.

3. The asbestos-related credit, restructuring charges and goodwill impairmentlosses would be considered to be operating since they are related to Dow

Chemical’s operating activities. (These items are both operating and nonrecurring – see b.)

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

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

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

company.7. Interest income is considered nonoperating

8. Interest expense and amortization of debt discount is nonoperating.

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P6-41.A concluded

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

1. Purchased in-process research and development and Acquisition-relatedexpenses – these are one-time (e.g., nonrecurring) costs incurred in connection

with the acquisition of another company and can properly be expensed underGAAP.

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

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

4. Restructuring charges – these relate to the company’s actions due to the

economic decline in 2008 and the expectations that future performance will notmeet prior expectations. Restructuring costs are considered “special items,”meaning that individually they are transitory, but as a category, they happenfrequently.

5. The charge for discontinued operations would be considered nonrecurring.

We would need to examine prior years’ income statements to discern if the othercategories in Dow’s income statement are to be considered transitory.

c. 2010: $2,321 + ($1,473 + $143 - $125 - $37) x (1-.35) = $3,266.1

$3,266.1 / $53,674 = 6.1%

2009: $676 + ($1,571 + $7 + $166 - $891 - $39) x (1-.35) = $1,205.1

$1,205.1 / $44,875 = 2.7%

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P6-42. (20 minutes)

a. 1. Percentage-of-completion based on number of employees trainedYear 2013 2014 2015 TotalNumber of employees trained 125 200 75 400Revenues (# 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 32,812.50 175,000.00Gross 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 2013 2014 2015 TotalCosts incurred $60,000 $75,000 $40,000 $175,000Percentage completed 34.29% 42.86% 22.86% 100.00%Revenues (% x $480,000) $164,571.43 $205,714.29 $109,714.29 $480,000.00Expenses 60,000.00 75,000.00 40,000.00 175,000.00Gross Profit $104,571.43 $130,714.29 $69,714.29 $305,000.00

3. Completed contract methodYear 2013 2014 2015 TotalRevenues $0 $0 $480,000 $480,000Expenses 0 0 175,000 175,000Gross 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 beestimated with a reasonable degree of accuracy, and (3) Elliot Company is areasonable credit risk, the best method would be to recognize revenues using thepercentage-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 isnot met.

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P6-43. (15 minutes)

a. Management would have an incentive to shift $1 million of income from the currentperiod into next. This might be accomplished by delaying revenue recognition oraccelerating 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 yearinto 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 nextyear. Even though this would reduce earnings this year, earnings are already so lowthat management does not expect to receive a bonus. Shifting earnings into a futureperiod increases the bonus in that period.

d. These incentives for earnings management would be mitigated if the “kinks” in thebonus formula were removed. Alternatively, some companies pay bonuses basedon a three-year moving average of earnings to minimize the impact of earningsmanagement.

This problem can provide an opportunity to discuss the “slippery slope” of earningsmanagement. For example, management’s optimism about next year in part b may notturn out to be warranted. Suppose next year’s “natural” earnings turns out to be $20million instead of $24 million. Management’s action in the first year will have reducednext year’s $20 million to $17 million, and earnings management would again berequired to meet the target. And, if meeting the target in one year causes the nextyear’s target to increase, things can get out of control very quickly.

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P6-44. (40 minutes)

(all in $ millions)

a. Net receivables as of January 28, 2012 were $2,033.Net receivables as of January 29, 2011 were $2,026.

b.Bad debts expense (+E, -SE) 101

Allowance for credit losses (+XA) 101

Allowance for credit losses (-XA) 153 Accounts receivable (-A) 153

Cash (+A) 22 Allowance for credit losses (+XA) 22

c. Estimated credit losses to gross credit card receivables are:

5.5% ($115/$2,074) in 20116.9% ($145/$2,103) in 2010

The decrease in the allowance for credit losses as a percent of credit cardreceivables is reflected in the aging of Nordstrom’s receivables. The percentage ofreceivables that are 30 or more days past due has decreased from 3.0% on January29, 2011 to 2.6% at January 28, 2012. This could be caused by (1) a generalimprovement in economic conditions (fewer customers are late or defaulting on theirobligations), (2) tighter credit policies (credit is denied to risky customers) and/or (3)more rigorous collection practices.

d. The receivables turnover rate is $10,497 / [($2,033 + $2,026)/2] = 5.17Days sales in accounts receivable is $365/5.17 = 70.6 days

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P6-45. (25 minutes)

For the instructor:This problem covers the accounting for product returns, which is not covered in thechapter. 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 + $634 million - $635 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) Recognizeexpected returns.

Revenue contra, returns (+XR, -SE) 500COGS contra, returns (+XE, +SE) 300Sales returns allowance (+L) 200

The sales returns allowance is equal to Gross sales ($5,000) times the probability ofreturn (10%) times the gross profit margin (40%), or $200. For these ten units, thecost of goods was $300.

Returns:(4) Process return

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

Cash (-A) 500

At the conclusion of this transaction, the customers have their cash, the inventorycosts have been adjusted to include the returned items, and the sales returnsallowance liability has a balance of zero because the actual returns coincided withthe expected returns.

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P6-45. concluded

c. The Gap’s reported gross profit is 36.2% of its net sales ($5,274million/$14,549million). So, if The Gap expects returns of items with gross profit of $634 million,those items must have had sales prices of $1,751 million ($634 million/0.362) and

cost of goods sold of $1,117 million ($1,751 million - $634 million). The entry thatwould have reflected The Gap’s accounting for these expected returns is thefollowing:

Recognize expectedreturns.

Revenue contra, returns (+XR, -SE) 1,751COGS contra, returns (+XE, +SE) 1,117Sales returns allowance (+L) 634

The Gap’s gross sales revenue would have been $16,300 million ($14,549 million +$1,751 million), and its expected returns as a percentage of sales would be 10.7%($1,751 million/$16,300 million).

The size of the allowance for 2011 ($634 million) relative to the end-of-year returnliability ($21 million) means that the vast majority of these product returns occurredduring the 2011 fiscal year, so it is more a reflection of actual experience than ofmanagement’s estimates of future events.

d. Under these circumstances, The Gap doesn’t have to worry about accounting forexpected returns, because it has not satisfied the requirements for revenuerecognition. If the amount to be received (or in this case, the amount to be kept) isnot yet “fixed or determinable,” the revenue should not be recognized until it is.

P6-46. (25 minutes)

a.Fiscal year

ending March 31 Net revenueGrowth

rate2005 3,129 – 2006 2,951 -5.7%2007 3,091 4.7%2008 3,665 18.6%2009 4,212 14.9%2010 3,654 -13.2%2011 3,589 -1.8%2012 4,143 15.4%

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P6-46. concluded

b.Fiscal year

ending

March 31

Net

revenue

Deferred netrevenue

(liability)

Purchases = Netrevenue + Change in

Deferred net revenue

Growth

rate2005 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%2010 3,654 766 4,159 1.8%2011 3,589 1,005 3,828 -8.0%2012 4,143 1,048 4,186 9.4%

When companies defer revenue, there is a lag between customers’ purchases and

the recognition of revenue on the income statement. When purchases growsignificantly (as they did in 2008) revenues grow in subsequent years. Whenpurchases fall off, we would expect revenues to fall off in subsequent years (see2009 and 2010). 2012 appears to be an anomaly. Purchases declined in 2011 butrevenue grew significantly in 2012.

c. If customer purchases in 2012 are a leading indicator of revenue in 2013, we wouldpredict a substantial revenue growth for 2013.

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CASES and PROJECTS

C6-47. (40 minutes)

a.Cash (+A) 120,000

Sales revenue (+R, +SE) 60,000Payable to merchant partners (+L) 60,000

b. Revenues were previously recorded at the full amount of the Groupon sale($120,000 in a above) and the amount payable to the merchant partner wasrecorded as an expense. This was changed in 2011 to record the sale of theGroupon, net of the amount due to the merchant partner as revenue. The effect ofthis change was that revenues and expenses were reduced by the amount paid tothe merchant partner. This did not alter the bottom line as net income does not

change. The NOPM ratio would increase due to the decrease in revenue without acorresponding decrease in operating income.

c.Sales revenue contra (-R, -SE) 6,000

Allowance for returns (+L) 6,000

Allowance for returns (-L) 6,000Payable to merchant partners (-L) 6,000

Cash (-A) 12,000

d. Cost of revenue (+E, -SE) 6,000 Allowance for returns (+L) 6,000

Allowance for returns (-L) 6,000Cash (-A) 6,000

e. Groupon could wait to recognize revenue until the 60-day period to pay themerchant partner has expired. By doing so, there would be no need to estimaterefunds that would involve reducing the payable or recovering a refund from themerchant partner. Groupon would still need to estimate refunds for any cancelation

that might occur after the end of the 60-day period when the merchant partner hasbeen paid. This is when Groupon’s risk is greatest, since it cannot recover any partof the refund from the merchant. However, by waiting 60 days before recognizingthe revenue (and estimating the refunds) Groupon would likely have a better ideaabout the amount of refunds that will likely occur.

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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 eachelement. Revenue is recognized for each specific element when it is clear that theelement has been delivered and the revenue is earned.

There are at least two possibilities for earnings management here. First, Dell couldmisallocate the sales price. By allocating more of the price to hardware and less tosoftware, Dell may be able to manage when earnings are reported. Second, Dellmay 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, Dellshould have deferred part of the revenue and recognized it ratably over the licenseperiod.

b. Extended warranties are typically sold separately from other products. Therefore,the revenue should be deferred and recognized ratably over the warranty contractperiod. Dell employees were apparently recording revenue at the time of sale, orwere 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 andearnings. This provides an incentive for these employees to take actions toaccelerate revenue recognition when it appears that targets may not be met. On theother hand, in periods when revenues and earnings exceed the targets, managersmay 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 revenuesand earnings. In addition, businesses spend a large amount of resources trying todesign incentive compensation plans that do not encourage this type of abuse.

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C6-49. (45 minutes)

a. 2011:i. Bad debt expense (+E, -SE) 13,989

Allowance for doubtful accounts (+XA, -A) 13,989

ii. Allowance for doubtful accounts (-XA, +A) 1,206 Accounts receivable (-A) 1,206

2012:iii. Bad debt expense (+E, -SE) 2,111

Allowance for doubtful accounts (+XA, -A) 2,111

iv. Allowance for doubtful accounts (-XA, +A) 14,903 Accounts receivable (-A) 14,903

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

Balance 6,859 2010 BalanceSales 13,989 (i)

(ii) 1,206

Balance 19,642 2011 Balance2,111 (iii)

(iv) 14,903

6,850 2012 Balance

b. 2011: $19,642 / ($168,310 + $19,642 + $65,664) = 7.7%2010: $6,850 / ($171,561 + $6,850 + $48,612) = 3.0%The extra provision for the Borders account significantly increased Wiley’s allowance

account for 2011.

c. If sales returns are material in amount and can be estimated with a reasonabledegree 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 iscredited. One important difference is that with sales returns (unlike bad debts) thecustomer returns the product to the company and it is often returned to inventory.Hence, the amount of allowance for returns is a net amount equal to the estimatedgross profit on expected returns.

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C6-49. concluded

d. To record estimated returns:

Sales revenue (est. sales returns) (-R, -SE) 112,948 Allowance for returns – A/R (+XA) 112,948

Allowance for returns – Inventory (+A) 17,761Cost of sales (-E, +SE) 17,761

Allowance for returns – royalties payable (+XL) 12,286Royalty expense (-E, +SE) 12,286

To record actual returns:

Allowance for returns – A/R (-XA, +A) 130,000 Accounts receivable (-A) 130,000

Inventory (+A) 20,000 Allowance for returns – Inventory (-A) 20,000

Royalties payable (-L) 13,963 Allowance for returns – Royalties payable (-XL) 13,963

The net amount reported in the allowance for returns consists of three separateamounts – one offsetting accounts receivable (a contra asset) an amount added toinventory (an adjunct asset) and a third amount offsetting royalties payable (a contraliability):

Allowance for returns – A/R: $65,664 + $112,948 - $130,000 = $48,612

Allowance for returns – Inventory: $9,485 + $17,761 - $20,000 = $7,246

Allowance for returns – Royalties: $7,270 + $12,286 - $13,963 = $5,593

Note that $130,000 - $20,000 - $13,963 = $96,037, and $112,948 - $17,761 -$12,286 = $82,901.

When these three accounts are combined, we get the net amount reported in theallowance for returns each year.

e. Accounts receivable turnover: $1,782,742 / [($171,561 + $168,310)/2] = 10.5 times.

Average collection period: 365 / 10.5 = 34.8 days.

CH6

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