Chap 005

AACSB assurance of learning standards in accounting and business education require documentation of outcomes assessment. Although schools, departments, and faculty may approach assessment and its documentation differently, one approach is to provide specific questions on exams that become the basis for assessment. To aid faculty in this endeavor, we have labeled each question, exercise and problem in Intermediate Accounting, 5e with the following AACSB learning skills:

Questions AACSB Tags Exercises (cont.)

AACSB Tags

5-1 Reflective thinking 5-9 Analytic5-2 Reflective thinking 5-10 Analytic5-3 Reflective thinking 5-11 Analytic5-4 Reflective thinking 5-12 Analytic5-5 Reflective thinking 5-13 Analytic5-6 Reflective thinking 5-14 Analytic5-7 Reflective thinking 5-15 Analytic5-8 Reflective thinking 5-16 Analytic5-9 Reflective thinking 5-17 Analytic

5-10 Reflective thinking 5-18 Reflective thinking5-11 Reflective thinking, Communications 5-19 Analytic, Communications5-12 Reflective thinking 5-20 Analytic5-13 Reflective thinking 5-21 Analytic5-14 Reflective thinking 5-22 Analytic5-15 Reflective thinking 5-23 Analytic5-16 Reflective thinking 5-24 Analytic5-17 Reflective thinking 5-25 Analytic5-18 Reflective thinking

Brief Exercises

CPA/CMA

5-1 Analytic 5-1 Analytic5-2 Analytic 5-2 Analytic5-3 Analytic 5-3 Analytic5-4 Analytic 5-4 Reflective thinking5-5 Reflective thinking, Communications 5-5 Analytic5-6 Analytic 5-6 Analytic5-7 Analytic 5-1 Reflective thinking5-8 Analytic 5-2 Reflective thinking5-9 Analytic 5-3 Analytic

5-10 Reflective thinking Problems5-11 Reflective thinking 5-1 Analytic5-12 Analytic 5-2 Analytic5-13 Analytic 5-3 Analytic5-14 Analytic 5-4 Communications, Analytic5-15 Analytic 5-5 Analytic

Exercises 5-6 Analytic

5-1 Analytic 5-7 Analytic

© The McGraw-Hill Companies, Inc., 2009Solutions Manual, Vol.1, Chapter 5 5-1

Chapter 5 Income Measurement and Profitability Analysis

5-2 Analytic 5-8 Analytic, Reflective thinking

Exercises (cont.)

Problems (cont.)

5-3 Analytic 5-9 Analytic5-4 Analytic 5-10 Analytic5-5 Analytic 5-11 Analytic5-6 Analytic 5-12 Analytic5-7 Analytic 5-13 Analytic5-8 Analytic 5-14 Analytic

Question 5-1 The realization principle requires that two criteria be satisfied before revenue can be

recognized:1. The earnings process is judged to be complete or virtually complete.2. There is reasonable certainty as to the collectibility of the asset to be received (usually

cash).

Question 5-2 At the time production is completed, there usually exists significant uncertainty as to the

collectibility of the asset to be received. We don’t know if the product will be sold, nor the selling price, nor the buyer if eventually the product is sold. Because of these uncertainties, revenue recognition usually is delayed until the point of product delivery.

Question 5-3 If the installment sale creates a situation where there is significant uncertainty concerning cash

collection and it is not possible to make an accurate assessment of future bad debts, revenue and cost recognition should be delayed beyond the point of delivery.

Question 5-4 The installment sales method recognizes gross profit by applying the gross profit percentage

on the sale to the amount of cash actually received each period. The cost recovery method defers all gross profit recognition until cash has been received equal to the cost of the item sold.

Question 5-5 Deferred gross profit is a contra installment receivable account. The balance in this account is

subtracted from gross installment receivables to arrive at installment receivables, net. The net amount of the receivables represents the portion of remaining payments that represent cost recovery.

© The McGraw-Hill Companies, Inc., 20095-2 Intermediate Accounting, 5/e

QUESTIONS FOR REVIEW OF KEY TOPICS

Question 5-6 Because the return of merchandise can retroactively negate the benefits of having made a sale,

the seller must meet certain criteria before revenue is recognized in situations when the right of return exists. The most critical of these criteria is that the seller must be able to make reliable estimates of future returns. In certain situations, these criteria are not satisfied at the point of delivery of the product.

Question 5-7 Sometimes a company arranges for another company to sell its product under consignment.

The “consignor” physically transfers the goods to the other company (the consignee), but the consignor retains legal title. If the consignee can’t find a buyer within an agreed-upon time, the consignee returns the goods to the consignor. However, if a buyer is found, the consignee remits the selling price (less commission and approved expenses) to the consignor.

Because the consignor retains the risks and rewards of ownership of the product and title does not pass to the consignee, the consignor does not record revenue (and related costs) until the consignee sells the goods and title passes to the eventual customer.

Question 5-8

For service revenue, if there is one final service that is critical to the earnings process, revenues and costs are deferred and recognized after this service has been performed. On the other hand, in many instances, service revenue activities occur over extended periods and recognizing revenue at any single date within that period would be inappropriate. Instead, it’s more meaningful to recognize revenue over time in proportion to the performance of the activity.

Question 5-9 The completed contract method of recognizing revenues and costs on long-term construction

contracts is equivalent to recognizing revenue at point of delivery, i.e., when the construction project is complete. The percentage-of-completion method assigns a fair share of the project’s expected revenues and costs to each period in which the earnings process takes place, i.e., the construction period. The “fair share” typically is estimated as the project's costs incurred each period as a percentage of the project's total estimated costs. The completed contract method should only be used when the lack of dependable estimates or inherent hazards cause forecasts of future costs to be doubtful.


Question 5-10 The completed contract method recognizes revenue, cost of construction, and gross profit at

the end of the contract, after the contract has been completed. The cost recovery method will recognize an amount of revenue that exactly offsets costs until all costs have been incurred, and then will recognize revenue and gross profit. Therefore, revenue and cost are recognized earlier under the cost recovery method than under the completed contract method. Assuming that the final costs are incurred just prior to completion of the contract, both approaches should recognize gross profit at the same time.

Question 5-11 The billings on construction contract account is a contra account to the construction in

progress asset. At the end of each reporting period, the balances in these two accounts are compared. If the net amount is a debit, it is reported on the balance sheet as an asset. Conversely, if the net amount is a credit, it is reported as a liability.

Question 5-12 An estimated loss on a long-term contract must be fully recognized in the first period the loss

is anticipated, regardless of the revenue recognition method used.

Question 5-13 This guidance requires that if an arrangement includes multiple elements, the revenue from the

arrangement should be allocated to the various elements based on the relative fair values of the individual elements. If part of an arrangement does not qualify for separate accounting, revenue recognition is delayed until revenue is recognized for the other parts.

Question 5-14Specific guidelines for revenue recognition of the initial franchise fee are provided by SFAS

45. A key to these guidelines is the concept of substantial performance. It requires that substantially all of the initial services of the franchisor required by the franchise agreement be performed before the initial franchise fee can be recognized as revenue. The term “substantial” requires professional judgment on the part of the accountant. In situations when the initial franchise fee is collectible in installments, even after substantial performance has occurred, the installment sales or cost recovery method should be used for profit recognition, if a reasonable estimate of uncollectibility cannot be made.


Question 5-15

Receivables turnover ratio = Net sales Average accounts receivable (net)

Inventory turnover ratio = Cost of goods sold Average inventory

Asset turnover ratio = Net sales Average total assets

Activity ratios are designed to provide information about a company’s effectiveness in managing assets. Activity or turnover of certain assets measures the frequency with which those assets are replaced. The greater the number of times an asset turns over, the less cash a company must devote to that asset, and the more cash it can commit to other purposes.

Question 5-16

Profit margin on sales = Net income Net sales

Return on assets = Net income Average total assets

Return on shareholders' = Net income equity Average shareholders' equity

A fundamental element of an analyst’s task is to develop an understanding of a firm’s profitability. Profitability ratios provide information about a company’s ability to earn an adequate return relative to sales or resources devoted to operations. Resources devoted to operations can be defined as total assets or only those assets provided by owners, depending on the evaluation objective.


Question 5-17

Return on equity = Profit margin X Asset turnover X Equity multiplier

Net incomeAve. total equity

= Net incomeTotal sales

X Total salesAve. total assets

X Ave. total assetsAve. total equity

The DuPont framework shows return on equity as being driven by profit margin (reflecting a company’s ability to earn income from sales), asset turnover (reflecting a company’s effectiveness in using assets to generate sales), and the equity multiplier (reflecting the extent to which a company has used debt to finance its assets).

Question 5-18These perspectives are referred to as the discrete and integral part approaches. Current interim

reporting requirements and existing practice generally view interim reports as integral parts of annual statements. However, the discrete approach is applied to some items. Most revenues and expenses are recognized in interim periods as incurred. However, if an expenditure clearly benefits more than just the period in which it is incurred, the expense should be spread among the periods benefited. Examples include annual repair expenses, property tax expense, and advertising expenses incurred in one quarter that clearly benefit later quarters. These are assigned to each quarter through the use of accruals and deferrals. On the other hand, major events such as discontinued operations, extraordinary items, and unusual or infrequent items should be reported separately in the interim period in which they occur.

2009 gross profit = $3,000,000 – 1,200,000 = $1,800,0002010 gross profit = 0

2009 Cost recovery % = Cost Sales: $1,200,000 = 40% (implying a gross profit % = 60%) $3,000,000

2009 gross profit = 2009 cash collection of $150,000 x 60% = $90,000 2010 gross profit = 2010 cash collection of $150,000 x 60% = $90,000


BRIEF EXERCISESBrief Exercise 5-1

Brief Exercise 5-2

No gross profit will be recognized in either 2009 or 2010. Gross profit will not be recognized until the entire $1,200,000 cost of the land is recovered. In this case, it will take 8 payments to recover the cost of the land ($1,200,000 $150,000 = 8), so gross profit recognition will equal 100% of the cash collected beginning with the ninth installment payment.

Initial deferred gross profit ($3,000,000 – 1,200,000) $1,800,000 Less gross profit recognized in 2009 ($150,000 x 60%) (90,000) Less gross profit recognized in 2010 ($150,000 x 60%) (90,000)Deferred gross profit at the end of 2010 $1,620,000

The seller must meet certain criteria before revenue can be recognized in situations when the right of return exists. The most critical of these criteria is that the seller must be

able to make reliable estimates of future returns. If Meyer’s management can make reliable estimates of the furniture that will be returned, revenue can be recognized when the product is delivered, assuming the company has no additional obligations to the buyer. If reliable estimates cannot be made because of significant uncertainty, revenue and related cost recognition is delayed until the uncertainty is resolved.

Total estimated cost to complete = $6 million + $9 million = $15 million% of completion = $6 million $15 million = 40%

Total estimated gross profit ($20 million – 15 million) = $5,000,000 multiplied by the % of completion 40 % Gross profit recognized the first year $2,000,000

First year revenue = $20,000,000 x 40% = $8,000,000

Assets:Accounts receivable ($7 million – 5 million) $2,000,000Cost plus profit ($6 million + $2 million*) in excess of billings ($7 million) 1,000,000


Brief Exercise 5-3

Brief Exercise 5-4

Brief Exercise 5-5

Brief Exercise 5-6

Brief Exercise 5-7

* Total estimated gross profit ($20 million – 15 million) = $5,000,000 multiplied by the % of completion 40 % Gross profit recognized in the first year $2,000,000

Year 1 = 0Year 2 = $4 million Revenue $20,000,000 Less: Costs in year 1 (6,000,000) Costs in year 2 (10,000,000) Actual profit $ 4,000,000

Year 1:Revenue: $6 millionCost: $6 millionGross profit: $0

Year 2:Revenue: $14 million ($20 million total - $6 million in year 1)Cost: $10 millionGross profit: $ 4 million

The anticipated loss of $3 million ($30 million contract price less total estimated costs of $33 million) must be recognized in the first year applying either method.

Specific conditions for revenue recognition of the initial franchise fee are provided by SFAS 45. A key to these conditions is the concept of substantial performance. It

requires that substantially all of the initial services of the franchisor required by the franchise agreement be performed before the initial franchise fee can be recognized as revenue. The term “substantial” requires professional judgment on the part of the accountant. Often, substantial performance is considered to have occurred when the franchise opens for business.

Continuing franchise fees are recognized over time as the services are performed.


Brief Exercise 5-8

Brief Exercise 5-9

Brief Exercise 5-10

Brief Exercise 5-11

Brief Exercise 5-12

*$600,000 – 200,000

Profit margin = Net income Sales

= $65,000 $420,000

= 15.5%

Return on assets = Net income Average total assets

= $65,000 $800,000

= 8.1%


Receivables turnover ratio = Net sales Average accounts receivable (net)

Receivables turnover ratio = $600,000 [$100,000 + 120,000] ÷ 2

= 5.45 times

Inventory turnover ratio = Cost of goods sold Average inventory

Inventory turnover ratio = $400,000* [$80,000 + 60,000] ÷ 2

= 5.71 times

Brief Exercise 5-13

Return on shareholders’ equity = Net income

Average shareholders’ equity

= $65,000 $522,500*

= 12.4%

Shareholders’ equity, beginning of period $500,000 Add: Net income 65,000 Deduct: Dividends (20,000)Shareholders’ equity, end of period $545,000

*Average shareholders equity = ($500,000 + 545,000) 2 = $522,500

Return on equity

= Profit margin

X Asset turnover X Equity multiplier

Net incomeAve. total

equity

= Net incomeTotal sales

X Total salesAve. total assets

X Ave. total assetsAve. total equity

Return on shareholders’ equity = Net income

Average shareholders’ equity

= $65,000 $522,500

= 12.4%


Brief Exercise 5-14

Profit margin = Net income Sales

= $65,000 $420,000

Asset Turnover = Sales

Average total assets

= $420,000 $800,000


= 15.5%

Brief Exercise 5-14 (concluded)

Equity Multiplier = Average total assets Average shareholders’ equity

= $800,000 $522,500

= 1.53

Inventory turnover ratio = Cost of goods sold Average inventory 6.0 = x $75,000Cost of goods sold = $75,000 x 6.0 = $450,000

Sales - Cost of goods sold = Gross profit$600,000 - $450,000 = $150,000


= 52.5%

Check: 12.4% ROE = 15.5% profit margin x 52.5% asset turnover x 1.53 equity multiplier.

Brief Exercise 5-15

Requirement 1Alpine West should recognize revenue over the ski season on an anticipated

usage basis, in this case equally throughout the season. The fact that the $450 price is nonrefundable is not relevant to the revenue recognition decision. Revenue should be recognized as it is earned, in this case as the services are provided during the ski season.

Requirement 2

November 6, 2009 To record the cash collectionCash.............................................................................. 450

Unearned revenue...................................................... 450

December 31, 2009 To recognize revenue earned in December (no revenue earned in November, as season starts on December 1).Unearned revenue ($450 x 1/5)....................................... 90

Revenue.................................................................... 90

Requirement 3$90 is included in revenue in the 2009 income statement. The $360 remaining

balance in unearned revenue is included in the current liability section of the 2009 balance sheet.

Requirement 1

2009 Cost recovery %: $234,000 = 65% (gross profit % = 35%) $360,000

2010 Cost recovery %: $245,000 = 70% (gross profit % = 30%) $350,000


EXERCISESExercise 5-1

Exercise 5-2

2009 gross profit:Cash collection from 2009 sales of $150,000 x 35% = $52,500

2010 gross profit:Cash collection from 2009 sales of $100,000 x 35% = $ 35,000

+ Cash collection from 2010 sales of $120,000 x 30% = 36,000 Total 2010 gross profit $71,000

Requirement 22009 deferred gross profit balance:2009 initial gross profit ($360,000 - 234,000) $126,000Less: Gross profit recognized in 2009 (52,500)Balance in deferred gross profit account $73,500

2010 deferred gross profit balance:2009 initial gross profit ($360,000 - 234,000) $ 126,000Less: Gross profit recognized in 2009 (52,500) Gross profit recognized in 2010 (35,000)

2010 initial gross profit ($350,000 - 245,000) 105,000Less: Gross profit recognized in 2010 (36,000)Balance in deferred gross profit account $107,500

2009 To record installment salesInstallment receivables.................................................. 360,000

Inventory................................................................... 234,000Deferred gross profit.................................................. 126,000

2009 To record cash collections from installment salesCash.............................................................................. 150,000

Installment receivables.............................................. 150,000

2009 To recognize gross profit from installment salesDeferred gross profit..................................................... 52,500

Realized gross profit.................................................. 52,500


Exercise 5-3







Requirement 1

Year Income recognized2009 $180,000 ($300,000 - 120,000)2010 - 0 -2011 - 0 -2012 - 0 - Total $180,000

Requirement 2Cost recovery %:

$120,000 ------------- = 40% (gross profit % = 60%) $300,000

Year Cash Collected Cost Recovery(40%) Gross Profit(60%)2009 $ 75,000 $ 30,000 $ 45,0002010 75,000 30,000 45,0002011 75,000 30,000 45,0002012 75,000 30,000 45,000

Totals $300,000 $120,000 $180,000


Exercise 5-4

Requirement 3

Year Cash Collected Cost Recovery Gross Profit2009 $ 75,000 $ 75,000 - 0 -2010 75,000 45,000 $ 30,0002011 75,000 - 0 - 75,0002012 75,000 - 0 - 75,000

Totals $300,000 $120,000 $180,000

Requirement 1

July 1, 2009 To record installment saleInstallment receivables.................................................. 300,000

Sales revenue............................................................. 300,000

Cost of goods sold......................................................... 120,000Inventory................................................................... 120,000

To record cash collection from installment saleCash.............................................................................. 75,000


July 1, 2010 To record cash collection from installment saleCash.............................................................................. 75,000



Exercise 5-5

Exercise 5-5 (continued)

Requirement 2





To recognize gross profit from installment saleDeferred gross profit..................................................... 45,000







Exercise 5-5 (concluded)

Requirement 3









Requirement 1

Cost of goods sold ($1,000,000 - 600,000) $400,000Add: Gross profit if using cost recovery method 100,000Cash collected $500,000

Requirement 2 $ 600,000Gross profit percentage = = 60%

$1,000,000

Cash collected x Gross profit percentage = Gross profit recognized

$500,000 x 60% = $300,000 gross profit


Exercise 5-6

Exercise 5-7

October 1, 2009To record the installment sale

Installment receivable....................................................4,000,000Inventory................................................................... 1,800,000Deferred gross profit.................................................. 2,200,000

To record the cash down payment from installment saleCash.............................................................................. 800,000

Installment receivable................................................ 800,000

To recognize gross profit from installment saleDeferred gross profit ($800,000 x 55%*)...................... 440,000


October 1, 2010To record the default and repossession

Repossessed inventory (fair value) ...............................1,300,000Deferred gross profit (balance)......................................1,760,000Loss on repossession (difference) ................................. 140,000

Installment receivable (balance)................................ 3,200,000

*$2,200,000 $4,000,000 = 55% gross profit percentage

Requirement 1

April 1, 2009 To record installment saleInstallment receivables.................................................. 2,400,000

Land.......................................................................... 480,000Gain on sale of land................................................... 1,920,000

April 1, 2009 To record cash collection from installment saleCash.............................................................................. 120,000



Exercise 5-8



Requirement 2

April 1, 2009 To record installment saleInstallment receivables.................................................. 2,400,000

Land.......................................................................... 480,000Deferred gain............................................................. 1,920,000



When payments are received, gain on sale of land is recognized, calculated by applying the gross profit percentage ($1,920,000 ÷ $2,400,000 = 80%) to the cash collected (80% x $120,000).



To recognize profit from installment saleDeferred gain................................................................ 96,000

Gain on sale of land (80% x $120,000)......................... 96,000



To recognize profit from installment saleDeferred gain................................................................ 96,000

Gain on sale of land (80% x $120,000)......................... 96,000

Requirement 1

2009 2010Contract price $2,000,000 $2,000,000Actual costs to date 300,000 1,875,000Estimated costs to complete 1,200,000 - 0 -Total estimated costs 1,500,000 1,875,000Gross profit (estimated in 2009) $ 500,000 $ 125,000

Gross profit recognition:2009: $ 300,000

= 20% x $500,000 = $100,000$1,500,000

2010: $125,000 - $100,000 = $25,000


Exercise 5-9

Requirement 22009 $ - 0 -2010 $125,000

Requirement 3

Balance SheetAt December 31, 2009

Current assets:Accounts receivable $ 130,000Costs and profit ($400,000*) in excess of billings ($380,000) 20,000

* Costs ($300,000) + profit ($100,000)



Requirement 4


Current assets:Accounts receivable $ 130,000

Current liabilities:Billings ($380,000) in excess of costs ($300,000) $ 80,000

Requirement 1($ in millions) 2009 2010 2011

Contract price $220 $220 $220Actual costs to date 40 120 170Estimated costs to complete 120 60 - 0 - Total estimated costs 160 180 170Estimated gross profit (actual in 2011) $ 60 $ 40 $ 50

Gross profit (loss) recognition:

2009: $40 = 25% x $60 = $15$160

2010: $120 = 66.67% x $40 = $26.67 - $15 = $11.67$180

2011: $220 – 170 = $50 – ($15 + 11.67) = $23.33

Requirement 22009: $220 x 25% = $55


Exercise 5-10

2010: $220 x 66.67% = $146.67 – 55 = $91.672011: $220 – 146.67 = $73.33

Requirement 3

Year Gross profit (loss) recognized2009 - 0 -2010 - 0 -2011 50

Total project income $50



Requirement 4

2009:Revenue: $40Cost: $40Gross profit: $ 0

2010:Revenue: $80Cost: $80Gross profit: $ 0

2011:Revenue: $100 ($220 contract price - $40 - $80)Cost: $ 50 Gross profit: $ 50

Requirement 5

2010: $120 = 60% x $20* = $12 - 15 = $(3) loss$200

*$220 – ($40 + 80 + 80) = $20

Requirement 12009 2010 2011

Contract price $8,000,000 $8,000,000 $8,000,000Actual costs to date 2,000,000 4,500,000 8,300,000Estimated costs to complete 4,000,000 3,600,000 - 0 - Total estimated costs 6,000,000 8,100,000 8,300,000Estimated gross profit (loss) (actual in 2011) $2,000,000 $ (100,000 ) $ (300,000 )



Exercise 5-11

2009: $2,000,000 = 33.3333% x $2,000,000 = $666,667$6,000,000

2010: $(100,000) - 666,667 = $(766,667)

2011: $(300,000) - (100,000) = $(200,000)



Requirement 2

2009 2010Construction in progress 2,000,000 2,500,000 Various accounts 2,000,000 2,500,000To record construction costs.

Accounts receivable 2,500,000 2,750,000 Billings on construction contract 2,500,000 2,750,000To record progress billings.

Cash 2,250,000 2,475,000 Accounts receivable 2,250,000 2,475,000To record cash collections.

Construction in progress (gross profit) 666,667Cost of construction 2,000,000 Revenue from long-term contracts (33.3333% x $8,000,000) 2,666,667To record gross profit.

Cost of construction (2) 2,544,000 Revenue from long-term contracts (1) 1,777,333 Construction in progress (loss) 766,667To record expected loss.

(1) and (2):Percent complete = $4,500,000 ÷ $8,100,000 = 55.55% Revenue recognized to date: 55.55% x $8,000,000 = $4,444,000 Less: Revenue recognized in 2009 (above) (2,666,667) Revenue recognized in 2010 1,777,333 (1) Plus: Loss recognized in 2010 (above) 766,667 Cost of construction, 2010 $2,544,000 (2)



Requirement 3

Balance Sheet 2009 2010

Current assets:Accounts receivable $250,000 $525,000Costs and profit ($2,666,667*) in excess of billings ($2,500,000) 166,667

Current liabilities:Billings ($5,250,000) in excess

of costs less loss ($4,400,000**) $850,000

* Costs ($2,000,000) + profit ($666,667)** Costs ($2,000,000 + $2,500,000) - loss ($100,000 = $766,667 - $666,667)

Requirement 1

Year Gross profit (loss) recognized2009 - 0 -2010 $(100,000)2011 (200,000 )

Total project loss $(300,000 )

Requirement 2

2009 2010Construction in progress 2,000,000 2,500,000 Various accounts 2,000,000 2,500,000To record construction costs.

Accounts receivable 2,500,000 2,750,000 Billings on construction contract 2,500,000 2,750,000To record progress billings.

Cash 2,250,000 2,475,000 Accounts receivable 2,250,000 2,475,000To record cash collections.


Exercise 5-12

Loss on long-term contract 100,000 Construction in progress 100,000To record an expected loss.



Requirement 3

Balance Sheet 2009 2010Current assets: Accounts receivable $250,000 $525,000

Current liabilities: Billings ($2,500,000) in excess of costs ($2,000,000) $500,000

Billings ($5,250,000) in excess of costs less loss ($4,400,000*) $850,000

* Costs ($2,000,000 + $2,500,000) - loss ($100,000)

Situation 1 - Percentage-of-Completion

2009 2010 2011Contract price $5,000,000 $5,000,000 $5,000,000Actual costs to date 1,500,000 3,600,000 4,500,000Estimated costs to complete 3,000,000 900,000 - 0 - Total estimated costs 4,500,000 4,500,000 4,500,000Estimated gross profit (actual in 2011) $ 500,000 $ 500,000 $ 500,000

Gross profit (loss) recognized:

2009: $1,500,000 = 33.3333% x $500,000 = $166,667

$4,500,000

2010: $3,600,000 = 80.0% x $500,000 = $400,000 - 166,667 = $233,333

$4,500,000


Exercise 5-13

2011: $500,000 - 400,000 = $100,000

Situation 1 - Completed Contract

Year Gross profit recognized2009 - 0 -2010 - 0 -2011 $500,000

Total gross profit $500,000




2009 2010 2011Contract price $5,000,000 $5,000,000 $5,000,000Actual costs to date 1,500,000 2,400,000 4,800,000Estimated costs to complete 3,000,000 2,400,000 - 0 - Total estimated costs 4,500,000 4,800,000 4,800,000Estimated gross profit (actual in 2011) $ 500,000 $ 200,000 $ 200,000


2009: $1,500,000 = 33.3333% x $500,000 = $166,667

$4,500,000

2010: $2,400,000 = 50.0% x $200,000 = $100,000 - 166,667 = $(66,667)

$4,800,000

2011: $200,000 - 100,000 = $100,000







2009 2010 2011Contract price $5,000,000 $5,000,000 $5,000,000Actual costs to date 1,500,000 3,600,000 5,200,000Estimated costs to complete 3,000,000 1,500,000 - 0 - Total estimated costs 4,500,000 5,100,000 5,200,000Estimated gross profit (loss) (actual in 2011) $ 500,000 $ (100,000 ) $ (200,000 )


2009: $1,500,000 = 33.3333% x $500,000 = $166,667

$4,500,000

2010: $(100,000) - 166,667 = $(266,667)

2011: $(200,000) - (100,000) = $(100,000)







2009 2010 2011Contract price $5,000,000 $5,000,000 $5,000,000Actual costs to date 500,000 3,500,000 4,500,000Estimated costs to complete 3,500,000 875,000 - 0 - Total estimated costs 4,000,000 4,375,000 4,500,000Estimated gross profit (actual in 2011) $1,000,000 $ 625,000 $ 500,000


2009: $ 500,000 = 12.5% x $1,000,000 = $125,000

$4,000,000

2010: $3,500,000 = 80.0% x $625,000 = $500,000 - 125,000 = $375,000

$4,375,000

2011: $500,000 - 500,000 = $ - 0 -







2009 2010 2011Contract price $5,000,000 $5,000,000 $5,000,000Actual costs to date 500,000 3,500,000 4,800,000Estimated costs to complete 3,500,000 1,500,000 - 0 - Total estimated costs 4,000,000 5,000,000 4,800,000Estimated gross profit (actual in 2011) $1,000,000 $ - 0 - $ 200,000


2009: $ 500,000 = 12.5% x $1,000,000 = $125,000

$4,000,000

2010: $ 0 - 125,000 = $(125,000)

2011: $200,000 - 0 = $200,000







2009 2010 2011Contract price $5,000,000 $5,000,000 $5,000,000Actual costs to date 500,000 3,500,000 5,300,000Estimated costs to complete 4,600,000 1,700,000 - 0 - Total estimated costs 5,100,000 5,200,000 5,300,000Estimated gross profit (loss) (actual in 2011) $ (100,000 ) $ (200,000 ) $ (300,000 )


2009: $(100,000)

2010: $(200,000) - (100,000) = $(100,000)

2011: $(300,000) - (200,000) = $(100,000)


Year Gross profit (loss) recognized2009 $(100,000)2010 (100,000)2011 (100,000 )


Requirement 1

Construction in progress = Costs incurred + Profit recognized

$100,000 = ? + $20,000

Actual costs incurred in 2009 = $80,000

Requirement 2Billings = Cash collections + Accounts Receivable

$94,000 = ? + $30,000© The McGraw-Hill Companies, Inc., 20095-36 Intermediate Accounting, 5/e

Exercise 5-14

Cash collections in 2009 = $64,000

Requirement 3Let A = Actual cost incurred + Estimated cost to complete

Actual cost incurred x (Contract price - A) = Profit recognized A

$80,000 ($1,600,000 - A) = $20,000 A

$128,000,000,000 - 80,000A = $20,000A

$100,000A = $128,000,000,000

A = $1,280,000

Estimated cost to complete = $1,280,000 - 80,000 = $1,200,000

Requirement 4 $80,000 = 6.25%$1,280,000

Requirement 1

Revenue should be recognized as follows:Software - date of shipment, July 1, 2009Technical support - evenly over the 12 months of the agreementUpgrade - date of shipment, January 1, 2010

The amounts are determined by an allocation of total contract price in proportion to the individual fair values of the components if sold separately:

Software - $210,000 ÷ $270,000 x $243,000 = $189,000Technical support - $30,000 ÷ $270,000 x $243,000 = 27,000Upgrade - $30,000 ÷ $270,000 x $243,000 = 27,000 Total $243,000


Exercise 5-15

Requirement 2

July 1, 2009 To record sale of softwareCash.............................................................................. 243,000

Revenue.................................................................... 189,000Unearned revenue ($27,000 + 27,000)........................... 54,000

Requirement 1

Conveyer ($20,000/$50,000) x $45,000 = $18,000Labeler ($10,000/$50,000) x $45,000 = 9,000Filler ($15,000/$50,000) x $45,000 = 13,500Capper ($5,000/$50,000) x $45,000 = 4,500 total $45,000

Requirement 2

All $45,000 of revenue is delayed until installation of the conveyer, because the usefulness of the other elements of the multi-part arrangement is contingent on its delivery.

October 1, 2009 To record franchise agreement and down paymentCash (10% x $300,000)..................................................... 30,000Note receivable............................................................. 270,000

Unearned franchise fee revenue................................. 300,000

January 15, 2010 To recognize franchise fee revenueUnearned franchise fee revenue..................................... 300,000

Franchise fee revenue................................................ 300,000


Exercise 5-16

Exercise 5-17

List A List B

h 1. Inventory turnover a. Net income divided by net sales. d 2. Return on assets b. Defers recognition until cash collected equals

cost. g 3. Return on shareholders' equity c. Defers recognition until project is complete. a 4. Profit margin on sales d. Net income divided by assets. b 5. Cost recovery method e. Risks and rewards of ownership retained

by seller. i 6. Percentage-of-completion method f. Contra account to construction in progress. c 7. Completed contract method g. Net income divided by shareholders' equity. k 8. Asset turnover h. Cost of goods sold divided by inventory. l 9. Receivables turnover i. Recognition is in proportion to work completed. m 10. Right of return j. Recognition is in proportion to cash received. f 11. Billings on construction contract k. Net sales divided by assets. j 12. Installment sales method l. Net sales divided by accounts receivable. e 13. Consignment sales m. Could cause the deferral of revenue recognition

beyond delivery point.

Requirement 1

Requirement 2By itself, very little. In general, the higher the inventory turnover, the lower the

investment must be for a given level of sales. It indicates how well inventory levels are managed and the quality of inventory, including the existence of obsolete or overpriced inventory.

However, to evaluate the adequacy of this ratio it should be compared with some norm such as the industry average. That indicates whether inventory management practices are in line with the competition.

It’s just one piece in the puzzle, though. Other points of reference should be considered. For instance, a high turnover can be achieved by maintaining too low


Exercise 5-18

Exercise 5-19Inventory turnover ratio = Cost of goods sold

Average inventory

= $1,840,000 [$690,000 + 630,000] ÷ 2

= 2.79 times

inventory levels and restocking only when absolutely necessary. This can be costly in terms of stockout costs.

The ratio also can be useful when assessing the current ratio. The more liquid inventory is, the lower the norm should be against which the current ratio should be compared.

Turnover ratios for Anderson Medical Supply Company for 2009:

The company turns its inventory over 6 times per year compared to the industry average of 5 times per year. The asset turnover ratio also is slightly better than the industry average (2 times per year versus 1.8 times). These ratios indicate that Anderson is able to generate more sales per dollar invested in inventory and in total assets than the industry averages. However, Anderson takes slightly longer to collect its accounts receivable (27.4 days compared to the industry average of 25 days).


Exercise 5-20

Inventory turnover ratio = $4,800,000 [$900,000 + 700,000] ÷ 2

= 6 timesReceivables turnover ratio = $8,000,000

[$700,000 + 500,000] ÷ 2

= 13.33 timesAverage collection period = 365

13.33

= 27.4 daysAsset turnover ratio = $8,000,000

[$4,300,000 + 3,700,000] ÷ 2

= 2 times

Requirement 1

a. Profit margin on sales $180 ÷ $5,200 = 3.5%b. Return on assets $180 ÷ [($1,900 + 1,700) ÷ 2] = 10%c. Return on shareholders’ equity $180 ÷ [($550 + 500) ÷ 2] = 34.3%

Requirement 2Retained earnings beginning of period $100,000Add: Net income 180,000

280,000Less: Retained earnings end of period 150,000Dividends paid $130,000

Requirement 1

a. Profit margin on sales $180 ÷ $5,200 = 3.5%b. Asset turnover $5,200 ÷ [($1,900 + 1,700) ÷ 2] = 2.89c. Equity multiplier [($1,900 + 1,700) ÷ 2] ÷ [($550 + 500) ÷ 2] = 3.43d. Return on shareholders’ equity $180 ÷ [($550 + 500) ÷ 2] = 34.3%

Requirement 2Profit margin x Asset turnover x Equity multiplier = ROE 3.5% x 2.89 x 3.43 = 34.7% ~ 34.3% (difference due

to rounding )

Quarter First Second Third

Cumulative income before taxes $50,000 $90,000 $190,000Estimated annual effective tax rate 34% 30% 36%

17,000 27,000 68,400Less: Income tax reported earlier 0 17,000 27,000Tax expense to be reported $17,000 $10,000 $ 41,400

Incentive compensation $300 million ÷ 4 = $ 75 million

Depreciation expense $60 million ÷ 4 = 15 millionGain on sale 23 million


Exercise 5-21

Exercise 5-22

Exercise 5-23

Exercise 5-24

1st 2nd 3rd 4thAdvertising $200,000 $200,000 $200,000 $200,000Property tax 87,500 87,500 87,500 87,500Equipment repairs 65,000 65,000 65,000 65,000Extraordinary casualty loss 0 185,000 0 0Research and development 0 32,000 32,000 32,000

CPA Exam Questions

1. b. The earnings process is completed upon delivery of the product. Therefore, in 2009, revenue for 50,000 gallons at $3 each is recognized. The payment terms do not affect revenue recognition.

2. d. The deferred gross profit on the balance sheet at December 31, 2010 should be the balances in the accounts receivable accounts for 2009 and 2010 multiplied times the appropriate gross profit percentage:

Accounts Receivable 2009 2010 Total Sales 600,000 900,000 Less: Collections (300,000) (300,000) Less: Write Offs (200,000) (50,000) Accounts Receivable Balance 100,000 550,000x Gross Profit Rate x 30% x 40% Deferred Gross Profit 12/31/10 30,000 220,000

The Combined Deferred Gross Profit on the Balance Sheet is $250,000 ($220,000 + $30,000).


Exercise 5-25

CPA / CMA REVIEW QUESTIONS

CPA Review Questions (concluded)

3. a. Year of sale2009 2010

a. Gross profit realized $240,000 $200,000b. Percentage 30% 40%c. Collections on sales (a/b) $800,000 $500,000Total sales 1,000,000 2,000,000Balance uncollected $200,000 $1,500,000

The total uncollected balance is $1,700,000 ($200,000 + $1,500,000).

4. d. Construction-in-progress represents the costs incurred plus the cumulative pro-rata share of gross profit under the percentage-of-completion method of accounting. Construction-in-progress does not include the cumulative effect of gross profit recognition under the completed contract method.

5. c.

2009 actual costs $20,000Total estimated costs ÷ 60,000Ratio = 1/3Contract Price x 100,000Revenue 33,3332009 actual costs -20,000Gross profit $13,333

6. d. Since the total cost of the contract, $3,100,000 ($930,000 + $2,170,000) is projected to exceed the contract price of $3,000,000, the excess cost of $100,000 must be recognized as a loss in 2009.


CMA Exam Questions

1. c. Revenue is recognized when (1) realized or realizable and (2) earned. On May 28, $500,000 of the sales price was realized while the remaining $500,000 was realizable in the form of a receivable. The revenue was earned on May 28 since the title of the goods passed to the purchaser. The cost-recovery method is not used because the receivable was not deemed uncollectible until June 10.

2. d. Based on the revenue recognition principle, revenue is normally recorded at the time of the sale or, occasionally, at the time cash is collected. However, sometimes neither the sales basis nor the cash basis is appropriate, such as when a construction contract extends over several accounting periods. As a result, contractors ordinarily recognize revenue using the percentage-of-completion method so that some revenue is recognized each year over the life of the contract. Hence, this method is an exception to the general principle of revenue recognition, primarily because it better matches revenues and expenses.

3. b. Given that one-third of all costs have already been incurred ($6,000,000), the company should recognize revenue equal to one-third of the contract price, or $8,000,000. Revenues of $8,000,000 minus costs of $6,000,000 equals a gross profit of $2,000,000.

REAGAN CORPORATIONIncome Statement

For the Year Ended December 31, 2009

Income before income taxes and extraordinary item ...................................... [1] $3,680,000Income tax expense ...................................... 1,472,000 Income before extraordinary item ................ 2,208,000Extraordinary item:Gain from settlement of lawsuit (net of $400,000 tax expense) ................................ 600,000


PROBLEMSProblem 5-1

Net Income .................................................. $2,808,000

Income before extraordinary item ................ 2.21Extraordinary gain ....................................... 0 .60 Net income ................................................... $ 2 .81

[1] Income from continuing operations before income taxes:Unadjusted $4,200,000Add: Gain from sale of equipment 50,000Deduct: Inventory write-off (400,000)

Depreciation expense (2009) (50,000)Overstated profit on installment sale (120,000 ) *

Adjusted $3,680,000

* Profit recognized ($400,000 - 240,000) $160,000Profit that should have been recognized (gross profit ratio of 40% x $100,000) (40,000 ) Overstated profit $120,000

Requirement 12009 Cost recovery % :

$180,000 = 60% (gross profit % = 40%)

$300,000

2010 Cost recovery %:

$280,000 = 70% (gross profit % = 30%)

$400,000

2009 gross profit:

Cash collection from 2009 sales = $120,000 x 40% = $48,000

2010 gross profit:

Cash collection from 2009 sales = $100,000 x 40% = $ 40,000 + Cash collection from 2010 sales = $150,000 x 30% = 45,000

Total 2010 gross profit $85,000

Requirement 2


Problem 5-2

Problem 5-2 (continued)







Requirement 3

Date Cash Collected Cost Recovery Gross Profit

20092009 sales $120,000 $120,000 - 0 -

20102009 sales $100,000 $ 60,000 $40,0002010 sales 150,000 150,000 - 0 -

2010 totals $250,000 $210,000 $40,000


Problem 5-2 (concluded)



2009 To record cash collection from installment salesCash.............................................................................. 120,000




2010 To record cash collection from installment salesCash.............................................................................. 250,000




Requirement 1

Total profit = $500,000 - 300,000 = $200,000

Installment sales method: Gross profit % = $200,000 ÷ $500,000 = 40%

8/31/09 8/31/10 8/31/11 8/31/12 8/31/13

Cash collections $100,000 $100,000 $100,000 $100,000 $100,000

a. Point of delivery method $200,000 - 0 - - 0 - - 0 - - 0 -


Problem 5-3

b. Installment sales method (40% x cash collected) $ 40,000 $ 40,000 $ 40,000 $ 40,000 $40,000

c. Cost recovery method - 0 - - 0 - - 0 - $100,000 $100,000



Requirement 2

Point of Delivery

Installment Sales Cost Recovery

Installment receivable 500,000 Sales revenue 500,000Cost of goods sold 300,000 Inventory 300,000To record sale on 8/31/09.

Installment receivable 500,000 500,000 Inventory 300,000 300,000 Deferred gross profitTo record sale on 8/31/09.

200,000 200,000

Cash 100,000 100,000 100,000 Installment receivable 100,000 100,000 100,000Entry made each Aug. 31.

Deferred gross profit 40,000 Realized gross profitTo record gross profit.(entry made each Aug. 31)

40,000

Deferred gross profit 100,000 Realized gross profitTo record gross profit.(entry made 8/31/12 & 8/31/13)

100,000



Requirement 3

Point of Delivery

Installment Sales

Cost Recovery

December 31, 2009AssetsInstallment receivablesLess: Deferred gross profitInstallment receivables, net

400,000 400,000(160,000)240,000

400,000(200,000)200,000

December 31, 2010AssetsInstallment receivablesLess: Deferred gross profitInstallment receivables, net

300,000 300,000(120,000)180,000

300,000(200,000)100,000

Requirement 1


Problem 5-4



All jobs consist of four equal payments: one payment when the job is completed and three payments over the next three years.

Bluebird: Job completed in 2007, so down payment made in 2007, another payment in 2008, and two payments remain. $400,000 gross receivable at 1/1/09 implies payments of ($400,000 2) = $200,000 in 2009 and 2010. Four payments of $200,000 implies total revenue of 4 x $200,000 = $800,000 on the job. 25% gross profit ratio implies cost of 75% x $800,000 = $600,000.

Cost recovery method gross profit: Payments in 2007 and 2008 have already recovered $400,000 of cost, so cost remaining to be recovered as of 1/1/09 is $600,000 total - $400,000 already recovered = $200,000. Therefore, the entire 2009 payment of $200,000 will be applied to cost recovery, and no gross profit is recognized in 2009.

Installment sales method gross profit: $200,000 payment x 25% gross profit ratio = $50,000 of gross profit recognized in 2009.

PitStop:Job completed in 2006, so down payment made in 2006, another payment in 2007, another in 2008, and one payment remains. $150,000 gross receivable at 1/1/09 implies a single payment of $150,000 in 2009. Four payments of $150,000 implies total revenue of 4 x $150,000 = $600,000 on the job. 35% gross profit ratio implies cost of 65% x $600,000 = $390,000.

Cost recovery method gross profit: Payments in 2006, 2007 and 2008 of a total of $450,000 have already recovered the entire $390,000 of cost and allowed recognition of $60,000 of gross profit. Therefore, the entire 2009 payment of $150,000 will be applied to gross profit.

Installment sales method gross profit: $150,000 payment x 35% gross profit ratio = $52,500 of gross profit recognized in 2009.

Requirement 2


Contract price $10,000,000 $10,000,000 $10,000,000Actual costs to date 2,400,000 6,000,000 8,200,000Estimated costs to complete 5,600,000 2,000,000 - 0 - Total estimated costs 8,000,000 8,000,000 8,200,000Estimated gross profit (loss) (actual in 2011) $ 2,000,000 $ 2,000,000 $ 1,800,000


2009: $2,400,000 = 30.0% x $2,000,000 = $600,000$8,000,000

2010: $6,000,000 = 75.0% x $2,000,000 = $1,500,000 - 600,000 = $900,000


Totals:Cost recovery method: $0 (Bluebird) + $150,000 (PitStop) = $150,000.

Installment sales method: $50,000 (Bluebird) + $52,500 (PitStop) = $102,500.

If Dan is focused on 2009, he would not be happy with a switch to the installment sales method, because that would produce gross profit of only $102,500, which is $47,500 less than he would show under the cost recovery method. It is true that the installment sales method recognizes gross profit faster than does the cost recovery method, but the installment sales method also recognizes gross profit more evenly than does the cost-recovery method. The timing of these jobs is such that 2009 is a year in which almost all of the gross profit associated with the PitStop job gets recognized, so 2009 looks more profitable under the cost recovery method.

Problem 5-5

$8,000,000

2011: $1,800,000 - 1,500,000 = $300,000



Requirement 2

2009 2010 2011

Construction in progress 2,400,000 3,600,000 2,200,000 Various accounts 2,400,000 3,600,000 2,200,000To record construction costs.

Accounts receivable 2,000,000 4,000,000 4,000,000 Billings on construction

contract2,000,000 4,000,000 4,000,000

To record progress billings.

Cash 1,800,000 3,600,000 4,600,000 Accounts receivable 1,800,000 3,600,000 4,600,000To record cash collections.

Construction in progress (gross profit)

600,000 900,000 300,000

Cost of construction (cost incurred)

2,400,000 3,600,000 2,200,000

Revenue from long-term contracts (1)

3,000,000 4,500,000 2,500,000

To record gross profit.

(1) Revenue recognized:2009: 30% x $10,000,000 = $3,000,0002010: 75% x $10,000,000 = $7,500,000

Less: Revenue recognized in 2009 (3,000,000)Revenue recognized in 2010 $4,500,0002011: 100% x $10,000,000 = $10,000,000

Less: Revenue recognized in 2009 & 2010 (7,500,000)Revenue recognized in 2011 $2,500,000



Requirement 3


Current assets:Accounts receivable $ 200,000 $600,000Construction in progress $3,000,000 $7,500,000

Less: Billings (2,000,000 ) (6,000,000 )Costs and profit in excess of billings 1,000,000 1,500,000


Costs incurred during the year $2,400,000 $3,800,000 $3,200,000Estimated costs to complete

as of year-end 5,600,000 3,100,000 -

2009 2010 2011Contract price $10,000,000 $10,000,000 $10,000,000Actual costs to date 2,400,000 6,200,000 9,400,000Estimated costs to complete 5,600,000 3,100,000 - 0 - Total estimated costs 8,000,000 9,300,000 9,400,000Estimated gross profit (actual in 2011) $ 2,000,000 $ 700,000 $ 600,000



Gross profit (loss) recognition:2009: $2,400,000

= 30.0% x $2,000,000 = $600,000$8,000,000

2010: $6,200,000 = 66.6667% x $700,000 = $466,667 - 600,000 = $(133,333)$9,300,000

2011: $600,000 - 466,667 = $133,333



as of year-end 5,600,000 4,100,000 -

2009 2010 2011Contract price $10,000,000 $10,000,000 $10,000,000Actual costs to date 2,400,000 6,200,000 10,100,000Estimated costs to complete 5,600,000 4,100,000 - 0 - Total estimated costs 8,000,000 10,300,000 10,100,000Estimated gross profit (loss) (actual in 2008) $ 2,000,000 $ (300,000 ) $ (100,000 )


2009: $2,400,000 = 30.0% x $2,000,000 = $600,000

$8,000,000

2010: $(300,000) - 600,000 = $(900,000)

2011: $(100,000) - (300,000) = $200,000


Requirement 1

Year Gross profit recognized2009 - 0 -2010 - 0 -2011 $1,800,000

Total gross profit $1,800,000

Requirement 2

2009 2010 2011Construction in progress 2,400,000 3,600,000 2,200,000 Various accounts 2,400,000 3,600,000 2,200,000To record construction costs.

Accounts receivable 2,000,000 4,000,000 4,000,000 Billings on construction

contract2,000,000 4,000,000 4,000,000

To record progress billings.

Cash 1,800,000 3,600,000 4,600,000 Accounts receivable 1,800,000 3,600,000 4,600,000To record cash collections.

Construction in progress (gross profit)

1,800,000

Cost of construction (costs incurred)

8,200,000

Revenue from long-term contracts (contract price)

10,000,000

To record gross profit.


Problem 5-6


Requirement 3


Current assets:Accounts receivable $ 200,000 $ 600,000

Construction in progress $2,400,000 $6,000,000 Less: Billings (2,000,000) (6,000,000)

Costs in excess of billings 400,000 - 0 -



as of year-end 5,600,000 3,100,000 -





as of year-end 5,600,000 4,100,000 -

Year Gross profit (loss) recognized2009 - 0 -2010 $(300,000)2011 200,000



Requirement 1

2009 2010 2011Contract price $4,000,000 $4,000,000 $4,000,000Actual costs to date 350,000 2,500,000 4,250,000Estimated costs to complete 3,150,000 1,700,000 - 0 - Total estimated costs 3,500,000 4,200,000 4,250,000Estimated gross profit (loss) (actual in 2011) $ 500,000 $ (200,000) $ (250,000 )



Requirement 2


2009: 10% x $500,000 = $50,000

2010: $(200,000) - 50,000 = $(250,000)

2011: $(250,000) - (200,000) = $(50,000)

Requirement 3


Current assets: Costs less loss ($2,300,000*) in excess of billings ($2,170,000) $ 130,000

Current liabilities: Billings ($720,000) in excess of costs and profit ($400,000) $ 320,000

*Cumulative costs ($2,500,000) less cumulative loss recognized ($200,000) = $2,300,000


Problem 5-7

Requirement 1

The completed contract method of recognizing revenues and costs on long-term construction contracts is equivalent to recognizing revenue at the point of delivery, i.e., when the construction project is complete. The percentage-of-completion method assigns a share of the project’s expected revenues and costs to each period in which the earnings process takes place, i.e., the construction period. The share is estimated based on the project's costs incurred each period as a percentage of the project's total estimated costs. The completed contract method should only be used when a lack of dependable estimates or inherent hazards make it difficult to forecast future costs and profits.

Requirement 22009 2010

Contract price $20,000,000 $20,000,000Actual costs to date 4,000,000 13,500,000Estimated costs to complete 12,000,000 4,500,000Total estimated costs 16,000,000 18,000,000Estimated gross profit $ 4,000,000 $ 2,000,000

a. Gross profit recognition:Under the completed contract method Citation would not report gross profit until the project is competed. Citation would have to report an overall gross loss on the contract in whatever period it first revises the estimates to determine that an overall loss will eventually occur. Citation never estimates the Altamont contract will earn a gross loss, so never has to recognize one.

b. Under the completed contract method Citation would not report any revenue in the 2009 or 2010 income statements.


Problem 5-8


c.


Current assets:Accounts receivable $ 200,000Costs ($4,000,000*) in excess of billings ($2,000,000) 2,000,000

* Under the completed contract method, this account would only include costs of $4,000,000


Contract price $20,000,000 $20,000,000Actual costs to date 4,000,000 13,500,000Estimated costs to complete 12,000,000 4,500,000Total estimated costs 16,000,000 18,000,000Estimated gross profit $ 4,000,000 $ 2,000,000

a. Gross profit recognition:2009: $ 4,000,000

= 25% x $4,000,000 = $1,000,000$16,000,000

2010: $13,500,000 = 75% x $2,000,000 = $1,500,000$18,000,000

Less: 2009 gross profit 1,000,000 2010 gross profit$ 500,000

b. 2009: $20,000,000 x 25% = $5,000,000

2010: $20,000,000 x 75% = $15,000,000 Less: 2009 revenue (5,000,000) $10,000,000



c.


Current assets:Accounts receivable $ 200,000Costs and profit ($5,000,000*) in excess of billings ($2,000,000) 3,000,000

* Costs ($4,000,000) + profit ($1,000,000)


Contract price $20,000,000 $20,000,000Actual costs to date 4,000,000 13,500,000Estimated costs to complete 12,000,000 9,000,000Total estimated costs 16,000,000 22,500,000Estimated gross profit $ 4,000,000 ($ 2,500,000 )

a. Gross profit recognition:

2010: Overall loss of ($2,500,000) – previously recognized gross profit of $1,000,000 = $3,500,000.

b. 2010: Easiest to solve using a journal entry:

Cost of construction (to balance) $10,500,000 Revenue from long-term contracts* $7,000,000 Construction in progress (loss) $3,500,000

*Total revenue recognized to date = (percentage complete)(total revenue) = ($13,500,000 / $22,500,000) x ($20,000,000) = (60%) x ($20,000,000)

= $12,000,000 Revenue recognized this period = total – revenue recognized in prior periods = $12,000,000 – $5,000,000 = $7,000,000



c.


Current assets:Accounts receivable

Current liabilities:

$ 200,000

Billings ($12,000,000) in excess of costs and profit ($11,000,000*) 1,000,000

* 2009 costs ($4,000,000) + 2009 profit ($1,000,000) + 2010 costs ($9,500,000) – 2010 loss ($3,500,000)

Requirement 5Citation should recognize revenue at the point of delivery, when the homes are

completed and title is transferred to the buyer. This is equivalent to the completed contract method for long-term contracts. The percentage-of-completion method is not appropriate in this case. There is no contract in place and until the completion of the home, the transfer of title, and the receipt of the full sales price, the earnings process is not virtually complete and there is still significant uncertainty as to cash collection. Also, the sales price is not fixed.

Requirement 6Income statement: Sales revenue (3 x $600,000) $1,800,000 Cost of goods sold (3 x $450,000) 1,350,000 Gross profit $ 450,000 Balance sheet: Current assets: Inventory (work in process) $2,700,000 Current liabilities: Customer deposits (or unearned revenue) 300,000*

*$600,000 x 10% = $60,000 x 5 = $300,000


Problem 5-9

Requirement 1

a. January 30, 2009

Cash ............................................................................. 200,000Note receivable ............................................................ 1,000,000

Unearned franchise fee revenue................................. 1,200,000

b. September 1, 2009

Unearned franchise fee revenue..................................... 1,200,000Franchise fee revenue ............................................... 1,200,000

c. September 30, 2009

Accounts receivable ($40,000 x 3%) ............................... 1,200Service revenue ........................................................ 1,200

d. January 30, 2010

Cash.............................................................................. 100,000Note receivable ......................................................... 100,000



Requirement 2a. January 30, 2009

Cash ............................................................................. 200,000Note receivable ............................................................ 1,000,000

Deferred franchise fee revenue.................................. 1,200,000

Note: Could also show as:Cash ............................................................................. 200,000Note receivable ............................................................ 1,000,000

Deferred franchise fee revenue.................................. 1,000,000Unearned franchise fee revenue................................. 200,000

b. September 1, 2009

Deferred franchise fee revenue ..................................... 200,000Franchise fee revenue (cash collected).......................... 200,000

c. September 30, 2009

Accounts receivable ($40,000 x 3%) ............................... 1,200Service revenue ........................................................ 1,200

d. January 30, 2010

Cash.............................................................................. 100,000Note receivable ......................................................... 100,000

Deferred franchise fee revenue ..................................... 100,000Franchise fee revenue ............................................... 100,000



Requirement 3


Current assets:Installment notes receivable ($1,000,000) less deferred franchise fee revenue ($1,000,000)

Current liabilities:

$ -0-

Unearned franchise fee revenue $200,000

Explanation: Revenue recognition on the entire note receivable is deferred. In addition, $200,000 of unearned revenue must be shown as a liability.

1. Inventory turnover ratio $6,300 ÷ [($800 + 600) ÷ 2] = 9.02. Average days in inventory 365 ÷ 9.0 = 40.56 days3. Receivables turnover ratio $9,000 ÷ [($600 + 400) ÷ 2] = 18.04. Average collection period 365 ÷ 18.0 = 20.28 days5. Asset turnover ratio $9,000 ÷ [($4,000 + 3,600) ÷ 2] = 2.376. Profit margin on sales $300 ÷ $9,000 = 3.33%7. Return on assets $300 ÷ [($4,000 + 3,600) ÷ 2] = 7.89%

or: 3.33% x 2.37 times = 7.89%8. Return on

shareholders’ equity $300 ÷ [($1,500 + 1,350) ÷ 2] = 21.1%9. Equity multiplier [($4,000 + 3,600) ÷ 2] ÷ [($1,500 + 1,350) ÷ 2] = 2.6710. DuPont framework 3.33% x 2.37 x 2.67 = 21.1%


Problem 5-10

Requirement 1

On average, J&J collects its receivables in 14 days less than Pfizer.

On average, J&J sells its inventory twice as fast as Pfizer.


Problem 5-11

Receivables turnover = Net sales Accounts receivable

J&J = $41,862 = 6.37 times$6,574

Pfizer = $45,188 = 5.15 times$8,775

Average collection period = 365 Receivables turnover

J&J = 365 = 57 days6.37

Pfizer = 365 = 71 days5.15

Inventory turnover = Cost of goods sold Inventories

J&J = $12,176 = 3.39 times$3,588

Pfizer = $9,832 = 1.68 times$5,837

Average days in inventory = 365 Inventory turnover

J&J = 365 = 108 days3.39

Pfizer = 365 = 217 days1.68


Requirement 2

The return on assets indicates a company's overall profitability, ignoring specific sources of financing. In this regard, J&J’s profitability is significantly higher than that of Pfizer.

Requirement 3

Profitability can be achieved by a high profit margin, high turnover, or a combination of the two.

Rate of return on assets = Profit margin x Asset on sales turnover

= Net income x Net sales Net sales Total assets

J&J = $ 7,197 x $41,862 $41,862 $48,263

= 17.19% x .867 times = 14.9%

Pfizer = $ 1,639 x $45,188 $45,188 $116,775

= 3.63% x .387 times = 1.4%

J&J’s profit margin is much higher than that of Pfizer, as is its asset turnover. These differences combine to produce a significantly higher return on assets for J&J.


Rate of return on assets = Net income Total assets

J&J = $7,197 = 14.9%$48,263

Pfizer = $1,639 = 1.4%$116,775


Requirement 4

J&J provided a much greater return to shareholders.

Requirement 5

The two companies have virtually identical equity multipliers, indicating that they are using leverage to the same extent to earn a return on equity that is higher than their return on assets.

a. Times interest earned ratio = (Net income + Interest + Taxes) ÷ Interest = 17

(Net income + $2 + 12) ÷ $2 = 17Net income + $14 = 17 x $2 Net income = $20

b. Return on assets = Net income ÷ Total assets = 10%Total assets = $20 ÷ 10% = $200

c. Profit margin on sales = Net income ÷ Sales = 5%Sales = $20 ÷ 5% = $400


Rate of return on = Net income shareholders’ equity Shareholders’ equity

J&J = $7,197 = 26.8%$26,869

Pfizer = $1,639 = 2.5%$65,377

Equity multiplier = Total Assets shareholders’ equity Shareholders’ equity

J&J = $48,263 = 1.80$26,869

Pfizer = $116,775 = 1.79%$65,377

Problem 5-12

d. Gross profit margin = Gross profit ÷ Sales = 40%Gross profit = $400 x 40% = $160Cost of goods sold = Sales – Gross profit = $400 – 160 = $240

e. Inventory turnover ratio = Cost of goods sold ÷ Inventory = 8Inventory = $240 ÷ 8 = $30

f. Receivables turnover ratio = Sales ÷ Accounts receivable = 20Accounts receivable = $400 ÷ 20 = $20

g. Current ratio = Current assets ÷ Current liabilities = 2.0Acid-test ratio = Quick assets ÷ Current liabilities = 1.0

Current assets ÷ 2 = Current liabilities Quick assets ÷ 1 = Current liabilities Current assets ÷ 2 = Quick assets ÷ 1Current assets = 2 x Quick assetsCash + accts. rec. + Inventory = 2 x (Cash + Accounts receivable)Cash + $20 + $30 = (2 x Cash) + (2 x $20) Cash + $50 = Cash + Cash + $40 Cash = $10

h. Acid-test ratio = (Cash + Accounts receivable) ÷ Current liabilities = 1.0Current liabilities = ($10 + 20) ÷ 1.0 = $30

i. Noncurrent assets = Total assets – Current assets = $200 – ($10+20+30) = $140

j. Return on shareholders’ equity = Net income ÷ Shareholders’ equity = 20%Shareholders’ equity = $20 ÷ 20% = $100



k. Debt to equity ratio = Total liabilities ÷ Shareholders’ equity = 1.0 Total liabilities = $100 x 1.0 = $100Long-term liabilities = Total liabilities - Current liabilities = $100 - 30 = $70

Requirement 1


CADUX CANDY COMPANYBalance Sheet

At December 31, 2009

AssetsCurrent assets: Cash $ 10 Accounts receivable (net) 20 Inventories 30 Total current assets 60 Property, plant, and equipment (net) 140 Total assets $200

Liabilities and Shareholders’ Equity Current liabilities $ 30 Long-term liabilities 70 Shareholders’ equity 100 Total liabilities and shareholders' equity $200

Problem 5-13Rate of return on assets = Net income

Total assets

Metropolitan = $ 593.8 = 14.8%$4,021.5

Republic = $ 424.6 = 10.6%$4,008.0

The return on assets indicates a company's overall profitability, ignoring specific sources of financing. In this regard, Metropolitan’s profitability exceeds that of Republic.

Requirement 2Profitability can be achieved by a high profit margin, high turnover, or a

combination of the two.

Rate of return on assets = Profit margin x Asset on sales turnover

= Net income x Net sales Net sales Total assets

Metropolitan = $ 593.8 x $5,698.0 $5,698.0 $4,021.5

= 10.4% x 1.42 times = 14.8%

Republic = $ 424.6 x $7,768.2 $7,768.2 $4,008.0

= 5.5% x 1.94 times = 10.7%

Republic’s profit margin is much less than that of Metropolitan, but partially makes up for it with a higher turnover.



Requirement 3

Republic provides a greater return to common shareholders.

Requirement 4

When the return on shareholders’ equity is greater than the return on assets, management is using debt funds to enhance the earnings for stockholders. Both firms do this. Republic’s higher leverage has been used to provide a higher return to shareholders than Metropolitan, even though its return on assets is less. Republic increased its return to shareholders 4.07 times (43.6% ÷ 10.7%) the return on assets. Metropolitan increased its return to shareholders 2.34 times (34.6% ÷ 14.8%) the return on assets.


Rate of return on = Net income shareholders’ equity Shareholders’ equity

Metropolitan = $593.8 = 34.6%$144.9 + 2,476.9 - 904.7

Republic = $424.6 = 43.6%$335.0 + 1,601.9 - 964.1

Equity multiplier = Total assets Shareholders’ equity

Metropolitan = $4,021.5 = 2.34$144.9 + 2,476.9 - 904.7

Republic = $4,008.0 = 4.12$335.0 + 1,601.9 - 964.1


Requirement 5

The current ratios of the two firms are comparable and within the range of the rule-of-thumb standard of 1 to 1. The more robust acid-test ratio reveals that Metropolitan is more liquid than Republic.

Requirement 6


Current ratio = Current assets Current liabilities

Metropolitan = $1,203.0 = .94$1,280.2

Republic = $1,478.7 = .83$1,787.1

Acid-test ratio = Quick assets Current liabilities

Metropolitan = $1,203.0 - 466.4 - 134.6 = .47 $1,280.2

Republic = $1,478.7 - 635.2 - 476.7 = .21 $1,787.1

Receivables turnover ratio = Sales Accounts receivable

Metropolitan = $5,698.0 = 13.5 times $422.7

Republic = $7,768.2 = 23.9 times $325.0

Republic’s receivables turnover is more rapid than Metropolitan’s, perhaps suggesting that its relative liquidity is not as bad as its acid-test ratio indicated.

Requirement 7

Both firms provide an adequate margin of safety.



Inventory turnover ratio = Cost of goods sold Inventory

Metropolitan = $2,909.0 = 6.2 times $466.4

Republic = $4,481.7 = 7.1 times $635.2

Times interest = Net income plus interest plus taxes earned ratio Interest

Metropolitan = $593.8 + 56.8 + 394.7 = 18.4 times $56.8

Republic = $424.6 + 46.6 + 276.1 = 16.0 times $46.6

Branson Electronics Company

Income Statement

Revenues $180,000Cost of goods sold 35,000 Gross profit 145,000Advertising expense1 (12,500)Other operating expenses2 (57,000 ) Income before income taxes 75,500Income tax expense3 (27,180 ) Net income $ 48,320

1$50,000 ÷ 4 = $12,5002$48,000 + [$59,000 – 50,000]3$75,500 x 36%

Requirement 1A bill and hold strategy accelerates the recognition of revenue. In this case, sales

that would normally have occurred in 1998 were recorded in 1997. Assuming a positive gross profit on these sales, earnings in 1997 is inflated.

Requirement 2A customer would probably not be expected to pay for goods purchased using

this bill and hold strategy until the goods were actually received. Receivables would therefore increase.

Requirement 3Sales that would normally have been recorded in 1998 were recorded in 1997.

This bill and hold strategy shifted sales revenue and therefore earnings from 1998 to 1997.

Requirement 4Earnings quality refers to the ability of reported earnings (income) to predict a

company’s future earnings. Sunbeam’s earnings management strategy produced a 1997 earnings figure that was not indicative of the company’s future profit-generating ability.


Problem 5-14

CASESReal World Case 5-1

Requirement 1

While revenue often is earned during a period of time, revenue usually is recognized at a point in time when both revenue recognition criteria are satisfied. These criteria usually are satisfied at the point of delivery. The revenue has been earned and there is reasonable certainty as to the collectibility of the asset (cash) to be received.

Usually, significant uncertainties exist at the time products are produced. At point of delivery, the product has been sold and the price and buyer are known. The only remaining uncertainty involves the ultimate cash collection, which can usually be accounted for by estimating and recording allowances for possible return of the product and for uncollectibility of the cash.

Requirement 2It would be useful to recognize revenue as the productive activity takes place

when the earnings process occurs over long periods of time. A good example is long-term projects in the construction industry.

Requirement 3Some revenue-producing activities call for revenue recognition after the product

has been delivered. These situations involve significant uncertainty as to the collectibility of the cash to be received, caused either by the possibility of the product being returned or, with credit sales, the possibility of bad debts. Usually, these remaining uncertainties can be accounted for by estimating and recording allowances for anticipated returns and bad debts, thus allowing revenue and related costs to be recognized at point of delivery. But occasionally, an abnormal degree of uncertainty causes point of delivery revenue recognition not to be appropriate. Revenue recognition after delivery sometimes is appropriate for installment sales and when a right of return exists.

Mega should recognize revenue for the initial fee equally over the estimated average period members will

continue to be members. Even though the fee is nonrefundable, it is not “earned” until services are provided. Since there is no contractual period of service, it must be estimated. Mega would be justified in recognizing only $3 of the initial fee immediately to offset the cost of the membership card. The payment option chosen by members does not affect the revenue recognition policy.

The monthly fee should be recognized as revenue upon billing, as long as adequate provision is made for possible uncollectible amounts.


Judgment Case 5-2

Judgment Case 5-3

The revenue recognition policy is questionable. The liberal trade-in policy causes gross profit to be overstated on the original sale and understated on the trade-in sale. This results from the granting of a trade-in allowance for the old computer that is greater than the old computer's resale value. Using the company's recognition policy, gross profit recognized on the two sales would be as follows:

Original sale Trade-in saleSales price $2,000,000 $2,380,000Cost of goods sold 1,200,000 1,500,000Gross profit $ 800,000 $ 880,000

Gross profit percentage 40% 37%

Of course, there is no guarantee that the customer will exercise the trade-in option. If, however, a large percentage of customers do exercise the option, and the distortion in gross profit is material, the company should adopt a revenue recognition policy that results in a more stable gross profit percentage for the two transactions.

The critical question that student groups should address is how to match revenues and expenses. There is no right or wrong answer. The process of

developing the proposed solutions will likely be more beneficial than the solutions themselves. Students should benefit from participating in the process, interacting first with other group members, then with the class as a whole.

Solutions could take one of two directions:1. Deferral of revenue recognition. As each ice cream cone is sold, a portion of

the sales price is deferred and a liability is recorded. This liability will then be reduced and revenue recognized when the free ice cream cone is awarded.

2. The accrual of estimated cost. This direction views the free ice cream cone as a promotional expense. The estimated cost of the free cone should be expensed as the ten required cones are sold. A corresponding liability is recorded which should increase to an amount equal to the cost of the free cone. When the free cone is awarded, the liability and inventory are reduced.

In either case, the accounting method must consider the fact that not all customers will take advantage of the free cone award.


Judgment Case 5-4

Communication Case 5-5

It is important that each student actively participate in the process. Domination by one or two individuals should be discouraged. Students should be encouraged to contribute to the group discussion by (a) offering information on relevant issues, and (b) clarifying or modifying ideas already expressed, or (c) suggesting alternative direction.

(Note: This case requires the student to reference a journal article.]

1. Fifty-five firms reported the use of one of the two long-term contract accounting methods.

2. Twenty-seven of the firms are manufacturing companies.3. Only one company uses the completed contract method. That company reported

using both methods.4. The most frequently used approach to estimating a percentage-of-completion is

the cost-to-cost method. (Note: This case requires the student to reference a journal article.]

1.

Abuse Expanation1. Cutoff manipulation The company either closes their books early (so some

current-year revenue is postponed until next year) or leaves them open too long (so some next-year revenue is included in the current year).

2. Deferring too much or too little revenue

The company has an arrangement under which revenue should be deferred (for example, they should be using the installment sales method), but they don’t defer the revenue. Or, a company could defer too much revenue to shift income into future periods.

3. Bill-and-hold sale The company records sales even though they haven’t yet delivered the goods to the customer.

4. Right-of-return sale The company sells to distributors or other customers and can’t estimate returns with sufficient accuracy due to the nature of the selling relationship.

2. Manipulating estimates of percentage complete in order to manipulate gross profit recognition.

3. These abuses tended to increase income (75% of the time), consistent with management generally having an incentive to increase income.


Research Case 5-6

Research Case 5-7

4. The auditors tended to require adjustment (56% of the time), consistent with auditors being concerned about income-increasing earnings management.

Discussion should include these elements.

Facts:Horizon Corporation, a computer manufacturer, reported profits from 2004

through 2007, but reported a $20 million loss in 2008 due to increased competition. The chief financial officer (CFO) circulated a memo suggesting the shipment of computers to J.B. Sales, Inc., in 2009 with a subsequent return of the merchandise to Horizon in 2010. Horizon would record a sale for the computers in 2009 and avoid an inventory write-off that would place the company in a loss position for that year.

The CFO is clearly asking Jim Fielding to recognize revenue in 2009 which he knows will be reversed as a sales return in 2010.

Ethical Dilemma:Is Jim's obligation to challenge the memo of the CFO and provide useful

information to users of the financial statements greater than the obligation to prevent a company loss in 2009 that may lead to bankruptcy?

Who is affected?

Jim FieldingCFO and other managersOther employeesShareholdersPotential shareholders CreditorsAuditors

Requirement 1

The three methods that could be used to recognize revenue and costs for this situation are (1) point of delivery, (2) the installment sales method, and (3) the cost recovery method.

2009 gross profit under the three methods:

(1) point of delivery:


Ethics Case 5-8

Judgment Case 5-9

$80,000 - 40,000 = $40,000

(2) installment sales method:

$40,000 = 50% = gross profit %$80,000

50% x $30,000 (cash collected) = $15,000

(3) cost recovery method:

No gross profit recognized since cost ($40,000) exceeds cash collected ($30,000).

Requirement 2Customers sometimes are allowed to pay for purchases in installments over long

periods of time. Uncertainty about collection of a receivable normally increases with the length of time allowed for payment. In most situations, the increased uncertainty concerning the collection of cash from installment sales can be accommodated satisfactorily by estimating uncollectible amounts. In these situations, point of delivery revenue recognition should be used.

If, however, the installment sale creates a situation where there is significant uncertainty concerning cash collection making it impossible to make an accurate assessment of future bad debts, revenue and cost recognition should be delayed. The installment sales method and the cost recovery method are available to handle such situations. These methods should be used only in situations involving exceptional uncertainty. The cost recovery method is the more conservative of the two.

Question 1No. In the SEC's view, it would be inappropriate for Company M to recognize the

membership fees as earned revenue upon billing or receipt of the initial fee with a corresponding accrual for estimated costs to provide the membership services. This conclusion is based on Company M's remaining and unfulfilled contractual obligation to perform services (i.e., make available and offer products for sale at a discounted price) throughout the membership period. Therefore, the earnings process, irrespective of whether a cancellation clause exists, is not complete.


Judgment Case 5-10

In addition, the ability of the member to receive a full refund of the membership fee up to the last day of the membership term raises an uncertainty as to whether the fee is fixed or determinable at any point before the end of the term. Generally, the SEC believes that a sales price is not fixed or determinable when a customer has the unilateral right to terminate or cancel the contract and receive a cash refund.

Question 2No. Products delivered to a consignee pursuant to a consignment arrangement are

not sales and do not qualify for revenue recognition until a sale occurs. The SEC believes that revenue recognition is not appropriate because the seller retains the risks and rewards of ownership of the product and title usually does not pass to the consignee.

Question 3Provided that the other criteria for revenue recognition are met, the SEC believes

that Company R should recognize revenue from sales made under its layaway program upon delivery of the merchandise to the customer. Until then, the amount of cash received should be recognized as a liability entitled such as "deposits received from customers for layaway sales" or a similarly descriptive caption. Because Company R retains the risks of ownership of the merchandise, receives only a deposit from the customer, and does not have an enforceable right to the remainder of the purchase price, the SEC would object to Company R recognizing any revenue upon receipt of the cash deposit. This is consistent with item two (2) in the SEC's criteria for bill-and-hold transactions that states that "the customer must have made a fixed commitment to purchase the goods."

Requirement 2

The standard lists the following factors that may impair the ability to make a reasonable estimate:

a. The susceptibility of the product to significant external factors, such as technological obsolescence or changes in demand.

b. Relatively long periods in which a particular product may be returned.c. Absence of historical experience with similar types of sales of similar

products, or inability to apply such experience because of changing circumstances, for example, changes in the selling enterprise’s marketing policies or relationships with its customers.

d. Absence of a large volume of relatively homogeneous transactions.


Research Case 5-11

Requirement 3The six criteria are:a. The seller’s price to the buyer is substantially fixed or determinable at the

date of sale.b. The buyer has paid the seller and the obligation is not contingent on resale

of the product.c. The buyer’s obligation to the seller would not be changed in the event of

theft or physical destruction or damage of the product.d. The buyer acquiring the product for resale has economic substance apart

from that provided by the seller.e. The seller does not have significant obligations for future performance to

directly bring about resale of the product by the buyer.f. The amount of future returns can be reasonably estimated.

Requirement 4Both companies recognize revenues from products sold when persuasive

evidence of an arrangement exists, the price is fixed or determinable, shipment is made and collectibility is reasonably assured. However, for sales to distributors under terms allowing the distributors certain rights of return and price protection on unsold merchandise held by them, AMD defers recognition of revenue and related profits until the merchandise is resold by the distributors.


Case 5-11 (concluded)

Requirement 5The two revenue recognition policies differ with respect to AMD’s sales to

distributors. Revenue for these sales is deferred until the merchandise is resold by the distributors. On the other hand, HP recognizes all sales when products are shipped even though they offer price protection as well as the right of return to customers. Estimates are recorded for customer returns, price protection, rebates and other offerings. Reasons for the difference in policies could relate to the types of products sold by the two companies, the distribution channels, and the actual agreements with customers. AMD sells semiconductors, a highly volatile industry. It may be more difficult for AMD to see through the distribution channels to reasonably estimate returns. Also, the agreements with distributors of AMD’s products may be more liberal than those of HP with respect to things like price protection and returns. For example, AMD might offer a longer time period for customers to return product than does HP. Also, AMD’s sales to distributors might be contingent on resale of the product to end users, one of the six criteria that must be met before revenue can be recognized when the right of return exists.

Requirement 1

This topic is addressed in EITF Issue No. 99-19.

Requirement 2The Issue lists the following indicators for use of the gross method:1. The company is the primary obligor in the arrangement.2. The company has general inventory risk (before customer order is placed or

upon customer return).3. The company has latitude in establishing price.4. The company changes the product or performs part of the service.5. The company has discretion in supplier selection.6. The company is involved in the determination of product or service

specifications.7. The company has physical loss inventory risk (after customer order or during

shipping).8. The company has credit risk.

The indicators for the use of the net method are:1. The supplier (not the company) is the primary obligor in the arrangement.2. The amount the company earns is fixed.3. The supplier (and not the company) has credit risk.


Research Case 5-12

Requirements 3 and 4In its footnote on Fulfillment partner revenue, the company describes the reasons

for making the switch from the net to the gross method:“Prior to July 1, 2003, the Company did not physically handle the merchandise

sold in these transactions, as the merchandise was shipped directly by a third party vendor, who also handled all customer returns related to these fulfillment partner sales. During that period, the Company recognized as revenue only the net portion of the price customers paid for the purchased products since the Company acted as an agent in such transactions. Beginning July 1, 2003, the Company took responsibility for returned items relating to these sales and began accepting returned items relating to these sales into the Company’s warehouse, and the Company now handles the possible resale of returned items. As a result, beginning July 1, 2003, the Company is considered to be the primary obligor for these sales transactions, and assumes the risk of loss on returned items. As a consequence, the Company now records revenue from sales transactions involving fulfillment partners on a gross basis, rather than on a net basis as was recorded prior to July 1, 2003.”



Requirement 5For their AdSense program, Google’s 2006 10K states: “In accordance with

Emerging Issues Task Force (“EITF”) Issue No. 99-19 … we report our Google AdSense revenues on a gross basis principally because we are the primary obligor to our advertisors.” That is consistent with the first indicator for use of the gross method listed under Requirement 2.

For Google Video, Google’s 2006 10K states: “We recognize as revenue the fees we receive from end users to the extent we are the primary obligor to them; however, to the extent we are not, we recognize as revenues the fees we receive from end users net of the amounts we pay to our video content providers in accordance with EITF 99-19.” That is also consistent with the primary obligor indicator.

1. Delta should recognize the $425 as revenue on May 15, the date the flight commences.

2. Revenue should be recognized evenly over the period beginning after Thanksgiving and ending April 30.

3. The $5,000 monthly charge is recognized as revenue each month. The $12,000 fee must be recognized evenly over the 36-month lease period.

4. Janora Hawkins should recognize the $60,000 as revenue on August 28, the date the case is settled successfully. This assumes reasonable certainty as to the collection.

Bill’s argument is that the completed contract method is preferable because it is analogous to point of delivery revenue recognition. That is, no revenue is recognized

until the completed product is delivered. John’s argument is that the important factor is the earnings process and that revenue should be recognized as the process takes place.

John’s argument is correct. In situations when the earnings process takes place over long periods of time, like long-term construction contracts, it is preferable to recognize revenue during the earnings process, rather than to wait until the process is complete.

Suggested Grading Concepts and Grading Scheme:Content (70%)_________ 45 Income differences.

________ Percentage-of-completion recognizes gross profit during construction based on an estimate of percent complete.

________ The completed contract method recognizes no gross profit until


Judgment Case 5-13

Judgment Case 5-14

Communication Case 5-15

project completion.________ For both methods, estimated losses are fully recognized in the first period the loss is anticipated.

_________ 10 Balance sheet differences.The two methods are similar. However, for profitable projects, the construction in progress account during construction will have a higherbalance when using the percentage-of-completion method due to theinclusion of gross profit.

_________ 15 According to generally accepted accounting principles, the percentage-of-completion method should be used in most situations. The completedcontract method distorts income when long-term projects span more than one accounting period.

________________ 70 points

Writing (30%)_________ 6 Terminology and tone appropriate to the audience of a company

controller.

_________ 12 Organization permits ease of understanding._______ Introduction that states purpose._______ Paragraphs that separate main points.

_________ 12 English_______ Sentences grammatically clear and well organized, concise.

_______ Word selection._______ Spelling._______ Grammar and punctuation.

________________ 30 points

Electrolux's revenue recognition policies for products and services are similar to revenue recognition policies in the U.S. Sales of products are

recorded when goods have been put at the disposal of the customers in accordance with agreed terms of delivery and when the risks and rewards of ownership have been transferred to the buyer. The terminology is somewhat different, but the end results, as compared to U.S. policies, should be similar in most cases.

A solution and extensive discussion materials can be obtained from the Deloitte Foundation.


International Case 5-16

Trueblood Accounting Case 5-17

A solution and extensive discussion materials can be obtained from the Deloitte Foundation.

Requirement 3

The following is from the 2006 10K of Jack in the Box, Inc. The responses to the question will vary if the company has since changed its revenue recognition policy.

a. These fees are recognized as revenue when the company has substantially performed all of its contractual obligations. This policy agrees with SFAS No. 45 guidelines.

b. Continuing payments are based on a percentage of sales.

Requirement 4Answers to this question will, of course, vary because students will research

financial statements of different companies. Likely candidates for comparison include most of the fast-food chains such as McDonalds and Wendys.

This case encourages students to obtain hands-on familiarity with an actual annual report and library sources of industry data. They also must apply the techniques

learned in the chapter. You may wish to provide students with multiple copies of the same annual reports and compare responses. Another approach is to divide the class into teams who evaluate reports from a group perspective.

Apparently, a significant increase in assets occurred during the last quarter. Total assets were $324 million and now they total $450 million, as can be calculated as

follows:Return on shareholders’ equity = Net income ÷ Shareholders’ equity = 14%Shareholders’ equity = $21 million ÷ 14% = $150 millionDebt to equity ratio = Total liabilities ÷ Shareholders’ equity = 2 Total liabilities = $150 million x 2 = $300 millionTotal assets = Total liabilities + Shareholders’ equity

= $300 million + 150 million = $450 million


Trueblood Accounting Case 5-18

Real World Case 5-19

Analysis Case 5-20

Judgment Case 5-21


Calculations ($ in 000s):a. Profit margin on sales = Net income ÷ Sales = 5%

Sales = $15 ÷ 5% = $300b. Return on assets = Net income ÷ Total assets = 7.5%

Total assets = $15 ÷ 7.5% = $200c. Gross profit margin = Gross profit ÷ Sales = 40%

Gross profit = $300 x 40% = $120Cost of goods sold = Sales – Gross profit = $300 – 120 = $180

d. Inventory turnover ratio = Cost of goods sold ÷ Inventory = 6Inventory = $180 ÷ 6 = $30

e. Receivables turnover ratio = Sales ÷ Accounts receivable = 25Accounts receivable = $300 ÷ 25 = $12


Integrating Case 5-22Balance Sheet

Assets Cash $ 15,000 given Accounts receivable (net) 12,000 (e) Inventory 30,000 (d) Prepaid expenses and other current assets 3,000 (i) Current assets 60,000 (h) Property, plant, and equipment (net) 140,000 (j)

$200,000 (b)Liabilities and Shareholders’ Equity Accounts payable $ 25,000 (g) Short-term notes 5,000 given Current liabilities 30,000 (f) Bonds payable 20,000 (l) Shareholders’ equity 150,000 (k)

$200,000 (b)Income Statement

Sales $300,000 (a)Cost of goods sold (180,000 ) (c) Gross profit 120,000 (c)Operating expenses (96,000) (o)Interest expense (2,000) (m)Tax expense (7,000 ) (n) Net income $ 15,000 given

f. Acid-test ratio = Cash + AR + ST Investments ÷ Current liabilities = .9Current liabilities = ($15 + 12 + 0) ÷.9 = $30

g. Accounts payable = Current liabilities – Short-term notes = $30 – 5 = $25h. Current ratio = Current assets ÷ Current liabilities = 2

Current assets = $30 x 2 = $60i. Prepaid expenses and other current assets =

Current assets – (Cash + AR + Inventory) = $60 – ($15 + 12 + 30) = $3j. Property, plant, and equipment = Total assets – Current assets = $200 – 60 = $140k. Return on shareholders’ equity = Net income ÷ Shareholders’ equity =10%

Shareholders’ equity = $15 ÷ 10% = $150l. Debt to equity ratio = Total liabilities ÷ Shareholders’ equity = 1/3

Total liabilities = $150 x 1/3 = $50Bonds payable = Total liabilities - Current liabilities = $50 - 30 = $20

m. Interest expense = 8% x (Short-term notes + Bonds )Interest expense = 8% x ($5 + 20) = $2

n Times interest earned ratio = (Net income + Interest +Taxes) ÷ Interest = 12Times interest earned ratio = ($15 + 2 + Taxes) ÷ 2 = 12Times interest earned ratio = ($15 + 2 + Taxes) = 24Tax expense = $24 – ($15 + 2) = $7

o. Operating expenses = (Sales – Cost of goods sold – Interest expense – Tax expense) – Net income = ($300 - 180 - 2 - 7) - 15 = $96


Chap 005

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Transcript of Chap 005