Chap005.doc

Chapter 05 - Income Measurement and Profitability Analysis

Chapter 5

Income Measurement and Profitability Analysis

QUESTIONS FOR REVIEW OF KEYQuestion 5-1 TOPICSThe 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 5-2At the time production is completed, there usually exists significant uncertainty as to the collectibility of the asset to be received. We dont 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 5-3If 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 5-4The 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 5-5Deferred 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.

5-1


Question 5-6Because 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 5-7Sometimes 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 cant 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 5-8For 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, its more meaningful to recognize revenue over time in proportion to the performance of the activity.

Question 5-9The 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 projects 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.

5-2


Question 5-10The 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 equal to the amount of cost that can be recovered, which typically is an amount that exactly offsets costs until all costs have been recovered, and then will recognize the remaining revenue and gross profit. Therefore, revenue and cost are recognized earlier under the cost recovery method than under the completed contract method, but gross profit recognition is delayed until late in the contract for both approaches. 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 5-11The 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 in the balance sheet as an asset. Conversely, if the net amount is a credit, it is reported as a liability.

Question 5-12An 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 5-13This 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 5-14IFRS has less specific guidance for recognizing revenue for multiple-deliverable arrangements. IAS No. 18 simply states that: in certain circumstances, it is necessary to apply the recognition criteria to the separately identifiable components of a single transaction in order to reflect the substance of the transaction and gives a couple of examples, whereas U.S. GAAP provides more restrictive guidance concerning how to allocate revenue to various components and when revenue from components can be recognized.

Question 5-15Specific guidelines for revenue recognition of the initial franchise fee are provided by FASB ASC 952605251. 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.

5-3


Question 5-16Receivables turnover ratio Inventory turnover ratio Asset turnover ratio = = = Net sales Average accounts receivable (net) Cost of goods sold Average inventory Net sales Average total assets

Activity ratios are designed to provide information about a companys 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 5-17Profit margin on sales Return on assets Return on shareholders' equity = = = Net income Net sales Net income Average total assets Net income Average shareholders' equity

A fundamental element of an analysts task is to develop an understanding of a firms profitability. Profitability ratios provide information about a companys 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.

5-4


Question 5-18Return on equity Net income Ave. total equity = = Profit margin Net income Total sales X X Asset turnover Total sales Ave. total assets X Equity multiplier X Ave. total assets Ave. total equity

The DuPont framework shows return on equity as being driven by profit margin (reflecting a companys ability to earn income from sales), asset turnover (reflecting a companys 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 5-19These 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.

5-5


BRIEF EXERCISESBrief Exercise 5-1 Brief Exercise 5-22011 gross profit = $3,000,000 1,200,000 = $1,800,000 2012 gross profit = 0

2011 Cost recovery % = Cost Sales: $1,200,000 = 40% (implying a gross profit % = 60%) $3,000,000

2011 gross profit = 2011 cash collection of $150,000 x 60% = $90,000 2012 gross profit = 2012 cash collection of $150,000 x 60% = $90,000

Brief Exercise 5-3

No gross profit will be recognized in either 2011 or 2012. 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.

Brief Exercise 5-4

Initial deferred gross profit ($3,000,000 1,200,000) $1,800,000 Less gross profit recognized in 2011 ($150,000 x 60%) (90,000) Less gross profit recognized in 2012 ($150,000 x 60%) (90,000) Deferred gross profit at the end of 2012 $1,620,000 The seller must meet certain criteria before revenue can Brief Exercise 5-5be 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 Meyers 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.

Brief Exercise 5-6

Total estimated cost to complete = $6 million + $9 million = $15 million % of completion = $6 million $15 million = 40%5-6


Total estimated gross profit ($20 million 15 million) = multiplied by the % of completion Gross profit recognized the first year First year revenue = $20,000,000 x 40% = $8,000,000

$5,000,000 40% $2,000,000

Brief Exercise 5-7

Assets: Accounts receivable ($7 million 5 million)$2,000,000 1,000,000 $5,000,000 40% $2,000,000

Cost plus profit ($6 million + $2 million*) in excess of billings ($7 million) * Total estimated gross profit ($20 million 15 million) = multiplied by the % of completion Gross profit recognized in the first year

Brief Exercise 5-8Revenue Less: Costs in year 1 Costs in year 2 Actual profit

Year 1 = 0 Year 2 = $4 million $20,000,000 (6,000,000) (10,000,000) $ 4,000,000 Year 1: Revenue: Cost: Gross profit: $6 million $6 million $0

Brief Exercise 5-9

Year 2: Revenue: $14 million ($20 million total $6 million in year 1) Cost: $10 million Gross 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. Orange has separate sales prices Brief Exercise 5-10 for the two parts of LearnIt-Plus, so that vendor-specific objective

Brief Exercise 5-115-7


evidence (VSOE) allows them to allocate revenue to those parts according to their relative selling prices. LearnIt will be allocated $200 x [$150 ($150 + $100)] = $120, and that revenue will be recognized upon delivery of the LearnIt software. LearnIt Office Hours will be allocated $200 x [$100 ($150 + $100)] = $80, and that revenue will be deferred and recognized over the life of the one-year period in which the Office Hours are delivered. If LearnIt were not sold separately, Orange would not have VSOE for all of the parts of the contract. In that case, revenue would be delayed until the later part was delivered. In this case, the $200 would be deferred and recognized over the life of the one-year period in which the Office Hours are delivered. Orange has separate sales prices for the two parts of Brief Exercise 5-12LearnIt-Plus, so the company can base its estimates of the fair value of those parts according to their relative selling prices. LearnIt will be allocated $200 x [$150 ($150 + $100)] = $120, and that revenue will be recognized upon delivery of the LearnIt software. LearnIt Office Hours will be allocated $200 x [$100 ($150 + $100)] = $80, and that revenue will be deferred and recognized over the life of the one-year period in which the Office Hours are delivered. If LearnIt were not sold separately, the accounting would be the same. Orange would estimate the fair value of LearnIt Office Hours to be $100 and allocate revenue in the same fashion as it did when that product was sold separately. (VSOE is not required under IFRS). Specific conditions for revenue recognition of the initial Brief Exercise 5-13franchise fee are provided by FASB ASC 952-605251. 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. Receivables turnover ratio Inventory turnover ratio Brief(net) Exercise 5-14 Receivablesturnover ratio Inventory turnover ratio = = = = *$600,000 200,0005-8

Net sales Cost of goods sold Average accounts receivable Average inventory $400,000* $600,000 [$100,000 + 60,000] 2 [$80,000 120,000] 2 5.71 5.45 times


Brief Exercise 5-15

Profit margin = =

= Sales $65,000 $420,000 15.5%

Net income

Return on assets

= = =

Net income Average total assets $65,000 $800,000 8.1%

Return on shareholders equity

=

Net income Average shareholders equity $65,000 $522,500* 12.4%

= =

Shareholders equity, beginning of period Add: Net income Deduct: Dividends Shareholders equity, end of period

$500,000 65,000 (20,000) $545,000

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

5-9


Brief Exercise 5-16 Return on equity = Profit margin X X Asset turnover X Equity multiplier

Net income = Net income Ave. total equity Total sales Return on shareholders equity = = = Profit margin = = = assets = =

Total sales X Ave. total assets Ave. total assets Ave. total equity

Net income Average shareholders equity $65,000 $522,500 12.4% Net income Sales $65,000 $420,000 15.5% Asset Turnover Sales = Average total $420,000 $800,000 52.5%

5-10


Brief Exercise 5-16 (concluded) Equity Multiplier = Average total assets Average shareholders equity $800,000 $522,500 1.53

= =

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

Brief Exercise 5-17Inventory turnover ratio = Cost of goods sold Average inventory 6.0 = x $75,000 Cost of goods sold = $75,000 x 6.0 = $450,000 Sales $600,000 Cost of goods sold = Gross profit $450,000 = $150,000

5-11


EXERCISES Exercise 5-1

Requirement 1 Alpine 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, 2011 To record the cash collection Cash............................................................................ .......................................................Unearned revenue ..............................................................................450

450

December 31, 2011 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 2011 income statement. The $360 remaining balance in unearned revenue is included in the current liability section of the 2011 balance sheet.

Exercise 5-2

Requirement 1 2011 Cost recovery %: $234,000 = 65% (gross profit % = 35%) $360,000

2012 Cost recovery %: $245,000 = 70% (gross profit % = 30%)5-12


$350,000 2011 gross profit: Cash collection from 2011 sales of $150,000 x 35% = 2012 gross profit: Cash collection from 2011 sales of $100,000 x 35% = + Cash collection from 2012 sales of $120,000 x 30% = Total 2012 gross profit Requirement 2 2011 deferred gross profit balance: 2011 initial gross profit ($360,000 234,000) Less: Gross profit recognized in 2011 Balance in deferred gross profit account 2012 deferred gross profit balance: 2011 initial gross profit ($360,000 234,000) Less: Gross profit recognized in 2011 Gross profit recognized in 2012 2012 initial gross profit ($350,000 245,000) Less: Gross profit recognized in 2012 Balance in deferred gross profit account $52,500 $ 35,000 36,000 $71,000

$126,000 (52,500) $73,500 $ 126,000 (52,500) (35,000) 105,000 (36,000) $107,500

Exercise 5-3

2011To record installment sales Installment receivables................................................ 360,000 .....................................................................Inventory .......................................................................234,000 ...................................................Deferred gross profit .......................................................................126,000 2011 To record cash collections from installment sales Cash............................................................................ 150,000 ................................................Installment receivables .......................................................................150,000

5-13


2011 To recognize gross profit from installment sales Deferred gross profit................................................... 52,500 ...................................................Realized gross profit .........................................................................52,500

2012 To record installment sales Installment receivables................................................ 350,000 .....................................................................Inventory .......................................................................245,000 ...................................................Deferred gross profit .......................................................................105,000 2012 To record cash collections from installment sales Cash............................................................................ 220,000 ................................................Installment receivables .......................................................................220,000 2012 To recognize gross profit from installment sales Deferred gross profit................................................... 71,000 ...................................................Realized gross profit .........................................................................71,000

Exercise 5-42011 2012 2013 2014 Total

Requirement 1 Year Income recognized $180,000 ($300,000 120,000) -0-0-0$180,000

Requirement 2 Cost recovery %: $120,000 ------------- = 40% (gross profit % = 60%) $300,000

5-14


Year 2011 2012 2013 2014 Totals

Cash Collected $ 75,000 75,000 75,000 75,000 $300,000

Cost Recovery(40%) $ 30,000 30,000 30,000 30,000 $120,000

Gross Profit(60%) $ 45,000 45,000 45,000 45,000 $180,000

Requirement 3 Year 2011 2012 2013 2014 Totals Cash Collected $ 75,000 75,000 75,000 75,000 $300,000 Cost Recovery $ 75,000 45,000 -0-0$120,000 Gross Profit -0$ 30,000 75,000 75,000 $180,000

5-15


Exercise 5-5

Requirement 1 July 1, 2011 To record installment sale Installment receivables.................................................... 300,000 Sales revenue............................................................... 300,000 Cost of goods sold........................................................... 120,000 Inventory..................................................................... 120,000 To record cash collection from installment sale Cash................................................................................ 75,000 Installment receivables................................................ 75,000 July 1, 2012 To record cash collection from installment sale Cash................................................................................ 75,000 Installment receivables................................................ 75,000

5-16


Exercise 5-5 (continued) Requirement 2 July 1, 2011 To record installment sale Installment receivables................................................ 300,000 .....................................................................Inventory .......................................................................120,000 ...................................................Deferred gross profit .......................................................................180,000 To record cash collection from installment sale Cash............................................................................ 75,000 ................................................Installment receivables .........................................................................75,000 To recognize gross profit from installment sale Deferred gross profit................................................... 45,000 ...................................................Realized gross profit .........................................................................45,000 July 1, 2012 To record cash collection from installment sale Cash............................................................................ 75,000 ................................................Installment receivables .........................................................................75,000 To recognize gross profit from installment sale Deferred gross profit................................................... 45,000 ...................................................Realized gross profit .........................................................................45,000

5-17


Exercise 5-5 (concluded) Requirement 3 July 1, 2011 To record installment sale Installment receivables................................................ 300,000 .....................................................................Inventory .......................................................................120,000 ...................................................Deferred gross profit .......................................................................180,000 To record cash collection from installment sale Cash............................................................................ 75,000 ................................................Installment receivables .........................................................................75,000 July 1, 2012 To record cash collection from installment sale Cash............................................................................ 75,000 ................................................Installment receivables .........................................................................75,000 To recognize gross profit from installment sale Deferred gross profit................................................... 30,000 ...................................................Realized gross profit .........................................................................30,000

Exercise 5-6

Requirement 1 Cost of goods sold ($1,000,000 600,000) 100,000 $500,000

$400,000 Add: Gross profit if using cost recovery method Cash collected Requirement 2 $ 600,000 Gross profit percentage = $1,000,000 = 60%

Cash collected x Gross profit percentage = Gross profit recognized $500,000 x 60% = $300,000 gross profit5-18


Exercise 5-7

October 1, 2011....... ............To record the installment sale Installment receivable.................................................4,000,000 .....................................................................Inventory ....................................................................1,800,000 ...................................................Deferred gross profit ....................................................................2,200,000 To record the cash down payment from installment sale Cash............................................................................ 800,000 .................................................Installment receivable .......................................................................800,000 To recognize gross profit from installment sale Deferred gross profit ($800,000 x 55%*)................... 440,000 ...................................................Realized gross profit .......................................................................440,000 October 1, 2012......................................................... To record the default and repossession Repossessed inventory (fair value) ............................1,300,000 Deferred gross profit (balance)...................................1,760,000 Loss on repossession (difference) .............................. 140,000 ..................................Installment receivable (balance) ....................................................................3,200,000

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

Exercise 5-8

Requirement 1

April 1, 2011 To record installment sale Installment receivables................................................ 2,400,000

5-19


............................................................................Land .................................................................... 480,000 ....................................................Gain on sale of land ....................................................................1,920,000 April 1, 2011 To record cash collection from installment sale Cash............................................................................ 120,000 ................................................Installment receivables .......................................................................120,000 April 1, 2012 To record cash collection from installment sale Cash............................................................................ 120,000 ................................................Installment receivables .......................................................................120,000

Requirement 2 April 1, 2011 To record installment sale Installment receivables................................................ 2,400,000 ............................................................................Land .......................................................................480,000 ..............................................................Deferred gain ....................................................................1,920,000

5-20


Exercise 5-8 (concluded) 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).

April 1, 2011 To record cash collection from installment sale Cash............................................................................ 120,000 ................................................Installment receivables .......................................................................120,000 To recognize profit from installment sale Deferred gain.............................................................. 96,000 ...............................................Gain on sale of land (80% x $120,000) .................................................................................... 96,000 April 1, 2012 To record cash collection from installment sale Cash............................................................................ 120,000 ................................................Installment receivables .......................................................................120,000 To recognize profit from installment sale Deferred gain.............................................................. 96,000 ...............................................Gain on sale of land (80% x $120,000) .................................................................................... 96,000

Exercise 5-9

Requirement 1 $2,000,000 300,000 1,200,000 1,500,000 $ 500,000 2011 2012 $2,000,000 1,875,000 -01,875,000 $ 125,000

Contract price Actual costs to date Estimated costs to complete Total estimated costs Gross profit (estimated in 2011)

Gross profit recognition: 2011: $ 300,000 = 20% x $500,000 = $100,000

5-21


$1,500,000 2012: $125,000 $100,000 = $25,000

Requirement 2 2011 2012 Requirement 3

$ -0$125,000

Balance Sheet At December 31, 2011 Current assets: Accounts receivable Costs and profit ($400,000*) in excess of billings ($380,000) * Costs ($300,000) + profit ($100,000) $ 130,000 20,000

5-22


Exercise 5-9 (concluded) Requirement 4 Balance Sheet At December 31, 2011 Current assets: Accounts receivable Current liabilities: Billings ($380,000) in excess of costs ($300,000) Requirement 1($ in millions)

$ 130,000 $ 80,000

2011 $220 120 60 180 $ 40

2012 $220 170 -0170 $ 50

Exercise 5-10

2013 Contract price 40 120 160 $ 60

$220 Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (actual in 2013) Gross profit (loss) recognition: 2011: $40

= 25% x $60 = $15 $160 2012: $120 = 66.67% x $40 = $26.67 $15 = $11.67 $180 2013: $220 170 = $50 ($15 + 11.67) = $23.33

Requirement 2 2011: $220 x 25% = $55 2012: $220 x 66.67% = $146.67 55 = $91.67 2013: $220 146.67 = $73.33

5-23


Requirement 3 Year 2011 2012 2013 Total project income Gross profit (loss) recognized -0-050 $50

5-24


Exercise 5-10 (concluded) Requirement 4 2011: Revenue: Cost: Gross profit: 2012: Revenue: Cost: Gross profit: 2013: Revenue: Cost: Gross profit: Requirement 5 2012: $120 = 60% x $20* = $12 15 = $(3) loss $200 *$220 ($40 + 80 + 80) = $20 Requirement 1 2011 $8,000,000 4,500,000 3,600,000 8,100,000 $ (100,000) 2012 2013 $8,000,000 8,300,000 -08,300,000 $ (300,000) $100 ($220 contract price $40 $80) $ 50 $ 50 $80 $80 $ 0 $40 $40 $ 0

Exercise 5-11

Contract price $8,000,000 Actual costs to date 2,000,000 Estimated costs to complete 4,000,000 Total estimated costs 6,000,000 Estimated gross profit (loss) (actual in 2013) $2,000,000 Gross profit (loss) recognition: 2011: $2,000,000

= 33.3333% x $2,000,000 = $666,667 $6,000,0005-25


2012: $(100,000) 666,667

= $(766,667)

2013: $(300,000) (100,000) = $(200,000)

5-26


Exercise 5-11 (continued) Requirement 2 Construction in progress Various accounts To record construction costs. Accounts receivable Billings on construction contract To record progress billings. Cash Accounts receivable To record cash collections. Construction in progress(gross profit)

2011 2012 2,000,000 2,500,000 2,000,000 2,500,000 2,500,000 2,750,000 2,500,000 2,750,000 2,250,000 2,475,000 2,250,000 2,475,000

Cost of construction Revenue from long-term contracts(33.3333% x $8,000,000)

666,667 2,000,000 2,666,667 2,544,000 1,777,333 766,667

To record gross profit. Cost of construction (2) Revenue from long-term contracts Construction in progress (loss) To record expected loss.(1)

(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 2011 (above) (2,666,667) Revenue recognized in 2012 1,777,333 (1) Plus: Loss recognized in 2012 (above) 766,667 Cost of construction, 2012 $2,544,000 (2)

5-27


Exercise 5-11 (concluded) Requirement 3 Balance Sheet Current assets: Accounts receivable Costs and profit ($2,666,667*) in excess of billings ($2,500,000) Current liabilities: Billings ($5,250,000) in excess of costs less loss ($4,400,000**) 2011 2012

$250,000 $525,000 166,667

$850,000

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

Exercise 5-12

Requirement 1 Year 2011 2012 2013 Total project loss

Gross profit (loss) recognized -0$(100,000) (200,000) $(300,000)

Requirement 2 2011 2012 2,000,000 2,500,000 2,000,000 2,500,000 2,500,000 2,750,000 2,500,000 2,750,000 2,250,000 2,475,000 2,250,000 2,475,000 100,000

Construction in progress Various accounts To record construction costs. Accounts receivable Billings on construction contract To record progress billings. Cash Accounts receivable To record cash collections. Loss on long-term contract

5-28


Construction in progress To record an expected loss.

100,000

5-29


Exercise 5-12 (concluded) Requirement 3 Balance Sheet Current assets: Accounts receivable Current liabilities: Billings ($2,500,000) in excess of costs($2,000,000)

2011 $250,000

2012 $525,000

$500,000 $850,000

Billings ($5,250,000) in excess of costs less loss ($4,400,000*)* Costs ($2,000,000 + $2,500,000) loss ($100,000)

Exercise 5-13

Situation 1 - Percentage-of-Completion $5,000,000 1,500,000 3,000,000 4,500,000 $ 500,000 2011 $5,000,000 3,600,000 900,000 4,500,000 $ 500,000 2012 2013 $5,000,000 4,500,000 -04,500,000 $ 500,000

Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (actual in 2013)

Gross profit (loss) recognized: 2011: $1,500,000 = 33.3333% x $500,000 = $166,667 $4,500,000 2012: $3,600,000 = 80.0% x $500,000 = $400,000 166,667 = $233,333 $4,500,000 2013: $500,000 400,000 = $100,000

5-30


Situation 1 - Completed Contract Year 2011 2012 2013 Total gross profit Gross profit recognized -0-0$500,000 $500,000

5-31


Exercise 5-13 (continued) Situation 2 - Percentage-of-Completion Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (actual in 2013) 2011 $5,000,000 1,500,000 3,000,000 4,500,000 $ 500,000 2012 $5,000,000 2,400,000 2,400,000 4,800,000 $ 200,000 2013 $5,000,000 4,800,000 -04,800,000 $ 200,000

Gross profit (loss) recognized: 2011: $1,500,000 = 33.3333% x $500,000 = $166,667 $4,500,000 2012: $2,400,000 = 50.0% x $200,000 = $100,000 166,667 = $(66,667) $4,800,000 2013: $200,000 100,000 = $100,000


5-32


Exercise 5-13 (continued) Situation 3 - Percentage-of-Completion Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (loss) (actual in 2013) 2011 $5,000,000 1,500,000 3,000,000 4,500,000 $ 500,000 2012 $5,000,000 3,600,000 1,500,000 5,100,000 $ (100,000) 2013 $5,000,000 5,200,000 -05,200,000 $ (200,000)

Gross profit (loss) recognized: 2011: $1,500,000 = 33.3333% x $500,000 = $166,667 $4,500,000 2012: 2013: $(100,000) 166,667 = $(266,667)

$(200,000) (100,000) = $(100,000)

Situation 3 - Completed Contract Year 2011 2012 2013 Total project loss Gross profit (loss) recognized -0$(100,000) (100,000) $(200,000)

5-33


Exercise 5-13 (continued) Situation 4 - Percentage-of-Completion Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (actual in 2013) 2011 $5,000,000 500,000 3,500,000 4,000,000 $1,000,000 2012 $5,000,000 3,500,000 875,000 4,375,000 $ 625,000 2013 $5,000,000 4,500,000 -04,500,000 $ 500,000

Gross profit (loss) recognized: 2011: $ 500,000 = 12.5% x $1,000,000 = $125,000 $4,000,000 2012: $3,500,000 = 80.0% x $625,000 = $500,000 125,000 = $375,000 $4,375,000 2013: $500,000 500,000 = $ - 0 -


5-34


Exercise 5-13 (continued) Situation 5 - Percentage-of-Completion Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (actual in 2013) 2011 $5,000,000 500,000 3,500,000 4,000,000 $1,000,000 2012 $5,000,000 3,500,000 1,500,000 5,000,000 $ -02013 $5,000,000 4,800,000 -04,800,000 $ 200,000

Gross profit (loss) recognized: 2011: $ 500,000 = 12.5% x $1,000,000 = $125,000 $4,000,000 2012: 2013: $ 0 125,000 = $(125,000) $200,000 0 = $200,000


5-35


Exercise 5-13 (concluded) Situation 6 - Percentage-of-Completion Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (loss) (actual in 2013) 2011 $5,000,000 500,000 4,600,000 5,100,000 $ (100,000) 2012 $5,000,000 3,500,000 1,700,000 5,200,000 $ (200,000) 2013 $5,000,000 5,300,000 -05,300,000 $ (300,000)

Gross profit (loss) recognized: 2011: 2012: 2013: $(100,000) $(200,000) (100,000) = $(100,000) $(300,000) (200,000) = $(100,000)

Situation 6 - Completed Contract Year 2011 2012 2013 Total project loss Gross profit (loss) recognized $(100,000) (100,000) (100,000) $(300,000)

Exercise 5-14

Requirement 1 Construction in progress = Costs incurred + Profit recognized = ? + $20,000

$100,000

Actual costs incurred in 2011 = $80,000 Requirement 2 Billings = Cash collections + Accounts Receivable $94,000 = ? + $30,000

5-36


Cash collections in 2011 = $64,000 Requirement 3 Let 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

Exercise 5-15

Requirement 1 Revenue should be recognized as follows: Software date of shipment, July 1, 2011 Technical support evenly over the 12 months of the agreement Upgrade date of shipment, January 1, 2012

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 Technical support Upgrade Total Requirement 2 $210,000 $270,000 x $243,000 = $189,000 $30,000 $270,000 x $243,000 = 27,000 $30,000 $270,000 x $243,000 = 27,000 $243,000

5-37


July 1, 2011

To record sale of software

Cash............................................................................ 243,000 ......................................................................Revenue .......................................................................189,000 Unearned revenue ($27,000 + 27,000) 54,000

Exercise 5-16

Requirement 1 ($20,000 $50,000) x $45,000 = $18,000 ($10,000 $50,000) x $45,000 = 9,000 ($15,000 $50,000) x $45,000 = 13,500 ($5,000 $50,000) x $45,000 = 4,500 $45,000

Conveyer Labeler Filler Capper total 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.

Exercise 5-17

Requirement 1 ($20,000 $50,000) x $45,000 = $18,000 ($10,000 $50,000) x $45,000 = 9,000 ($15,000 $50,000) x $45,000 = 13,500 ($5,000 $50,000) x $45,000 = 4,500 $45,000

Conveyer Labeler Filler Capper total Requirement 2

Under IFRS, it is likely that Richardson would recognize revenue the same as in Requirement 1, because (a) revenue for each part can be estimated reliably and (b) the receipt of economic benefits is probable.

Exercise 5-185-38


October 1, 2011 To record franchise agreement and down payment Cash (10% x $300,000).................................................. 30,000 Note receivable........................................................... 270,000 Unearned franchise fee revenue...... 300,000

January 15, 2012 To recognize franchise fee revenue Unearned franchise fee revenue.................................. 300,000 .................................................Franchise fee revenue .......................................................................300,000

Exercise 5-19h d g a b i c k l m f j e 1. Inventory turnover 2. Return on assets 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13.

List AList B

a. Net income divided by net sales. b. Defers recognition until cash collected equals cost. Return on shareholders' equity c. Defers recognition until project is complete. Profit margin on sales d. Net income divided by assets. Cost recovery method e. Risks and rewards of ownership retained by seller. Percentage-of-completion method f. Contra account to construction in progress. Completed contract method g. Net income divided by shareholders' equity. Asset turnover h. Cost of goods sold divided by inventory. Receivables turnover i. Recognition is in proportion to work completed. Right of return j. Recognition is in proportion to cash received. Billings on construction contract k. Net sales divided by assets. Installment sales method l. Net sales divided by accounts receivable. Consignment sales m. Could cause the deferral of revenue recognition beyond delivery point.

Exercise 5-20

Requirement 1

5-39


Inventory turnover ratio

= = =

Cost of goods sold Average inventory $1,840,000 [$690,000 + 630,000] 2 2.79 times

Requirement 2 By itself, this one ratio provides very little information. 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. Its 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 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.

Exercise 5-21

Turnover ratios for Anderson Medical Supply Company for 2011: = = = = = =

$4,800,000 $8,000,000 [$900,000 + 700,000] 2 365 [$700,000 + 500,000] 2 $8,000,000 613.33 times The [$4,300,000 +times 13.33 3,700,000] company 2 27.4 days turns its inventory = 2 times 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,5-40

Inventory turnover ratio Receivables turnover ratio Average collection period Asset turnover ratio


Anderson takes slightly longer to collect its accounts receivable (27.4 days compared to the industry average of 25 days).

Exercise 5-22

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% $100,000 180,000 280,000 150,000 $130,000

Requirement 2 Retained earnings beginning of period Add: Net income Less: Retained earnings end of period Dividends paid

Exercise 5-23Requirement 1a. b. c. d. Profit margin on sales $180 $5,200 = 3.5% Asset turnover $5,200 [($1,900 + 1,700) 2] = 2.89 Equity multiplier [($1,900 + 1,700) 2] [($550 + 500) 2] = 3.43 Return on shareholders equity $180 [($550 + 500) 2] = 34.3%

Requirement 2 Profit 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 Second Third $90,000

First Cumulative income before taxes $50,000 $190,000 Estimated annual effective tax rate 34% 30% 36% 17,000 27,000 68,400 Less: Income tax reported earlier 0 17,000 27,000 Tax expense to be reported $17,000 $10,000 $ 41,400 Incentive compensation $300 million 4 = $ 75 million Exercise 5-25 Depreciation expense $60 million 4 = 15 million Gain on sale 23 million

Exercise 5-24

1st

2nd 3rd 4th

Exercise 5-26

5-41


Advertising $200,000 Property tax 87,500 Equipment repairs 65,000 Extraordinary casualty loss 0 Research and development 0

$200,000 87,500 65,000 185,000 32,000

$200,000 87,500 65,000 0 32,000

$200,000 87,500 65,000 0 32,000

Exercise 5-27Requirement 1The specific citation that specifies the the circumstances and conditions under which it is appropriate to use the percentage-of-completion method is: Revenue Recognition ConstructionType and ProductionType ContractsRecognitionCircumstances Appropriate for Using the Percentage-of-Completion Method. Requirement 2 FASB ASC 605352557 reads as follows: The percentage-of-completion method is considered preferable as an accounting policy in circumstances in which reasonably dependable estimates can by made and in which all the following conditions exist: a. Contracts executed by the parties normally include provisions that clearly specify the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement. b. The buyer can be expected to satisfy all obligations under the contract. c. The contractor can be expected to perform all contractual obligations.

The FASB Accounting Standards Codification represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is: 1. When a provision for loss is recognized for a percentage-of-completion contract: FASB ASC 605352546: Revenue RecognitionConstructionType and ProductionType ContractsRecognitionProvisions for Losses on Contracts.

Exercise 5-28

5-42


2.

Circumstances indicating when the installment method or cost recovery method is appropriate for revenue recognition: FASB ASC 60510254: Revenue RecognitionOverallRecognition Installment and Cost Recovery Methods of Revenue Recognition. (Note: ASC 60510253 also provides some guidance, as it indicates when installment method is NOT acceptable). Criteria determining when a seller can recognize revenue at the time of sale from a sales transaction in which the buyer has the right to return the product: FASB ASC 60515251: Revenue RecognitionProductsRecognition GeneralSales of Product when Right of Return Exists.

3.

5-43


CPA / CMA REVIEW QUESTIONSCPA Exam Questions1. b. The earnings process is completed upon delivery of the product. Therefore, in 2011, revenue for 50,000 gallons at $3 each is recognized. The payment terms do not affect revenue recognition. 2. d. The deferred gross profit in the balance sheet at December 31, 2012 should be the balances in the accounts receivable accounts for 2011 and 2012 multiplied times the appropriate gross profit percentage: Accounts Receivable Total Sales Less: Collections Less: Write Offs Accounts Receivable Balance x Gross Profit Rate Deferred Gross Profit 12/31/2012 2011 2012 600,000 900,000 (300,000) (300,000) (200,000) (50,000) 100,000 550,000 x 30% x 40% 30,000 220,000

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

5-44


CPA Review Questions (concluded) 3. a. Year of sale 2011 2012 a. Gross profit realized $240,000 $200,000 b. Percentage 30% 40% c. Collections on sales (a/b) $800,000 $500,000 Total sales 1,000,000 2,000,000 Balance 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. 2011 actual costs Total estimated costs Ratio Contract Price Revenue 2011 actual costs Gross profit $20,000 60,000 = 1/3 x 100,000 33,333 -20,000 $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 2011.

5-45


CMA Exam Questions1.

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. 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. 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.

2.

3.

5-46


PROBLEMSProblem 5-1REAGAN CORPORATION Income Statement For the Year Ended December 31, 2011[1] $3,680,000

Income before income taxes and extraordinary item ....................................... Income tax expense ....................................... Income before extraordinary item .................. Extraordinary item: Gain from settlement of lawsuit (net of $400,000 tax expense) ................................. Net Income .................................................... Income before extraordinary item .................. Extraordinary gain ......................................... Net income ....................................................[1]

1,472,000 2,208,000 600,000 $2,808,000 2.21 0.60 $ 2.81

Income from continuing operations before income taxes: Unadjusted $4,200,000 Add: Gain from sale of equipment 50,000 Deduct: Inventory write-off (400,000) Depreciation expense (2011) (50,000) Overstated profit on installment sale (120,000) * Adjusted $3,680,000 $160,000 (40,000) $120,000

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

Problem 5-2

Requirement 1 2011 Cost recovery % : = 60% (gross profit % = 40%)

$180,000 $300,000 2012 Cost recovery %: $280,000 = 70% (gross profit % = 30%)5-47


$400,000 2011 gross profit: Cash collection from 2011 sales = $120,000 x 40% = 2012 gross profit: Cash collection from 2011 sales = $100,000 x 40% = + Cash collection from 2012 sales = $150,000 x 30% = Total 2012 gross profit Requirement 2 2011 To record installment sales Installment receivables................................................ 300,000 .....................................................................Inventory .......................................................................180,000 ...................................................Deferred gross profit .......................................................................120,000 2011 To record cash collections from installment sales Cash............................................................................ 120,000 ................................................Installment receivables .......................................................................120,000 2011 To recognize gross profit from installment sales Deferred gross profit................................................... 48,000 ...................................................Realized gross profit .........................................................................48,000 $ 40,000 45,000 $85,000 $48,000

5-48


Problem 5-2 (continued) 2012 To record installment sales Installment receivables................................................ 400,000 .....................................................................Inventory .......................................................................280,000 ...................................................Deferred gross profit .......................................................................120,000 2012 To record cash collections from installment sales Cash............................................................................ 250,000 ................................................Installment receivables .......................................................................250,000 2012 To recognize gross profit from installment sales Deferred gross profit................................................... 85,000 ...................................................Realized gross profit .........................................................................85,000

Requirement 3 Date 2011 2011 sales 2012 2011 sales 2012 sales 2012 totals Cash Collected $120,000 $100,000 150,000 $250,000 Cost Recovery $120,000 $ 60,000 150,000 $210,000 Gross Profit -0$40,000 -0$40,000

5-49


Problem 5-2 (concluded) 2011 To record installment sales Installment receivables................................................ 300,000 .....................................................................Inventory .......................................................................180,000 ...................................................Deferred gross profit .......................................................................120,000 2011 To record cash collection from installment sales Cash............................................................................ 120,000 ................................................Installment receivables .......................................................................120,000 2012 To record installment sales Installment receivables................................................ 400,000 .....................................................................Inventory .......................................................................280,000 ...................................................Deferred gross profit .......................................................................120,000 2012 To record cash collection from installment sales Cash............................................................................ 250,000 ................................................Installment receivables .......................................................................250,000 2012 To recognize gross profit from installment sales Deferred gross profit................................................... 40,000 ...................................................Realized gross profit .........................................................................40,000

Problem 5-3Total profit = $500,000 300,000 = $200,000Installment sales method: Gross profit % = $200,000 $500,000 = 40%8/31/11 8/31/12 8/31/13 8/31/14 8/31/15

Requirement 1

5-50


Cash collections a. Point of delivery method b. Installment sales method(40% x cash collected)

$100,000 $100,000 $100,000 $100,000 $100,000 $200,000 -0-0-0-0$40,000

$ 40,000 $ 40,000 $ 40,000 $ 40,000 -0-0-

c. Cost recovery method

- 0 - $100,000 $100,000

5-51


Problem 5-3 (continued) Requirement 2Point of Delivery 500,000 500,000 300,000 300,000 Installment Sales

Cost Recovery

Installment receivable Sales revenue Cost of goods sold Inventory To record sale on 8/31/11. Installment receivable Inventory Deferred gross profit To record sale on 8/31/11. Cash Installment receivable Entry made each Aug. 31. Deferred gross profit Realized gross profit To record gross profit.(entry made each Aug. 31)

500,000 300,000 200,000 100,000 100,000 40,000 40,000 100,000 100,000

500,000 300,000 200,000 100,000 100,000

Deferred gross profit Realized gross profit To record gross profit.(entry made 8/31/14 & 8/31/15)

100,000 100,000

5-52


Problem 5-3 (concluded) Requirement 3 Point of Delivery December 31, 2011 Assets Installment receivables Less: Deferred gross profit Installment receivables, net December 31, 2012 Assets Installment receivables Less: Deferred gross profit Installment receivables, net 400,000 Installment Sales 400,000 (160,000) 240,000 Cost Recovery 400,000 (200,000) 200,000

300,000

300,000 (120,000) 180,000

300,000 (200,000) 100,000

5-53


Problem 5-4Requirement 1

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 2009, so down payment made in 2009, another payment in 2010, and two payments remain. $400,000 gross receivable at 1/1/2011 implies payments of ($400,000 2) = $200,000 in 2011 and 2012. 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 2009 and 2010 have already recovered $400,000 of cost, so cost remaining to be recovered as of 1/1/2011 is $600,000 total $400,000 already recovered = $200,000. Therefore, the entire 2011 payment of $200,000 will be applied to cost recovery, and no gross profit is recognized in 2011. Installment sales method gross profit: $200,000 payment x 25% gross profit ratio = $50,000 of gross profit recognized in 2011. PitStop: Job completed in 2008, so down payment made in 2008, another payment in 2009, another in 2010, and one payment remains. $150,000 gross receivable at 1/1/2011 implies a single payment of $150,000 in 2011. 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 2008, 2009 and 2010 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 2011 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 2011.

5-54


Problem 5-4 (concluded) Totals: Cost recovery method: $0 (Bluebird) + $150,000 (PitStop) = $150,000. Installment sales method: $50,000 (Bluebird) + $52,500 (PitStop) = $102,500. Requirement 2 If Dan is focused on 2011, 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 costrecovery method. The timing of these jobs is such that 2011 is a year in which almost all of the gross profit associated with the PitStop job gets recognized, so 2011 looks more profitable under the cost recovery method.

Problem 5-5Requirement 1Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (loss) (actual in 2013) 2011 $10,000,000 2,400,000 5,600,000 8,000,000 $ 2,000,000 2012 $10,000,000 6,000,000 2,000,000 8,000,000 $ 2,000,000 2013 $10,000,000 8,200,000 -08,200,000 $ 1,800,000

Gross profit (loss) recognition: 2011: $2,400,000 = 30.0% x $2,000,000 = $600,000 $8,000,000 2012: $6,000,000 = 75.0% x $2,000,000 = $1,500,000 600,000 = $900,000 $8,000,000 2013: $1,800,000 1,500,000 = $300,000

5-55


Problem 5-5 (continued) Requirement 2 2011 Construction in progress Various accounts To record construction costs. Accounts receivable Billings on construction contract To record progress billings. Cash Accounts receivable To record cash collections. Construction in progress (gross profit) Cost of construction (cost incurred) Revenue from long-term contracts (1) To record gross profit. 2012 2013

2,400,000 3,600,000 2,200,000 2,400,000 3,600,000 2,200,000 2,000,000 4,000,000 4,000,000 2,000,000 4,000,000 4,000,000

1,800,000 3,600,000 4,600,000 1,800,000 3,600,000 4,600,000 600,000 2,400,000 3,000,000 900,000 3,600,000 4,500,000 300,000 2,200,000 2,500,000

(1) Revenue recognized: 2011: 30% x $10,000,000 = 2012: 75% x $10,000,000 = Less: Revenue recognized in 2011 Revenue recognized in 2012 2013: 100% x $10,000,000 = Less: Revenue recognized in 2011 & 2012 Revenue recognized in 2013

$3,000,000 $7,500,000 (3,000,000) $4,500,000 $10,000,000 (7,500,000) $2,500,000

5-56


Problem 5-5 (continued) Requirement 3 Balance Sheet Current assets: Accounts receivable Construction in progress Less: Billings Costs and profit in excess of billings 2011 $ 200,000 $3,000,000 (2,000,000) 1,000,000 $7,500,000 (6,000,000) 1,500,000 2012 $600,000

Requirement 4 Costs incurred during the year Estimated costs to complete as of year-end Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (actual in 2013) 2011 $2,400,000 5,600,000 2011 $10,000,000 2,400,000 5,600,000 8,000,000 $ 2,000,000 2012 $3,800,000 3,100,000 2012 $10,000,000 6,200,000 3,100,000 9,300,000 $ 700,000 2013 $3,200,000 2013 $10,000,000 9,400,000 -09,400,000 $ 600,000

5-57


Problem 5-5 (concluded) Gross profit (loss) recognition: 2011: $2,400,000 = 30.0% x $2,000,000 = $600,000 $8,000,000 2012: $6,200,000 = 66.6667% x $700,000 = $466,667 600,000 = $(133,333) $9,300,000 2013: $600,000 466,667 = $133,333

Requirement 5 Costs incurred during the year Estimated costs to complete as of year-end Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (loss) (actual in 2013) 2011 $2,400,000 5,600,000 2011 $10,000,000 2,400,000 5,600,000 8,000,000 $ 2,000,000 2012 $3,800,000 4,100,000 2012 $10,000,000 6,200,000 4,100,000 10,300,000 $ (300,000) 2013 $3,900,000 2013 $10,000,000 10,100,000 -010,100,000 $ (100,000)

Gross profit (loss) recognition: 2011: $2,400,000 = 30.0% x $2,000,000 = $600,000 $8,000,000 2012: 2013: $(300,000) 600,000 = $(900,000) $(100,000) (300,000) = $200,000 Requirement 1 Year 20115-58

Problem 5-6

Gross profit recognized -0-


2012 2013 Total gross profit Requirement 2

-0$1,800,000 $1,800,000

Construction in progress Various accounts To record construction costs. Accounts receivable Billings on construction contract To record progress billings. Cash Accounts receivable To record cash collections. Construction in progress (gross profit) Cost of construction (costs incurred) Revenue from long-term contracts (contract price) To record gross profit.

2011 2012 2013 2,400,000 3,600,000 2,200,000 2,400,000 3,600,000 2,200,000 2,000,000 4,000,000 4,000,000 2,000,000 4,000,000 4,000,000

1,800,000 3,600,000 4,600,000 1,800,000 3,600,000 4,600,000 1,800,000 8,200,000 10,000,000

5-59


Problem 5-6 (concluded) Requirement 3 Balance Sheet Current assets: Accounts receivable Construction in progress Less: Billings Costs in excess of billings 2011 $ 200,000 $2,400,000 (2,000,000) 400,000 $6,000,000 (6,000,000) -02012 $ 600,000

Requirement 4 Costs incurred during the year Estimated costs to complete as of year-end Year 2011 2012 2013 Total gross profit Requirement 5 Costs incurred during the year Estimated costs to complete as of year-end Year 2011 2012 2013 Total project loss 2011 $2,400,000 5,600,000 2012 $3,800,000 4,100,000 2013 $3,900,000 2011 $2,400,000 5,600,000 2012 $3,800,000 3,100,000 2013 $3,200,000 -

Gross profit recognized -0-0$600,000 $600,000

Gross profit (loss) recognized -0$(300,000) 200,000 $(100,000)

Problem 5-7

Requirement 1 Year5-60

Gross profit recognized


2011 2012 2013 Total gross profit Requirement 2

-0-0$1,800,000 $1,800,000

Construction in progress Various accounts To record construction costs. Accounts receivable Billings on construction contract To record progress billings. Cash Accounts receivable To record cash collections. Construction in progress (gross profit) Cost of construction (costs incurred) Revenue from long-term contracts (contract price) To record gross profit.

2011 2012 2013 2,400,000 3,600,000 2,200,000 2,400,000 3,600,000 2,200,000 2,000,000 4,000,000 4,000,000 2,000,000 4,000,000 4,000,000

1,800,000 3,600,000 4,600,000 1,800,000 3,600,000 4,600,000 1,800,000 2,400,000 2,400,000 3,600,000 3,600,000 2,200,000 4,000,000

5-61


Problem 5-7 (concluded) Requirement 3 Balance Sheet Current assets: Accounts receivable Construction in progress Less: Billings Costs in excess of billings 2011 $ 200,000 $2,400,000 (2,000,000) 400,000 $6,000,000 (6,000,000) -02012 $ 600,000

Requirement 4 Costs incurred during the year Estimated costs to complete as of year-end Year 2011 2012 2013 Total gross profit Requirement 5 Costs incurred during the year Estimated costs to complete as of year-end Year 2011 2012 2013 Total project loss 2011 $2,400,000 5,600,000 2012 $3,800,000 4,100,000 2013 $3,900,000 2011 $2,400,000 5,600,000 2012 $3,800,000 3,100,000 2013 $3,200,000 -

Gross profit recognized -0-0$600,000 $600,000

Gross profit (loss) recognized -0$(300,000) 200,000 $(100,000)

Problem 5-8

Requirement 1 2011 2012 2013

5-62


Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (loss) (actual in 2013) Year 2011 2012 2013 Total project loss Requirement 2Gross profit (loss) recognition:

$4,000,000 350,000 3,150,000 3,500,000 $ 500,000

$4,000,000 2,500,000 1,700,000 4,200,000 $ (200,000)

$4,000,000 4,250,000 -04,250,000 $ (250,000)

Gross profit (loss) recognized -0$(200,000) (50,000) $(250,000)

2011: 2012: 2013:

10% x $500,000 = $50,000 $(200,000) 50,000 = $(250,000) $(250,000) (200,000) = $(50,000)

Requirement 3 Balance Sheet Current assets: Costs less loss ($2,300,000*) in excess of billings ($2,170,000) Current liabilities: Billings ($720,000) in excess of costs and profit ($400,000) 2011 2012

$ 130,000

$ 320,000

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

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-ofcompletion method assigns a share of the projects 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

Problem 5-9

5-63


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 2 Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit a. 2011 $20,000,000 4,000,000 12,000,000 16,000,000 $ 4,000,000 2012 $20,000,000 13,500,000 4,500,000 18,000,000 $ 2,000,000

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. Under the completed contract method Citation would not report any revenue in the 2011 or 2012 income statements.

b.

5-64


Problem 5-9 (continued) c. Balance Sheet At December 31, 2011 Current assets: Accounts receivable Costs ($4,000,000*) in excess of billings ($2,000,000) $ 200,000 2,000,000

* Under the completed contract method, this account would only include costs of $4,000,000 Requirement 3 Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit a. 2011 $20,000,000 4,000,000 12,000,000 16,000,000 $ 4,000,000 2012 $20,000,000 13,500,000 4,500,000 18,000,000 $ 2,000,000

Gross profit recognition: 2011: $ 4,000,000 = 25% x $4,000,000 = $1,000,000 $16,000,000 2012: $13,500,000 = 75% x $2,000,000 = $1,500,000 $18,000,000 Less: 2011 gross profit 1,000,000 2012 gross profit$ 500,000

b.

2011: $20,000,000 x 25% =

$5,000,000

2012: $20,000,000 x 75% = $15,000,000 Less: 2011 revenue (5,000,000) $10,000,000

5-65


Problem 5-9 (continued) c. Balance Sheet At December 31, 2011 Current assets: Accounts receivable Costs and profit ($5,000,000*) in excess of billings ($2,000,000) * Costs ($4,000,000) + profit ($1,000,000) Requirement 4 Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit a. Gross profit recognition: 2012: Overall loss of ($2,500,000) previously recognized gross profit of $1,000,000 = $3,500,000. b. 2012: Easiest to solve using a journal entry: Cost of construction (to balance) Revenue from long-term contracts* Construction in progress (loss)*

$ 200,000 3,000,000

2011 $20,000,000 4,000,000 12,000,000 16,000,000 $ 4,000,000

2012 $20,000,000 13,500,000 9,000,000 22,500,000 ($ 2,500,000)

$10,500,000 $7,000,000 $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

5-66


Problem 5-9 (continued) c. Balance Sheet At December 31, 2012 Current assets: Accounts receivable Current liabilities: Billings ($12,000,000) in excess of costs and profit ($11,000,000*) $ 1,600,000

1,000,000

* 2011 costs ($4,000,000) + 2011 profit ($1,000,000) + 2012 costs ($9,500,000) 2012 loss ($3,500,000) Requirement 5 Citation 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 6 Income statement: Sales revenue (3 x $600,000) Cost of goods sold (3 x $450,000) Gross profit

$1,800,000 1,350,000 $ 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 5-10

Requirement 1

5-67


a.

January 30, 2011

Cash ........................................................................... 200,000 Note receivable .......................................................... 1,000,000 ..................................Unearned franchise fee revenue ....................................................................1,200,000

b.

September 1, 2011

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

c.

September 30, 2011 Accounts receivable ($40,000 x 3%) ............................ ..........................................................Service revenue ...........................................................................1,200 1,200

d.

January 30, 2012 100,000

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

5-68


Problem 5-10 (continued) Requirement 2 a. January 30, 2011 Cash ........................................................................... 200,000 Note receivable .......................................................... 1,000,000 ...................................Deferred franchise fee revenue ....................................................................1,200,000 Note: Could also show as: Cash ........................................................................... 200,000 Note receivable .......................................................... 1,000,000 ...................................Deferred franchise fee revenue ....................................................................1,000,000 ..................................Unearned franchise fee revenue .......................................................................200,000

b.

September 1, 2011 200,000

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

c.

September 30, 2011 Accounts receivable ($40,000 x 3%) ............................ ..........................................................Service revenue ...........................................................................1,200 1,200

d.

January 30, 2012

5-69


Cash............................................................................ ..........................................................Note receivable .......................................................................100,000 Deferred franchise fee revenue .................................. ................................................Franchise fee revenue .......................................................................100,000

100,000

100,000

5-70


Problem 5-10 (concluded) Requirement 3

Balance Sheet At December 31, 2011 Current assets: Installment notes receivable ($1,000,000) less deferred franchise fee revenue ($1,000,000) Current liabilities: Unearned franchise fee revenue $ -0-

$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.

Problem 5-111. Inventory turnover ratio$6,300 [($800 + 600) 2] = 9.0

2. Average days in inventory365 9.0 = 40.56 days 3. Receivables turnover ratio $9,000 [($600 + 400) 2] = 18.0 4. Average collection period 365 18.0 = 20.28 days 5. Asset turnover ratio $9,000 [($4,000 + 3,600) 2] = 2.37 6. 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] = 2.67 10. DuPont framework 3.33% x 2.37 x 2.67 = 21.1%

5-71


Problem 5-12 Receivables turnoverJ&J Pfizer Inventory turnover

Requirement 1 = = = = Net sales Accounts receivable $41,862 $6,574 = 6.37 times 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.

$45,188 goods sold times = 5.15 Cost of $8,775 Inventories 365 $12,176 = 3.39 times Receivables turnover $3,588 365 $9,832 6.37 $5,837 = 57 days = 1.68 times

Average collection period == J&J J&J Pfizer = =

Pfizer = Average days in inventory = J&J Pfizer = =

365 365 = 71 days 5.15 Inventory turnover 365 3.39 365 1.68 = 108 days = 217 days

5-72


Problem 5-12 (continued) Requirement 2 Rate of return on assets J&J Pfizer = = = Net income Total assets $7,197 $48,263 = 14.9% The return on assets indicates a company's overall profitability, ignoring specific sources of financing. In this regard, J&Js

$1,639 1.4% = $116,775 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 = J&J = = Pfizer = = = Profit margin on sales x x x x x x Asset turnover

Net income Net sales $ 7,197 $41,862 17.19% $ 1,639 $45,188 3.63%

Net sales Total assets $41,862 $48,263 .867 times $45,188 $116,775 .387 times = 1.4% = 14.9%

J&Js 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.

5-73


Problem 5-12 (concluded) Requirement 4 Rate of return on = shareholders equity J&J Pfizer = = Net income Shareholders equity $7,197 $26,869 = 26.8% J&J provided a much greater return to shareholders.

$1,639 = 2.5% Requirement 5 $65,377 Total Assets The two Equity multiplier = companies have shareholders equity Shareholders equity virtually identical J&J $48,263 equity multipliers, = = 1.80 indicating that they $26,869 are using leverage Pfizer $116,775 = = 1.79 to the same extent $65,377 to earn a return on equity that is higher than their return on assets. a. Times interest earned ratio = (Net income + Interest + Taxes) Problem 5-13 Interest = 17 (Net income + $2 + 12) $2 = 17 Net 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 d. Gross profit margin = Gross profit Sales = 40% Gross profit = $400 x 40% = $160 Cost of goods sold = Sales Gross profit = $400 160 = $240 e. Inventory turnover ratio = Cost of goods sold Inventory = 8 Inventory = $240 8 = $30 f. Receivables turnover ratio = Sales Accounts receivable = 20 Accounts receivable = $400 20 = $20

5-74


g. Current ratio = Current assets Current liabilities = 2.0 Acid-test ratio = Quick assets Current liabilities = 1.0 Current assets 2 = Current liabilities Quick assets 1 = Current liabilities Current assets 2 = Quick assets 1 Current assets = 2 x Quick assets Cash + 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 = 1.0 Current 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

5-75


Problem 5-13 (concluded) k. Debt to equity ratio = Total liabilities Shareholders equity = 1.0 Total liabilities = $100 x 1.0 = $100 Long-term liabilities = Total liabilities Current liabilities = $100 30 = $70 CADUX CANDY COMPANY Balance Sheet At December 31, Net income Rate of return on assets Assets = Current assets: Total assets Cash Metropolitan $ 593.8 Accounts receivable (net) = $4,021.5 Inventories Total current assets Republic = Property, plant, and equipment (net) $ 424.6 $4,008.0 Total assets

2011

Problem 5-14Requirement 1 The

return on assets $ 10 14.8% indicates a = 20 company's 30 overall 60 10.6% profitability, = 140 ignoring specific $200 sources of financing. In this Liabilities and Shareholders Equity regard, Current liabilities $ 30 Metropolitans Long-term liabilities 70 Shareholders equity 100 profitability exceeds that of Total liabilities and shareholders' equity $200 Republic.

Requirement 2 Profitability can be achieved by a high profit margin, high turnover, or a combination of the two. Rate of return on assets = Net income Net sales $ 593.8 $5,698.0 10.4% x x = Profit margin on sales x x Asset turnover

Net sales Total assets

Metropolitan = =

$5,698.0 $4,021.5 1.42 times = 14.8%

5-76


Republic = =

$ 424.6 $7,768.2 5.5%

x x

$7,768.2 $4,008.0 1.94 times = 10.7%

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

5-77


Problem 5-14 (continued) Requirement 3 Rate of return on shareholders equity Metropolitan Republic = = = Net income Shareholders equity $593.8 $144.9 + 2,476.9 904.7 $424.6 $335.0 + 1,601.9 964.1 = 34.6% = 43.6%

Republic provides a greater return to common shareholders. Requirement 4 Equity multiplier Metropolitan Republic = = = Total assets Shareholders equity $4,021.5 $144.9 + 2,476.9 904.7 $4,008.0 $335.0 + 1,601.9 964.1 = 2.34 = 4.12

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. Republics 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.

5-78

Chapter 05 - Inc

Chap005.doc

Documents

Transcript of Chap005.doc