Spiceland SM 17eCh05

7/25/2019 Spiceland SM 17eCh05

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The McGraw-Hill Companies, Inc., 2007

Solutions Manual, Vol.1, Chapter 5 5-1

Question 5-1The 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 sellingprice, nor the buyer if eventually the product is sold. Because of these uncertainties, revenuerecognition 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 costrecognition should be delayed beyond the point of delivery.

Question 5-4The installment sales methodrecognizes gross profit by applying the gross profit percentage on

the sale to the amount of cash actually received each period. The cost recovery methoddefers algross 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 neamount of the receivables represents the portion of remaining payments that represent cost recovery.

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 ofreturn exists. The most critical of these criteria is that the seller must be able to make reliableestimates of future returns. In certain situations, these criteria are not satisfied at the point of deliveryof the product.

Chapter 5 Income Measurement and Profitability Analysis

QUESTIONS FOR REVIEW OF KEY TOPICS
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5-2 Intermediate Accounting, 4/e

Answers to Questions (continued)

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, theconsignee returns the goods to the consignor. However, if a buyer is found, the consignee remits theselling price (less commission and approved expenses) to the consignor.

Because the consignor retains the risks and rewards of ownership of the product and title doesnot pass to the consignee, the consignor does not record revenue (and related costs) until theconsignee 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 andcosts 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 anysingle date within that period would be inappropriate. Instead, its more meaningful to recognizerevenue 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 projectis complete. The percentage-of-completion method assigns a fair share of the projects expectedrevenues and costs to each period in which the earnings process takes place, i.e., the constructionperiod. The fair share means the project's costs incurred each period as a percentage of theproject'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 5-10The billings on construction contract account is a contra account to the asset, construction in

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

Question 5-11An 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 5-12These SOPs require 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 theindividual elements, regardless of any separate prices stated within the contract for each element.


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Answers to Questions (continued)

Question 5-13Specific 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 beperformed before the initial franchise fee can be recognized as revenue. The term substantialrequires professional judgment on the part of the accountant. In situations when the initial franchisefee is collectible in installments, even after substantial performance has occurred, the installmentsales or cost recovery method should be used for profit recognition, if a reasonable estimate ofuncollectibility cannot be made.

Question 5-14

Receivables turnover ratio = Net sales

Average accounts receivable (net)

Inventory turnover ratio = Cost of goods soldAverage inventory

Asset turnover ratio = Net salesAverage total assets

Activity ratios are designed to provide information about a companys effectiveness inmanaging 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 companymust devote to that asset, and the more cash it can commit to other purposes.


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Answers to Questions (concluded)

Question 5-15

Profit margin on sales = Net incomeNet sales

Return on assets = Net incomeAverage total assets

Return on shareholders' = Net incomeequity 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 adequatereturn relative to sales or resources devoted to operations. Resources devoted to operations can bedefined as total assets or only those assets provided by owners, depending on the evaluationobjective.

Question 5-16These 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 ofannual statements. However, the discrete approach is applied to some items. Most revenues andexpenses are recognized in interim periods as incurred. However, if an expenditure clearly benefitsmore 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 expensesincurred in one quarter that clearly benefit later quarters. These are assigned to each quarter throughthe 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 interimperiod in which they occur.


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Brief Exercise 5-1

2006 gross profit = $3,000,000 1,200,000 = $1,800,0002007 gross profit = 0

Brief Exercise 5-2

2006 Cost recovery % :$1,200,000

= 40% (gross profit % = 60%)$3,000,000

2006 gross profit = 2006 cash collection of $150,000 x 60% = $90,0002007 gross profit = 2007 cash collection of $150,000 x 60% = $90,000

Brief Exercise 5-3

No gross profit will be recognized in either 2006 or 2007. Gross profit will notbe recognized until the entire $1,200,000 cost of the land is recovered. In this casegross profit recognition will equal 100% of the cash collected beginning with the ninthinstallment payment ($1,200,000 $150,000 = 8 payments to recover the cost of the

land).

Brief Exercise 5-4

Initial deferred gross profit ($3,000,000 1,200,000) $1,800,000Less gross profit recognized in 2006 ($150,000 x 60%) (90,000)Less gross profit recognized in 2007 ($150,000 x 60%) (90,000)

Deferred gross profit at the end of 2007 $1,620,000

BRIEF EXERCISES


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Brief Exercise 5-5The 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 theseller must be able to make reliable estimates of future returns. If Meyers

management can make reliable estimates of the furniture that will be returned, revenuecan be recognized when the product is delivered, assuming the company has noadditional obligations to the buyer. If reliable estimates cannot be made because ofsignificant uncertainty, revenue and related cost recognition is delayed until theuncertainty is resolved.

Brief Exercise 5-6

% of completion = $6 million $15 million = 40%

Total estimated gross profit ($20 million 15 million) = $5,000,000multiplied 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

Brief Exercise 5-7

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

* Total estimated gross profit ($20 million 15 million) = $5,000,000multiplied by the % of completion 40%

Gross profit recognized in the first year $2,000,000

Brief Exercise 5-8


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Year 1 = 0Year 2 = $4 million

Revenue $20,000,000Less: Costs in year 1 (6,000,000)

Costs in year 2 (10,000,000)Actual profit $ 4,000,000

Brief Exercise 5-9The 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.

Brief Exercise 5-10Specific 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 franchisorrequired by the franchise agreement be performed before the initial franchise fee canbe recognized as revenue. The term substantial requires professional judgment onthe part of the accountant. Often, substantial performance is considered to haveoccurred when the franchise opens for business.

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

Brief Exercise 5-11

Receivables turnover ratio = Net salesAverage accounts receivable (net)


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*$600,000 200,000

Inventory turnover ratio = Cost of goods soldAverage inventory

Inventory turnover ratio=

$400,000*[$80,000 + 60,000] 2

= 5.71 times


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Brief Exercise 5-12

Profit margin = Net incomeSales

= $65,000

$420,000

= 15.5%

Return on assets = Net incomeAverage total assets

= $65,000$800,000

= 8.1%

Return on shareholdersequity = Net income

Average shareholders equity

= $65,000$522,500*

= 12.4%

Shareholders equity, beginning of period $500,000Add: 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


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Brief Exercise 5-13

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


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Exercise 5-1

Requirement 1

2006 Cost recovery %:$234,000

= 65% (gross profit % = 35%)$360,000

2007 Cost recovery %:$245,000

= 70% (gross profit % = 30%)

$350,000

2006 gross profit:

Cash collection from 2006 sales of $150,000 x 35% = $52,500

2007 gross profit:Cash collection from 2006 sales of $100,000 x 35% = $ 35,000

+ Cash collection from 2007 sales of $120,000 x 30% = 36,000Total 2007 gross profit $71,000

Requirement 22006 deferred gross profit balance:2006 initial gross profit ($360,000 - 234,000) $126,000Less: Gross profit recognized in 2006 (52,500)Balance in deferred gross profit account $73,500

2007 deferred gross profit balance:2006 initial gross profit ($360,000 - 234,000) $ 126,000Less: Gross profit recognized in 2006 (52,500)

Gross profit recognized in 2007 (35,000)

2007 initial gross profit ($350,000 - 245,000) 105,000Less: Gross profit recognized in 2007 (36,000)Balance in deferred gross profit account $107,500

EXERCISES


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Exercise 5-2

2006 To record installment sales

Installment receivables.................................................. 360,000Inventory................................................................... 234,000Deferred gross profit ................................................. 126,000

2006 To record cash collections from installment salesCash .............................................................................. 150,000

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

2006 To recognize gross profit from installment sales

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

2007 To record installment salesInstallment receivables.................................................. 350,000

Inventory................................................................... 245,000Deferred gross profit ................................................. 105,000



2007 To recognize gross profit from installment salesDeferred gross profit ..................................................... 71,000

Realized gross profit.................................................. 71,000


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Exercise 5-3

Requirement 1

Year Income recognized

2006 $180,000 ($300,000 - 120,000)2007 - 0 -

2008 - 0 -2009 - 0 -

Total $180,000

Requirement 2

Year Cash Collected Cost Recovery(40%) Gross Profit(60%)

2006 $ 75,000 $ 30,000 $ 45,0002007 75,000 30,000 45,0002008 75,000 30,000 45,0002009 75,000 30,000 45,000Totals $300,000 $120,000 $180,000

Requirement 3

Year Cash Collected Cost Recovery Gross Profit

2006 $ 75,000 $ 75,000 - 0 -2007 75,000 45,000 $ 30,0002008 75,000 - 0 - 75,0002009 75,000 - 0 - 75,000Totals $300,000 $120,000 $180,000


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Exercise 5-4

Requirement 1

July 1, 2006 To record installment sale

Installment receivables.................................................. 300,000Sales revenue............................................................. 300,000

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

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


July 1, 2007 To record cash collection from installment saleCash .............................................................................. 75,000



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Exercise 5-4 (continued)

Requirement 2





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







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Exercise 5-4 (concluded)

Requirement 3









Exercise 5-5

Requirement 1

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

Requirement 2

$ 600,000

Gross profit percentage = = 60%$1,000,000

Cash collected x Gross profit percentage = Gross profit recognized

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


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Exercise 5-6

Requirement 1

April 1, 2006 To record installment saleInstallment receivables.................................................. 2,400,000

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

April 1, 2006 To record cash collection from installment saleCash .............................................................................. 120,000


April 1, 2007 To record cash collection from installment sale

Cash .............................................................................. 120,000Installment receivables .............................................. 120,000


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Requirement 2

April 1, 2006 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).

April 1, 2006 To record cash collection from installment sale

Cash .............................................................................. 120,000Installment receivables .............................................. 120,000

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

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

April 1, 2007 To record cash collection from installment saleCash .............................................................................. 120,000


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

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


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Exercise 5-7

Requirement 1

2006 2007Contract price $2,000,000 $2,000,000

Actual 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 2006) $ 500,000 $ 125,000

Gross profit recognition:2006: $ 300,000

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

2007: $125,000 - $100,000 = $25,000

Requirement 2

2006 $ - 0 -2007 $125,000

Requirement 3

Balance Sheet

At December 31, 2006Current assets:

Accounts receivable $ 130,000Costs and profit ($400,000*)in excess

of billings ($380,000) 20,000

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


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Requirement 4

Balance Sheet

At December 31, 2006Current assets:

Accounts receivable $ 130,000

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


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Exercise 5-8

Requirement 1

($ in millions) 2006 2007 2008Contract price $220 $220 $220

Actual costs to date 40 120 170Estimated costs to complete 120 60 - 0 -Total estimated costs 160 180 170Estimated gross profit (actual in 2008) $ 60 $ 40 $ 50

Gross profit (loss) recognition:

2006: $40= 25% x $60 = $15

$160

2007: $120= 66.67% x $40 = $26.67 - $15 = $11.67

$180

2008: $220 170 = $50 ($15 + 11.67) = $23.33

Requirement 2

2006: $220 x 25% = $552007: $220 x 66.67% = $146.67 55 = $91.672008: $220 146.67 = $73.33

Requirement 3

Year Gross profit (loss) recognized2006 - 0 -2007 - 0 -2008 50

Total project income $50

Requirement 4

2007: $120= 60% x $20* = $12 - 15 = $(3) loss

$200*$220 ($40 + 80 + 80) = $20


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Exercise 5-9

Requirement 1

2006 2007 2008Contract price $8,000,000 $8,000,000 $8,000,000

Actual 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 2008) $2,000,000 $ (100,000) $ (300,000)


2006: $2,000,000

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

2007: $(100,000) - 666,667 = $(766,667)

2008: $(300,000) - (100,000) = $(200,000)


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Requirement 2

2006 2007

Construction in progress 2,000,000 2,500,000Various accounts 2,000,000 2,500,000

To record construction costs.

Accounts receivable 2,500,000 2,750,000Billings on construction contract 2,500,000 2,750,000

To 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) 666,667

Cost of construction 2,000,000Revenue from long-term contracts

(33.3333% x $8,000,000) 2,666,667To record gross profit.

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

To 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 = $4,444,000Less: Revenue recognized in 2006 (above) (2,666,667)Revenue recognized in 2007 1,777,333 (1)

Plus: Loss recognized in 2007 (above) 766,667Cost of construction, 2007 $2,544,000 (2)


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Requirement 3

Balance Sheet 2006 2007

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)


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Exercise 5-10

Requirement 1

Year Gross profit (loss) recognized

2006 - 0 -2007 $(100,000)

2008 (200,000)Total project loss $(300,000)

Requirement 2

2006 2007Construction in progress 2,000,000 2,500,000

Various accounts 2,000,000 2,500,000To record construction costs.

Accounts receivable 2,500,000 2,750,000Billings on construction contract 2,500,000 2,750,000


Cash 2,250,000 2,475,000Accounts receivable 2,250,000 2,475,000

To record cash collections.

Loss on long-term contract 100,000Construction in progress 100,000

To record an expected loss.


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Requirement 3

Balance Sheet 2006 2007Current 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


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Exercise 5-11Situation 1 - Percentage-of-Completion

2006 2007 2008Contract 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 2008) $ 500,000 $ 500,000 $ 500,000

Gross profit (loss) recognized:

2006: $1,500,000= 33.3333% x $500,000 = $166,667

$4,500,000

2007: $3,600,000= 80.0% x $500,000 = $400,000 - 166,667 =$233,333

$4,500,000

2008: $500,000 - 400,000 = $100,000

Situation 1 - Completed Contract

Year Gross profit recognized2006 - 0 -2007 - 0 -2008 $500,000

Total gross profit $500,000


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Situation 2 - Percentage-of-Completion

2006 2007 2008Contract 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 2008) $ 500,000 $ 200,000 $ 200,000


2006: $1,500,000= 33.3333% x $500,000 = $166,667

$4,500,000

2007: $2,400,000= 50.0% x $200,000 = $100,000 - 166,667 =$(66,667)

$4,800,000

2008: $200,000 - 100,000 = $100,000





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2006 2007 2008Contract price $5,000,000 $5,000,000 $5,000,000Actual costs to date 1,500,000 3,600,000 5,200,000

Estimated 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 2008) $ 500,000 $ (100,000) $ (200,000)


2006: $1,500,000= 33.3333% x $500,000 = $166,667

$4,500,000

2007: $(100,000) - 166,667 = $(266,667)

2008: $(200,000) - (100,000) = $(100,000)


Year Gross profit (loss) recognized2006 - 0 -2007 $(100,000)2008 (100,000)

Total project loss $(200,000)


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2006 2007 2008Contract price $5,000,000 $5,000,000 $5,000,000Actual costs to date 500,000 3,500,000 4,500,000

Estimated 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 2008) $1,000,000 $ 625,000 $ 500,000


2006: $ 500,000= 12.5% x $1,000,000 = $125,000

$4,000,000

2007: $3,500,000= 80.0% x $625,000 = $500,000 - 125,000 = $375,000

$4,375,000

2008: $500,000 - 500,000 = $ - 0 -





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Estimated 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 2008) $1,000,000 $ - 0 - $ 200,000


2006: $ 500,000= 12.5% x $1,000,000 = $125,000

$4,000,000

2007: $ 0 - 125,000 = $(125,000)

2008: $200,000 - 0 = $200,000





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Estimated 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 2008) $ (100,000) $ (200,000) $ (300,000)


2006: $(100,000)

2007: $(200,000) - (100,000) = $(100,000)

2008: $(300,000) - (200,000) = $(100,000)


Year Gross profit (loss) recognized

2006 $(100,000)2007 (100,000)2008 (100,000)

Total project loss $(300,000)


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Exercise 5-12

Requirement 1

Construction in progress = Costs incurred + Profit recognized

$100,000 = ? + $20,000

Actual costs incurred in 2006 = $80,000

Requirement 2

Billings = Cash collections + Accounts Receivable

$94,000 = ? + $30,000

Cash collections in 2006 = $64,000Requirement 3

Let A = Actual cost incurred + Estimated cost to complete

Actual cost incurredx (Contract price - A) = Profit recognized

A

$80,000

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

$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


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Exercise 5-13

Requirement 1

Revenue should be recognized as follows:

Software - date of shipment, July 1, 2006Technical support - evenly over the 12 months of the agreement

Upgrade - date of shipment, January 1, 2007

The amounts are determined by an allocation of total contract price inproportion 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

Requirement 2

July 1, 2006 To record sale of softwareCash .............................................................................. 243,000

Revenue .................................................................... 189,000

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


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Exercise 5-14

October 1, 2006 To record franchise agreementand down payment

Cash (10% x $300,000) ..................................................... 30,000Note receivable ............................................................. 270,000

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

January 15, 2007 To recognize franchise fee revenue

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

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

Exercise 5-151. c2. d3. a4. b


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Exercise 5-16

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.


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Exercise 5-17

Requirement 1

Requirement 2

By itself, very little. In general, the higher the inventory turnover, the lower theinvestment 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 oroverpriced inventory.

However, to evaluate the adequacy of this ratio it should be compared with somenorm 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 lowinventory levels and restocking only when absolutely necessary. This can be costly interms 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 becompared.

Inventory turnover ratio = Cost of goods sold

Average inventory

= $1,840,000[$690,000 + 630,000] 2

= 2.79 times


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Exercise 5-18Turnover ratios for Anderson Medical Supply Company for 2006:

The company turns its inventory over 6 times per year compared to the industryaverage 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 thatAnderson is able to generate more sales per dollar invested in inventory and in totalassets than the industry averages. However, Anderson takes slightly longer to collectits accounts receivable (27.4 days compared to the industry average of 25 days).

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

= 6 times

Receivables turnover ratio = $8,000,000[$700,000 + 500,000] 2

= 13.33 times

Average collection period = 36513.33

= 27.4 days

Asset turnover ratio = $8,000,000[$4,300,000 + 3,700,000] 2

= 2 times


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Exercise 5-19

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 2

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

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

Exercise 5-20

1. c. Revenue is recognized when (1) realized or realizable and (2) earned. On May28, $500,000 of the sales price was realized while the remaining $500,000 wasrealizable 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 notused 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 whena construction contract extends over several accounting periods. As a result,contractors ordinarily recognize revenue using the percentage-of-completionmethod so that some revenue is recognized each year over the life of thecontract. Hence, this method is an exception to the general principle of revenuerecognition, primarily because it better matches revenues and expenses.

3.b. Given that one-third of all costs have already been incurred ($6,000,000), thecompany 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 grossprofit of $2,000,000.

Exercise 5-21Quarter

First Second Third


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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

Exercise 5-22Incentive compensation $300 million 4 = $ 75 millionDepreciation expense $60 million 4 = 15 millionGain on sale 23 million

Exercise 5-231st 2nd 3rd 4th

Advertising $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


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Problem 5-1

REAGAN CORPORATIONIncome Statement

For the Year Ended December 31, 2006

Income before income taxes and

extraordinary item ..................................... [1]$3,680,000

Income tax expense ..................................... 1,472,000Income before extraordinary item ................ 2,208,000Extraordinary item:Gain from settlement of lawsuit (net of

$400,000 tax expense) ................................ 600,000Net 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 (2006) (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

PROBLEMS


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Problem 5-2

Requirement 1

2006 Cost recovery % :

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

$300,000

2007 Cost recovery %:

$280,000

= 70% (gross profit % = 30%)$400,000

2006 gross profit:

Cash collection from 2006 sales = $120,000 x 40% = $48,000

2007 gross profit:

Cash collection from 2006 sales = $100,000 x 40% = $ 40,000+ Cash collection from 2007 sales = $150,000 x 30% = 45,000

Total 2007 gross profit $85,000

Requirement 2








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Problem 5-2 (continued)





2007 To recognize gross profit from installment sales

Deferred gross profit ..................................................... 85,000Realized gross profit.................................................. 85,000

Requirement 3

Date Cash Collected Cost Recovery Gross Profit

2006

2006 sales $120,000 $120,000 - 0 -

20072006 sales $100,000 $ 60,000 $40,0002007 sales 150,000 150,000 - 0 -2007 totals $250,000 $210,000 $40,000


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Problem 5-2 (concluded)


Installment receivables.................................................. 300,000Inventory................................................................... 180,000

Deferred gross profit ................................................. 120,000

2006 To record cash collection from installment salesCash .............................................................................. 120,000




2007 To record cash collection from installment salesCash .............................................................................. 250,000





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Problem 5-3

Requirement 1

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

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

8/31/06 8/31/07 8/31/08 8/31/09 8/31/10

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

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

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


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Requirement 2

Point of

Delivery

Installment

Sales Cost RecoveryInstallment receivable 500,000

Sales revenue 500,000Cost of goods sold 300,000

Inventory 300,000To record sale on 8/31/06.

Installment receivable 500,000 500,000Inventory 300,000 300,000Deferred gross profit

To record sale on 8/31/06.

200,000 200,000

Cash 100,000 100,000 100,000Installment receivable 100,000 100,000 100,000

Entry made each Aug. 31.

Deferred gross profit 40,000Realized gross profit

To record gross profit.(entry made each Aug. 31)

40,000

Deferred gross profit 100,000Realized gross profit

To record gross profit.(entry made 8/31/09 & 8/31/10)

100,000


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Requirement 3

Point of

Delivery

Installment

Sales

Cost

RecoveryDecember 31, 2006

Assets

Installment receivablesLess: Deferred gross profitInstallment receivables, net

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

400,000(200,000)200,000

December 31, 2007

AssetsInstallment receivablesLess: Deferred gross profitInstallment receivables, net

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

300,000(200,000)100,000


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Problem 5-4

Requirement 1

2006 2007 2008Contract price $10,000,000 $10,000,000 $10,000,000

Actual 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 2008) $ 2,000,000 $ 2,000,000 $ 1,800,000


2006: $2,400,000= 30.0% x $2,000,000 = $600,000

$8,000,000

2007: $6,000,000= 75.0% x $2,000,000 = $1,500,000 - 600,000 = $900,000

$8,000,000

2008: $1,800,000 - 1,500,000 = $300,000

Requirement 2

2006 2007 2008

Construction in progress 2,400,000 3,600,000 2,200,000Various accounts 2,400,000 3,600,000 2,200,000

To record construction costs.

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


Cash 1,800,000 3,600,000 4,600,000Accounts receivable 1,800,000 3,600,000 4,600,000


Construction in progress (gross profit) 600,000 900,000 300,000Cost 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 2,500,000To record gross profit.


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(1) Revenue recognized:2006: 30% x $10,000,000 = $3,000,000

2007: 75% x $10,000,000 = $7,500,000Less: Revenue recognized in 2006 (3,000,000)

Revenue recognized in 2007 $4,500,0002008: 100% x $10,000,000 = $10,000,000

Less: Revenue recognized in 2006 & 2007 (7,500,000)Revenue recognized in 2008 $2,500,000

Requirement 3


Current assets:Accounts receivable $ 200,000 $600,000Construction in progress $3,000,000 $7,500,000Less: Billings (2,000,000) (6,000,000)

Costs and profit in excess

of billings 1,000,000 1,500,000

Requirement 42006 2007 2008

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 -

2006 2007 2008Contract 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 2008) $ 2,000,000 $ 700,000 $ 600,000


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Gross profit (loss) recognition:2006: $2,400,000

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

2007: $6,200,000= 66.6667% x $700,000 = $466,667 - 600,000 = $(133,333)

$9,300,000

2008: $600,000 - 466,667 = $133,333

Requirement 5

2006 2007 2008Costs incurred during the year $2,400,000 $3,800,000 $3,900,000Estimated costs to complete

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

2006 2007 2008Contract 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)


2006: $2,400,000

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

2007: $(300,000) - 600,000 = $(900,000)

2008: $(100,000) - (300,000) = $200,000


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Problem 5-5

Requirement 1

Year Gross profit recognized2006 - 0 -2007 - 0 -2008 $1,800,000

Total gross profit $1,800,000

Requirement 2

2006 2007 2008Construction 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 4,000,000Billings on construction contract 2,000,000 4,000,000 4,000,000


Cash 1,800,000 3,600,000 4,600,000Accounts receivable 1,800,000 3,600,000 4,600,000


Construction in progress (gross profit) 1,800,000

Cost of construction (costs incurred) 8,200,000Revenue from long-term contracts

(contract price)10,000,000

To record gross profit.

Requirement 3


Current assets:

Accounts receivable $ 200,000 $ 600,000Construction in progress $2,400,000 $6,000,000Less: Billings (2,000,000) (6,000,000)

Costs in excess of billings 400,000 - 0 -


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Requirement 4

2006 2007 2008

Costs incurred during the year $2,400,000 $3,800,000 $3,200,000Estimated costs to completeas of year-end 5,600,000 3,100,000 -



Requirement 5

2006 2007 2008

Costs incurred during the year $2,400,000 $3,800,000 $3,900,000Estimated costs to complete

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

Year Gross profit (loss) recognized2006 - 0 -2007 $(300,000)

2008 200,000Total project loss $(100,000)


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Problem 5-6

Requirement 1

2006 2007 2008Contract 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 2008) $ 500,000 $ (200,000) $(250,000)

Year Gross profit (loss) recognized2006 - 0 -2007 $(200,000)

2008 (50,000)Total project loss $(250,000)

Requirement 2


2006: 10% x $500,000 = $50,000

2007: $(200,000) - 50,000 = $(250,000)

2008: $(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


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Problem 5-7Requirement 1

a. January 30, 2006

Cash ............................................................................. 200,000

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

b. September 1, 2006

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

c. September 30, 2006

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

Service revenue ........................................................ 1,200

d. January 30, 2007

Cash .............................................................................. 100,000

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


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Requirement 2

a. January 30, 2006

Cash ............................................................................. 200,000

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

b. September 1, 2006

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

c. September 30, 2006

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

Service revenue ........................................................ 1,200

d. January 30, 2007

Cash .............................................................................. 100,000

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

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


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Problem 5-8

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%


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Problem 5-9

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..

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 = 365Receivables turnover

J&J = 365 = 57 days6.37

Pfizer = 365 = 71 days5.15

Inventory turnover = Cost of goods soldInventories

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

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

Average days in inventory = 365Inventory turnover

J&J = 365 = 108 days3.39

Pfizer = 365 = 217 days1.68


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Requirement 2

The return on assets indicates a company's overall profitability, ignoring specificsources of financing. In this regard, J&Js profitability is significantly higher than

that of Pfizer.

Requirement 3

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

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

= Net income

xNet 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&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 forJ&J.

Rate of return on assets = Net incomeTotal assets

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

Pfizer = $1,639 = 1.4%

$116,775


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Requirement 4

J&J provided a much greater return to shareholders.

Rate of return on = Net incomeshareholders equity Shareholders equity

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

Pfizer = $1,639 = 2.5%

$65,377


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Problem 5-10a. Times interest earned ratio = (Net income + Interest + Taxes) Interest = 17

(Net income + $2 + 12) $2 = 17Net income + $14 = 17 x $2Net 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 = $240e. Inventory turnover ratio = Cost of goods sold Inventory = 8

Inventory = $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 liabilitiesCurrent 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 + $40Cash = $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


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k. Debt to equity ratio = Total liabilities Shareholders equity = 1.0Total liabilities = $100 x 1.0 = $100

Long-term liabilities = Total liabilities - Current liabilities = $100 - 30 = $70

CADUX CANDY COMPANY

Balance Sheet

At December 31, 2006

Assets

Current assets:Cash $ 10

Accounts receivable (net) 20Inventories 30Total current assets 60

Property, plant, and equipment (net) 140Total assets $200

Liabilities and Shareholders Equity

Current liabilities $ 30Long-term liabilities 70Shareholders equity 100

Total liabilities and shareholders' equity $200


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Problem 5-11

Requirement 1

Thereturn on assetsindicates a company's overall profitability, ignoring specificsources of financing. In this regard, Metropolitans profitability exceeds that of

Republic.Requirement 2

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

Rate of return on assets = Profit margin x Asseton 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%

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

Rate of return on assets = Net income

Total assets

Metropolitan = $ 593.8 = 14.8%

$4,021.5

Republic = $ 424.6 = 10.6%$4,008.0


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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. Republics higher leverage has been used to provide a higher return toshareholders than Metropolitan, even though its return on assets is less. Republicincreased 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%) thereturn on assets.

Rate of return on = Net incomeshareholders 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

Debt to equity ratio = Total liabilitiesShareholders equity

Metropolitan = $2,304.4 = 1.34$144.9 + 2,476.9 - 904.7

Republic = $3,035.2 = 3.12$335.0 + 1,601.9 - 964.1


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Requirement 5

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

Requirement 6

Current ratio = Current assetsCurrent liabilities

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

Republic = $1,478.7 = .83

$1,787.1

Acid-test ratio = Quick assetsCurrent 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


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Republics receivables turnover is more rapid than Metropolitans, perhapssuggesting that its relative liquidity is not as bad as its acid-test ratio indicated.

Requirement 7

Both firms provide an adequate margin of safety.

Problem 5-12Branson Electronics Company

Income Statement

Revenues $180,000Cost of goods sold 35,000

Gross profit 145,000

Advertising 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%


Inventory turnoverratio = Cost of goods soldInventory

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 taxesearned 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


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Real World Case 5-1

Requirement 1A bill and hold strategy accelerates the recognition of revenue. In this case, salesthat would normally have occurred in 1998 were recorded in 1997. Assuming a

positive gross profit on these sales, earnings in 1997 is inflated.

Requirement 2

A customer would probably not be expected to pay for goods purchased usingthis bill and hold strategy until the goods were actually received. Receivables wouldtherefore increase.

Requirement 3

Sales 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 to1997.

Requirement 4

Earnings quality refers to the ability of reported earnings (income) to predict acompanys future earnings. Sunbeams earnings management strategy produced a1997 earnings figure that was not indicative of the companys future profit-generatingability.

CASES


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Judgment Case 5-2

Requirement 1

While revenue often is earned during a period of time, revenue usually isrecognized 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 beenearned and there is reasonable certainty as to the collectibility of the asset (cash) to bereceived.

Usually, significant uncertainties exist at the time products are produced. Atpoint of delivery, the product has been sold and the price and buyer are known. Theonly remaining uncertainty involves the ultimate cash collection, which can usually beaccounted for by estimating and recording allowances for possible return of the

product and for uncollectibility of the cash.

Requirement 2

It would be useful to recognize revenue as the productive activity takes placewhen the earnings process occurs over long periods of time. A good example is long-term projects in the construction industry.

Requirement 3

Some revenue-producing activities call for revenue recognition afterthe product

has been delivered. These situations involve significant uncertainty as to thecollectibility 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, theseremaining uncertainties can be accounted for by estimating and recording allowances

for anticipated returns and bad debts, thus allowing revenue and related costs to berecognized at point of delivery. But occasionally, an abnormal degree of uncertaintycauses point of delivery revenue recognition not to be appropriate. Revenuerecognition afterdelivery sometimes is appropriate for installment sales and when aright of return exists.


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Judgment Case 5-3The 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-insale. This results from the granting of a trade-in allowance for the old computer thatis 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-inoption. If, however, a large percentage of customers do exercise the option, and thedistortion 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.


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Communication Case 5-4The 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 theproposed solutions will likely be more beneficial than the solutions themselvesStudents 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 bereduced 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 asa promotional expense. The estimated cost of the free cone should beexpensed as the ten required cones are sold. A corresponding liability is

recorded which should increase to an amount equal to the cost of the freecone. When the free cone is awarded, the liability and inventory are reduced.

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

It is important that each student actively participate in the process. Domination

by one or two individuals should be discouraged. Students should be encouraged tocontribute to the group discussion by (a) offering information on relevant issues, and(b) clarifying or modifying ideas already expressed, or (c) suggesting alternative

direction.


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Research Case 5-5(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.


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Ethics Case 5-6Discussion should include these elements.

Facts:

Horizon Corporation, a computer manufacturer, reported profits from 2001through 2004, but reported a $20 million loss in 2005 due to increased competitionThe chief financial officer (CFO) circulated a memo suggesting the shipment ofcomputers to J.B. Sales, Inc., in 2006 with a subsequent return of the merchandise toHorizon in 2007. Horizon would record a sale for the computers in 2006 and avoid aninventory 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 2006 which heknows will be reversed as a sales return in 2007.

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 acompany loss in 2006 that may lead to bankruptcy?

Who is affected?

Jim FieldingCFO and other managersOther employees

ShareholdersPotential shareholdersCreditorsAuditors


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Judgment Case 5-7

Requirement 1

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

recovery method.2006 gross profit under the three methods:

(1) point of delivery:

$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 2

Customers sometimes are allowed to pay for purchases in installments over longperiods of time. Uncertainty about collection of a receivable normally increases with

the length of time allowed for payment. In most situations, the increased uncertaintyconcerning the collection of cash from installment sales can be accommodatedsatisfactorily by estimating uncollectible amounts. In these situations, point ofdelivery revenue recognition should be used.

If, however, the installment sale creates a situation where there is significantuncertainty concerning cash collection making it impossible to make an accurateassessment of future bad debts, revenue and cost recognition should be delayed. The

installment sales method and the cost recovery method are available to handle suchsituations. These methods should be used only in situations involving exceptionaluncertainty. The cost recovery method is the more conservative of the two.


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Judgment Case 5-8

Question 1

No. In the SEC's view, it would be inappropriate for Company M to recognize themembership fees as earned revenue upon billing or receipt of the initial fee with a

corresponding accrual for estimated costs to provide the membership services. Thisconclusion is based on Company M's remaining and unfulfilled contractual obligationto perform services (i.e., make available and offer products for sale at a discounted

price) throughout the membership period. Therefore, the earnings process, irrespectiveof whether a cancellation clause exists, is not complete.

In addition, the ability of the member to receive a full refund of the membershipfee up to the last day of the membership term raises an uncertainty as to whether thefee is fixed or determinable at any point before the end of the term. Generally, theSEC 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 2

No. Products delivered to a consignee pursuant to a consignment arrangement arenot 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 risksand rewards of ownership of the product and title usually does not pass to theconsignee.

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 layawayprogram upon delivery of the merchandise to the customer. Until then, the amount ofcash received should be recognized as a liability entitled such as "deposits receivedfrom customers for layaway sales" or a similarly descriptive caption. BecauseCompany R retains the risks of ownership of the merchandise, receives only a depositfrom 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 criteriafor bill-and-hold transactions that states that "the customer must have made a fixedcommitment to purchase the goods."


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Research Case 5-9

Requirement 2

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

a.

The susceptibility of the product to significant external factors, such astechnological 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 changingcircumstances, for example, changes in the selling enterprises marketing

policies or relationships with its customers.d. Absence of a large volume of relatively homogeneous transactions.

Requirement 3The six criteria are:a. The sellers 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 buyers 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 todirectly bring about resale of the product by the buyer.

f. The amount of future returns can be reasonably estimated.

Requirement 4

Both companies recognize revenues from products sold when persuasiveevidence of an arrangement exists, the price is fixed or determinable, shipment ismade and collectibility is reasonably assured. However, for sales to distributors underterms allowing the distributors certain rights of return and price protection on unsold

merchandise held by them, AMD defers recognition of revenue and related profitsuntil the merchandise is resold by the distributors.


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Case 5-9 (concluded)

Requirement 5

The two revenue recognition policies differ with respect to AMDs sales todistributors. 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 shippedeven 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 productssold by the two companies, the distribution channels, and the actual agreements withcustomers. AMD sells semiconductors, a highly volatile industry. It may be moredifficult for AMD to see through the distribution channels to reasonably estimatereturns. Also, the agreements with distributors of AMDs products may be moreliberal than those of HP with respect to things like price protection and returns. Forexample, AMD might offer a longer time period for customers to return product thandoes HP. Also, AMDs 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 berecognized when the right of return exists.

Judgment Case 5-101. 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 tothe collection.


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Judgment Case 5-11Bills argument is that the completed contract method is preferable because it is

analogous to point of delivery revenue recognition. That is, no revenue is recognizeduntil the completed product is delivered. Johns argument is that the important factor

is the earnings process and that revenue should be recognized as the process takesplace.

Johns argument is correct. In situations when the earnings process takes placeover long periods of time, like long-term construction contracts, it is preferable torecognize revenue during the earnings process, rather than to wait until the process iscomplete.


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Communication Case 5-12Suggested G

Documents

Spiceland SM 17eCh05