intermediate accounting 7e, chapter 5 solutions

© The McGraw-Hill Companies, Inc., 2013 Solutions Manual, Vol.1, Chapter 5 5–1

AACSB assurance of learning standards in accounting and business education require documentation of outcomes assessment. Although schools, departments, and faculty may approach assessment and its documentation differently, one approach is to provide specific questions on exams that become the basis for assessment. To aid faculty in this endeavor, we have labeled each question, exercise, and problem in Intermediate Accounting, 7e, with the following AACSB learning skills: Questions AACSB Tags

5–1 Reflective thinking










5–11 Diversity, Reflective thinking

















Brief Exercises

AACSB Tags

5–1 Analytic


5–3 Analytic

5–4 Analytic

5–5 Analytic

5–6 Reflective thinking, Communications

5–7 Analytic

5–8 Analytic

5–9 Analytic

5–10 Diversity, Analytic

5–11 Analytic

5–12 Reflective thinking, Analytic

5–13 Diversity, Reflective thinking, Analytic

5–14 Analytic

5–15 Analytic

5–16 Analytic

5–17 Analytic

5–18 Analytic




5–22 Analytic

5–23 Analytic


5–25 Analytic

Chapter 5 Income Measurement and Profitability Analysis

© The McGraw-Hill Companies, Inc., 2013 5–2 Intermediate Accounting, 7/e

Exercises AACSB Tags



5–3 Analytic

5–4 Analytic

5–5 Analytic

5–6 Analytic

5–7 Analytic

5–8 Analytic

5–9 Analytic


5–11 Analytic


5–13 Analytic

5–14 Analytic

5–15 Analytic

5–16 Analytic


5–18 Analytic

5–19 Analytic


5–21 Analytic


5–23 Analytic, Communications


5–25 Analytic

5–26 Analytic

5–27 Analytic

5–28 Analytic

5–29 Analytic






5–35 Analytic



5–38 Analytic

CPA/CMA AACSB Tags 1 Analytic

2 Analytic

3 Analytic

4 Reflective thinking

5 Analytic

6 Analytic

7 Diversity, Reflective thinking

8 Diversity, Analytic



1 Analytic

2 Reflective thinking

3 Analytic

Problems

5–1 Analytic

5–2 Analytic

5–3 Analytic


5–5 Analytic

5–6 Analytic


5–8 Analytic



5–11 Analytic


5–13 Analytic


5–15 Analytic



5–18 Analytic

5–19 Analytic


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

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

cash).

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

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

Question 5–3 A principal has primary responsibility for delivering a product or service, and recognizes as

revenue the gross amount received from a customer. An agent doesn’t primarily deliver goods or services, but acts as a facilitator that earns a commission for helping sellers to transact with buyers, and recognizes as revenue only the commission it receives for facilitating the sale.

Question 5–4 If the installment sale creates a situation where there is significant uncertainty concerning cash

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

Question 5–5 The installment sales method recognizes gross profit by applying the gross profit percentage on

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

Question 5–6 Deferred gross profit is a contra installment receivable account. The balance in this account is

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

QUESTIONS FOR REVIEW OF KEY TOPICS


Question 5–7 Because the return of merchandise can retroactively negate the benefits of having made a sale,

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

Question 5–8 Sometimes a company arranges for another company to sell its product under consignment.

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

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

Question 5–9 For service revenue, if there is one final service that is critical to the earnings process, revenues

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

Question 5–10 The completed contract method of recognizing revenues and costs on long-term construction

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


Question 5–11 The completed contract method recognizes revenue, cost of construction, and gross profit at

the end of the contract, after the contract has been completed. The cost recovery method will recognize an amount of revenue 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 5–12 The billings on construction contract account is a contra account to the construction in progress

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

Question 5–13 An estimated loss on a long-term contract must be fully recognized in the first period the loss

is anticipated, regardless of the revenue recognition method used.

Question 5–14 This guidance requires that if an arrangement includes multiple elements, the revenue from the

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

Question 5–15 IFRS 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 5–16 Specific guidelines for revenue recognition of the initial franchise fee are provided by FASB

ASC 952–605–25–1. A key to these guidelines is the concept of substantial performance. It requires that substantially all of the initial services of the franchisor required by the franchise agreement be performed before the initial franchise fee can be recognized as revenue. The term “substantial” requires professional judgment on the part of the accountant. In situations when the initial franchise fee is collectible in installments, even after substantial performance has occurred, the installment sales or cost recovery method should be used for profit recognition, if a reasonable estimate of uncollectibility cannot be made.


Question 5–17 Receivables turnover ratio = Net sales Average accounts receivable (net) Inventory turnover ratio = Cost of goods sold Average inventory Asset turnover ratio = Net sales Average total assets

Activity ratios are designed to provide information about a company’s effectiveness in

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

Question 5–18 Profit margin on sales = Net income Net sales Return on assets = Net income Average total assets Return on shareholders' = Net income equity Average shareholders' equity

A fundamental element of an analyst’s task is to develop an understanding of a firm’s

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


Question 5–19

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

Net income Avg. total equity

= Net income Total sales

X Total sales Avg. total assets

X Avg. total assets Avg. total equity

The DuPont framework shows return on equity as being driven by profit margin (reflecting a

company’s ability to earn income from sales), asset turnover (reflecting a company’s effectiveness in using assets to generate sales), and the equity multiplier (reflecting the extent to which a company has used debt to finance its assets).

Question 5–20 These 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.

Question 5–21 U.S. GAAP views interim reports as an integral part of the annual report, so amounts that

affect multiple interim periods are accrued or deferred and then charged to each of the periods they affect. IFRS takes much more of a discrete-period approach than does U.S. GAAP, such that costs for repairs, property taxes, advertising, etc., that do not meet the definition of an asset at the end of an interim period are expensed entirely in the period in which they occur.


SUPPLEMENT QUESTIONS FOR REVIEW OF KEY TOPICS

Question 5–22 The five key steps in recognizing revenue under the new standard are: 1. Identify a contract(s) with a customer. 2. Identify the separate performance obligation(s) in the contract. 3. Determine the transaction price. 4. Allocate the transaction price to the separate performance obligations. 5. Recognize revenue when (or as) the entity satisfies each performance obligation.

Question 5–23

Under the proposed ASU, a good or service is a separate performance obligation if it is distinct, which is the case if either:

1. The seller regularly sells the good or service separately, or 2. A buyer could use the good or service on its own or in combination with goods or services the

buyer could obtain elsewhere.

Question 5–24 Under the proposed ASU, if an entity grants a customer the option to acquire additional goods or services, that promise gives rise to a separate performance obligation in the contract only if the option provides a material right to the customer that the customer would not receive without entering into the contract. If the option provides a material right, the customer in effect pays the entity in advance for future goods or services and the entity recognizes revenue when those future goods or services are transferred or when the option expires.

Question 5–25 Under the proposed ASU, if an arrangement has multiple separate performance obligations, the seller allocates the transaction price to the separate performance obligations in proportion to the stand-alone selling prices of the goods or services underlying those performance obligations. If the seller can’t observe actual stand-alone selling prices, the seller should estimate them.

Question 5–26 Under the proposed ASU, a performance obligation for a good is satisfied when control of the good is transferred to the buyer. Four key indicators that control of a good has passed from the seller to the buyer are:

1. Buyer has an unconditional obligation to pay. 2. Buyer has legal title. 3. Buyer has physical possession. 4. Buyer has the risks and rewards of ownership.


Question 5–27 Under the proposed ASU, if a seller provides the service of integrating products and services into one asset (for example, as is done in the construction industry), the risks of providing the goods and services are not separable, so that arrangement is treated as a single service-related performance obligation. The performance obligation is viewed as satisfied over time if at least one of two criteria is met:

1. The seller is creating or enhancing an asset that the buyer controls as the service is performed.

2. The seller is not creating an asset that the buyer controls or that has alternative use to the seller, and at least one of the following conditions hold:

a. The customer receives and consumes a benefit as the seller performs. b. Another seller would not need to reperform the tasks performed to date if that other

seller were to fulfill the remaining obligation. c. The seller has the right to payment for performance even if the customer could

cancel the contract at the customer’s discretion.


BRIEF EXERCISES

Brief Exercise 5–1 2013 gross profit = $3,000,000 – 1,200,000 = $1,800,000 2014 gross profit = 0

Brief Exercise 5–2

Indicators that the seller is a principal (recognizing gross revenue) as opposed to an agent (recognizing net revenue) include the following: The company is primarily responsible for providing the product or service to the

customer. The company has general inventory risk, meaning that the company owns

inventory prior to a customer ordering it and after a customer returns it. The company has discretion in setting prices and identifying suppliers.

In this transaction, Amazon never bears inventory risk, and is paid a fixed commission such that it has no discretion in setting prices. Therefore, Amazon appears to be an agent, and would only recognize revenue on the transaction equal to the amount of the commission it receives.

Brief Exercise 5–3 2013 Cost recovery % = Cost Sales: $1,200,000 = 40% (implying a gross profit % = 60%) $3,000,000

2013 gross profit = 2013 cash collection of $150,000 x 60% = $90,000 2014 gross profit = 2014 cash collection of $150,000 x 60% = $90,000

Brief Exercise 5–4 No gross profit will be recognized in either 2013 or 2014. Gross profit will not be

recognized until the entire $1,200,000 cost of the land is recovered. In this case, it will take eight 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 5–5 Initial deferred gross profit ($3,000,000 – 1,200,000) $1,800,000 Less gross profit recognized in 2013 ($150,000 x 60%) (90,000) Less gross profit recognized in 2014 ($150,000 x 60%) (90,000) Deferred gross profit at the end of 2014 $1,620,000

Brief Exercise 5–6 The seller must meet certain criteria before revenue can be recognized in

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

Brief Exercise 5–7 Total estimated cost to complete = $6 million + 9 million = $15 million % of completion = $6 million $15 million = 40% Total estimated gross profit ($20 million – 15 million) = $5,000,000 multiplied by the % of completion 40% Gross profit recognized the first year $2,000,000 First year revenue = $20,000,000 x 40% = $8,000,000


Brief Exercise 5–8 Assets: Accounts receivable ($7 million – 5 million) $2,000,000 Cost plus profit ($6 million + 2 million*) in excess of billings ($7 million) 1,000,000 * Total estimated gross profit ($20 million – 15 million) = $5,000,000 multiplied by the % of completion 40% Gross profit recognized in the first year $2,000,000

Brief Exercise 5–9 Year 1 = 0 Year 2 = $4 million Revenue $20,000,000 Less: Costs in year 1 (6,000,000) Costs in year 2 (10,000,000) Actual profit $ 4,000,000

Brief Exercise 5–10 Year 1:

Revenue: $6 million Cost: $6 million Gross profit: $0

Year 2:

Revenue: $14 million ($20 million total – 6 million in year 1) Cost: $10 million Gross profit: $ 4 million

Brief Exercise 5–11 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.


Brief Exercise 5–12 Orange has separate sales prices for the two parts of LearnIt-Plus, so that vendor-

specific objective 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.

Brief Exercise 5–13 Orange has separate sales prices for the two parts of LearnIt-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).

Brief Exercise 5–14 Specific conditions for revenue recognition of the initial franchise fee are

provided by FASB ASC 952–605–25–1. 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.



*$600,000 – 200,000

Receivables turnover ratio = Net sales Average accounts receivable (net) Receivables turnover ratio = $600,000 [$100,000 + 120,000] ÷ 2 = 5.45 times

Inventory turnover ratio = Cost of goods sold Average inventory

Inventory turnover ratio = $400,000* [$80,000 + 60,000] ÷ 2 = 5.71 times



Profit margin = Net income Sales

= $65,000 $420,000

= 15.5%

Return on assets = Net income Average total assets

= $65,000 $800,000

= 8.1%

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

= $65,000 $522,500*

= 12.4%

Shareholders’ equity, beginning of period $500,000 Add: Net income 65,000 Deduct: Dividends (20,000) Shareholders’ equity, end of period $545,000 *Average shareholders’ equity = ($500,000 + 545,000) 2 = $522,500



Return on equity

= Profit margin

X Asset turnover X Equity multiplier

Net income Avg. total

equity

= Net income Total sales

X Total sales Avg. total assets

X Avg. total assets Avg. total equity

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

= $65,000 $522,500

= 12.4%

Profit margin = Net income Sales

= $65,000 $420,000

= 15.5%

Asset turnover = Sales Average total assets

= $420,000 $800,000

= .525 times


Brief Exercise 5–17 (concluded)

Equity multiplier = Average total assets Average shareholders’ equity

= $800,000 $522,500

= 1.53

Check: 12.4% ROE = 15.5% profit margin x .525 times asset turnover x 1.53 equity multiplier.

Brief Exercise 5–18 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


SUPPLEMENT BRIEF EXERCISES


An agreement needs to have the following five characteristics to qualify as a contract for revenue recognition purposes under the proposed ASU:

1. Commercial substance. The contract is expected to affect the seller’s future cash flows.

2. Approval. Each party to the contract has approved the contract and is committed to satisfying their respective obligations.

3. Rights. Each party’s rights are specified with respect to the goods and services to be transferred.

4. Payment terms. The terms and manner of payment are specified. 5. Performance. A contract does not exist if either party can terminate a wholly

unperformed contract without penalty. The Richter agreement does not satisfy characteristic number 4, and may not satisfy characteristics 3 and 5 as well. Therefore, it does not qualify as a contract for purposes of recognizing revenue.

Brief Exercise 5–20 Yes, these are separate performance obligations, because each good is sold separately to individual customers.

Brief Exercise 5–21 Yes, they are separate. The renewal option is a material right because it allows the customer to renew at a better price than could be obtained without the right.


Total estimated contract price = $25,000 + (50% x $10,000) = $30,000


Brief Exercise 5–23 Based on relative stand-alone selling prices, the software comprises 80% of the total fair values ($80,000 ÷ ($20,000 + 80,000)), and the technical support comprises 20% ($20,000 ÷ ($20,000 + 80,000)). Therefore, the seller would recognize $72,000 ($90,000 80%) in revenue up front when the software is delivered, and defer the remaining $18,000 ($90,000 20%) and recognize it ratably over the next six months as the technical support service is provided, making the following journal entry:

Cash 90,000 Revenue 72,000 Unearned revenue 18,000

Brief Exercise 5–24 A performance obligation is satisfied over time if at least one of two criteria is met:

1. The seller is creating or enhancing an asset that the buyer controls as the service is performed.

2. The seller is not creating an asset that the buyer controls or that has alternative use to the seller, and at least one of the following conditions hold:

a. The customer receives and consumes a benefit as the seller performs the service.

b. Another seller would not need to reperform the tasks performed to date if that other seller were to fulfill the remaining obligation.

c. The seller has the right to payment for performance even if the customer could cancel the contract at the customer’s discretion.

Under Estate’s construction agreement with CyberB, if for some reason Estate could not complete construction, CyberB would own the partially completed building and could retain another construction company to complete the job. A new construction contractor would not need to reperform Estate’s work if the new contractor completed the job. Therefore, criterion 2b is satisfied.



Patterson initially would record the payment as unearned revenue. Then Patterson would accrue interest expense of $10,000 x 5% = $500 in year one of the contract, and interest expense of ($10,000 + 500) x 5% = $525 in year two of the contract, in each case debiting interest expense and crediting unearned revenue. Therefore, at the point in time Patterson delivers the novel, it would have unearned revenue totaling $10,000 + 500 + 525 = $11,025, and would recognize that amount as revenue.


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, 2013 Cash ................................................................................ 450 Unearned revenue ....................................................... 450 To record the cash collection December 31, 2013 Unearned revenue ($450 x 1/5) ....................................... 90 Revenue ...................................................................... 90 To recognize revenue earned in December (no revenue earned in November, as season starts on December 1).

Requirement 3 $90 is included in revenue in the 2013 income statement. The $360 remaining

balance in unearned revenue is included in the current liability section of the 2013 balance sheet.

EXERCISES


Exercise 5–2 When other parties are involved in providing goods or services to a seller’s customer, the seller has to determine whether its performance obligation is to provide the goods or services itself, making the seller a principal, or the seller arranges for another party to provide those goods or services, making the seller an agent. That determination affects whether the seller recognizes revenue in the amount of consideration received in exchange for those goods or services (if principal) or in the amount of any fee or commission received in exchange for arranging for the other party to provide the goods or services (if agent).

Requirement 1 AuctionCo is a principal because it obtained control of the used bicycle before the bicycle was sold. Therefore, AuctionCo should recognize revenue of $30.

Requirement 2 AuctionCo is an agent because it never controlled the product before it was sold. Therefore, AuctionCo should recognize revenue for the commission fees of $10 retained upon sending $20 to the original owner.

Requirement 3 In this case it appears that AuctionCo is acting as an agent, given that the bicycles are shipped directly from the owner to the customer. However, additional aspects of the arrangement could make it more appropriate to treat AuctionCo as a principal. For example, if AuctionCo must pay the bicycle owner the $20 wholesale price regardless of whether the bicycle is sold, then AuctionCo would appear to have purchased the bicycle and should be treated as a principal.


Exercise 5–3 Requirement 1 2013 cost recovery %: $234,000 = 65% (gross profit % = 35%) $360,000 2014 cost recovery %: $245,000 = 70% (gross profit % = 30%) $350,000 2013 gross profit: Cash collection from 2013 sales of $150,000 x 35% = $52,500 2014 gross profit: Cash collection from 2013 sales of $100,000 x 35% = $ 35,000 + Cash collection from 2014 sales of $120,000 x 30% = 36,000 Total 2014 gross profit $71,000

Requirement 2 2013 deferred gross profit balance: 2013 initial gross profit ($360,000 – 234,000) $126,000 Less: Gross profit recognized in 2013 (52,500) Balance in deferred gross profit account $73,500 2014 deferred gross profit balance: 2013 initial gross profit ($360,000 – 234,000) $ 126,000 Less: Gross profit recognized in 2013 (52,500) Gross profit recognized in 2014 (35,000) 2014 initial gross profit ($350,000 – 245,000) 105,000 Less: Gross profit recognized in 2014 (36,000) Balance in deferred gross profit account $107,500


Exercise 5–4

2013 Installment receivables .................................................... 360,000 Inventory ..................................................................... 234,000 Deferred gross profit ................................................... 126,000 To record installment sales 2013 Cash ................................................................................. 150,000 Installment receivables ................................................ 150,000 To record cash collections from installment sales 2013 Deferred gross profit ....................................................... 52,500 Realized gross profit ................................................... 52,500 To recognize gross profit from installment sales

2014 Installment receivables .................................................... 350,000 Inventory ..................................................................... 245,000 Deferred gross profit ................................................... 105,000 To record installment sales 2014 Cash ................................................................................. 220,000 Installment receivables ................................................ 220,000 To record cash collections from installment sales 2014 Deferred gross profit ....................................................... 71,000 Realized gross profit ................................................... 71,000 To recognize gross profit from installment sales


Exercise 5–5 Requirement 1 Year Income recognized 2013 $180,000 ($300,000 – 120,000) 2014 - 0 - 2015 - 0 - 2016 - 0 - Total $180,000

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

Year Cash Collected Cost Recovery(40%) Gross Profit(60%) 2013 $ 75,000 $ 30,000 $ 45,000 2014 75,000 30,000 45,000 2015 75,000 30,000 45,000 2016 75,000 30,000 45,000

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

Requirement 3

Year Cash Collected Cost Recovery Gross Profit 2013 $ 75,000 $ 75,000 - 0 - 2014 75,000 45,000 $ 30,000 2015 75,000 - 0 - 75,000 2016 75,000 - 0 - 75,000

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



July 1, 2013 Installment receivables .................................................... 300,000 Sales revenue ............................................................... 300,000 To record installment sale Cost of goods sold ........................................................... 120,000 Inventory ..................................................................... 120,000 To record cost of installment sale Cash ................................................................................. 75,000 Installment receivables ................................................ 75,000 To record cash collection from installment sale July 1, 2014 Cash ................................................................................. 75,000 Installment receivables ................................................ 75,000 To record cash collection from installment sale


Exercise 5–6 (continued)

Requirement 2

July 1, 2013 Installment receivables ................................................... 300,000 Inventory ..................................................................... 120,000 Deferred gross profit ................................................... 180,000 To record installment sale Cash ................................................................................ 75,000 Installment receivables ............................................... 75,000 To record cash collection from installment sale Deferred gross profit ....................................................... 45,000 Realized gross profit ................................................... 45,000 To recognize gross profit from installment sale July 1, 2014 Cash ................................................................................ 75,000 Installment receivables ............................................... 75,000 To record cash collection from installment sale Deferred gross profit ....................................................... 45,000 Realized gross profit ................................................... 45,000 To recognize gross profit from installment sale


Exercise 5–6 (concluded)

Requirement 3

July 1, 2013 Installment receivables .................................................... 300,000 Inventory ..................................................................... 120,000 Deferred gross profit ................................................... 180,000 To record installment sale Cash ................................................................................. 75,000 Installment receivables ................................................ 75,000 To record cash collection from installment sale July 1, 2014 Cash ................................................................................. 75,000 Installment receivables ................................................ 75,000 To record cash collection from installment sale Deferred gross profit ....................................................... 30,000 Realized gross profit ................................................... 30,000 To recognize gross profit from installment sale

Exercise 5–7 Requirement 1 Cost of goods sold ($1,000,000 – 600,000) $400,000 Add: Gross profit if using cost recovery method 100,000 Cash 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% = $300,000 gross profit


Exercise 5–8

October 1, 2013 Installment receivable ...................................................... 4,000,000 Inventory ..................................................................... 1,800,000 Deferred gross profit ................................................... 2,200,000 To record the installment sale Cash ................................................................................ 800,000 Installment receivable ................................................. 800,000 To record the cash down payment from installment sale Deferred gross profit ($800,000 x 55%*) ...................... 440,000 Realized gross profit ................................................... 440,000 To recognize gross profit from installment sale October 1, 2014 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 To record the default and repossession ......................

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



April 1, 2013 Installment receivables .................................................... 2,400,000 Land ............................................................................. 480,000 Gain on sale of land .................................................... 1,920,000 To record installment sale April 1, 2013 Cash ................................................................................. 120,000 Installment receivables ................................................ 120,000 To record cash collection from installment sale April 1, 2014 Cash ................................................................................. 120,000 Installment receivables ................................................ 120,000 To record cash collection from installment sale

Requirement 2

April 1, 2013 Installment receivables .................................................... 2,400,000 Land ............................................................................. 480,000 Deferred gain ............................................................... 1,920,000 To record installment sale



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, 2013 Cash ................................................................................ 120,000 Installment receivables ............................................... 120,000 To record cash collection from installment sale Deferred gain .................................................................. 96,000 Gain on sale of land (80% x $120,000) .......................... 96,000 To recognize profit from installment sale April 1, 2014 Cash ................................................................................ 120,000 Installment receivables ............................................... 120,000 To record cash collection from installment sale Deferred gain .................................................................. 96,000 Gain on sale of land (80% x $120,000) .......................... 96,000 To recognize profit from installment sale


Exercise 5–10

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 605–35–25–46: “Revenue Recognition–Construction–Type and Production–Type Contracts–Recognition–Provisions for Losses on Contracts.”

2. Circumstances indicating when the installment method or cost recovery

method is appropriate for revenue recognition: FASB ASC 605–10–25–4: “Revenue Recognition–Overall–Recognition– Installment and Cost Recovery Methods of Revenue Recognition.” (Note: ASC 605–10–25–3 also provides some guidance, as it indicates when installment method is not acceptable).

3. 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 605–15–25–1: “Revenue Recognition–Products–Recognition– General–Sales of Product when Right of Return Exists.”


Exercise 5–11 Requirement 1 2013 2014 Contract price $2,000,000 $2,000,000 Actual costs to date 300,000 1,875,000 Estimated costs to complete 1,200,000 - 0 - Total estimated costs 1,500,000 1,875,000 Gross profit (estimated in 2013) $ 500,000 $ 125,000 Gross profit recognition: 2013: $ 300,000 = 20% x $500,000 = $100,000 $1,500,000 2014: $125,000 – 100,000 = $25,000

Requirement 2 2013 $ - 0 - 2014 $125,000

Requirement 3

Balance Sheet

At December 31, 2013

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

20,000

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



Requirement 4

Balance Sheet


Current assets: Accounts receivable $ 130,000

Current liabilities:

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


Exercise 5–12 Requirement 1 ($ in millions) 2013 2014 2015 Contract price $220 $220 $220 Actual costs to date 40 120 170 Estimated costs to complete 120 60 - 0 - Total estimated costs 160 180 170 Estimated gross profit (actual in 2015) $ 60 $ 40 $ 50 Gross profit (loss) recognition: 2013: $40 = 25% x $60 = $15 $160 2014: $120 = 66.67% x $40 = $26.67 – 15 = $11.67 $180 2015: $220 – 170 = $50 – (15 + 11.67) = $23.33

Requirement 2 2013: $220 x 25% = $55

2014: $220 x 66.67% = $146.67 – 55 = $91.67 2015: $220 – 146.67 = $73.33

Requirement 3

Year Gross profit (loss) recognized2013 - 0 - 2014 - 0 - 2015 50

Total project income $50



Requirement 4 2013:

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

2014: Revenue: $80 Cost: 80 Gross profit: $ 0

2015: Revenue: $100 ($220 contract price – 40 – 80) Cost: 50 Gross profit: $ 50

Requirement 5 2014: $120 = 60% x $20* = $12 – 15 = $(3) loss $200 *$220 – (40 + 80 + 80) = $20


Exercise 5–13 Requirement 1 2013 2014 2015 Contract price $8,000,000 $8,000,000 $8,000,000 Actual costs to date 2,000,000 4,500,000 8,300,000 Estimated costs to complete 4,000,000 3,600,000 - 0 - Total estimated costs 6,000,000 8,100,000 8,300,000 Estimated gross profit (loss) (actual in 2015) $2,000,000 $ (100,000) $ (300,000) Gross profit (loss) recognition: 2013: $2,000,000 = 33.3333% x $2,000,000 = $666,667 $6,000,000 2014: $(100,000) – 666,667 = $(766,667) 2015: $(300,000) – (100,000) = $(200,000)


Exercise 5–13 (continued)

Requirement 2

2013 2014 Construction in progress 2,000,000 2,500,000 Various accounts 2,000,000 2,500,000To record construction costs Accounts receivable 2,500,000 2,750,000 Billings on construction contract 2,500,000 2,750,000To record progress billings Cash 2,250,000 2,475,000 Accounts receivable 2,250,000 2,475,000To record cash collections Construction in progress (gross profit)

666,667

Cost of construction 2,000,000 Revenue from long-term contracts (33.3333% x $8,000,000) 2,666,667To record gross profit Cost of construction (2) 2,544,000 Revenue from long-term contracts (1) 1,777,333 Construction in progress (loss) 766,667To record expected loss

(1) and (2): Percent complete = $4,500,000 ÷ $8,100,000 = 55.55% Revenue recognized to date: 55.55% x $8,000,000 = $4,444,000 Less: Revenue recognized in 2013 (above) (2,666,667) Revenue recognized in 2014 1,777,333 (1) Plus: Loss recognized in 2014 (prior page) 766,667 Cost of construction, 2014 $2,544,000 (2)



Requirement 3

Balance Sheet 2013 2014 Current assets: Accounts receivable $250,000 $525,000Costs and profit ($2,666,667*) in excess of billings ($2,500,000)

166,667

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

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

$850,000

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



Year Gross profit (loss) recognized 2013 - 0 - 2014 $(100,000) 2015 (200,000)

Total project loss $(300,000)

Requirement 2

2013 2014 Construction in progress 2,000,000 2,500,000 Various accounts 2,000,000 2,500,000To record construction costs Accounts receivable 2,500,000 2,750,000 Billings on construction contract 2,500,000 2,750,000To record progress billings Cash 2,250,000 2,475,000 Accounts receivable 2,250,000 2,475,000To record cash collections Loss on long-term contract 100,000 Construction in progress 100,000To record expected loss



Requirement 3

Balance Sheet 2013 2014Current assets: Accounts receivable $250,000 $525,000 Current liabilities: Billings ($2,500,000) in excess of costs ($2,000,000)

$500,000

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

$850,000

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


Exercise 5–15 SUMMARY Percentage-of-Completion Completed Contract Situation 2013 2014 2015 2013 2014 2015 1 $166,667 $233,333 $100,000 $0 $0 $500,000 2 $166,667 $(66,667) $100,000 $0 $0 $200,000 3 $166,667 $(266,667) $(100,000) $0 $(100,000) $(100,000) 4 $125,000 $375,000 $0 $0 $0 $500,000 5 $125,000 $(125,000) $200,000 $0 $0 $200,000 6 $(100,000) $(100,000) $(100,000) $(100,000) $(100,000) $(100,000)


Exercise 5–15 (continued) Situation 1 - Percentage-of-Completion 2013 2014 2015 Contract price $5,000,000 $5,000,000 $5,000,000 Actual costs to date 1,500,000 3,600,000 4,500,000 Estimated costs to complete 3,000,000 900,000 - 0 - Total estimated costs 4,500,000 4,500,000 4,500,000 Estimated gross profit (actual in 2015) $ 500,000 $ 500,000 $ 500,000 Gross profit (loss) recognized: 2013: $1,500,000 = 33.3333% x $500,000 = $166,667 $4,500,000 2014: $3,600,000 = 80.0% x $500,000 = $400,000 – 166,667 = $233,333 $4,500,000 2015: $500,000 – 400,000 = $100,000 Situation 1 - Completed Contract

Year Gross profit recognized2013 - 0 - 2014 - 0 - 2015 $500,000

Total gross profit $500,000


Exercise 5–15 (continued) Situation 2 - Percentage-of-Completion 2013 2014 2015 Contract price $5,000,000 $5,000,000 $5,000,000 Actual costs to date 1,500,000 2,400,000 4,800,000 Estimated costs to complete 3,000,000 2,400,000 - 0 - Total estimated costs 4,500,000 4,800,000 4,800,000 Estimated gross profit (actual in 2015) $ 500,000 $ 200,000 $ 200,000 Gross profit (loss) recognized: 2013: $1,500,000 = 33.3333% x $500,000 = $166,667 $4,500,000 2014: $2,400,000 = 50.0% x $200,000 = $100,000 – 166,667 = $(66,667) $4,800,000 2015: $200,000 – 100,000 = $100,000 Situation 2 - Completed Contract

Year Gross profit recognized 2013 - 0 - 2014 - 0 - 2015 $200,000



Exercise 5–15 (continued) Situation 3 - Percentage-of-Completion 2013 2014 2015 Contract price $5,000,000 $5,000,000 $5,000,000 Actual 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 5,200,000 Estimated gross profit (loss) (actual in 2015) $ 500,000 $ (100,000) $ (200,000) Gross profit (loss) recognized: 2013: $1,500,000 = 33.3333% x $500,000 = $166,667 $4,500,000 2014: $(100,000) – 166,667 = $(266,667) 2015: $(200,000) – (100,000) = $(100,000) Situation 3 - Completed Contract

Year Gross profit (loss) recognized2013 - 0 - 2014 $(100,000) 2015 (100,000)



Exercise 5–15 (continued) Situation 4 - Percentage-of-Completion 2013 2014 2015 Contract price $5,000,000 $5,000,000 $5,000,000 Actual 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 4,500,000 Estimated gross profit (actual in 2015) $1,000,000 $ 625,000 $ 500,000 Gross profit (loss) recognized: 2013: $ 500,000 = 12.5% x $1,000,000 = $125,000 $4,000,000 2014: $3,500,000 = 80.0% x $625,000 = $500,000 – 125,000 = $375,000 $4,375,000 2015: $500,000 – 500,000 = $ - 0 - Situation 4 - Completed Contract




Exercise 5–15 (continued) Situation 5 - Percentage-of-Completion 2013 2014 2015 Contract price $5,000,000 $5,000,000 $5,000,000 Actual costs to date 500,000 3,500,000 4,800,000 Estimated costs to complete 3,500,000 1,500,000 - 0 - Total estimated costs 4,000,000 5,000,000 4,800,000 Estimated gross profit (actual in 2015) $1,000,000 $ - 0 - $ 200,000 Gross profit (loss) recognized: 2013: $ 500,000 = 12.5% x $1,000,000 = $125,000 $4,000,000 2014: $0 – 125,000 = $(125,000) 2015: $200,000 – 0 = $200,000 Situation 5 - Completed Contract

Year Gross profit recognized2013 - 0 - 2014 - 0 - 2015 $200,000



Exercise 5–15 (concluded) Situation 6 - Percentage-of-Completion 2013 2014 2015 Contract price $5,000,000 $5,000,000 $5,000,000 Actual costs to date 500,000 3,500,000 5,300,000 Estimated costs to complete 4,600,000 1,700,000 - 0 - Total estimated costs 5,100,000 5,200,000 5,300,000 Estimated gross profit (loss) (actual in 2015) $ (100,000) $ (200,000) $ (300,000) Gross profit (loss) recognized: 2013: $(100,000) 2014: $(200,000) – (100,000) = $(100,000) 2015: $(300,000) – (200,000) = $(100,000) Situation 6 - Completed Contract

Year Gross profit (loss) recognized 2013 $(100,000) 2014 (100,000) 2015 (100,000)



Exercise 5–16 Requirement 1 Construction in progress = Costs incurred + Profit recognized $100,000 = ? + $20,000 Actual costs incurred in 2013 = $80,000

Requirement 2 Billings = Cash collections + Accounts receivable $94,000 = ? + $30,000 Cash collections in 2013 = $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 5–17

Requirement 1

The specific citation that specifies the the circumstances and conditions under which it is appropriate to use the percentage-of-completion method is: FASB ASC 605–35–25–57: “Revenue Recognition–Construction–Type and Production–Type Contracts–Recognition–Circumstances Appropriate for Using the Percentage-of-Completion Method.”

Requirement 2

FASB ASC 605–35–25–57 reads as follows: “The percentage-of-completion method is considered preferable as an accounting policy in circumstances in which reasonably dependable estimates can be 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.”


Exercise 5–18 Requirement 1 Revenue should be recognized as follows: Software – date of shipment, July 1, 2013 Technical support – evenly over the 12 months of the agreement Upgrade – date of shipment, January 1, 2014 The amounts are determined by an allocation of total contract price in proportion to the individual fair values of the components if sold separately: Software $210,000 ÷ $270,000 x $243,000 = $189,000 Technical support $30,000 ÷ $270,000 x $243,000 = 27,000 Upgrade $30,000 ÷ $270,000 x $243,000 = 27,000 Total $243,000

Requirement 2

July 1, 2013 Cash ................................................................................ 243,000 Revenue ...................................................................... 189,000 Unearned revenue ($27,000 + 27,000) ........................... 54,000 To record sale of software



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

Requirement 2

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



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

Requirement 2

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 5–21

October 1, 2013 Cash (10% x $300,000) ....................................................... 30,000 Note receivable ................................................................ 270,000 Unearned franchise fee revenue .................................. 300,000 To record franchise agreement and down payment

January 15, 2014 Unearned franchise fee revenue ...................................... 300,000 Franchise fee revenue .................................................. 300,000 To recognize franchise fee revenue

Exercise 5–22 List A List B h 1. Inventory turnover a. Net income divided by net sales. d 2. Return on assets b. Defers recognition until cash collected equals cost. g 3. Return on shareholders' equity c. Defers recognition until project is complete. a 4. Profit margin on sales d. Net income divided by assets. b 5. Cost recovery method e. Risks and rewards of ownership retained by seller. i 6. Percentage-of-completion method f. Contra account to construction in progress. c 7. Completed contract method g. Net income divided by shareholders' equity. k 8. Asset turnover h. Cost of goods sold divided by inventory. l 9. Receivables turnover i. Recognition is in proportion to work completed. m 10. Right of return j. Recognition is in proportion to cash received. f 11. Billings on construction contract k. Net sales divided by assets. j 12. Installment sales method l. Net sales divided by accounts receivable. e 13. Consignment sales m. Could cause the deferral of revenue recognition beyond delivery point.



Requirement 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.

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

Inventory turnover ratio = Cost of goods sold Average inventory = $1,840,000 [$690,000 + 630,000] ÷ 2 = 2.79 times


Exercise 5–24 Turnover ratios for Anderson Medical Supply Company for 2013:

The company turns its inventory over 6 times per year compared to the industry

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

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 = 365 13.33 = 27.4 days

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



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 $100,000 Add: Net income 180,000 280,000 Less: Retained earnings end of period 150,000 Dividends paid $130,000


a. Profit margin on sales $180 ÷ $5,200 = 3.46% b. Asset turnover $5,200 ÷ [($1,900 + 1,700) ÷ 2] = 2.89 c. Equity multiplier [($1,900 + 1,700) ÷ 2] ÷ [($550 + 500) ÷ 2] = 3.43 d. Return on shareholders’ equity $180 ÷ [($550 + 500) ÷ 2] = 34.3%

Requirement 2 Profit margin x Asset turnover x Equity multiplier = ROE 3.46% x 2.89 x 3.43 = 34.3%

Exercise 5–27

Quarter First Second Third

Cumulative income before taxes $50,000 $90,000 $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


Exercise 5–28 Incentive compensation $300 million ÷ 4 = $75 million Depreciation expense $60 million ÷ 4 = $15 million Gain on sale $23 million

Exercise 5–29 Quarters Ending March 31 June 30 Sept. 30 Dec. 31

Advertising $200,000 $200,000 $200,000 $200,000 Property tax 87,500 87,500 87,500 87,500 Equipment repairs 65,000 65,000 65,000 65,000 Extraordinary casualty loss - 0 - 185,000 - 0 - - 0 - Research and development - 0 - 96,000 0 0 Note: this solution assumes that advertising, property tax, and equipment repairs are viewed as benefitting all periods following the one in which the expenditure is made, but that the extraordinary casualty loss and the R&D consulting fee only benefit the periods in which they occurred.

Exercise 5–30 Quarters Ending March 31 June 30 Sept. 30 Dec. 31

Advertising $800,000 - 0 - - 0 - - 0 - Property tax 350,000 - 0 - - 0 - - 0 - Equipment repairs 260,000 - 0 - - 0 - - 0 - Extraordinary casualty loss - 0 - 185,000 - 0 - - 0 - Research and development - 0 - 96,000 - 0 - - 0 -


SUPPLEMENT EXERCISES

Exercise 5–31

Requirement 1 The discount voucher provides a material right to the customer that the customer would not receive otherwise, because the customer can receive a 30 percent discount with the voucher but only a 10 percent discount without the voucher. That right to receive a discount could be sold separately. Therefore, the discount voucher given by Clarks is a separate performance obligation.

Requirement 2 Cash 70,000

Revenue (to balance) 66,000 Unearned revenue (discount option) 4,000 (1,000 pairs (30% – 10% discount) 20% estimated to redeem coupon $100 average purchase)

Note: the accompanying journal entry to record cost of goods sold would be: Cost of goods sold 40,000

Inventory 40,000 To record cost of 1,000 pairs of boots sold


Exercise 5–32

Requirement 1 Even though Manhattan Today received payments from customers for an annual subscription, the subscription activity does not transfer goods or services to customers. Therefore, the annual fee is viewed as a prepayment for future delivery of goods or services, and would be recognized as unearned revenue when received.

Requirement 2 The delivery of newspapers meets the criteria for a separate performance obligation, because it is regularly sold separately.

The coupon for a 40 percent discount on a carriage ride is a separate performance obligation. First, it is an option that conveys a material right to the recipient (as opposed to just a general marketing offer). Second, it meets the criteria for a separate performance obligation because the recipient could use it in combination with additional cash to enjoy a carriage ride.

Requirement 3 The value of the coupon would be $15.60 (40% discount $130 carriage fee 30% of customers redeeming coupon). Of the $150 subscription fee, $14.13 ($150 ($15.60 ($15.60 + 150)) would be attributed to the coupon. Requirement 4

Upon receiving the subscription fee, the journal entry should be:

Cash 150 Unearned Revenue, subscription 135.87 Unearned Revenue, coupon 14.13


Exercise 5–33 The license granted by Pfizer is not a separate performance obligation. The only way to exploit the license is via utilizing ongoing R&D services from Pfizer. The license does not provide utility on its own or together with other goods or services that HealthPro has received previously from Pfizer or that are available from other entities. Rather, the license requires Pfizer’s R&D services and proprietary expertise to be valuable. Therefore, Pfizer would combine the license with the R&D services to HealthPro and account for them as a single performance obligation.


$50,000 + ($20,000 x 20%) = $54,000

Requirement 2 The most likely amount is $50,000, because the probability of exceeding the performance threshold is less than 50%.

Requirement 3 Given that the outcome is binary (Thomas either will receive the bonus or not), the most likely amount often would be preferred. However, both amounts can be justified theoretically. (The probability-weighted amount is an expected value, and thus over all such contracts is the best estimate of the average amount that will be received.)

Requirement 4 Given that aspects of receipt of the bonus are beyond Thomas’s control (because Bran is responsible for implementation), Thomas would view the bonus as not reasonably assured. Therefore, Thomas would recognize only $50,000 upon delivery of the plan and wait until receipt of the bonus is reasonably assured (likely waiting until cost saving reaches the prespecified target) before recognizing the bonus.


Exercise 5–35 The transaction price should be limited to the fixed amount of consideration until the end of the year because the asset management company cannot predict the amount of value that the fund will provide by year-end. Even if Seneca could predict that amount with some accuracy, it would not be able to recognize revenue associated with the bonus because that amount would not be reasonably assured until after year-end. 1. Record the first quarterly payment.

Cash or accounts receivable 100,000

Revenue 100,000 2. Record the amount of additional revenue at the end of year.

Cash or accounts receivable ($800,000 x 10%) 80,000 Revenue 80,000


Exercise 5–36 Determining whether Toys4U satisfies the performance obligation requires consideration of indicators that McDonald’s has obtained control of the dolls. Consider the following indicators:

1. The buyer has an unconditional obligation to pay. A customer is unconditionally obliged to pay for a good or service typically because the customer has obtained control of the good or service in exchange and the passage of time does not remove the obligation. In this case, McDonald’s does not pay Toys4U until the dolls are sold, so McDonald’s is conditionally (not unconditionally) obliged to pay for the toys.

2. The buyer has the legal title. Legal title often indicates which party has the ability to direct the use of, and receive the benefit from, a good or service. The facts do not state whether title transfers.

3. The customer has physical possession and control of goods. In this case,

McDonald’s has possession of the dolls.

4. The buyer has the risks and rewards of owndership. In this case, given that McDonald’s returns unsold dolls to Toys4U, McDonald’s does not appear to be holding the risks of ownership.

It appears that Toys4U has not transferred control upon delivery because (1) McDonald’s has a conditional rather than unconditional obligation to pay, and (2) Toys4U appears to retain the risk of ownership. This is essentially a consignment arrangement, and Toys4U should not recognize sales until McDonald’s sells dolls to customers.


Exercise 5–37 In this example, Kerry obtained the access code for Level I in the software on December 1, meaning that Kerry has obtained the control of the right to use the software for Level I on that date. Therefore, on that date Cutler should recognize $50 of revenue for Level I. When Tom passed the Level I test on December 31, 2012, and purchased access to Level II, Cutler licensed Level II to Kerry on the same day. However, Kerry received the access code for Level II on January 10, 2013, so control over Level II in the software was not transferred to Kerry until January 10. Therefore, Cutler should recognize $10 of revenue for Level II on January 10, 2013, rather than December 31, 2012, because it did not satisfy a separate performance obligation until the access code was provided to its customer.



Record unearned revenue upon receipt of initial payment:

Cash 20,000 Unearned revenue 20,000

Requirement 2

1. Record interest expense at end of the first year of the contract:

Interest expense ($20,000 x 4%) 800 Unearned revenue 800

2. Record interest expense at end of the second year of the contract:

Interest expense ({$20,000 + 800} x 4%) 832 Unearned revenue 832

3. Record interest expense at end of the third year of the contract:

Interest expense ({$20,000 + 800 + 832} x 4%) 865 Unearned revenue 865

Requirement 3

Record revenue upon Stewart’s satisfaction of his performance obligation:

Unearned revenue ($20,000 + 800 + 832 + 865) 22,497 Revenue 22,497


CPA / CMA REVIEW QUESTIONS CPA Exam Questions

1. b. The earnings process is completed upon delivery of the product. Therefore, in 2014, revenue for 50,000 gallons at $3 each is recognized on January 15. The payment terms do not affect revenue recognition.

2. d. The deferred gross profit in the balance sheet at December 31, 2014, should be the balances in the accounts receivable accounts on that date for 2013 and 2014 sales multiplied by the appropriate gross profit percentage:

Accounts receivable: sales in 2013 2014 Total sales $ 600,000 $ 900,000 Less: Collections to date (300,000) (300,000) Less: Write-offs to date (200,000) (50,000) Accounts receivable balance 100,000 550,000 x Gross profit rate x 30% x 40% Deferred gross profit 12/31/2014

$ 30,000 $ 220,000

The combined deferred gross profit in the balance sheet is $250,000 ($30,000 + 220,000).


CPA Review Questions (continued) 3. a.

Year of sale

2013 2014 a. Gross profit realized $240,000 $200,000 b. Percentage 30% 40% c. Collections on sales (a/b) $800,000 $500,000 Sales 1,000,000 2,000,000 Balance uncollected at December 31, 2014 $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.

5. c.

2013 actual costs $20,000Total estimated costs ÷ 60,000Ratio = 1/3Contract price x 100,000Revenue 33,3332013 actual costs –20,000Gross profit $13,333

6. d. Since the total cost of the contract, $3,100,000 ($930,000 + 2,170,000), is projected to exceed the contract price of $3,000,000, the excess cost of $100,000 must be recognized as a loss in 2013.

7. c. “Cash collection is at least reasonably possible” is not a requirement for revenue recognition under IFRS.


CPA Review Questions (concluded)

8. a. Under the cost recovery approach, an amount of revenue is recognized that is equal to cost incurred, so long as cost incurred is probable to be recovered. Since $1,000,000 of cost was incurred, $1,000,000 of revenue is recognized.

9. a. IFRS does not provide extensive guidance determining how contracts are to be separated into components for purposes of revenue recognition.

10. d. IFRS recognizes interim expenses more discretely than does U.S. GAAP, such that the expense is recognized in the period in which it occurs rather than being accrued as a prepaid expense asset when an amount is paid and then amortized to expense over the year. Therefore, under IFRS Barrett would recognize the entire $50,000 as expense in the first period, and not accrue any prepaid expense asset. Under U.S. GAAP Barrett would accrue an asset when it made the tax payment and then reduce the asset by $12,500 each interim period while recognizing $12,500 of expense each interim period.

CMA Exam Questions

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

2. d. 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 practice of recognizing revenue at the point of sale, primarily because it better matches revenues and expenses.

3. b. Given that one-third of all costs have already been incurred ($6,000,000), the company should recognize revenue equal to one-third of the contract price, or


$8,000,000. Revenues of $8,000,000 minus costs of $6,000,000 equals a gross profit of $2,000,000.


Problem 5–1

REAGAN CORPORATION

Income Statement

For the Year Ended December 31, 2013

Income before income taxes and extraordinary item .......................................

[1] $3,680,000

Income tax expense ....................................... 1,472,000 Income before extraordinary item ................. 2,208,000 Extraordinary item: Gain from settlement of lawsuit (net of $400,000 tax expense) ..................................

600,000 Net income .................................................... $2,808,000

Income before extraordinary item ................. 2.21 Extraordinary gain ......................................... 0.60 Net income .................................................... $ 2.81

[1] 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 (2013) (50,000) Overstated profit on installment sale (120,000) * Adjusted $3,680,000

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

PROBLEMS


Problem 5–2 Requirement 1 2013 cost recovery % :

$180,000 = 60% (gross profit % = 40%) $300,000

2014 cost recovery %:

$280,000 = 70% (gross profit % = 30%) $400,000

2013 gross profit:

Cash collection from 2013 sales = $120,000 x 40% = $48,000

2014 gross profit:

Cash collection from 2013 sales = $100,000 x 40% = $ 40,000 + Cash collection from 2014 sales = $150,000 x 30% = 45,000 Total 2014 gross profit $85,000

Requirement 2

2013 Installment receivables ................................................... 300,000 Inventory ..................................................................... 180,000 Deferred gross profit ................................................... 120,000 To record installment sales Cash ................................................... 120,000 Installment receivables ............................................... 120,000 To record cash collections from installment sales Deferred gross profit ....................................................... 48,000 Realized gross profit ................................................... 48,000 To recognize gross profit from installment sales


Problem 5–2 (continued)

2014 Installment receivables .................................................... 400,000 Inventory ..................................................................... 280,000 Deferred gross profit ................................................... 120,000 To record installment sales Cash ................................................................................. 250,000 Installment receivables ................................................ 250,000 To record cash collections from installment sales Deferred gross profit ....................................................... 85,000 Realized gross profit ................................................... 85,000 To recognize gross profit from installment sales

Requirement 3

Date Cash Collected Cost Recovery Gross Profit

2013

2013 sales $120,000 $120,000 - 0 -

2014 2013 sales $100,000 $ 60,000 $40,000 2014 sales 150,000 150,000 - 0 -

2014 totals $250,000 $210,000 $40,000


Problem 5–2 (concluded)

2013 Installment receivables ................................................... 300,000 Inventory ..................................................................... 180,000 Deferred gross profit ................................................... 120,000 To record installment sales Cash ................................................................................ 120,000 Installment receivables ............................................... 120,000 To record cash collection from installment sales 2014 Installment receivables ................................................... 400,000 Inventory ..................................................................... 280,000 Deferred gross profit ................................................... 120,000 To record installment sales Cash ................................................................................ 250,000 Installment receivables ............................................... 250,000 To record cash collection from installment sales Deferred gross profit ....................................................... 40,000 Realized gross profit ................................................... 40,000 To recognize gross profit from installment sales


Problem 5–3 Requirement 1 Total profit = $500,000 – 300,000 = $200,000 Installment sales method: Gross profit % = $200,000 ÷ $500,000 = 40%

8/31/13 8/31/14 8/31/15 8/31/16 8/31/17 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



Requirement 2

Point of

Delivery Installment

Sales

Cost RecoveryInstallment receivable 500,000 Sales revenue 500,000 Cost of goods sold 300,000 Inventory 300,000 To record sale on 8/31/13 Installment receivable 500,000 500,000 Inventory 300,000 300,000 Deferred gross profit To record sale on 8/31/13

200,000 200,000

Cash 100,000 100,000 100,000 Installment receivable 100,000 100,000 100,000To record cash collections (Entry made each Aug. 31)

Deferred gross profit 40,000 Realized gross profit To record gross profit (Entry made each Aug. 31)

40,000

Deferred gross profit 100,000 Realized gross profit To record gross profit (Entry made 8/31/16 & 8/31/17)

100,000



Requirement 3

Point of

Delivery Installment

Sales Cost

Recovery December 31, 2013 Assets Installment receivables Less: Deferred gross profit Installment receivables, net

400,000

400,000 (160,000) 240,000

400,000 (200,000) 200,000

December 31, 2014 Assets

Installment receivables Less: Deferred gross profit Installment receivables, net

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

300,000 (200,000) 100,000


Problem 5–4 Requirement 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 2011, so down payment made in 2011, another payment in 2012, and two payments remain. $400,000 gross receivable at 1/1/2013 implies payments of ($400,000 2) = $200,000 in 2013 and 2014. Four payments of $200,000 implies total revenue of 4 x $200,000 = $800,000 on the job. Twenty-five percent gross profit ratio implies cost of 75% x $800,000 = $600,000. Cost recovery method gross profit: Payments in 2011 and 2012 have already recovered $400,000 of cost, so cost remaining to be recovered as of 1/1/2013 is $600,000 total – $400,000 already recovered = $200,000. Therefore, the entire 2013 payment of $200,000 will be applied to cost recovery, and no gross profit is recognized in 2013. Installment sales method gross profit: $200,000 payment x 25% gross profit ratio = $50,000 of gross profit recognized in 2013.

PitStop: Job completed in 2010, so down payment made in 2010, another payment in 2011, another in 2012, and one payment remains. $150,000 gross receivable at 1/1/2013 implies a single payment of $150,000 in 2013. Four payments of $150,000 implies total revenue of 4 x $150,000 = $600,000 on the job. Thirty-five percent gross profit ratio implies cost of 65% x $600,000 = $390,000. Cost recovery method gross profit: Payments in 2010, 2011, and 2012 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 2013 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 2013.


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 2013, he would not be happy with a switch to the installment sales method, because that would produce gross profit of only $102,500, which is $47,500 less than he would show under the cost recovery method. It is true that the installment sales method recognizes gross profit faster than does the cost recovery method, but the installment sales method also recognizes gross profit more evenly than does the cost recovery method. The timing of these jobs is such that 2013 is a year in which almost all of the gross profit associated with the PitStop job gets recognized, so 2013 looks more profitable under the cost recovery method.


Problem 5–5 Requirement 1 2013 2014 2015 Contract price $10,000,000 $10,000,000 $10,000,000 Actual costs to date 2,400,000 6,000,000 8,200,000 Estimated costs to complete 5,600,000 2,000,000 - 0 - Total estimated costs 8,000,000 8,000,000 8,200,000 Estimated gross profit (loss) (actual in 2015) $ 2,000,000 $ 2,000,000 $ 1,800,000

Gross profit (loss) recognition:

2013: $2,400,000 = 30.0% x $2,000,000 = $600,000 $8,000,000

2014: $6,000,000 = 75.0% x $2,000,000 = $1,500,000 – 600,000 = $900,000 $8,000,000

2015: $1,800,000 – 1,500,000 = $300,000



Requirement 2

2013 2014 2015 Construction in progress 2,400,000 3,600,000 2,200,000 Various accounts 2,400,000 3,600,000 2,200,000To record construction costs Accounts receivable 2,000,000 4,000,000 4,000,000 Billings on construction

contract 2,000,000 4,000,000 4,000,000

To record progress billings Cash 1,800,000 3,600,000 4,600,000 Accounts receivable 1,800,000 3,600,000 4,600,000To record cash collections Construction in progress (gross profit)

600,000 900,000 300,000

Cost of construction (cost incurred)

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

Revenue from long-term contracts (1)

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

To record gross profit

(1) Revenue recognized: 2013: 30% x $10,000,000 = $3,000,000 2014: 75% x $10,000,000 = $7,500,000 Less: Revenue recognized in 2013 (3,000,000) Revenue recognized in 2014 $4,500,000 2015: 100% x $10,000,000 = $10,000,000 Less: Revenue recognized in 2013 & 2014 (7,500,000) Revenue recognized in 2015 $2,500,000



Requirement 3

Balance Sheet 2013 2014 Current assets: Accounts receivable $ 200,000 $600,000Construction in progress $3,000,000 $7,500,000

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

1,000,000

1,500,000

Requirement 4 2013 2014 2015 Costs incurred during the year $2,400,000 $3,800,000 $3,200,000 Estimated costs to complete as of year-end 5,600,000 3,100,000 - 2013 2014 2015 Contract price $10,000,000 $10,000,000 $10,000,000 Actual costs to date 2,400,000 6,200,000 9,400,000 Estimated costs to complete 5,600,000 3,100,000 - 0 - Total estimated costs 8,000,000 9,300,000 9,400,000 Estimated gross profit (actual in 2015) $ 2,000,000 $ 700,000 $ 600,000


Problem 5–5 (concluded) Gross profit (loss) recognition: 2013: $2,400,000 = 30.0% x $2,000,000 = $600,000 $8,000,000 2014: $6,200,000 = 66.6667% x $700,000 = $466,667 – 600,000 = $(133,333) $9,300,000 2015: $600,000 – 466,667 = $133,333

Requirement 5 2013 2014 2015 Costs incurred during the year $2,400,000 $3,800,000 $3,900,000 Estimated costs to complete as of year-end 5,600,000 4,100,000 - 2013 2014 2015 Contract price $10,000,000 $10,000,000 $10,000,000 Actual costs to date 2,400,000 6,200,000 10,100,000 Estimated costs to complete 5,600,000 4,100,000 - 0 - Total estimated costs 8,000,000 10,300,000 10,100,000 Estimated gross profit (loss) (actual in 2015) $ 2,000,000 $ (300,000) $ (100,000) Gross profit (loss) recognition: 2013: $2,400,000 = 30.0% x $2,000,000 = $600,000 $8,000,000 2014: $(300,000) – 600,000 = $(900,000) 2015: $(100,000) – (300,000) = $200,000


Problem 5–6 Requirement 1

Year Gross profit recognized2013 - 0 - 2014 - 0 - 2015 $1,800,000

Total gross profit $1,800,000

Requirement 2

2013 2014 2015Construction in progress 2,400,000 3,600,000 2,200,000 Various accounts 2,400,000 3,600,000 2,200,000To record construction costs Accounts receivable 2,000,000 4,000,000 4,000,000 Billings on construction

contract 2,000,000 4,000,000 4,000,000


1,800,000

Cost of construction (costs incurred)

8,200,000

Revenue from long-term contracts (contract price)

10,000,000




Requirement 3

Balance Sheet 2013 2014

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

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

Costs in excess of billings 400,000 - 0 -

Requirement 4 2013 2014 2015 Costs incurred during the year $2,400,000 $3,800,000 $3,200,000 Estimated costs to complete as of year-end 5,600,000 3,100,000 -




Year Gross profit (loss) recognized 2013 - 0 - 2014 $(300,000) 2015 200,000




Year Gross profit recognized2013 - 0 - 2014 - 0 - 2015 $1,800,000

Total gross profit $1,800,000

Requirement 2

2013 2014 2015Construction in progress 2,400,000 3,600,000 2,200,000 Various accounts 2,400,000 3,600,000 2,200,000To record construction costs Accounts receivable 2,000,000 4,000,000 4,000,000 Billings on construction

contract 2,000,000 4,000,000 4,000,000


1,800,000

Cost of construction (costs incurred)

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

Revenue from long-term contracts (contract price)

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




Requirement 3


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

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

Costs in excess of billings 400,000 - 0 -





Year Gross profit (loss) recognized 2013 - 0 - 2014 $(300,000) 2015 200,000



Problem 5–8 Requirement 1 2013 2014 2015 Contract price $4,000,000 $4,000,000 $4,000,000 Actual costs to date 350,000 2,500,000 4,250,000 Estimated costs to complete 3,150,000 1,700,000 - 0 - Total estimated costs 3,500,000 4,200,000 4,250,000 Estimated gross profit (loss) (actual in 2015) $ 500,000 $ (200,000) $ (250,000)

Year Gross profit (loss) recognized2013 - 0 - 2014 $(200,000) 2015 (50,000)


Requirement 2

Gross profit (loss) recognition: 2013: 10% x $500,000 = $50,000 2014: $(200,000) – 50,000 = $(250,000) 2015: $(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



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

Requirement 2 2013 2014 Contract price $20,000,000 $20,000,000 Actual costs to date 4,000,000 13,500,000 Estimated costs to complete 12,000,000 4,500,000 Total estimated costs 16,000,000 18,000,000 Estimated gross profit $ 4,000,000 $ 2,000,000 a. Gross profit recognition: Under the completed contract method Citation would not report gross profit until

the project is competed. Citation would have to report an overall gross loss on the contract in whatever period it first revises the estimates to determine that an overall loss will eventually occur. Citation never estimates the Altamont contract will earn a gross loss, so never has to recognize one.

b. Under the completed contract method Citation would not report any revenue in

the 2013 or 2014 income statements.



c.

Balance Sheet


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

2,000,000

* Under the completed contract method, this account would only include costs

of $4,000,000

Requirement 3 2013 2014 Contract price $20,000,000 $20,000,000 Actual costs to date 4,000,000 13,500,000 Estimated costs to complete 12,000,000 4,500,000 Total estimated costs 16,000,000 18,000,000 Estimated gross profit $ 4,000,000 $ 2,000,000

a. Gross profit recognition: 2013: $ 4,000,000 = 25% x $4,000,000 = $1,000,000 $16,000,000

2014: $13,500,000 = 75% x $2,000,000 = $1,500,000 $18,000,000 Less: 2013 gross profit 1,000,000 2014 gross profit $ 500,000 b. 2013: $20,000,000 x 25% = $5,000,000 2014: $20,000,000 x 75% = $15,000,000 Less: 2013 revenue (5,000,000) $10,000,000



c.

Balance Sheet


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

3,000,000

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

Requirement 4 2013 2014 Contract price $20,000,000 $20,000,000 Actual costs to date 4,000,000 13,500,000 Estimated costs to complete 12,000,000 9,000,000 Total estimated costs 16,000,000 22,500,000 Estimated gross profit $ 4,000,000 ($ 2,500,000) a. Gross profit recognition: 2014: Overall loss of ($2,500,000) – previously recognized gross profit of

$1,000,000 = $3,500,000. b. 2014: Easiest to solve using a journal entry: Cost of construction (to balance) $10,500,000 Revenue from long-term contracts* $7,000,000 Construction in progress (loss) $3,500,000 *Total revenue recognized to date = (percentage complete)(total revenue) = ($13,500,000 ÷ $22,500,000) x ($20,000,000) = (60%) x ($20,000,000) = $12,000,000 Revenue recognized this period = total – revenue recognized in prior periods = $12,000,000 – 5,000,000 = $7,000,000



c.

Balance Sheet At December 31, 2014

Current assets: Accounts receivable


$ 1,600,000

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

1,000,000

* 2013 costs ($4,000,000) + 2013 profit ($1,000,000) + 2014 costs

($9,500,000) – 2014 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) $1,800,000 Cost of goods sold (3 x $450,000) 1,350,000 Gross profit $ 450,000 Balance sheet: Current assets: Inventory (work in process) $2,700,000 Current liabilities: Customer deposits (or unearned revenue) $300,000* *$600,000 x 10% = $60,000 x 5 = $300,000


Problem 5–10 Requirement 1 a. January 30, 2013

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

b. September 1, 2013

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

c. September 30, 2013

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

d. January 30, 2014

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



Requirement 2 a. January 30, 2013

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, 2013

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

c. September 30, 2013

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

d. January 30, 2014

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



Requirement 3

Balance Sheet


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


$ -0-

Unearned franchise fee revenue $200,000

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

Problem 5–11 1. Inventory turnover ratio $6,300 ÷ [($800 + 600) ÷ 2] = 9.0 2. Average days in inventory 365 ÷ 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%



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 = 365 Receivables turnover

J&J = 365 = 57 days 6.37

Pfizer = 365 = 71 days 5.15

Inventory turnover = Cost of goods sold Inventories

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

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

Average days in inventory = 365 Inventory turnover

J&J = 365 = 108 days 3.39

Pfizer = 365 = 217 days 1.68



Requirement 2

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

Requirement 3

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

Rate of return on assets = Profit margin x Asset on sales turnover = Net income x Net sales Net sales Total assets J&J = $ 7,197 x $41,862 $41,862 $48,263 = 17.19% x .867 times = 14.9% Pfizer = $ 1,639 x $45,188 $45,188 $116,775 = 3.63% x .387 times = 1.4%

No, the combinations of profit margin and asset turnover are not similar. J&J’s profit margin is much higher than that of Pfizer, as is its asset turnover. These differences combine to produce a significantly higher return on assets for J&J.

Rate of return on assets = Net income Total assets

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

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



Requirement 4

J&J provided a much greater return to shareholders.

Requirement 5

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

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

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

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

Equity multiplier = Total Assets shareholders’ equity Shareholders’ equity

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

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


Problem 5–13 a. Times interest earned ratio = (Net income + Interest + Taxes) ÷ 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

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


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, 2013 Assets Current assets: Cash $ 10 Accounts receivable (net) 20 Inventories 30 Total current assets 60 Property, plant, and equipment (net) 140 Total assets $200 Liabilities and Shareholders’ Equity Current liabilities $ 30 Long-term liabilities 70 Shareholders’ equity 100 Total liabilities and shareholders' equity $200



The return on assets indicates a company's overall profitability, ignoring specific

sources of financing. In this regard, Metropolitan’s profitability exceeds that of Republic.

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

combination of the two.

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

Metropolitan = $ 593.8 x $5,698.0 $5,698.0 $4,021.5 = 10.4% x 1.42 times = 14.8% Republic = $ 424.6 x $7,768.2 $7,768.2 $4,008.0 = 5.5% x 1.94 times = 10.7%

Republic’s profit margin is much less than that of Metropolitan, but partially

makes up for it with a higher turnover.

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



Requirement 3

Republic provides a greater return to common shareholders.

Requirement 4

When the return on shareholders’ equity is greater than the return on assets,

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

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

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

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

Equity multiplier = Total assets Shareholders’ equity

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

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



Requirement 5

The current ratios of the two firms are comparable and within the range of the

rule-of-thumb standard of 1 to 1. The more robust acid-test ratio reveals that Metropolitan is more liquid than Republic.

Requirement 6

Current ratio = Current assets Current liabilities

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

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

Acid-test ratio = Quick assets Current liabilities

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

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

Receivables turnover ratio = Sales Accounts receivable

Metropolitan = $5,698.0 = 13.5 times $422.7

Republic = $7,768.2 = 23.9 times $325.0


Republic’s receivables turnover is more rapid than Metropolitan’s, perhaps

suggesting that its relative liquidity is not as bad as its acid-test ratio indicated.

Requirement 7

Both firms provide an adequate margin of safety.


Inventory turnover ratio = Cost of goods sold Inventory

Metropolitan = $2,909.0 = 6.2 times $466.4

Republic = $4,481.7 = 7.1 times $635.2

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

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

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


Problem 5–15 Branson Electronics Company Income Statement

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

1$50,000 ÷ 4 = $12,500 2$48,000 + [59,000 – 50,000] 3$75,500 x 36%


SUPPLEMENT PROBLEMS


a. The gym membership is one separate performance obligation. Since the discount voucher provides a material right to the customer that the customer would not receive otherwise (a 25 percent discount rather than a 10 percent discount), the discount voucher also is a separate performance obligation.

b. To allocate the contract price to the performance obligation, we should first consider that Fit & Slim would offer a 10 percent discount on the yoga course to all customers as part of a seasonal promotion. So, a 25 percent discount provides a customer with an incremental value of 15 percent (25% – 10%). Thus, the estimated standalone selling price of the course voucher provided by Fit & Slim is $36 ($600 initial price of the course 15% incremental discount 40% likelihood of exercising the option). Since the standalone selling price of the annual membership fee is $800, Fit & Slim would allocate $34.45 {$800 [36 ÷ ($36 + 800)]} of the $800 transaction price to the discount voucher on yoga course.

c. Since the discount voucher of the yoga course would be a separate performance obligation, Fit & Slim would recognize revenue for the sale of annual membership fee and discount voucher.

Cash 800

Unearned revenue, membership fees 765.55 Unearned revenue, yoga coupon 34.45



Requirement 2

a. The option to pay $15 for additional visits does not constitute a material right, because it is in the range ($12 to $18) of normal fees paid by nonmembers. Therefore, it is not a separate performance obligation in the contract.

b. Since the option to visit on additional days is not a separate performance obligation, F&S should not allocate any of the contract price to it. Therefore, the entire $500 payment is allocated to the 50 visits associated with the coupon book.

c. Cash 500 Unearned revenue, coupon book 500

F&S could recognize (1/40) $500 of revenue for each visit, since a coupon book yields approximately 40 visits. Alternatively, F&S could recognize revenue over the year following sale of the coupon book.


Problem 5–17

Scenario 1: The terms of the contract and all the related facts and circumstances indicate that Star controls the room as it is built. Star has an unconditional obligation to pay throughout the contract as evidenced by the required progress payments (with no refund of payment for any work performed to date) and by the requirement to pay for any partially completed work in the event of contract termination. Although Star does not obtain legal title of the equipment until completion of the job, Crown’s retention of title is a protective right, and not an indicator that it has retained control. Consequently, Crown’s performance obligation is to provide Star with construction services, and Crown would recognize revenue over time throughout the construction process.

Scenario 2: The terms of the contract and all the related facts and circumstances

indicate that Star does not obtain control of the gym until it is delivered. Star does not obtain title to the equipment until the job is completed, and if the contract is terminated prior to completion, Crown retains the equipment, suggesting that Crown retains control of the equipment throughout the job. Consequently, Crown’s performance obligation is to provide Star with a completed gym, and Crown would defer revenue recognition until the end of the construction process.

Scenario 3: The terms of the contract and all the related facts and circumstances indicate that Coco has the ability to direct the use of, and receive the benefit from, the consulting services as they are performed. The restaurant has an unconditional obligation to pay throughout the contract as evidenced by the nonrefundable progress payments, and the right to a report regardless of contract termination. Also, the report is not of alternate use to CostDriver. Therefore, the CostDriver Company’s performance obligation is to provide the restaurant with services continuously during the three months of the contract, and CostDriver should recognize revenue over the life of the contract.

Scenario 4: The terms of the contract and all the related facts and circumstances

indicate that Edwards, the customer, obtains control of the apartment on completion of the contract. Edwards obtains title and physical possession of the apartment only on completion of the contract. Consequently, the Tower’s performance obligation is to provide the customer with a completed apartment, and the Tower should not recognize revenue until delivery of the apartment.


Problem 5–18 Note: The contract requires 6 payments of $20,000, plus or minus $10,000 at the end of the life of the contract. So the contract will provide either [(6 $20,000) – $10,000] = $110,000, or [(6 $20,000) + $10,000] = $130,000. a) Revis would estimate the transaction price as follows:

Possible Expected Prices Probability Consideration $130,000 ([$20,000 6] + $10,000) 80% $104,000 $110,000 ([$20,000 6] – $10,000) 20% 22,000 Expected contract price at inception $126,000

Each month Revis would recognize $21,000 ($126,000 ÷ 6) of revenue, using the following journal entry:

Cash 20,000 Expected bonus receivable 1,000 Revenue 21,000

After six months the Expected bonus receivable will have accumulated to $6,000 (6 $1,000).

b) If Revis receives the bonus, it will record the following entry:

Cash 10,000 Expected bonus receivable 6,000 Revenue 4,000 c) If Revis pays the penalty, it will record the following entry: Revenue 16,000 Expected bonus receivable 6,000 Cash 10,000



At the contract’s inception, Velocity would calculate the transaction price to be the probability-weighted average of the two possible eventual prices:

Possible Expected Prices Probabilities Consideration $500,000 ([$60,000 8] + $20,000) 80% $400,000 $460,000 ([$60,000 8] – $20,000) 20% 92,000 Transaction price at contract inception: $492,000

Velocity would allocate the transaction price, $492,000, to the performance obligation to provide consulting services. Because those services are provided evenly over the eight months, Velocity would recognize revenue of $61,500 ($492,000 ÷ 8 months = $61,500).

But Burger Boy is unconditionally obligated to pay only $60,000 per month ($1,500 less than the revenue recognized), so Velocity would recognize an Expected bonus receivable of $1,500 in the first month to reflect the most likely bonus to be received at the end of the contract. This is the revenue recognized in excess of its unconditional right to consideration. Therefore, the journal entry to record the revenue that Velocity would recognize each month for the first four months is as follows: Accounts receivable 60,000 Expected bonus receivable 1,500 Revenue 61,500



Requirement 2 The expected bonus receivable would increase to $6,000 (4 $1,500) by the end of the fourth month, equal to half of the total expected bonus of $12,000 ($492,000 – [8 $60,000]). After four months, the estimated likelihood of receiving the bonus is revised, so the estimated transaction price decreases to $484,000:

Possible Expected Prices Probabilities Consideration

$500,000 ([$60,000 8] + $20,000) 60% $300,000 $460,000 ([$60,000 8] – $20,000) 40% 184,000

Transaction price after four months: $484,000 Therefore, as of that date the expected bonus receivable should equal $2,000, which is half of the new expected bonus of $4,000 ($484,000 – [8 $60,000]). Recording that adjustment requires a reduction of the expected bonus receivable from $6,000 to $2,000:

Revenue 4,000 Expected bonus receivable 4,000

This entry reduces the expected bonus receivable to $2,000, with the offsetting debit a reduction in revenue. Over the remaining four months, expected bonus receivable will increase by $500 each month, accumulating to $4,000 by the end of the contract.

Requirement 3 Because services are provided evenly over the eight months, Velocity would recognize revenue of $60,500 ($484,000 ÷ 8 months = $60,500) in each of months five through eight. Because Burger Boy pays $60,000 per month ($500 less than the revenue recognized), Velocity would recognize an expected bonus receivable of $500 each month to reflect the revenue recognized in excess of its unconditional right to $60,000. The journal entry would be: Accounts receivable 60,000 Expected bonus receivable 500 Revenue 60,500



Requirement 4 At the end of contract, Velocity learns that it will receive the bonus of $20,000. It already has recognized revenue of $4,000 associated with the bonus. Therefore, Velocity recognizes additional accounts receivable and additional revenue of $16,000 ($20,000 – 4,000). Expected bonus receivable 16,000 Revenue 16,000 Accounts receivable 20,000 Expected bonus receivable 20,000

OR Accounts receivable 20,000 Expected bonus receivable 4,000 Revenue 16,000


Real World Case 5–1 Requirement 1

A bill and hold strategy accelerates the recognition of revenue. In this case, sales that would normally have occurred in 1998 were recorded in 1997. Assuming a positive gross profit on these sales, earnings in 1997 is inflated.

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

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

Requirement 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 to 1997.

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

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

CASES


Judgment Case 5–2 Requirement 1

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

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

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

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

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

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


Judgment Case 5–3 Mega should recognize revenue for the initial fee equally over the estimated

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

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

Judgment Case 5–4

The revenue recognition policy is questionable. The liberal trade-in policy causes gross profit to be overstated on the original sale and understated on the trade-in sale. This results from the granting of a trade-in allowance for the old computer that is greater than the old computer's resale value. Using the company's recognition policy, gross profit recognized on the two sales would be as follows: Original sale Trade-in sale Sales price $2,000,000 $2,380,000 Cost of goods sold 1,200,000 1,500,000 Gross profit $ 800,000 $ 880,000 Gross profit percentage 40% 37%

Of course, there is no guarantee that the customer will exercise the trade-in

option. If, however, a large percentage of customers do exercise the option, and the distortion in gross profit is material, the company should adopt a revenue recognition policy that results in a more stable gross profit percentage for the two transactions.


Communication Case 5–5 The critical question that student groups should address is how to match revenues

and expenses. There is no right or wrong answer. The process of developing the proposed solutions will likely be more beneficial than the solutions themselves. Students should benefit from participating in the process, interacting first with other group members, then with the class as a whole.

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

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

2. The accrual of estimated cost. This direction views the free ice cream cone as a promotional expense. The estimated cost of the free cone should be expensed as the 10 required cones are sold. A corresponding liability is recorded which should increase to an amount equal to the cost of the free cone. When the free cone is awarded, the liability and inventory are reduced.

In either case, the accounting method must consider the fact that not all

customers will take advantage of the free cone award. It is important that each student actively participate in the process. Domination by

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

Research Case 5–6 (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.


Research Case 5–7 (Note: This case requires the student to reference a journal article.) 1.

Abuse Expanation 1. Cutoff manipulation The company either closes their books early (so some

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

2. Deferring too much or too little revenue

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

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

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

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

profit recognition. 3. These abuses tended to increase income (75% of the time), consistent with

management generally having an incentive to increase income. 4. The auditors tended to require adjustment (56% of the time), consistent with

auditors being concerned about income-increasing earnings management.


Ethics Case 5–8 Discussion should include these elements.

Facts:

Horizon Corporation, a computer manufacturer, reported profits from 2008 through 2011, but reported a $20 million loss in 2012 due to increased competition. The chief financial officer (CFO) circulated a memo suggesting the shipment of computers to J.B. Sales, Inc., in 2013 with a subsequent return of the merchandise to Horizon in 2014. Horizon would record a sale for the computers in 2013 and avoid an inventory write-off that would place the company in a loss position for that year.

The CFO is clearly asking Jim Fielding to recognize revenue in 2013 that he knows will be reversed as a sales return in 2014. Ethical Dilemma:

Is Jim's obligation to challenge the memo of the CFO and provide useful information to users of the financial statements greater than the obligation to prevent a company loss in 2013 that may lead to bankruptcy? Who is affected? Jim Fielding CFO and other managers Other employees Shareholders Potential shareholders Creditors Auditors


Judgment Case 5–9 Requirement 1

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

2013 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 long

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

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


Judgment Case 5–10 Note: the SEC guidance on these issues can be found in the FASB’s codification at

FASB ASC 605–10–S99: “Revenue Recognition–Overall–SEC Materials.”

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

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

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

[ASC 605–10–S99, SAB Topic 13.A.4, Fixed or Determinable Sales Price, a. Refundable fees for services.]

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

not sales and do not qualify for revenue recognition until a sale occurs. The SEC believes that revenue recognition is not appropriate because the seller retains the risks and rewards of ownership of the product and title usually does not pass to the consignee. [ASC 605–10–S99, SAB Topic 13.A.2, Persuasive Evidence of an Arrangement.]


Case 5–10 (concluded)

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

that Company R should recognize revenue from sales made under its layaway program upon delivery of the merchandise to the customer. Until then, the amount of cash received should be recognized as a liability entitled such as "deposits received from customers for layaway sales" or a similarly descriptive caption. Because Company R retains the risks of ownership of the merchandise, receives only a deposit from the customer, and does not have an enforceable right to the remainder of the purchase price, the SEC would object to Company R recognizing any revenue upon receipt of the cash deposit. This is consistent with item two (2) in the SEC's criteria for bill-and-hold transactions that states that "the customer must have made a fixed commitment to purchase the goods." [ASC 605–10–S99, SAB Topic 13.A.3, Delivery and Performance, e. Layaway sales arrangements.]


Research Case 5–11 Requirement 1

The relevant literature can be found in the FASB’s codification at FASB ASC 605–15–25–1: “Revenue Recognition–Products–Recognition–General–Sales of Product when Right of Return Exists.”

Requirement 2 GAAP lists the following factors that may impair the ability to make a reasonable

estimate (see ASC 605–15–25–3). a. The susceptibility of the product to significant external factors, such as

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

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

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

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

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

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

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

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

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



Requirement 4 Both companies recognize revenues from products sold when persuasive

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

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

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


Research Case 5–12 Requirement 1

This topic is addressed in EITF Issue No. 99-19 The FASB ASC cross-reference addresses this topic in paragraphs under FASB ASC 605–45.

Requirement 2 The relevant literature can be found in the FASB’s codification at FASB ASC

605–45–45–1 through 605–45–45–18: “Revenue Recognition–Principal Agent Considerations–Other Presentation Matters–Overall Considerations of Reporting Revenue Gross as a Principal vs. Net as an Agent.”

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

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

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

shipping). 8. The company has credit risk.

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

Requirements 3 and 4 For their AdSense program, Google’s 2010 10K states: “We recognize as revenues the fees charged advertisers each time a user clicks on one of the text-based ads that are displayed next to the search results pages on our website or on the search results pages or content pages of our Google Network members’ websites and, for those advertisers who use our cost-per impression pricing, the fees charged advertisers each time an ad is displayed on our members’ websites. We report our Google AdSense revenues on a gross basis principally because we are the primary obligor to our advertisers.” That is consistent with the first indicator for use of the gross method listed under Requirement 2, so Google’s reasoning appears appropriate.


Judgment Case 5–13 1. Delta should recognize the $425 as revenue on May 15, the date the flight

commences. 2. Revenue should be recognized evenly over the period beginning after

Thanksgiving and ending April 30. 3. The $5,000 monthly charge is recognized as revenue each month. The

$12,000 fee must be recognized evenly over the 36-month lease period. 4. Janora Hawkins should recognize the $60,000 as revenue on August 28, the

date the case is settled successfully. This assumes reasonable certainty as to the collection.

Judgment Case 5–14 Bill’s argument is that the completed contract method is preferable because it is

analogous to point of delivery revenue recognition. That is, no revenue is recognized until the completed product is delivered. John’s argument is that the important factor is the earnings process and that revenue should be recognized as the process takes place.

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


Communication Case 5–15

Suggested Grading Concepts and Grading Scheme: Content (70%) _______ 45 Income differences. _______ Percentage-of-completion recognizes gross profit during construction based on an estimate of percent complete. _______ The completed contract method recognizes no gross profit until project completion. _______ For both methods, estimated losses are fully recognized in the first period the loss is anticipated. _______ 10 Balance sheet differences. The two methods are similar. However, for profitable projects, the construction in progress account during construction will have a higher balance when using the percentage-of-completion method due to the inclusion of gross profit. _______ 15 According to generally accepted accounting principles, the percentage-of-completion method should be used in most situations. The completed

contract method distorts income when long-term projects span more than one accounting period.

_____ _______ 70 points Writing (30%) _______ 6 Terminology and tone appropriate to the audience of a company controller. _______ 12 Organization permits ease of understanding. ______ Introduction that states purpose. ______ Paragraphs that separate main points. _______ 12 English ______ Sentences grammatically clear and well organized, concise. ______ Word selection. ______ Spelling. ______ Grammar and punctuation. _____ _______ 30 points


IFRS Case 5–16 Vodafone’s revenue recognition policies for products and services are similar to

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


IFRS Case 5–17 Requirement 1

Per the revenue recognition section of ThyssenKrupp’s 2010 annual report, note 1: Summary of Significant Accounting Policies:

The company’s normal method for accounting for long-term construction contracts is the percentage of completion method, used when it can make accurate estimates of contract income: “… Construction contract revenue and expense are accounted for using the percentage-of-completion method, which recognizes revenue as performance of the contract progresses. The contract progress is determined based on the percentage of costs incurred to date to total estimated cost for each contract after giving effect to the most recent estimates of total cost.”

When the company cannot make accurate estimates of contract income, it uses the cost recovery method: “…Where the income of a construction contract cannot be estimated reliably, contract revenue that is probable to be recovered is recognized to the extent of contract costs incurred. Contract costs are recognized as expenses in the period in which they are incurred.”

(from 2010 Annual report) Note 1: Summary of significant accounting policies

The consolidated financial statements have been prepared on a historical cost basis, except for certain financial instruments that are stated at fair value. The consolidated financial statements are presented in Euros since this is the currency in which the majority of the Group’s transactions are denominated, with all amounts rounded to the nearest million except when otherwise indicated; this may result in differences compared to the unrounded figures.

Requirement 2 The primary difference is that, under U.S. GAAP, the company would use the

completed contract method in circumstances in which it cannot make accurate estimates of contract income.

Trueblood Accounting Case 5–18 A solution and extensive discussion materials can be obtained from the Deloitte

Foundation.


Trueblood Accounting Case 5–19 A solution and extensive discussion materials can be obtained from the Deloitte

Foundation.

Real World Case 5–20 Requirement 3

The following is from the 2010 10K of Jack in the Box, Inc. The responses to the question will vary if the company has since changed its revenue recognition policy.

a. These fees are recognized as revenue when the company has substantially performed all of its contractual obligations. This policy agrees with GAAP.

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

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

financial statements of different companies. Likely candidates for comparison include most of the fast-food chains such as McDonald’s, and Wendy’s, and Arby’s


Real World Case 5–21 Requirement 2 Excerpt from Orbitz’s 2010 Annual Report: Revenue Recognition We recognize revenue when it is earned and realizable, when persuasive evidence of an arrangement exists, services have been rendered, the price is fixed or determinable, and collectability is reasonably assured. We have two primary types of contractual arrangements with our vendors, which we refer to herein as the "merchant" and "retail" models. Under both the merchant and retail models, we record revenue earned net of all amounts paid to our suppliers. Under the merchant model, we generate revenue for our services based on the difference between the total amount the customer pays for the travel product and the negotiated net rate plus estimated taxes that the supplier charges us for that product. Customers generally pay us for reservations at the time of booking. Initially, we record these customer receipts as accrued merchant payables and either deferred income or net revenue, depending on the travel product. In the merchant model, we do not take on credit risk with the customer, however we are subject to chargebacks and fraud risk which we monitor closely; we have the ability to determine the price; we are not responsible for the actual delivery of the flight, hotel room or car rental; we take no inventory risk; we have no ability to determine or change the products or services delivered; and the customer chooses the supplier. We recognize net revenue under the merchant model when we have no further obligations to the customer. . . . Under the retail model, we pass reservations booked by our customers to the travel supplier for a commission. In the retail model, we do not take on credit risk with the customer; we are not the primary obligor with the customer; we have no latitude in determining pricing; we take no inventory risk; we have no ability to determine or change the products or services delivered; and the customer chooses the supplier. We recognize net revenue under the retail model when the reservation is made, secured by a customer with a credit card and we have no further obligations to the customer.


Case 5–21 (continued) Excerpt from priceline.com’s 2010 Annual Report:

Merchant Revenues and Cost of Merchant Revenues

Name Your Own Price® Services: Merchant revenues for Name Your Own Price® services and related cost of revenues are derived from transactions where the Company is the merchant of record and, among other things, selects suppliers and determines the price it will accept from the customer. The Company recognizes such revenues and costs if and when it fulfills the customer’s non-refundable offer. Merchant revenues and cost of merchant revenues include the selling price and cost, respectively, of the travel services and are reported on a gross basis. . . .

Merchant Price-Disclosed Hotel Service: Merchant revenues for the Company’s merchant price-disclosed services are derived from transactions where its customers purchase hotel room reservations or rental car reservations from suppliers at disclosed rates which are subject to contractual arrangements. The Company records the difference between the customer selling price and the supplier cost of its merchant price-disclosed reservation services on a net basis in merchant revenue.

Agency Revenues Agency revenues are derived from travel related transactions where the

Company is not the merchant of record and where the prices of the services sold are determined by third parties. Agency revenues include travel commissions, customer processing fees and global distribution system (“GDS”) reservation booking fees and are reported at the net amounts received, without any associated cost of revenue. Such revenues are generally recognized by the Company when the customers complete their travel.



Requirement 3 a) Orbitz’s “merchant model” revenues

This is reported net: “We record revenue earned net of all amounts paid to our suppliers under both our merchant and retail models.”

b) Orbitz’s “retail model” revenues

This is reported net: “We record revenue earned net of all amounts paid to our suppliers under both our merchant and retail models.”

c) priceline.com’s “merchant revenues for ‘Name Your Own Price®’ services”

This is reported gross: “Merchant revenues and cost of merchant revenues include the selling price and cost, respectively, of the travel services and are reported on a gross basis.”

d) priceline.com’s “merchant revenues for ‘Price-Disclosed Hotel’ services”

This is reported net: “The Company records the difference between the selling price and the cost of the hotel room reservation as merchant revenue.”

e) priceline.com’s agency revenues:

This is reported net: “Agency revenues . . . are reported at the net amounts received, without any associated cost of revenue.”

Requirement 4

Yes, it appears that relatively similar services can be accounted for as gross v. net depending on how they are structured. Priceline’s “Name your own Price®” service appears similar to services that Orbitz might offer under its merchant model, yet Priceline would recognize revenue gross and Orbitz would recognize revenue net. If similar things are treated differently, comparability is reduced.


Analysis Case 5–22 This case encourages students to obtain hands-on familiarity with an actual

annual report and library sources of industry data. They also must apply the techniques learned in the chapter. You may wish to provide students with multiple copies of the same annual reports and compare responses. Another approach is to divide the class into teams who evaluate reports from a group perspective.

Judgment Case 5–23 Apparently, a significant increase in assets occurred during the last quarter. Total

assets were $324 million and now they total $450 million, as can be calculated as follows: Return on shareholders’ equity = Net income ÷ Shareholders’ equity = 14%

Shareholders’ equity = $21 million ÷ 14% = $150 million Debt to equity ratio = Total liabilities ÷ Shareholders’ equity = 2

Total liabilities = $150 million x 2 = $300 million Total assets = Total liabilities + Shareholders’ equity = $300 million + 150 million = $450 million


Integrating Case 5–24 Balance Sheet Assets

Cash $ 15,000 given Accounts receivable (net) 12,000 (e) Inventory 30,000 (d) Prepaid expenses and other current assets 3,000 (i) Current assets 60,000 (h) Property, plant, and equipment (net) 140,000 (j) $200,000 (b) Liabilities and Shareholders’ Equity

Accounts payable $ 25,000 (g) Short-term notes 5,000 given Current liabilities 30,000 (f) Bonds payable 20,000 (l) Shareholders’ equity 150,000 (k) $200,000 (b) Income Statement Sales $300,000 (a) Cost of goods sold (180,000) (c) Gross profit 120,000 (c) Operating expenses (96,000) (o) Interest expense (2,000) (m) Tax expense (7,000) (n) Net income $ 15,000 given


Case 5–24 (concluded) Calculations ($ in 000s): a. Profit margin on sales = Net income ÷ Sales = 5%

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

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

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

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

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

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

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

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

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

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

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

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

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

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


Air France–KLM Case

Requirement 1

a. AF’s balance sheet indicates current deferred revenue on ticket sales of €2,440 million as of March 31, 2011. While it is possible that AF has some noncurrent deferred revenue on ticket sales, none is indicated in note 31 (other noncurrent liabilities).

b. The journal entry would be:

Deferred revenue on ticket sales 2,440 Sales revenue 2,440

c. This seems consistent with U.S. GAAP. A liability for deferred revenue is recognized when tickets are purchased, and then the deferred revenue is reduced and revenue is recognized when the transportation service is provided.

Requirement 2

a. From note 3.7: “In accordance with the IFRIC 13, these ‘miles’ are considered distinct elements from a sale with multiple elements and one part of the price of the initial sale of the airfare is allocated to these ‘miles’ and deferred until the groups commitments relating to these ‘miles’ has been met. The deferred amount due in relation to the acquisition of miles by members is estimated:

- According to the fair value of ‘miles,’ defined as the amount at which the benefits can be sold separately. - After taking into account the redemption rate, corresponding to the probability that the miles will be used by members, using statistical method.”


Air France-KLM Case (concluded) b. Per the balance sheet, AF has a liability for “Frequent flyer programs” of €806

million. c. AF’s approach is consistent with U.S. GAAP’s accounting for multiple-

element contracts (ASC 605–25–15), in that the revenue associated with AF miles is deferred and recognized separately from the revenue associated with the flights that customers use to earn the miles.

Note: Accounting for customer loyalty programs is unresolved in U.S. GAAP. Currently, this issue is not included in the scope of guidance about multiple-deliverable contracts (see ASC 605–25–15–2A) or customer payments and incentives (see 605–50–15–3). Airlines typically use the “incremental cost” method, which does not break out the travel credits as a separate component of revenue and instead only accrues a liability for the estimated incremental cost of providing future travel services. Yet, if companies sell “points” in their customer loyalty programs to third parties, the portion of the sale that is for travel is estimated and recognized as passenger revenue when the transportation is provided, similar to how it would be treated under normal accounting for multiple deliverables.

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