Chapter 5 Income Measurement and Profitability Analysis 1 Question 5-1 The realization principle requires that two criteria be satisfied before revenue can be recognized: 1. The earnings process is judged to be complete or virtually complete. 2. There is reasonable certainty as to the collectibility of the asset to be received (usually cash). Question 5-2 At the time production is completed, there usually exists significant uncertainty as to the collectibility of the asset to be received. We don’t know if the product will be sold, nor the selling price, nor the buyer if eventually the product is sold. Because of these uncertainties, revenue recognition usually is delayed until the point of product delivery. Question 5-3 If the installment sale creates a situation where there is significant uncertainty concerning cash collection and it is not possible to make an accurate assessment of future bad debts, revenue and cost recognition should be delayed beyond the point of delivery. Question 5-4 The installment sales method recognizes gross profit by applying the gross profit percentage on the sale to the amount of cash actually received each period. The cost recovery method defers all gross profit recognition until cash has been received equal to the cost of the item sold. Question 5-5 Deferred gross profit is a contra installment receivable account. The balance in this account is subtracted from gross installment receivables to arrive at installment receivables, net. The net amount of the receivables represents the portion of remaining payments that represent cost recovery. Question 5-6 Because the return of merchandise can retroactively negate the benefits of having made a sale, the seller must meet certain criteria before revenue is recognized in situations when the right of return exists. The most critical of these criteria is that the seller must be able to make reliable estimates of future returns. In certain situations, these criteria are not satisfied at the point of delivery of the product. Chapter 5 Income Measurement and Profitability Analysis QUESTIONS FOR REVIEW OF KEY TOPICS 2 Answers to Questions (continued) Question 5-7 Sometimes a company arranges for another company to sell its product under consignment. The “consignor” physically transfers the goods to the other company (the consignee), but the consignor retains legal title. If the consignee can’t find a buyer within an agreed-upon time, the consignee returns the goods to the consignor. However, if a buyer is found, the consignee remits the selling price (less commission and approved expenses) to the consignor. Because the consignor retains the risks and rewards of ownership of the product and title does not pass to the consignee, the consignor does not record revenue (and related costs) until the consignee sells the goods and title passes to the eventual customer. Question 5-8 For service revenue, if there is one final service that is critical to the earnings process, revenues and costs are deferred and recognized after this service has been performed. On the other hand, in many instances, service revenue activities occur over extended periods and recognizing revenue at any single date within that period would be inappropriate. Instead, it’s more meaningful to recognize revenue over time in proportion to the performance of the activity. Question 5-9 The completed contract method of recognizing revenues and costs on long-term construction contracts is equivalent to recognizing revenue at point of delivery, i.e., when the construction project is complete. The percentage-of-completion method assigns a fair share of the project’s expected revenues and costs to each period in which the earnings process takes place, i.e., the construction period. The “fair share” means the project's costs incurred each period as a percentage of the project's total estimated costs. The completed contract method should only be used when the lack of dependable estimates or inherent hazards cause forecasts of future costs to be doubtful. Question 5-10 The billings on construction contract account is a contra account to the asset, construction in progress. At the end of each reporting period, the balances in these two accounts are compared. If the net amount is a debit, it is reported on the balance sheet as an asset. Conversely, if the net amount is a credit, it is reported as a liability. Question 5-11 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 5-12 These SOP’s require that if an arrangement includes multiple elements, the revenue from the arrangement should be allocated to the various elements based on the relative fair values of the individual elements, “regardless of any separate prices stated within the contract for each element.” 3 Answers to Questions (continued) Question 5-13 Specific guidelines for revenue recognition of the initial franchise fee are provided by SFAS 45. A key to these guidelines is the concept of substantial performance. It requires that substantially all of the initial services of the franchisor required by the franchise agreement be performed before the initial franchise fee can be recognized as revenue. The term “substantial” requires professional judgment on the part of the accountant. In situations when the initial franchise fee is collectible in installments, even after substantial performance has occurred, the installment sales or cost recovery method should be used for profit recognition, if a reasonable estimate of uncollectibility cannot be made. Question 5-14 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. 4 Answers to Questions (concluded) Question 5-15 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 5-16 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. 5 Brief Exercise 5-1 2006 gross profit = $3,000,000 – 1,200,000 = $1,800,000 2007 gross profit = 0 Brief Exercise 5-2 2006 Cost recovery % : $1,200,000 = 40% (gross profit % = 60%) $3,000,000 2006 gross profit = 2006 cash collection of $150,000 x 60% = $90,000 2007 gross profit = 2007 cash collection of $150,000 x 60% = $90,000 Brief Exercise 5-3 No gross profit will be recognized in either 2006 or 2007. Gross profit will not be recognized until the entire $1,200,000 cost of the land is recovered. In this case, gross profit recognition will equal 100% of the cash collected beginning with the ninth installment payment ($1,200,000 ÷ $150,000 = 8 payments to recover the cost of the land). Brief Exercise 5-4 Initial deferred gross profit ($3,000,000 – 1,200,000) $1,800,000 Less gross profit recognized in 2006 ($150,000 x 60%) (90,000) Less gross profit recognized in 2007 ($150,000 x 60%) (90,000) Deferred gross profit at the end of 2007 $1,620,000 BRIEF EXERCISES 6 Brief Exercise 5-5 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 5-6 % 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 5-7 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 5-8 7 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 5-9 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 5-10 Specific conditions for revenue recognition of the initial franchise fee are provided by SFAS 45. A key to these conditions is the concept of substantial performance. It requires that substantially all of the initial services of the franchisor required by the franchise agreement be performed before the initial franchise fee can be recognized as revenue. The term “substantial” requires professional judgment on the part of the accountant. Often, substantial performance is considered to have occurred when the franchise opens for business. Continuing franchise fees are recognized over time as the services are performed. 8 Brief Exercise 5-11 *$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 9 Brief Exercise 5-12 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 10 Brief Exercise 5-13 Inventory turnover ratio = Cost of goods sold ÷ Average inventory 6.0 = x ÷ $75,000 Cost of goods sold = $75,000 x 6.0 = $450,000 Sales - Cost of goods sold = Gross profit $600,000 - $450,000 = $150,000 11 Exercise 5-1 Requirement 1 2006 Cost recovery %: $234,000 = 65% (gross profit % = 35%) $360,000 2007 Cost recovery %: $245,000 = 70% (gross profit % = 30%) $350,000 2006 gross profit: Cash collection from 2006 sales of $150,000 x 35% = $52,500 2007 gross profit: Cash collection from 2006 sales of $100,000 x 35% = $ 35,000 + Cash collection from 2007 sales of $120,000 x 30% = 36,000 Total 2007 gross profit $71,000 Requirement 2 2006 deferred gross profit balance: 2006 initial gross profit ($360,000 - 234,000) $126,000 Less: Gross profit recognized in 2006 (52,500) Balance in deferred gross profit account $73,500 2007 deferred gross profit balance: 2006 initial gross profit ($360,000 - 234,000) $ 126,000 Less: Gross profit recognized in 2006 (52,500) Gross profit recognized in 2007 (35,000) 2007 initial gross profit ($350,000 - 245,000) 105,000 Less: Gross profit recognized in 2007 (36,000) Balance in deferred gross profit account $107,500 EXERCISES 12 Exercise 5-2 2006 To record installment sales Installment receivables ................................................... 360,000 Inventory ..................................................................... 234,000 Deferred gross profit ................................................... 126,000 2006 To record cash collections from installment sales Cash ................................................................................ 150,000 Installment receivables ............................................... 150,000 2006 To recognize gross profit from installment sales Deferred gross profit ....................................................... 52,500 Realized gross profit ................................................... 52,500 2007 To record installment sales Installment receivables ................................................... 350,000 Inventory ..................................................................... 245,000 Deferred gross profit ................................................... 105,000 2007 To record cash collections from installment sales Cash ................................................................................ 220,000 Installment receivables ............................................... 220,000 2007 To recognize gross profit from installment sales Deferred gross profit ....................................................... 71,000 Realized gross profit ................................................... 71,000 13 Exercise 5-3 Requirement 1 Year Income recognized 2006 $180,000 ($300,000 - 120,000) 2007 - 0 - 2008 - 0 - 2009 - 0 - Total $180,000 Requirement 2 Year Cash Collected Cost Recovery(40%) Gross Profit(60%) 2006 $ 75,000 $ 30,000 $ 45,000 2007 75,000 30,000 45,000 2008 75,000 30,000 45,000 2009 75,000 30,000 45,000 Totals $300,000 $120,000 $180,000 Requirement 3 Year Cash Collected Cost Recovery Gross Profit 2006 $ 75,000 $ 75,000 - 0 - 2007 75,000 45,000 $ 30,000 2008 75,000 - 0 - 75,000 2009 75,000 - 0 - 75,000 Totals $300,000 $120,000 $180,000 14 Exercise 5-4 Requirement 1 July 1, 2006 To record installment sale Installment receivables ................................................... 300,000 Sales revenue .............................................................. 300,000 Cost of goods sold .......................................................... 120,000 Inventory ..................................................................... 120,000 To record cash collection from installment sale Cash ................................................................................ 75,000 Installment receivables ............................................... 75,000 July 1, 2007 To record cash collection from installment sale Cash ................................................................................ 75,000 Installment receivables ............................................... 75,000 15 Exercise 5-4 (continued) Requirement 2 July 1, 2006 To record installment sale Installment receivables ................................................... 300,000 Inventory ..................................................................... 120,000 Deferred gross profit ................................................... 180,000 To record cash collection from installment sale Cash ................................................................................ 75,000 Installment receivables ............................................... 75,000 To recognize gross profit from installment sale Deferred gross profit ....................................................... 45,000 Realized gross profit ................................................... 45,000 July 1, 2007 To record cash collection from installment sale Cash ................................................................................ 75,000 Installment receivables ............................................... 75,000 To recognize gross profit from installment sale Deferred gross profit ....................................................... 45,000 Realized gross profit ................................................... 45,000 16 Exercise 5-4 (concluded) Requirement 3 July 1, 2006 To record installment sale Installment receivables ................................................... 300,000 Inventory ..................................................................... 120,000 Deferred gross profit ................................................... 180,000 To record cash collection from installment sale Cash ................................................................................ 75,000 Installment receivables ............................................... 75,000 July 1, 2007 To record cash collection from installment sale Cash ................................................................................ 75,000 Installment receivables ............................................... 75,000 To recognize gross profit from installment sale Deferred gross profit ....................................................... 30,000 Realized gross profit ................................................... 30,000 Exercise 5-5 Requirement 1 Cost of goods sold ($1,000,000 - 600,000) $400,000 Add: Gross profit if use 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 17 Exercise 5-6 Requirement 1 April 1, 2006 To record installment sale Installment receivables ................................................... 2,400,000 Land ............................................................................ 480,000 Gain on sale of land .................................................... 1,920,000 April 1, 2006 To record cash collection from installment sale Cash ................................................................................ 120,000 Installment receivables ............................................... 120,000 April 1, 2007 To record cash collection from installment sale Cash ................................................................................ 120,000 Installment receivables ............................................... 120,000 18 Exercise 5-6 (concluded) Requirement 2 April 1, 2006 To record installment sale Installment receivables ................................................... 2,400,000 Land ............................................................................ 480,000 Deferred gain .............................................................. 1,920,000 When payments are received, gain on sale of land is recognized, calculated by applying the gross profit percentage ($1,920,000 ÷ $2,400,000 = 80%) to the cash collected (80% x $120,000). April 1, 2006 To record cash collection from installment sale Cash ................................................................................ 120,000 Installment receivables ............................................... 120,000 To recognize profit from installment sale Deferred gain .................................................................. 96,000 Gain on sale of land (80% x $120,000) .......................... 96,000 April 1, 2007 To record cash collection from installment sale Cash ................................................................................ 120,000 Installment receivables ............................................... 120,000 To recognize profit from installment sale Deferred gain .................................................................. 96,000 Gain on sale of land (80% x $120,000) .......................... 96,000 19 Exercise 5-7 Requirement 1 2006 2007 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 2006) $ 500,000 $ 125,000 Gross profit recognition: 2006: $ 300,000 = 20% x $500,000 = $100,000 $1,500,000 2007: $125,000 - $100,000 = $25,000 Requirement 2 2006 $ - 0 - 2007 $125,000 Requirement 3 Balance Sheet At December 31, 2006 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) 20 Exercise 5-7 (concluded) Requirement 4 Balance Sheet At December 31, 2006 Current assets: Accounts receivable $ 130,000 Current liabilities: Billings ($380,000) in excess of costs ($300,000) $ 80,000 21 Exercise 5-8 Requirement 1 ($ in millions) 2006 2007 2008 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 2008) $ 60 $ 40 $ 50 Gross profit (loss) recognition: 2006: $40 = 25% x $60 = $15 $160 2007: $120 = 66.67% x $40 = $26.67 - $15 = $11.67 $180 2008: $220 – 170 = $50 – ($15 + 11.67) = $23.33 Requirement 2 2006: $220 x 25% = $55 2007: $220 x 66.67% = $146.67 – 55 = $91.67 2008: $220 – 146.67 = $73.33 Requirement 3 Year Gross profit (loss) recognized 2006 - 0 - 2007 - 0 - 2008 50 Total project income $50 Requirement 4 2007: $120 = 60% x $20* = $12 - 15 = $(3) loss $200 *$220 – ($40 + 80 + 80) = $20 22 Exercise 5-9 Requirement 1 2006 2007 2008 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 2008) $2,000,000 $ (100,000) $ (300,000) Gross profit (loss) recognition: 2006: $2,000,000 = 33.3333% x $2,000,000 = $666,667 $6,000,000 2007: $(100,000) - 666,667 = $(766,667) 2008: $(300,000) - (100,000) = $(200,000) 23 Exercise 5-9 (continued) Requirement 2 2006 2007 Construction in progress 2,000,000 2,500,000 Various accounts 2,000,000 2,500,000 To record construction costs. Accounts receivable 2,500,000 2,750,000 Billings on construction contract 2,500,000 2,750,000 To record progress billings. Cash 2,250,000 2,475,000 Accounts receivable 2,250,000 2,475,000 To 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) 2,666,667 To record gross profit. Cost of construction (2) 2,544,000 Revenue from long-term contracts (1) 1,777,333 Construction in progress (loss) 766,667 To record expected loss. (1) and (2): Percent complete = $4,500,000 ÷ $8,100,000 = 55.55% Revenue recognized to date: 55.55% x $8,000,000 = $4,444,000 Less: Revenue recognized in 2006 (above) (2,666,667) Revenue recognized in 2007 1,777,333 (1) Plus: Loss recognized in 2007 (above) 766,667 Cost of construction, 2007 $2,544,000 (2) 24 Exercise 5-9 (concluded) Requirement 3 Balance Sheet 2006 2007 Current assets: Accounts receivable $250,000 $525,000 Costs 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) 25 Exercise 5-10 Requirement 1 Year Gross profit (loss) recognized 2006 - 0 - 2007 $(100,000) 2008 (200,000) Total project loss $(300,000) Requirement 2 2006 2007 Construction in progress 2,000,000 2,500,000 Various accounts 2,000,000 2,500,000 To record construction costs. Accounts receivable 2,500,000 2,750,000 Billings on construction contract 2,500,000 2,750,000 To record progress billings. Cash 2,250,000 2,475,000 Accounts receivable 2,250,000 2,475,000 To record cash collections. Loss on long-term contract 100,000 Construction in progress 100,000 To record an expected loss. 26 Exercise 5-10 (concluded) Requirement 3 Balance Sheet 2006 2007 Current 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 27 Exercise 5-11 Situation 1 - Percentage-of-Completion 2006 2007 2008 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 2008) $ 500,000 $ 500,000 $ 500,000 Gross profit (loss) recognized: 2006: $1,500,000 = 33.3333% x $500,000 = $166,667 $4,500,000 2007: $3,600,000 = 80.0% x $500,000 = $400,000 - 166,667 = $233,333 $4,500,000 2008: $500,000 - 400,000 = $100,000 Situation 1 - Completed Contract Year Gross profit recognized 2006 - 0 - 2007 - 0 - 2008 $500,000 Total gross profit $500,000 28 Exercise 5-11 (continued) Situation 2 - Percentage-of-Completion 2006 2007 2008 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 2008) $ 500,000 $ 200,000 $ 200,000 Gross profit (loss) recognized: 2006: $1,500,000 = 33.3333% x $500,000 = $166,667 $4,500,000 2007: $2,400,000 = 50.0% x $200,000 = $100,000 - 166,667 = $(66,667) $4,800,000 2008: $200,000 - 100,000 = $100,000 Situation 2 - Completed Contract Year Gross profit recognized 2006 - 0 - 2007 - 0 - 2008 $200,000 Total gross profit $200,000 29 Exercise 5-11 (continued) Situation 3 - Percentage-of-Completion 2006 2007 2008 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 2008) $ 500,000 $ (100,000) $ (200,000) Gross profit (loss) recognized: 2006: $1,500,000 = 33.3333% x $500,000 = $166,667 $4,500,000 2007: $(100,000) - 166,667 = $(266,667) 2008: $(200,000) - (100,000) = $(100,000) Situation 3 - Completed Contract Year Gross profit (loss) recognized 2006 - 0 - 2007 $(100,000) 2008 (100,000) Total project loss $(200,000) 30 Exercise 5-11 (continued) Situation 4 - Percentage-of-Completion 2006 2007 2008 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 2008) $1,000,000 $ 625,000 $ 500,000 Gross profit (loss) recognized: 2006: $ 500,000 = 12.5% x $1,000,000 = $125,000 $4,000,000 2007: $3,500,000 = 80.0% x $625,000 = $500,000 - 125,000 = $375,000 $4,375,000 2008: $500,000 - 500,000 = $ - 0 - Situation 4 - Completed Contract Year Gross profit recognized 2006 - 0 - 2007 - 0 - 2008 $500,000 Total gross profit $500,000 31 Exercise 5-11 (continued) Situation 5 - Percentage-of-Completion 2006 2007 2008 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 2008) $1,000,000 $ - 0 - $ 200,000 Gross profit (loss) recognized: 2006: $ 500,000 = 12.5% x $1,000,000 = $125,000 $4,000,000 2007: $ 0 - 125,000 = $(125,000) 2008: $200,000 - 0 = $200,000 Situation 5 - Completed Contract Year Gross profit recognized 2006 - 0 - 2007 - 0 - 2008 $200,000 Total gross profit $200,000 32 Exercise 5-11 (concluded) Situation 6 - Percentage-of-Completion 2006 2007 2008 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 2008) $ (100,000) $ (200,000) $ (300,000) Gross profit (loss) recognized: 2006: $(100,000) 2007: $(200,000) - (100,000) = $(100,000) 2008: $(300,000) - (200,000) = $(100,000) Situation 6 - Completed Contract Year Gross profit (loss) recognized 2006 $(100,000) 2007 (100,000) 2008 (100,000) Total project loss $(300,000) 33 Exercise 5-12 Requirement 1 Construction in progress = Costs incurred + Profit recognized $100,000 = ? + $20,000 Actual costs incurred in 2006 = $80,000 Requirement 2 Billings = Cash collections + Accounts Receivable $94,000 = ? + $30,000 Cash collections in 2006 = $64,000 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 34 Exercise 5-13 Requirement 1 Revenue should be recognized as follows: Software - date of shipment, July 1, 2006 Technical support - evenly over the 12 months of the agreement Upgrade - date of shipment, January 1, 2007 The amounts are determined by an allocation of total contract price 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, 2006 To record sale of software Cash ................................................................................ 243,000 Revenue ...................................................................... 189,000 Unearned revenue ($27,000 + 27,000) ........................... 54,000 35 Exercise 5-14 October 1, 2006 To record franchise agreement and down payment Cash (10% x $300,000) ...................................................... 30,000 Note receivable ............................................................... 270,000 Unearned franchise fee revenue ................................. 300,000 January 15, 2007 To recognize franchise fee revenue Unearned franchise fee revenue...................................... 300,000 Franchise fee revenue ................................................. 300,000 Exercise 5-15 1. c 2. d 3. a 4. b 36 Exercise 5-16 List A List B h 1. Inventory turnover a. Net income divided by net sales. d 2. Return on assets b. Defers recognition until cash collected equals cost. g 3. Return on shareholders' equity c. Defers recognition until project is complete. a 4. Profit margin on sales d. Net income divided by assets. b 5. Cost recovery method e. Risks and rewards of ownership retained by seller. i 6. Percentage-of-completion method f. Contra account to construction in progress. c 7. Completed contract method g. Net income divided by shareholders' equity. k 8. Asset turnover h. Cost of goods sold divided by inventory. l 9. Receivables turnover i. Recognition is in proportion to work completed. m 10. Right of return j. Recognition is in proportion to cash received. f 11. Billings on construction contract k. Net sales divided by assets. j 12. Installment sales method l. Net sales divided by accounts receivable. e 13. Consignment sales m. Could cause the deferral of revenue recognition beyond delivery point. 37 Exercise 5-17 Requirement 1 Requirement 2 By itself, very little. In general, the higher the inventory turnover, the lower the investment must be for a given level of sales. It indicates how well inventory levels are managed and the quality of inventory, including the existence of obsolete or overpriced inventory. However, to evaluate the adequacy of this ratio it should be compared with some norm such as the industry average. That indicates whether inventory management practices are in line with the competition. It’s just one piece in the puzzle, though. Other points of reference should be considered. For instance, a high turnover can be achieved by maintaining too low 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 38 Exercise 5-18 Turnover ratios for Anderson Medical Supply Company for 2006: 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 39 Exercise 5-19 Requirement 1 a. Profit margin on sales $180 ÷ $5,200 = 3.5% b. Return on assets $180 ÷ [($1,900 + 1,700) ÷ 2] = 10% c. Return on shareholders’ equity $180 ÷ [($550 + 500) ÷ 2] = 34.3% Requirement 2 Retained earnings beginning of period $100,000 Add: Net income 180,000 280,000 Less: Retained earnings end of period 150,000 Dividends paid $130,000 Exercise 5-20 1. c. Revenue is recognized when (1) realized or realizable and (2) earned. On May 28, $500,000 of the sales price was realized while the remaining $500,000 was realizable in the form of a receivable. The revenue was earned on May 28 since the title of the goods passed to the purchaser. The cost-recovery method is not used because the receivable was not deemed uncollectible until June 10. 2. d. Based on the revenue recognition principle, revenue is normally recorded at the time of the sale or, occasionally, at the time cash is collected. However, sometimes neither the sales basis nor the cash basis is appropriate, such as when a construction contract extends over several accounting periods. As a result, contractors ordinarily recognize revenue using the percentage-of- completion method so that some revenue is recognized each year over the life of the contract. Hence, this method is an exception to the general principle of revenue recognition, primarily because it better matches revenues and expenses. 3. b. Given that one-third of all costs have already been incurred ($6,000,000), the company should recognize revenue equal to one-third of the contract price, or $8,000,000. Revenues of $8,000,000 minus costs of $6,000,000 equals a gross profit of $2,000,000. 40 Exercise 5-21 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 5-22 Incentive compensation $300 million ÷ 4 = $ 75 million Depreciation expense $60 million ÷ 4 = 15 million Gain on sale 23 million Exercise 5-23 1st 2nd 3rd 4th 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 32,000 32,000 32,000 41 Problem 5-1 REAGAN CORPORATION Income Statement For the Year Ended December 31, 2006 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 (2006) (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 42 Problem 5-2 Requirement 1 2006 Cost recovery % : $180,000 = 60% (gross profit % = 40%) $300,000 2007 Cost recovery %: $280,000 = 70% (gross profit % = 30%) $400,000 2006 gross profit: Cash collection from 2006 sales = $120,000 x 40% = $48,000 2007 gross profit: Cash collection from 2006 sales = $100,000 x 40% = $ 40,000 + Cash collection from 2007 sales = $150,000 x 30% = 45,000 Total 2007 gross profit $85,000 Requirement 2 2006 To record installment sales Installment receivables ................................................... 300,000 Inventory ..................................................................... 180,000 Deferred gross profit ................................................... 120,000 2006 To record cash collections from installment sales Cash ................................................................................ 120,000 Installment receivables ............................................... 120,000 2006 To recognize gross profit from installment sales Deferred gross profit ....................................................... 48,000 Realized gross profit ................................................... 48,000 43 Problem 5-2 (continued) 2007 To record installment sales Installment receivables ................................................... 400,000 Inventory ..................................................................... 280,000 Deferred gross profit ................................................... 120,000 2007 To record cash collections from installment sales Cash ................................................................................ 250,000 Installment receivables ............................................... 250,000 2007 To recognize gross profit from installment sales Deferred gross profit ....................................................... 85,000 Realized gross profit ................................................... 85,000 Requirement 3 Date Cash Collected Cost Recovery Gross Profit 2006 2006 sales $120,000 $120,000 - 0 - 2007 2006 sales $100,000 $ 60,000 $40,000 2007 sales 150,000 150,000 - 0 - 2007 totals $250,000 $210,000 $40,000 44 Problem 5-2 (concluded) 2006 To record installment sales Installment receivables ................................................... 300,000 Inventory ..................................................................... 180,000 Deferred gross profit ................................................... 120,000 2006 To record cash collection from installment sales Cash ................................................................................ 120,000 Installment receivables ............................................... 120,000 2007 To record installment sales Installment receivables ................................................... 400,000 Inventory ..................................................................... 280,000 Deferred gross profit ................................................... 120,000 2007 To record cash collection from installment sales Cash ................................................................................ 250,000 Installment receivables ............................................... 250,000 2007 To recognize gross profit from installment sales Deferred gross profit ....................................................... 40,000 Realized gross profit ................................................... 40,000 45 Problem 5-3 Requirement 1 Total profit = $500,000 - 300,000 = $200,000 Installment sales method: Gross profit % = $200,000 ÷ $500,000 = 40% 8/31/06 8/31/07 8/31/08 8/31/09 8/31/10 Cash collections $100,000 $100,000 $100,000 $100,000 $100,000 a. Point of delivery method $200,000 - 0 - - 0 - - 0 - - 0 - b. Installment sales method (40% x cash collected) $ 40,000 $ 40,000 $ 40,000 $ 40,000 $40,000 c. Cost recovery method - 0 - - 0 - - 0 - $100,000 $100,000 46 Problem 5-3 (continued) Requirement 2 Point of Delivery Installment Sales Cost Recovery Installment receivable 500,000 Sales revenue 500,000 Cost of goods sold 300,000 Inventory 300,000 To record sale on 8/31/06. Installment receivable 500,000 500,000 Inventory 300,000 300,000 Deferred gross profit To record sale on 8/31/06. 200,000 200,000 Cash 100,000 100,000 100,000 Installment receivable 100,000 100,000 100,000 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 8/31/09 & 8/31/10) 100,000 47 Problem 5-3 (concluded) Requirement 3 Point of Delivery Installment Sales Cost Recovery December 31, 2006 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, 2007 Assets Installment receivables Less: Deferred gross profit Installment receivables, net 300,000 300,000 (120,000) 180,000 300,000 (200,000) 100,000 48 Problem 5-4 Requirement 1 2006 2007 2008 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 2008) $ 2,000,000 $ 2,000,000 $ 1,800,000 Gross profit (loss) recognition: 2006: $2,400,000 = 30.0% x $2,000,000 = $600,000 $8,000,000 2007: $6,000,000 = 75.0% x $2,000,000 = $1,500,000 - 600,000 = $900,000 $8,000,000 2008: $1,800,000 - 1,500,000 = $300,000 Requirement 2 2006 2007 2008 Construction in progress 2,400,000 3,600,000 2,200,000 Various accounts 2,400,000 3,600,000 2,200,000 To 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 4,600,000 To 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. 49 Problem 5-4 (continued) (1) Revenue recognized: 2006: 30% x $10,000,000 = $3,000,000 2007: 75% x $10,000,000 = $7,500,000 Less: Revenue recognized in 2006 (3,000,000) Revenue recognized in 2007 $4,500,000 2008: 100% x $10,000,000 = $10,000,000 Less: Revenue recognized in 2006 & 2007 (7,500,000) Revenue recognized in 2008 $2,500,000 Requirement 3 Balance Sheet 2006 2007 Current assets: Accounts receivable $ 200,000 $600,000 Construction 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 2006 2007 2008 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 - 2006 2007 2008 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 2008) $ 2,000,000 $ 700,000 $ 600,000 50 Problem 5-4 (concluded) Gross profit (loss) recognition: 2006: $2,400,000 = 30.0% x $2,000,000 = $600,000 $8,000,000 2007: $6,200,000 = 66.6667% x $700,000 = $466,667 - 600,000 = $(133,333) $9,300,000 2008: $600,000 - 466,667 = $133,333 Requirement 5 2006 2007 2008 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 - 2006 2007 2008 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 2008) $ 2,000,000 $ (300,000) $ (100,000) Gross profit (loss) recognition: 2006: $2,400,000 = 30.0% x $2,000,000 = $600,000 $8,000,000 2007: $(300,000) - 600,000 = $(900,000) 2008: $(100,000) - (300,000) = $200,000 51 Problem 5-5 Requirement 1 Year Gross profit recognized 2006 - 0 - 2007 - 0 - 2008 $1,800,000 Total gross profit $1,800,000 Requirement 2 2006 2007 2008 Construction in progress 2,400,000 3,600,000 2,200,000 Various accounts 2,400,000 3,600,000 2,200,000 To 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 4,600,000 To record cash collections. Construction in progress (gross profit) 1,800,000 Cost of construction (costs incurred) 8,200,000 Revenue from long-term contracts (contract price) 10,000,000 To record gross profit. Requirement 3 Balance Sheet 2006 2007 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 - 52 Problem 5-5 (concluded) Requirement 4 2006 2007 2008 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 recognized 2006 - 0 - 2007 - 0 - 2008 $600,000 Total gross profit $600,000 Requirement 5 2006 2007 2008 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 - Year Gross profit (loss) recognized 2006 - 0 - 2007 $(300,000) 2008 200,000 Total project loss $(100,000) 53 Problem 5-6 Requirement 1 2006 2007 2008 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 2008) $ 500,000 $ (200,000) $ (250,000) Year Gross profit (loss) recognized 2006 - 0 - 2007 $(200,000) 2008 (50,000) Total project loss $(250,000) Requirement 2 Gross profit (loss) recognition: 2006: 10% x $500,000 = $50,000 2007: $(200,000) - 50,000 = $(250,000) 2008: $(250,000) - (200,000) = $(50,000) Requirement 3 Balance Sheet 2006 2007 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 54 Problem 5-7 Requirement 1 a. January 30, 2006 Cash ............................................................................... 200,000 Note receivable .............................................................. 1,000,000 Unearned franchise fee revenue ................................. 1,200,000 b. September 1, 2006 Unearned franchise fee revenue...................................... 1,200,000 Franchise fee revenue ................................................ 1,200,000 c. September 30, 2006 Accounts receivable ($40,000 x 3%) ................................ 1,200 Service revenue .......................................................... 1,200 d. January 30, 2007 Cash ................................................................................ 100,000 Note receivable .......................................................... 100,000 55 Problem 5-7 (concluded) Requirement 2 a. January 30, 2006 Cash ............................................................................... 200,000 Note receivable .............................................................. 1,000,000 Deferred franchise fee revenue ................................... 1,200,000 b. September 1, 2006 Deferred franchise fee revenue ...................................... 200,000 Franchise fee revenue (cash collected) ........................... 200,000 c. September 30, 2006 Accounts receivable ($40,000 x 3%) ................................ 1,200 Service revenue .......................................................... 1,200 d. January 30, 2007 Cash ................................................................................ 100,000 Note receivable .......................................................... 100,000 Deferred franchise fee revenue ...................................... 100,000 Franchise fee revenue ................................................ 100,000 56 Problem 5-8 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% 57 Problem 5-9 Requirement 1 On average, J&J collects its receivables in 14 days less than Pfizer. On average, J&J sells its inventory twice as fast as Pfizer.. Receivables turnover = Net sales Accounts receivable J&J = $41,862 = 6.37 times $6,574 Pfizer = $45,188 = 5.15 times $8,775 Average collection period = 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 58 Problem 5-9 (continued) Requirement 2 The return on assets indicates a company's overall profitability, ignoring specific sources of financing. In this regard, J&J’s profitability is significantly higher than that of Pfizer. Requirement 3 Profitability can be achieved by a high profit margin, high turnover, or a combination of the two. Rate of return on assets = Profit margin x Asset on sales turnover = Net income x Net sales Net sales Total assets J&J = $ 7,197 x $41,862 $41,862 $48,263 = 17.19% x .867 times = 14.9% Pfizer = $ 1,639 x $45,188 $45,188 $116,775 = 3.63% x .387 times = 1.4% J&J’s profit margin is much higher than that of Pfizer, as is its asset turnover. These differences combine to produce a significantly higher return on assets for J&J. Rate of return on assets = Net income Total assets J&J = $7,197 = 14.9% $48,263 Pfizer = $1,639 = 1.4% $116,775 59 Problem 5-9 (concluded) Requirement 4 J&J provided a much greater return to shareholders. 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 60 Problem 5-10 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 61 Problem 5-10 (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, 2006 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 62 Problem 5-11 Requirement 1 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 63 Problem 5-11 (continued) 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 Debt to equity ratio = Total liabilities Shareholders’ equity Metropolitan = $2,304.4 = 1.34 $144.9 + 2,476.9 - 904.7 Republic = $3,035.2 = 3.12 $335.0 + 1,601.9 - 964.1 64 Problem 5-11 (continued) 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 65 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. Problem 5-12 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% Problem 5-11 (concluded) 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 66 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 67 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 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 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. 68 Judgment Case 5-3 The revenue recognition policy is questionable. The liberal trade-in policy causes gross profit to be overstated on the original sale and understated on the trade-in sale. This results from the granting of a trade-in allowance for the old computer that is greater than the old computer's resale value. Using the company's recognition policy, gross profit recognized on the two sales would be as follows: Original sale Trade-in 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. 69 Communication Case 5-4 The critical question that student groups should address is how to match revenues and expenses. There is no right or wrong answer. The process of developing the proposed solutions will likely be more beneficial than the solutions themselves. Students should benefit from participating in the process, interacting first with other group members, then with the class as a whole. Solutions could take one of two directions: 1. Deferral of revenue recognition. As each ice cream cone is sold, a portion of the sales price is deferred and a liability is recorded. This liability will then be reduced and revenue recognized when the free ice cream cone is awarded. 2. The accrual of estimated cost. This direction views the free ice cream cone as a promotional expense. The estimated cost of the free cone should be expensed as the ten required cones are sold. A corresponding liability is recorded which should increase to an amount equal to the cost of the free cone. When the free cone is awarded, the liability and inventory are reduced. In either case, the accounting method must consider the fact that not all customers will take advantage of the free cone award. 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. 70 Research Case 5-5 (Note: This case requires the student to reference a journal article.] 1. Fifty-five firms reported the use of one of the two long-term contract accounting methods. 2. Twenty-seven of the firms are manufacturing companies. 3. Only one company uses the completed contract method. That company reported using both methods. 4. The most frequently used approach to estimating a percentage-of-completion is the cost-to-cost method. 71 Ethics Case 5-6 Discussion should include these elements. Facts: Horizon Corporation, a computer manufacturer, reported profits from 2001 through 2004, but reported a $20 million loss in 2005 due to increased competition. The chief financial officer (CFO) circulated a memo suggesting the shipment of computers to J.B. Sales, Inc., in 2006 with a subsequent return of the merchandise to Horizon in 2007. Horizon would record a sale for the computers in 2006 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 2006 which he knows will be reversed as a sales return in 2007. Ethical Dilemma: Is Jim's obligation to challenge the memo of the CFO and provide useful information to users of the financial statements greater than the obligation to prevent a company loss in 2006 that may lead to bankruptcy? Who is affected? Jim Fielding CFO and other managers Other employees Shareholders Potential shareholders Creditors Auditors 72 Judgment Case 5-7 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. 2006 gross profit under the three methods: (1) point of delivery: $80,000 - 40,000 = $40,000 (2) installment sales method: $40,000 = 50% = gross profit % $80,000 50% x $30,000 (cash collected) = $15,000 (3) cost recovery method: No gross profit recognized since cost ($40,000) exceeds cash collected ($30,000). Requirement 2 Customers sometimes are allowed to pay for purchases in installments over 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. 73 Judgment Case 5-8 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. 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. 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." 74 Research Case 5-9 Requirement 2 The standard lists the following factors that may impair the ability to make a reasonable estimate: a. The susceptibility of the product to significant external factors, such as technological obsolescence or changes in demand. b. Relatively long periods in which a particular product may be returned. c. Absence of historical experience with similar types of sales of similar products, or inability to apply such experience because of changing circumstances, for example, changes in the selling enterprise’s marketing policies or relationships with its customers. d. Absence of a large volume of relatively homogeneous transactions. 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. 75 Case 5-9 (concluded) 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 they offer price protection as well as the right of return to customers. Estimates are recorded for customer returns, price protection, rebates and other offerings. Reasons for the difference in policies could relate to the types of products sold by the two companies, the distribution channels, and the actual agreements with customers. AMD sells semiconductors, a highly volatile industry. It may be more difficult for AMD to see through the distribution channels to reasonably estimate returns. Also, the agreements with distributors of AMD’s products may be more liberal than those of HP with respect to things like price protection and returns. For example, AMD might offer a longer time period for customers to return product than does HP. Also, AMD’s sales to distributors might be contingent on resale of the product to end users, one of the six criteria that must be met before revenue can be recognized when the right of return exists. Judgment Case 5-10 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. 76 Judgment Case 5-11 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. 77 Communication Case 5-12 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 78 International Case 5-13 Electrolux's revenue recognition policies for products and services are similar to revenue recognition policies in the U.S. Sales of products are recorded when goods have been put at the disposal of the customers in accordance with agreed terms of delivery and when the risks and rewards of ownership have been transferred to the buyer. The terminology is somewhat different, but the end results, as compared to U.S. policies, should be similar in most cases. Trueblood Accounting Case 5-14 A solution and extensive discussion materials can be obtained from the Deloitte Foundation. Real World Case 5-15 Requirement 3 The following is from the 2003 10K of Jack in the Box, Inc. The responses to the question will vary if the company has since changed its revenue recognition policy. a. These fees are recognized as revenue when the company has substantially performed all of its contractual obligations. This policy agrees with SFAS No. 45 guidelines. b. Continuing payments are based on a percentage of sales. Requirement 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 McDonalds and Wendys. 79 Analysis Case 5-16 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 5-17 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 80 Integrating Case 5-18 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 81 Case 5-18 (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 = $96 82 Analysis Case 5-19 Requirement 1 Revenue is recognized upon delivery of shipments or the completion of the service for their office and print services, logistics and trade services businesses. For shipments in transit, revenue is recorded based on the percentage of service completed at the balance sheet date. Requirement 2 ($ in millions) $ 6,067 = 25% $24,710 Requirement 3 ($ in millions) a. Receivables turnover ratio $24,710 ÷ [($3,027 + 2,627) ÷ 2] = 8.74 b. Profit margin on sales $838 ÷ $24,710 = 3.39% c. Return on assets $838 ÷ [($19,134 + 15,385) ÷ 2] = 4.86% d. Return on shareholders’ equity $838 ÷ [($8,036 + 7,288) ÷ 2] = 10.9% Solution Manual for Intermediate Accounting David J. Spiceland, James F. Sepe, Lawrence A. Tomassini 9780072994025, 9780072524482
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