Income Measurement and Profitability Analysis - Homework 5 Solutions | ACCT 4111, Study notes of Financial Accounting

Download Income Measurement and Profitability Analysis - Homework 5 Solutions | ACCT 4111 and more Study notes Financial Accounting in PDF only on Docsity! Chapter 05 - Income Measurement and Profitability Analysis 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. 5-1 Chapter 5 Income Measurement and Profitability Analysis QUESTIONS FOR REVIEW OF KEY TOPICS Chapter 05 - Income Measurement and Profitability Analysis Question 5-6 Because the return of merchandise can retroactively negate the benefits of having made a sale, the seller must meet certain criteria before revenue is recognized in situations when the right of return exists. The most critical of these criteria is that the seller must be able to make reliable estimates of future returns. In certain situations, these criteria are not satisfied at the point of delivery of the product. Question 5-7 Sometimes a company arranges for another company to sell its product under consignment. The “consignor” physically transfers the goods to the other company (the consignee), but the consignor retains legal title. If the consignee can’t find a buyer within an agreed-upon time, the consignee returns the goods to the consignor. However, if a buyer is found, the consignee remits the selling price (less commission and approved expenses) to the consignor. Because the consignor retains the risks and rewards of ownership of the product and title does not pass to the consignee, the consignor does not record revenue (and related costs) until the consignee sells the goods and title passes to the eventual customer. Question 5-8 For service revenue, if there is one final service that is critical to the earnings process, revenues and costs are deferred and recognized after this service has been performed. On the other hand, in many instances, service revenue activities occur over extended periods and recognizing revenue at any single date within that period would be inappropriate. Instead, it’s more meaningful to recognize revenue over time in proportion to the performance of the activity. Question 5-9 The completed contract method of recognizing revenues and costs on long-term construction contracts is equivalent to recognizing revenue at point of delivery, i.e., when the construction project is complete. The percentage-of-completion method assigns a fair share of the project’s expected revenues and costs to each period in which the earnings process takes place, i.e., the construction period. The “fair share” typically is estimated as the project's costs incurred each period as a percentage of the project's total estimated costs. The completed contract method should only be used when the lack of dependable estimates or inherent hazards cause forecasts of future costs to be doubtful. 5-2 Chapter 05 - Income Measurement and Profitability Analysis Question 5-18 Return on equity = Profit margin X Asset turnover X Equity multiplier Net income Ave. total equity = Net income Total sales X Total sales Ave. total assets X Ave. total assets Ave. 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 5-19 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. 5-5 Chapter 05 - Income Measurement and Profitability Analysis BRIEF EXERCISES 2011 gross profit = $3,000,000 – 1,200,000 = $1,800,000 2012 gross profit = 0 2011 Cost recovery % = Cost  Sales: $1,200,000 = 40% (implying a gross profit % = 60%) $3,000,000 2011 gross profit = 2011 cash collection of $150,000 x 60% = $90,000 2012 gross profit = 2012 cash collection of $150,000 x 60% = $90,000 No gross profit will be recognized in either 2011 or 2012. Gross profit will not be recognized until the entire $1,200,000 cost of the land is recovered. In this case, it will take 8 payments to recover the cost of the land ($1,200,000  $150,000 = 8), so gross profit recognition will equal 100% of the cash collected beginning with the ninth installment payment. Initial deferred gross profit ($3,000,000 – 1,200,000) $1,800,000 Less gross profit recognized in 2011 ($150,000 x 60%) (90,000) Less gross profit recognized in 2012 ($150,000 x 60%) (90,000) Deferred gross profit at the end of 2012 $1,620,000 The seller must meet certain criteria before revenue can 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. 5-6 Brief Exercise 5-1 Brief Exercise 5-2 Brief Exercise 5-3 Brief Exercise 5-4 Brief Exercise 5-5 Chapter 05 - Income Measurement and Profitability Analysis Total estimated cost to complete = $6 million + $9 million = $15 million % of completion = $6 million  $15 million = 40% Total estimated gross profit ($20 million – 15 million) = $5,000,000 multiplied by the % of completion 40 % Gross profit recognized the first year $2,000,000 First year revenue = $20,000,000 x 40% = $8,000,000 Assets: Accounts receivable ($7 million – 5 million) $2,000,000 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 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 Year 1: Revenue: $6 million Cost: $6 million Gross profit: $0 5-7 Brief Exercise 5-6 Brief Exercise 5-7 Brief Exercise 5-8 Brief Exercise 5-9 Chapter 05 - Income Measurement and Profitability Analysis = $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 5-10 Chapter 05 - Income Measurement and Profitability Analysis Brief Exercise 5-16 Return on equity = Profit margin X Asset turnover X Equity multiplier Net income Ave. total equity = Net income Total sales X Total sales Ave. total assets X Ave. total assets Ave. 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 Asset Turnover = Sales Average total assets = $420,000 $800,000 5-11 = 15.5% = 52.5% Chapter 05 - Income Measurement and Profitability Analysis Brief Exercise 5-16 (concluded) Equity Multiplier = Average total assets Average shareholders’ equity = $800,000 $522,500 = 1.53 Inventory turnover ratio = Cost of goods sold  Average inventory 6.0 = x  $75,000 Cost of goods sold = $75,000 x 6.0 = $450,000 Sales – Cost of goods sold = Gross profit $600,000 – $450,000 = $150,000 5-12 Check: 12.4% ROE = 15.5% profit margin x 52.5% asset turnover x 1.53 equity multiplier. Brief Exercise 5-17 Chapter 05 - Income Measurement and Profitability Analysis 2012 To record installment sales Installment receivables................................................... 350,000 Inventory..................................................................... 245,000 Deferred gross profit................................................... 105,000 2012 To record cash collections from installment sales Cash................................................................................ 220,000 Installment receivables............................................... 220,000 2012 To recognize gross profit from installment sales Deferred gross profit....................................................... 71,000 Realized gross profit................................................... 71,000 Requirement 1 Year Income recognized 2011 $180,000 ($300,000 – 120,000) 2012 - 0 - 2013 - 0 - 2014 - 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%) 2011 $ 75,000 $ 30,000 $ 45,000 2012 75,000 30,000 45,000 2013 75,000 30,000 45,000 2014 75,000 30,000 45,000 Totals $300,000 $120,000 $180,000 Requirement 3 5-15 Exercise 5-4 Chapter 05 - Income Measurement and Profitability Analysis 5-16 Year Cash Collected Cost Recovery Gross Profit 2011 $ 75,000 $ 75,000 - 0 - 2012 75,000 45,000 $ 30,000 2013 75,000 - 0 - 75,000 2014 75,000 - 0 - 75,000 Totals $300,000 $120,000 $180,000 Chapter 05 - Income Measurement and Profitability Analysis Exercise 5-5 Requirement 1 July 1, 2011 To record installment sale Installment receivables................................................... 300,000 Sales revenue.............................................................. 300,000 Cost of goods sold.......................................................... 120,000 Inventory..................................................................... 120,000 To record cash collection from installment sale Cash................................................................................ 75,000 Installment receivables............................................... 75,000 July 1, 2012 To record cash collection from installment sale Cash................................................................................ 75,000 Installment receivables............................................... 75,000 5-17 Chapter 05 - Income Measurement and Profitability Analysis October 1, 2011 To record the installment sale Installment receivable.....................................................4,000,000 Inventory..................................................................... 1,800,000 Deferred gross profit................................................... 2,200,000 To record the cash down payment from installment sale Cash................................................................................ 800,000 Installment receivable................................................. 800,000 To recognize gross profit from installment sale Deferred gross profit ($800,000 x 55%*)....................... 440,000 Realized gross profit................................................... 440,000 October 1, 2012 To record the default and repossession Repossessed inventory (fair value) ................................1,300,000 Deferred gross profit (balance).......................................1,760,000 Loss on repossession (difference) .................................. 140,000 Installment receivable (balance)................................. 3,200,000 *$2,200,000  $4,000,000 = 55% gross profit percentage Requirement 1 April 1, 2011 To record installment sale Installment receivables................................................... 2,400,000 Land............................................................................ 480,000 Gain on sale of land.................................................... 1,920,000 April 1, 2011 To record cash collection from installment sale 5-20 Exercise 5-7 Exercise 5-8 Chapter 05 - Income Measurement and Profitability Analysis Cash................................................................................ 120,000 Installment receivables............................................... 120,000 April 1, 2012 To record cash collection from installment sale Cash................................................................................ 120,000 Installment receivables............................................... 120,000 Requirement 2 April 1, 2011 To record installment sale Installment receivables................................................... 2,400,000 Land............................................................................ 480,000 Deferred gain.............................................................. 1,920,000 5-21 Chapter 05 - Income Measurement and Profitability Analysis Exercise 5-8 (concluded) When payments are received, gain on sale of land is recognized, calculated by applying the gross profit percentage ($1,920,000 ÷ $2,400,000 = 80%) to the cash collected (80% x $120,000). April 1, 2011 To record cash collection from installment sale Cash................................................................................ 120,000 Installment receivables............................................... 120,000 To recognize profit from installment sale Deferred gain.................................................................. 96,000 Gain on sale of land (80% x $120,000).......................... 96,000 April 1, 2012 To record cash collection from installment sale Cash................................................................................ 120,000 Installment receivables............................................... 120,000 To recognize profit from installment sale Deferred gain.................................................................. 96,000 Gain on sale of land (80% x $120,000).......................... 96,000 Requirement 1 2011 2012 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 2011) $ 500,000 $ 125,000 Gross profit recognition: 2011: $ 300,000 = 20% x $500,000 = $100,000 $1,500,000 2012: $125,000 – $100,000 = $25,000 5-22 Exercise 5-9 Chapter 05 - Income Measurement and Profitability Analysis 2013: $220 – 146.67 = $73.33 Requirement 3 Year Gross profit (loss) recognized 2011 - 0 - 2012 - 0 - 2013 50 Total project income $50 5-25 Chapter 05 - Income Measurement and Profitability Analysis Exercise 5-10 (concluded) Requirement 4 2011: Revenue: $40 Cost: $40 Gross profit: $ 0 2012: Revenue: $80 Cost: $80 Gross profit: $ 0 2013: Revenue: $100 ($220 contract price – $40 – $80) Cost: $ 50 Gross profit: $ 50 Requirement 5 2012: $120 = 60% x $20* = $12 – 15 = $(3) loss $200 *$220 – ($40 + 80 + 80) = $20 Requirement 1 2011 2012 2013 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 2013) $2,000,000 $ (100,000 ) $ (300,000 ) Gross profit (loss) recognition: 5-26 Exercise 5-11 Chapter 05 - Income Measurement and Profitability Analysis 2011: $2,000,000 = 33.3333% x $2,000,000 = $666,667 $6,000,000 2012: $(100,000) – 666,667 = $(766,667) 2013: $(300,000) – (100,000) = $(200,000) 5-27 Chapter 05 - Income Measurement and Profitability Analysis Loss on long-term contract 100,000 Construction in progress 100,000 To record an expected loss. 5-30 Chapter 05 - Income Measurement and Profitability Analysis Exercise 5-12 (concluded) Requirement 3 Balance Sheet 2011 2012 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 * Costs ($2,000,000 + $2,500,000) – loss ($100,000) Situation 1 - Percentage-of-Completion 2011 2012 2013 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 2013) $ 500,000 $ 500,000 $ 500,000 Gross profit (loss) recognized: 2011: $1,500,000 = 33.3333% x $500,000 = $166,667 $4,500,000 2012: $3,600,000 = 80.0% x $500,000 = $400,000 – 166,667 = $233,333 $4,500,000 5-31 Exercise 5-13 Chapter 05 - Income Measurement and Profitability Analysis 2013: $500,000 – 400,000 = $100,000 Situation 1 - Completed Contract Year Gross profit recognized 2011 - 0 - 2012 - 0 - 2013 $500,000 Total gross profit $500,000 5-32 Chapter 05 - Income Measurement and Profitability Analysis Exercise 5-13 (continued) Situation 4 - Percentage-of-Completion 2011 2012 2013 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 2013) $1,000,000 $ 625,000 $ 500,000 Gross profit (loss) recognized: 2011: $ 500,000 = 12.5% x $1,000,000 = $125,000 $4,000,000 2012: $3,500,000 = 80.0% x $625,000 = $500,000 – 125,000 = $375,000 $4,375,000 2013: $500,000 – 500,000 = $ - 0 - Situation 4 - Completed Contract Year Gross profit recognized 2011 - 0 - 2012 - 0 - 2013 $500,000 Total gross profit $500,000 5-35 Chapter 05 - Income Measurement and Profitability Analysis Exercise 5-13 (continued) Situation 5 - Percentage-of-Completion 2011 2012 2013 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 2013) $1,000,000 $ - 0 - $ 200,000 Gross profit (loss) recognized: 2011: $ 500,000 = 12.5% x $1,000,000 = $125,000 $4,000,000 2012: $ 0 – 125,000 = $(125,000) 2013: $200,000 – 0 = $200,000 Situation 5 - Completed Contract Year Gross profit recognized 2011 - 0 - 2012 - 0 - 2013 $200,000 Total gross profit $200,000 5-36 Chapter 05 - Income Measurement and Profitability Analysis Exercise 5-13 (concluded) Situation 6 - Percentage-of-Completion 2011 2012 2013 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 2013) $ (100,000 ) $ (200,000 ) $ (300,000 ) Gross profit (loss) recognized: 2011: $(100,000) 2012: $(200,000) – (100,000) = $(100,000) 2013: $(300,000) – (200,000) = $(100,000) Situation 6 - Completed Contract Year Gross profit (loss) recognized 2011 $(100,000) 2012 (100,000) 2013 (100,000 ) Total project loss $(300,000 ) Requirement 1 Construction in progress = Costs incurred + Profit recognized $100,000 = ? + $20,000 Actual costs incurred in 2011 = $80,000 Requirement 2 Billings = Cash collections + Accounts Receivable 5-37 Exercise 5-14 Chapter 05 - Income Measurement and Profitability Analysis 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. October 1, 2011 To record franchise agreement and down payment Cash (10% x $300,000)...................................................... 30,000 Note receivable............................................................... 270,000 Unearned franchise fee revenue.................................. 300,000 January 15, 2012 To recognize franchise fee revenue Unearned franchise fee revenue...................................... 300,000 Franchise fee revenue................................................. 300,000 5-40 Exercise 5-18 Exercise 5-19 Chapter 05 - Income Measurement and Profitability Analysis List A List B h 1. Inventory turnover a. Net income divided by net sales. d 2. Return on assets b. Defers recognition until cash collected equals cost. g 3. Return on shareholders' equity c. Defers recognition until project is complete. a 4. Profit margin on sales d. Net income divided by assets. b 5. Cost recovery method e. Risks and rewards of ownership retained by seller. i 6. Percentage-of-completion method f. Contra account to construction in progress. c 7. Completed contract method g. Net income divided by shareholders' equity. k 8. Asset turnover h. Cost of goods sold divided by inventory. l 9. Receivables turnover i. Recognition is in proportion to work completed. m 10. Right of return j. Recognition is in proportion to cash received. f 11. Billings on construction contract k. Net sales divided by assets. j 12. Installment sales method l. Net sales divided by accounts receivable. e 13. Consignment sales m. Could cause the deferral of revenue recognition beyond delivery point. Requirement 1 Requirement 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. 5-41 Exercise 5-20 Inventory turnover ratio = Cost of goods sold Average inventory = $1,840,000 [$690,000 + 630,000] ÷ 2 = 2.79 times Chapter 05 - Income Measurement and Profitability Analysis The ratio also can be useful when assessing the current ratio. The more liquid inventory is, the lower the norm should be against which the current ratio should be compared. Turnover ratios for Anderson Medical Supply Company for 2011: 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). 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% 5-42 Exercise 5-21 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 Exercise 5-22 Chapter 05 - Income Measurement and Profitability Analysis 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.” 5-45 Chapter 05 - Income Measurement and Profitability Analysis CPA Exam Questions 1. b. The earnings process is completed upon delivery of the product. Therefore, in 2011, revenue for 50,000 gallons at $3 each is recognized. The payment terms do not affect revenue recognition. 2. d. The deferred gross profit in the balance sheet at December 31, 2012 should be the balances in the accounts receivable accounts for 2011 and 2012 multiplied times the appropriate gross profit percentage: Accounts Receivable 2011 2012 Total Sales 600,000 900,000 Less: Collections (300,000) (300,000) Less: Write Offs (200,000) (50,000) Accounts Receivable Balance 100,000 550,000 x Gross Profit Rate x 30% x 40% Deferred Gross Profit 12/31/2012 30,000 220,000 The Combined Deferred Gross Profit in the Balance Sheet is $250,000 ($220,000 + $30,000). 5-46 CPA / CMA REVIEW QUESTIONS Chapter 05 - Income Measurement and Profitability Analysis CPA Review Questions (concluded) 3. a. Year of sale 2011 2012 a. Gross profit realized $240,000 $200,000 b. Percentage 30% 40% c. Collections on sales (a/b) $800,000 $500,000 Total sales 1,000,000 2,000,000 Balance uncollected $200,000 $1,500,000 The total uncollected balance is $1,700,000 ($200,000 + $1,500,000). 4. d. Construction-in-progress represents the costs incurred plus the cumulative pro-rata share of gross profit under the percentage-of-completion method of accounting. Construction-in-progress does not include the cumulative effect of gross profit recognition under the completed contract method. 5. c. 2011 actual costs $20,000 Total estimated costs ÷ 60,000 Ratio = 1/3 Contract Price x 100,000 Revenue 33,333 2011 actual costs -20,000 Gross 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 2011. 5-47 Chapter 05 - Income Measurement and Profitability Analysis $280,000 = 70% (gross profit % = 30%) $400,000 2011 gross profit: Cash collection from 2011 sales = $120,000 x 40% = $48,000 2012 gross profit: Cash collection from 2011 sales = $100,000 x 40% = $ 40,000 + Cash collection from 2012 sales = $150,000 x 30% = 45,000 Total 2012 gross profit $85,000 Requirement 2 2011 To record installment sales Installment receivables................................................... 300,000 Inventory..................................................................... 180,000 Deferred gross profit................................................... 120,000 2011 To record cash collections from installment sales Cash................................................................................ 120,000 Installment receivables............................................... 120,000 2011 To recognize gross profit from installment sales Deferred gross profit....................................................... 48,000 Realized gross profit................................................... 48,000 5-50 Chapter 05 - Income Measurement and Profitability Analysis Problem 5-2 (continued) 2012 To record installment sales Installment receivables................................................... 400,000 Inventory..................................................................... 280,000 Deferred gross profit................................................... 120,000 2012 To record cash collections from installment sales Cash................................................................................ 250,000 Installment receivables............................................... 250,000 2012 To recognize gross profit from installment sales Deferred gross profit....................................................... 85,000 Realized gross profit................................................... 85,000 Requirement 3 Date Cash Collected Cost Recovery Gross Profit 2011 2011 sales $120,000 $120,000 - 0 - 2012 2011 sales $100,000 $ 60,000 $40,000 2012 sales 150,000 150,000 - 0 - 2012 totals $250,000 $210,000 $40,000 5-51 Chapter 05 - Income Measurement and Profitability Analysis Problem 5-2 (concluded) 2011 To record installment sales Installment receivables................................................... 300,000 Inventory..................................................................... 180,000 Deferred gross profit................................................... 120,000 2011 To record cash collection from installment sales Cash................................................................................ 120,000 Installment receivables............................................... 120,000 2012 To record installment sales Installment receivables................................................... 400,000 Inventory..................................................................... 280,000 Deferred gross profit................................................... 120,000 2012 To record cash collection from installment sales Cash................................................................................ 250,000 Installment receivables............................................... 250,000 2012 To recognize gross profit from installment sales Deferred gross profit....................................................... 40,000 Realized gross profit................................................... 40,000 Requirement 1 Total profit = $500,000 – 300,000 = $200,000 Installment sales method: Gross profit % = $200,000 ÷ $500,000 = 40% 8/31/11 8/31/12 8/31/13 8/31/14 8/31/15 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 5-52 Problem 5-3 Chapter 05 - Income Measurement and Profitability Analysis Problem 5-3 (concluded) Requirement 3 Point of Delivery Installment Sales Cost Recovery December 31, 2011 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, 2012 Assets Installment receivables Less: Deferred gross profit Installment receivables, net 300,000 300,000 (120,000) 180,000 300,000 (200,000) 100,000 5-55 Chapter 05 - Income Measurement and Profitability Analysis Requirement 1 5-56 Problem 5-4 All jobs consist of four equal payments: one payment when the job is completed and three payments over the next three years. Bluebird: Job completed in 2009, so down payment made in 2009, another payment in 2010, and two payments remain. $400,000 gross receivable at 1/1/2011 implies payments of ($400,000  2) = $200,000 in 2011 and 2012. Four payments of $200,000 implies total revenue of 4 x $200,000 = $800,000 on the job. 25% gross profit ratio implies cost of 75% x $800,000 = $600,000. Cost recovery method gross profit: Payments in 2009 and 2010 have already recovered $400,000 of cost, so cost remaining to be recovered as of 1/1/2011 is $600,000 total – $400,000 already recovered = $200,000. Therefore, the entire 2011 payment of $200,000 will be applied to cost recovery, and no gross profit is recognized in 2011. Installment sales method gross profit: $200,000 payment x 25% gross profit ratio = $50,000 of gross profit recognized in 2011. PitStop: Job completed in 2008, so down payment made in 2008, another payment in 2009, another in 2010, and one payment remains. $150,000 gross receivable at 1/1/2011 implies a single payment of $150,000 in 2011. Four payments of $150,000 implies total revenue of 4 x $150,000 = $600,000 on the job. 35% gross profit ratio implies cost of 65% x $600,000 = $390,000. Cost recovery method gross profit: Payments in 2008, 2009 and 2010 of a total of $450,000 have already recovered the entire $390,000 of cost and allowed recognition of $60,000 of gross profit. Therefore, the entire 2011 payment of $150,000 will be applied to gross profit. Installment sales method gross profit: $150,000 payment x 35% gross profit ratio = $52,500 of gross profit recognized in 2011. Chapter 05 - Income Measurement and Profitability Analysis Problem 5-4 (concluded) Requirement 2 Requirement 1 2011 2012 2013 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 2013) $ 2,000,000 $ 2,000,000 $ 1,800,000 Gross profit (loss) recognition: 2011: $2,400,000 = 30.0% x $2,000,000 = $600,000 $8,000,000 2012: $6,000,000 = 75.0% x $2,000,000 = $1,500,000 – 600,000 = $900,000 5-57 Totals: Cost recovery method: $0 (Bluebird) + $150,000 (PitStop) = $150,000. Installment sales method: $50,000 (Bluebird) + $52,500 (PitStop) = $102,500. If Dan is focused on 2011, he would not be happy with a switch to the installment sales method, because that would produce gross profit of only $102,500, which is $47,500 less than he would show under the cost recovery method. It is true that the installment sales method recognizes gross profit faster than does the cost recovery method, but the installment sales method also recognizes gross profit more evenly than does the cost-recovery method. The timing of these jobs is such that 2011 is a year in which almost all of the gross profit associated with the PitStop job gets recognized, so 2011 looks more profitable under the cost recovery method. Problem 5-5 Chapter 05 - Income Measurement and Profitability Analysis Problem 5-5 (continued) Requirement 3 Balance Sheet 2011 2012 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 2011 2012 2013 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 - 2011 2012 2013 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 2013) $ 2,000,000 $ 700,000 $ 600,000 5-60 Chapter 05 - Income Measurement and Profitability Analysis Problem 5-5 (concluded) Gross profit (loss) recognition: 2011: $2,400,000 = 30.0% x $2,000,000 = $600,000 $8,000,000 2012: $6,200,000 = 66.6667% x $700,000 = $466,667 – 600,000 = $(133,333) $9,300,000 2013: $600,000 – 466,667 = $133,333 Requirement 5 2011 2012 2013 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 - 2011 2012 2013 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 2013) $ 2,000,000 $ (300,000 ) $ (100,000 ) Gross profit (loss) recognition: 2011: $2,400,000 = 30.0% x $2,000,000 = $600,000 $8,000,000 2012: $(300,000) – 600,000 = $(900,000) 2013: $(100,000) – (300,000) = $200,000 5-61 Chapter 05 - Income Measurement and Profitability Analysis Requirement 1 Year Gross profit recognized 2011 - 0 - 2012 - 0 - 2013 $1,800,000 Total gross profit $1,800,000 Requirement 2 2011 2012 2013 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. 5-62 Problem 5-6 Chapter 05 - Income Measurement and Profitability Analysis Problem 5-7 (concluded) Requirement 3 Balance Sheet 2011 2012 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 2011 2012 2013 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 2011 - 0 - 2012 - 0 - 2013 $600,000 Total gross profit $600,000 Requirement 5 2011 2012 2013 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 2011 - 0 - 2012 $(300,000) 2013 200,000 Total project loss $(100,000 ) 5-65 Chapter 05 - Income Measurement and Profitability Analysis Requirement 1 2011 2012 2013 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 2013) $ 500,000 $ (200,000) $ (250,000 ) Year Gross profit (loss) recognized 2011 - 0 - 2012 $(200,000) 2013 (50,000 ) Total project loss $(250,000 ) Requirement 2 Gross profit (loss) recognition: 2011: 10% x $500,000 = $50,000 2012: $(200,000) – 50,000 = $(250,000) 2013: $(250,000) – (200,000) = $(50,000) Requirement 3 Balance Sheet 2011 2012 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 5-66 Problem 5-8 Chapter 05 - Income Measurement and Profitability Analysis Requirement 1 The completed contract method of recognizing revenues and costs on long-term construction contracts is equivalent to recognizing revenue at the point of delivery, i.e., when the construction project is complete. The percentage-of-completion method assigns a share of the project’s expected revenues and costs to each period in which the earnings process takes place, i.e., the construction period. The share is estimated based on the project's costs incurred each period as a percentage of the project's total estimated costs. The completed contract method should only be used when a lack of dependable estimates or inherent hazards make it difficult to forecast future costs and profits. Requirement 2 2011 2012 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 2011 or 2012 income statements. 5-67 Problem 5-9 Chapter 05 - Income Measurement and Profitability Analysis Problem 5-9 (continued) c. Balance Sheet At December 31, 2012 Current assets: Accounts receivable Current liabilities: $ 1,600,000 Billings ($12,000,000) in excess of costs and profit ($11,000,000*) 1,000,000 * 2011 costs ($4,000,000) + 2011 profit ($1,000,000) + 2012 costs ($9,500,000) – 2012 loss ($3,500,000) Requirement 5 Citation should recognize revenue at the point of delivery, when the homes are completed and title is transferred to the buyer. This is equivalent to the completed contract method for long-term contracts. The percentage-of-completion method is not appropriate in this case. There is no contract in place and until the completion of the home, the transfer of title, and the receipt of the full sales price, the earnings process is not virtually complete and there is still significant uncertainty as to cash collection. Also, the sales price is not fixed. Requirement 6 Income statement: Sales revenue (3 x $600,000) $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 5-70 Problem 5-10 Chapter 05 - Income Measurement and Profitability Analysis Requirement 1 a. January 30, 2011 Cash ............................................................................... 200,000 Note receivable .............................................................. 1,000,000 Unearned franchise fee revenue.................................. 1,200,000 b. September 1, 2011 Unearned franchise fee revenue...................................... 1,200,000 Franchise fee revenue ................................................ 1,200,000 c. September 30, 2011 Accounts receivable ($40,000 x 3%) ................................ 1,200 Service revenue .......................................................... 1,200 d. January 30, 2012 Cash................................................................................ 100,000 Note receivable .......................................................... 100,000 5-71 Chapter 05 - Income Measurement and Profitability Analysis Problem 5-10 (continued) Requirement 2 a. January 30, 2011 Cash ............................................................................... 200,000 Note receivable .............................................................. 1,000,000 Deferred franchise fee revenue................................... 1,200,000 Note: Could also show as: Cash ............................................................................... 200,000 Note receivable .............................................................. 1,000,000 Deferred franchise fee revenue................................... 1,000,000 Unearned franchise fee revenue.................................. 200,000 b. September 1, 2011 Deferred franchise fee revenue ...................................... 200,000 Franchise fee revenue (cash collected)........................... 200,000 c. September 30, 2011 Accounts receivable ($40,000 x 3%) ................................ 1,200 Service revenue .......................................................... 1,200 d. January 30, 2012 Cash................................................................................ 100,000 Note receivable .......................................................... 100,000 Deferred franchise fee revenue ...................................... 100,000 Franchise fee revenue ................................................ 100,000 5-72 Chapter 05 - Income Measurement and Profitability Analysis Problem 5-12 (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. 5-75 Rate of return on assets = Net income Total assets J&J = $7,197 = 14.9% $48,263 Pfizer = $1,639 = 1.4% $116,775 Chapter 05 - Income Measurement and Profitability Analysis Problem 5-12 (concluded) Requirement 4 J&J provided a much greater return to shareholders. Requirement 5 The two companies have virtually identical equity multipliers, indicating that they are using leverage to the same extent to earn a return on equity that is higher than their return on assets. a. Times interest earned ratio = (Net income + Interest + Taxes) ÷ Interest = 17 (Net income + $2 + 12) ÷ $2 = 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 5-76 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 Chapter 05 - Income Measurement and Profitability Analysis 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 5-77 Chapter 05 - Income Measurement and Profitability Analysis Problem 5-14 (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. 5-80 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 Chapter 05 - Income Measurement and Profitability Analysis Problem 5-14 (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 5-81 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 Chapter 05 - Income Measurement and Profitability Analysis Problem 5-14 (concluded) 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. 5-82 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 Chapter 05 - Income Measurement and Profitability Analysis 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. 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. 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. 5-85 Judgment Case 5-3 Judgment Case 5-4 Chapter 05 - Income Measurement and Profitability Analysis 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. (Note: This case requires the student to reference a journal article.] 1. Fifty-five firms reported the use of one of the two long-term contract accounting methods. 2. Twenty-seven of the firms are manufacturing companies. 3. Only one company uses the completed contract method. That company reported using both methods. 4. The most frequently used approach to estimating a percentage-of-completion is the cost-to-cost method. (Note: This case requires the student to reference a journal article.] 1. Abuse Expanation 1. Cutoff manipulation The company either closes their books early (so some 5-86 Communication Case 5-5 Research Case 5-6 Research Case 5-7 Chapter 05 - Income Measurement and Profitability Analysis 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. Discussion should include these elements. Facts: Horizon Corporation, a computer manufacturer, reported profits from 2006 through 2009, but reported a $20 million loss in 2010 due to increased competition. The chief financial officer (CFO) circulated a memo suggesting the shipment of computers to J.B. Sales, Inc., in 2011 with a subsequent return of the merchandise to Horizon in 2012. Horizon would record a sale for the computers in 2011 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 2011 which he knows will be reversed as a sales return in 2012. 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 2011 that may lead to bankruptcy? Who is affected? 5-87 Ethics Case 5-8 Chapter 05 - Income Measurement and Profitability Analysis 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.] 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. 5-90 Research Case 5-11 Chapter 05 - Income Measurement and Profitability Analysis 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. 5-91 Chapter 05 - Income Measurement and Profitability Analysis Case 5-11 (concluded) 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. Requirement 1 This topic is addressed in EITF Issue No. 99-19. 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. 5-92 Research Case 5-12 Chapter 05 - Income Measurement and Profitability Analysis 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. Requirement 1 Per the revenue recognition section of ThyssenKrupp’s 2008 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.” 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. A solution and extensive discussion materials can be obtained from the Deloitte Foundation. A solution and extensive discussion materials can be obtained from the Deloitte Foundation. Requirement 3 The following is from the 2008 10K of Jack in the Box, Inc. The responses to the question will vary if the company has since changed its revenue recognition policy. 5-95 IFRS Case 5-17 Trueblood Accounting Case 5-18 Trueblood Accounting Case 5-19 Real World Case 5-20 Chapter 05 - Income Measurement and Profitability Analysis 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 McDonalds and Wendys. This case encourages students to obtain hands-on familiarity with an actual annual report and library sources of industry data. They also must apply the techniques learned in the chapter. You may wish to provide students with multiple copies of the same annual reports and compare responses. Another approach is to divide the class into teams who evaluate reports from a group perspective. Apparently, a significant increase in assets occurred during the last quarter. Total assets were $324 million and now they total $450 million, as can be calculated as follows: Return on shareholders’ equity = Net income ÷ Shareholders’ equity = 14% Shareholders’ equity = $21 million ÷ 14% = $150 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 = $450 million 5-96 Analysis Case 5-21 Judgment Case 5-22 Chapter 05 - Income Measurement and Profitability Analysis Case 5-23 (concluded) Calculations ($ 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 5-97 Integrating Case 5-23 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