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Chapter 5

Income Measurement and Profitability Analysis

QUESTIONS FOR REVIEW OF KEY TOPICS


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 dont know if the product will be sold, nor the selling
price, nor the buyer if eventually the product is sold. Because of these uncertainties, revenue
recognition usually is delayed until the point of product delivery.

Question 5-3
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.

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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 cant find a buyer within an agreed-upon time, the
consignee returns the goods to the consignor. However, if a buyer is found, the consignee remits the
selling price (less commission and approved expenses) to the consignor.
Because the consignor retains the risks and rewards of ownership of the product and title does
not pass to the consignee, the consignor does not record revenue (and related costs) until the
consignee sells the goods and title passes to the eventual customer.

Question 5-8
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, its 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 projects 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 SOPs require that if an arrangement includes multiple elements, the revenue from the
arrangement should be allocated to the various elements based on the relative fair values of the
individual elements, regardless of any separate prices stated within the contract for each element.

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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 companys effectiveness in


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

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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'
equity

Net income
Average shareholders' equity

A fundamental element of an analysts task is to develop an understanding of a firms


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

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.

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BRIEF EXERCISES
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)
Less gross profit recognized in 2006 ($150,000 x 60%)
Less gross profit recognized in 2007 ($150,000 x 60%)
Deferred gross profit at the end of 2007
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$1,800,000
(90,000)
(90,000)
$1,620,000
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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 Meyers
management can make reliable estimates of the furniture that will be returned, revenue
can be recognized when the product is delivered, assuming the company has no
additional obligations to the buyer. If reliable estimates cannot be made because of
significant uncertainty, revenue and related cost recognition is delayed until the
uncertainty is resolved.

Brief Exercise 5-6


% of completion = $6 million $15 million = 40%
Total estimated gross profit ($20 million 15 million) =
multiplied by the % of completion
Gross profit recognized the first year

$5,000,000
40%
$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)
Cost plus profit ($6 million + $2 million*)
in excess of billings ($7 million)
* Total estimated gross profit ($20 million 15 million) =
multiplied by the % of completion
Gross profit recognized in the first year

$2,000,000
1,000,000
$5,000,000
40%
$2,000,000

Brief Exercise 5-8


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Year 1 = 0
Year 2 = $4 million
Revenue
Less: Costs in year 1
Costs in year 2
Actual profit

$20,000,000
(6,000,000)
(10,000,000)
$ 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.

Brief Exercise 5-11


Receivables turnover ratio

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Receivables turnover ratio

Net sales
The McGraw-Hill
Companies,
Average accounts
receivable
(net) Inc., 2007
5-7

$600,000
[$100,000 + 120,000] 2

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Inventory turnover ratio


Inventory turnover ratio

Cost of goods sold


Average inventory

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

5.71 times

*$600,000 200,000

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Brief Exercise 5-12


Profit margin

Return on assets

Return on shareholders
equity

Net income
Sales

$65,000
$420,000

15.5%

Net income
Average total assets

$65,000
$800,000

8.1%

Net income
Average shareholders equity

$65,000
$522,500*

12.4%

Shareholders equity, beginning of period


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

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

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

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Brief Exercise 5-13


Inventory turnover ratio = Cost of goods sold Average inventory
6.0
=
x

$75,000
Cost of goods sold
= $75,000 x 6.0 = $450,000
Sales
$600,000

- Cost of goods sold = Gross profit


$450,000
= $150,000

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

$ 35,000
36,000
$71,000

Requirement 2
2006 deferred gross profit balance:
2006 initial gross profit ($360,000 - 234,000)
Less: Gross profit recognized in 2006
Balance in deferred gross profit account

$126,000
(52,500)
$73,500

2007 deferred gross profit balance:


2006 initial gross profit ($360,000 - 234,000)
Less: Gross profit recognized in 2006
Gross profit recognized in 2007

$ 126,000
(52,500)
(35,000)

2007 initial gross profit ($350,000 - 245,000)


Less: Gross profit recognized in 2007
Balance in deferred gross profit account

105,000
(36,000)
$107,500

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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

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Exercise 5-3
Requirement 1
Year
2006
2007
2008
2009
Total

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

Requirement 2
Year
2006
2007
2008
2009
Totals

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

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

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

Cost Recovery
$ 75,000
45,000
-0-0$120,000

Gross Profit
-0$ 30,000
75,000
75,000
$180,000

Requirement 3
Year
2006
2007
2008
2009
Totals

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

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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

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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

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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)
Add: Gross profit if use cost recovery method
Cash collected

$400,000
100,000
$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

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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

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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)..........................

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Exercise 5-7
Requirement 1
Contract price
Actual costs to date
Estimated costs to complete
Total estimated costs
Gross profit (estimated in 2006)

2006
$2,000,000
300,000
1,200,000
1,500,000
$ 500,000

2007
$2,000,000
1,875,000
-01,875,000
$ 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
2007

$
-0$125,000

Requirement 3
Balance Sheet
At December 31, 2006
Current assets:
Accounts receivable
Costs and profit ($400,000*) in excess
of billings ($380,000)

$ 130,000
20,000

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

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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

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Exercise 5-8
Requirement 1
($ in millions)

Contract price
Actual costs to date
Estimated costs to complete
Total estimated costs
Estimated gross profit (actual in 2008)

2006
$220
40
120
160
$ 60

2007
$220
120
60
180
$ 40

2008
$220
170
-0170
$ 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
2006
2007
2008
Total project income

Gross profit (loss) recognized


-0-050
$50

Requirement 4
2007:
$120
= 60% x $20* = $12 - 15 = $(3) loss
$200
*$220 ($40 + 80 + 80) = $20

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Exercise 5-9
Requirement 1
Contract price
Actual costs to date
Estimated costs to complete
Total estimated costs
Estimated gross profit (loss)
(actual in 2008)

2006
$8,000,000
2,000,000
4,000,000
6,000,000

2007
$8,000,000
4,500,000
3,600,000
8,100,000

2008
$8,000,000
8,300,000
-08,300,000

$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)

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Exercise 5-9 (continued)


Requirement 2
Construction in progress
Various accounts
To record construction costs.

2006
2007
2,000,000
2,500,000
2,000,000
2,500,000

Accounts receivable
Billings on construction contract
To record progress billings.

2,500,000
2,750,000
2,500,000
2,750,000

Cash
Accounts receivable
To record cash collections.

2,250,000
2,475,000
2,250,000
2,475,000

Construction in progress
(gross profit)

Cost of construction
Revenue from long-term contracts

666,667
2,000,000

(33.3333% x $8,000,000)

2,666,667

To record gross profit.


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

(1)

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

(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)

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Exercise 5-9 (concluded)


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

2006

2007

$250,000 $525,000
166,667

$850,000

* Costs ($2,000,000) + profit ($666,667)

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Exercise 5-10
Requirement 1
Year
2006
2007
2008
Total project loss

Gross profit (loss) recognized


-0$(100,000)
(200,000)
$(300,000)

Requirement 2

Construction in progress
Various accounts
To record construction costs.

2006
2007
2,000,000
2,500,000
2,000,000
2,500,000

Accounts receivable
Billings on construction contract
To record progress billings.

2,500,000
2,750,000
2,500,000
2,750,000

Cash
Accounts receivable
To record cash collections.

2,250,000
2,475,000
2,250,000
2,475,000

Loss on long-term contract


Construction in progress
To record an expected loss.

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100,000
100,000

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Exercise 5-10 (concluded)


Requirement 3
Balance Sheet
Current assets:
Accounts receivable

2006
$250,000

2007
$525,000

Current liabilities:
Billings ($2,500,000) in excess of costs
($2,000,000)

Billings ($5,250,000) in excess of costs less


loss ($4,400,000)

The McGraw-Hill Companies, Inc., 2007


5-26

$500,000
$850,000

Intermediate Accounting, 4/e

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Exercise 5-11
Situation 1 - Percentage-of-Completion
Contract price
Actual costs to date
Estimated costs to complete
Total estimated costs
Estimated gross profit
(actual in 2008)

2006
$5,000,000
1,500,000
3,000,000
4,500,000

2007
$5,000,000
3,600,000
900,000
4,500,000

2008
$5,000,000
4,500,000
-04,500,000

$ 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
2006
2007
2008
Total gross profit

Solutions Manual, Vol.1, Chapter 5

Gross profit recognized


-0-0$500,000
$500,000

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Exercise 5-11 (continued)


Situation 2 - Percentage-of-Completion
Contract price
Actual costs to date
Estimated costs to complete
Total estimated costs
Estimated gross profit
(actual in 2008)

2006
$5,000,000
1,500,000
3,000,000
4,500,000

2007
$5,000,000
2,400,000
2,400,000
4,800,000

2008
$5,000,000
4,800,000
-04,800,000

$ 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
2006
2007
2008
Total gross profit

The McGraw-Hill Companies, Inc., 2007


5-28

Gross profit recognized


-0-0$200,000
$200,000

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Exercise 5-11 (continued)


Situation 3 - Percentage-of-Completion
Contract price
Actual costs to date
Estimated costs to complete
Total estimated costs
Estimated gross profit (loss)
(actual in 2008)

2006
$5,000,000
1,500,000
3,000,000
4,500,000

2007
$5,000,000
3,600,000
1,500,000
5,100,000

2008
$5,000,000
5,200,000
-05,200,000

$ 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
2006
2007
2008
Total project loss

Solutions Manual, Vol.1, Chapter 5

Gross profit (loss) recognized


-0$(100,000)
(100,000)
$(200,000)

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Exercise 5-11 (continued)


Situation 4 - Percentage-of-Completion
Contract price
Actual costs to date
Estimated costs to complete
Total estimated costs
Estimated gross profit
(actual in 2008)

2006
$5,000,000
500,000
3,500,000
4,000,000

2007
$5,000,000
3,500,000
875,000
4,375,000

2008
$5,000,000
4,500,000
-04,500,000

$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
2006
2007
2008
Total gross profit

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5-30

Gross profit recognized


-0-0$500,000
$500,000

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Exercise 5-11 (continued)


Situation 5 - Percentage-of-Completion
Contract price
Actual costs to date
Estimated costs to complete
Total estimated costs
Estimated gross profit
(actual in 2008)

2006
$5,000,000
500,000
3,500,000
4,000,000

2007
$5,000,000
3,500,000
1,500,000
5,000,000

2008
$5,000,000
4,800,000
-04,800,000

$1,000,000

$ 200,000

-0-

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
2006
2007
2008
Total gross profit

Solutions Manual, Vol.1, Chapter 5

Gross profit recognized


-0-0$200,000
$200,000

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Exercise 5-11 (concluded)


Situation 6 - Percentage-of-Completion
Contract price
Actual costs to date
Estimated costs to complete
Total estimated costs
Estimated gross profit (loss)
(actual in 2008)

2006
$5,000,000
500,000
4,600,000
5,100,000

2007
$5,000,000
3,500,000
1,700,000
5,200,000

2008
$5,000,000
5,300,000
-05,300,000

$ (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
2006
2007
2008
Total project loss

The McGraw-Hill Companies, Inc., 2007


5-32

Gross profit (loss) recognized


$(100,000)
(100,000)
(100,000)
$(300,000)

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Exercise 5-12
Requirement 1
Construction in progress = Costs incurred + Profit recognized
$100,000

$20,000

Actual costs incurred in 2006 = $80,000


Requirement 2
Billings = Cash collections + Accounts Receivable
$94,000 =

$30,000

Cash collections in 2006 = $64,000


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

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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

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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.
2.
3.
4.

c
d
a
b

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Exercise 5-16
List A
h
d

1. Inventory turnover
2. Return on assets

g
a
b

3.
4.
5.

i
c
k
l
m
f
j
e

6.
7.
8.
9.
10.
11.
12.
13.

List B

a. Net income divided by net sales.


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

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Exercise 5-17
Requirement 1
Inventory turnover ratio

Cost of goods sold


Average inventory

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

2.79 times

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.
Its just one piece in the puzzle, though. Other points of reference should be
considered. For instance, a high turnover can be achieved by maintaining too low
inventory levels and restocking only when absolutely necessary. This can be costly in
terms of stockout costs.
The ratio also can be useful when assessing the current ratio. The more liquid
inventory is, the lower the norm should be against which the current ratio should be
compared.

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

Receivables turnover ratio

Average collection period

Asset turnover ratio

$4,800,000
[$900,000 + 700,000] 2

6 times

$8,000,000
[$700,000 + 500,000] 2

13.33 times

365
13.33

27.4 days

$8,000,000
[$4,300,000 + 3,700,000] 2

2 times

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).

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Exercise 5-19
Requirement 1
a. Profit margin on sales
b. Return on assets
c. Return on shareholders equity

$180 $5,200 = 3.5%


$180 [($1,900 + 1,700) 2] = 10%
$180 [($550 + 500) 2] = 34.3%

Requirement 2
Retained earnings beginning of period
Add: Net income

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

Less: Retained earnings end of period


Dividends paid

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.

Exercise 5-21
First
Solutions Manual, Vol.1, Chapter 5

Quarter
Second

Third

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Cumulative income before taxes


$50,000
Estimated annual effective tax rate
34%
17,000
Less: Income tax reported earlier
0
Tax expense to be reported
$17,000

$90,000 $190,000
30%
36%
27,000
68,400
17,000
27,000
$10,000
$ 41,400

Exercise 5-22
Incentive compensation
Depreciation expense
Gain on sale

$300 million 4 = $ 75 million


$60 million 4 =
15 million
23 million

Exercise 5-23
1st
Advertising
$200,000
Property tax
87,500
Equipment repairs
65,000
Extraordinary casualty loss
0
Research and development
0

The McGraw-Hill Companies, Inc., 2007


5-40

2nd
$200,000
87,500
65,000
185,000
32,000

3rd
$200,000
87,500
65,000
0
32,000

4th
$200,000
87,500
65,000
0
32,000

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PROBLEMS
Problem 5-1
REAGAN CORPORATION
Income Statement
For the Year Ended December 31, 2006
Income before income taxes and
extraordinary item .....................................
Income tax expense .....................................
Income before extraordinary item ................
Extraordinary item:
Gain from settlement of lawsuit (net of
$400,000 tax expense) ................................
Net Income ..................................................

[1] $3,680,000

1,472,000
2,208,000
600,000
$2,808,000

Income before extraordinary item ................


Extraordinary gain .......................................
Net income ..................................................
[1]

2.21
0.60
$ 2.81

Income from continuing operations before income taxes:


Unadjusted
$4,200,000
Add:
Gain from sale of equipment
50,000
Deduct: Inventory write-off
(400,000)
Depreciation expense (2006)
(50,000)
Overstated profit on installment sale
(120,000) *
Adjusted
$3,680,000

* Profit recognized ($400,000 - 240,000)


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

Solutions Manual, Vol.1, Chapter 5

$160,000
(40,000)
$120,000

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Problem 5-2
Requirement 1
2006 Cost recovery % :
$180,000
= 60% (gross profit % = 40%)
$300,000
2007 Cost recovery %:
$280,000
= 70% (gross profit % = 30%)
$400,000
2006 gross profit:
Cash collection from 2006 sales = $120,000 x 40% =

$48,000

2007 gross profit:


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

$ 40,000
45,000
$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

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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
2007 sales
2007 totals

$100,000
150,000
$250,000

$ 60,000
150,000
$210,000

$40,000
-0$40,000

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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

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Problem 5-3
Requirement 1
Total profit = $500,000 - 300,000 = $200,000
Installment sales method: Gross profit % = $200,000 $500,000 = 40%
8/31/06

8/31/07

8/31/08

8/31/09

8/31/10

Cash collections

$100,000 $100,000 $100,000 $100,000 $100,000

a. Point of delivery method

$200,000

-0-

-0-

-0-

-0-

$ 40,000 $ 40,000 $ 40,000 $ 40,000

$40,000

b. Installment sales method


(40% x cash collected)

c. Cost recovery method

Solutions Manual, Vol.1, Chapter 5

-0-

-0-

- 0 - $100,000 $100,000

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Problem 5-3 (continued)


Requirement 2

Installment receivable
Sales revenue
Cost of goods sold
Inventory
To record sale on 8/31/06.

Point of
Delivery
500,000
500,000
300,000
300,000

Installment receivable
Inventory
Deferred gross profit
To record sale on 8/31/06.
Cash
Installment receivable
Entry made each Aug. 31.
Deferred gross profit
Realized gross profit
To record gross profit.

Installment
Sales

500,000

Cost Recovery

500,000
300,000
200,000

100,000

100,000
100,000

300,000
200,000
100,000

100,000

100,000

40,000
40,000

(entry made each Aug. 31)

Deferred gross profit


Realized gross profit
To record gross profit.

100,000
100,000

(entry made 8/31/09 & 8/31/10)

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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

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Problem 5-4
Requirement 1
Contract price
Actual costs to date
Estimated costs to complete
Total estimated costs
Estimated gross profit (loss)
(actual in 2008)

2006
$10,000,000
2,400,000
5,600,000
8,000,000

2007
$10,000,000
6,000,000
2,000,000
8,000,000

2008
$10,000,000
8,200,000
-08,200,000

$ 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
Various accounts
To record construction costs.

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

Accounts receivable
Billings on construction contract
To record progress billings.

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

Cash
Accounts receivable
To record cash collections.

1,800,000
3,600,000
4,600,000
1,800,000
3,600,000
4,600,000

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.

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Problem 5-4 (continued)


(1) Revenue recognized:
2006: 30% x $10,000,000 =
2007: 75% x $10,000,000 =
Less: Revenue recognized in 2006
Revenue recognized in 2007
2008: 100% x $10,000,000 =
Less: Revenue recognized in 2006 & 2007
Revenue recognized in 2008

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

Requirement 3
Balance Sheet
Current assets:
Accounts receivable
Construction in progress
Less: Billings
Costs and profit in excess
of billings

2006

2007

$ 200,000
$3,000,000
(2,000,000)

$600,000
$7,500,000
(6,000,000)

1,000,000

1,500,000

Requirement 4
Costs incurred during the year
Estimated costs to complete
as of year-end
Contract price
Actual costs to date
Estimated costs to complete
Total estimated costs
Estimated gross profit
(actual in 2008)

Solutions Manual, Vol.1, Chapter 5

2006
$2,400,000

2007
$3,800,000

2008
$3,200,000

5,600,000

3,100,000

2006
$10,000,000
2,400,000
5,600,000
8,000,000

2007
$10,000,000
6,200,000
3,100,000
9,300,000

2008
$10,000,000
9,400,000
-09,400,000

$ 2,000,000

$ 700,000

$ 600,000

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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
Costs incurred during the year
Estimated costs to complete
as of year-end
Contract price
Actual costs to date
Estimated costs to complete
Total estimated costs
Estimated gross profit (loss)
(actual in 2008)

2006
$2,400,000

2007
$3,800,000

5,600,000

4,100,000

2006
$10,000,000
2,400,000
5,600,000
8,000,000

2007
$10,000,000
6,200,000
4,100,000
10,300,000

$ 2,000,000

$ (300,000)

2008
$3,900,000
2008
$10,000,000
10,100,000
-010,100,000
$ (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

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Problem 5-5
Requirement 1
Year
2006
2007
2008
Total gross profit

Gross profit recognized


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

Requirement 2

Construction in progress
Various accounts
To record construction costs.

2006
2007
2008
2,400,000
3,600,000
2,200,000
2,400,000
3,600,000
2,200,000

Accounts receivable
Billings on construction contract
To record progress billings.

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

Cash
Accounts receivable
To record cash collections.

1,800,000
3,600,000
4,600,000
1,800,000
3,600,000
4,600,000

Construction in progress (gross profit)


Cost of construction (costs incurred)
Revenue from long-term contracts

1,800,000
8,200,000
10,000,000

(contract price)

To record gross profit.

Requirement 3
Balance Sheet
Current assets:
Accounts receivable
Construction in progress
Less: Billings
Costs in excess of billings

Solutions Manual, Vol.1, Chapter 5

2006

2007

$ 200,000

$ 600,000

$2,400,000
(2,000,000)

$6,000,000
(6,000,000)
400,000

-0-

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Problem 5-5 (concluded)


Requirement 4
Costs incurred during the year
Estimated costs to complete
as of year-end
Year
2006
2007
2008
Total gross profit

2006
$2,400,000

2007
$3,800,000

5,600,000

3,100,000

2008
$3,200,000
-

Gross profit recognized


-0-0$600,000
$600,000

Requirement 5
Costs incurred during the year
Estimated costs to complete
as of year-end
Year
2006
2007
2008
Total project loss

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2006
$2,400,000

2007
$3,800,000

5,600,000

4,100,000

2008
$3,900,000
-

Gross profit (loss) recognized


-0$(300,000)
200,000
$(100,000)

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Problem 5-6
Requirement 1
Contract price
Actual costs to date
Estimated costs to complete
Total estimated costs
Estimated gross profit (loss)
(actual in 2008)

2006
$4,000,000
350,000
3,150,000
3,500,000

2007
$4,000,000
2,500,000
1,700,000
4,200,000

2008
$4,000,000
4,250,000
-04,250,000

$ 500,000

$ (200,000)

$ (250,000)

Year
2006
2007
2008
Total project loss

Gross profit (loss) recognized


-0$(200,000)
(50,000)
$(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

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

2007

$ 130,000

$ 320,000

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

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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%) ................................


Service revenue ........................................................
d.

1,200
1,200

January 30, 2007

Cash ..............................................................................
Note receivable .........................................................

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


Franchise fee revenue (cash collected) ..........................
c.

200,000

September 30, 2006

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


Service revenue ........................................................
d.

200,000

1,200
1,200

January 30, 2007

Cash ..............................................................................
Note receivable .........................................................

100,000

Deferred franchise fee revenue .....................................


Franchise fee revenue ...............................................

100,000

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100,000
100,000

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Problem 5-8
1.
2.
3.
4.
5.
6.
7.

Inventory turnover ratio


Average days in inventory
Receivables turnover ratio
Average collection period
Asset turnover ratio
Profit margin on sales
Return on assets
or:
8. Return on
shareholders equity

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$6,300 [($800 + 600) 2] = 9.0


365 9.0 = 40.56 days
$9,000 [($600 + 400) 2] = 18.0
365 18.0 = 20.28 days
$9,000 [($4,000 + 3,600) 2] = 2.37
$300 $9,000 = 3.33%
$300 [($4,000 + 3,600) 2] = 7.89%
3.33% x 2.37 times = 7.89%
$300 [($1,500 + 1,350) 2] = 21.1%

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Problem 5-9
Requirement 1
=

Net sales
Accounts receivable

J&J

$41,862
$6,574

= 6.37 times

Pfizer

$45,188
$8,775

= 5.15 times

Receivables turnover

Average collection period =

365
Receivables turnover

J&J

365
6.37

= 57 days

Pfizer

365
5.15

= 71 days

On average, J&J collects its receivables in 14 days less than Pfizer.


Inventory turnover

Cost of goods sold


Inventories

J&J

$12,176
$3,588

= 3.39 times

Pfizer

$9,832
$5,837

= 1.68 times

Average days in inventory =

365
Inventory turnover

J&J

365
3.39

= 108 days

Pfizer

365
1.68

= 217 days

On average, J&J sells its inventory twice as fast as Pfizer..

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Problem 5-9 (continued)


Requirement 2
Rate of return on assets

Net income
Total assets

J&J

$7,197
$48,263

14.9%

Pfizer

$1,639
$116,775

1.4%

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


sources of financing. In this regard, J&Js profitability is significantly higher than
that of Pfizer.
Requirement 3
Profitability can be achieved by a high profit margin, high turnover, or a
combination of the two.
Rate of return on assets =
=
J&J

Net income
Net sales

$ 7,197
$41,862

$41,862
$48,263

.867 times

=
Pfizer

Profit margin
on sales

17.19%

Asset
turnover

Net sales
Total assets

$ 1,639
$45,188

$45,188
$116,775

3.63%

.387 times

14.9%

1.4%

J&Js profit margin is much higher than that of Pfizer, as is its asset turnover.
These differences combine to produce a significantly higher return on assets for
J&J.
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Problem 5-9 (concluded)


Requirement 4
Rate of return on =
shareholders equity

Net income
Shareholders equity

J&J

$7,197
$26,869

= 26.8%

Pfizer

$1,639
$65,377

= 2.5%

J&J provided a much greater return to shareholders.

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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

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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
Accounts receivable (net)
Inventories
Total current assets
Property, plant, and equipment (net)
Total assets

$ 10
20
30
60
140
$200

Liabilities and Shareholders Equity


Current liabilities
$ 30
Long-term liabilities
70
Shareholders equity
100
Total liabilities and shareholders' equity
$200

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Problem 5-11
Requirement 1
Rate of return on assets

Net income
Total assets

Metropolitan

$ 593.8
$4,021.5

14.8%

Republic

$ 424.6
$4,008.0

10.6%

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


sources of financing. In this regard, Metropolitans profitability exceeds that of
Republic.
Requirement 2
Profitability can be achieved by a high profit margin, high turnover, or a
combination of the two.
Rate of return on assets =
=

Net income
Net sales

Metropolitan =
=
Republic =
=

Profit margin
on sales
x

Asset
turnover

Net sales
Total assets

$ 593.8
$5,698.0

$5,698.0
$4,021.5

10.4%

1.42 times =

$ 424.6
$7,768.2

$7,768.2
$4,008.0

5.5%

1.94 times =

14.8%

10.7%

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

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Problem 5-11 (continued)


Requirement 3
Rate of return on
shareholders equity

Net income
Shareholders equity

Metropolitan

$593.8
$144.9 + 2,476.9 - 904.7

= 34.6%

Republic

$424.6
$335.0 + 1,601.9 - 964.1

= 43.6%

Republic provides a greater return to common shareholders.


Requirement 4
Debt to equity ratio

Total liabilities
Shareholders equity

Metropolitan

$2,304.4
$144.9 + 2,476.9 - 904.7

= 1.34

Republic

$3,035.2
$335.0 + 1,601.9 - 964.1

= 3.12

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

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Problem 5-11 (continued)


Requirement 5
Current ratio

Current assets
Current liabilities

Metropolitan

$1,203.0
$1,280.2

.94

Republic

$1,478.7
$1,787.1

.83

Acid-test ratio

Metropolitan

$1,203.0 - 466.4 - 134.6


$1,280.2

.47

Republic

$1,478.7 - 635.2 - 476.7


$1,787.1

.21

Quick assets
Current liabilities

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
Sales
Accounts receivable

Receivables turnover ratio

Metropolitan

$5,698.0
$422.7

= 13.5 times

Republic

$7,768.2
$325.0

= 23.9 times

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Problem 5-11 (concluded)


Cost of goods sold
Inventory

Inventory turnover ratio

Metropolitan

$2,909.0
$466.4

= 6.2 times

Republic

$4,481.7
$635.2

= 7.1 times

Republics receivables turnover is more rapid than Metropolitans, perhaps


suggesting that its relative liquidity is not as bad as its acid-test ratio indicated.
Requirement 7
Times interest
earned ratio

Net income plus interest plus taxes


Interest

Metropolitan

$593.8 + 56.8 + 394.7


$56.8

= 18.4 times

Republic

$424.6 + 46.6 + 276.1


$46.6

= 16.0 times

Both firms provide an adequate margin of safety.

Problem 5-12
Branson Electronics Company
Income Statement
Revenues
Cost of goods sold
Gross profit
Advertising expense1
Other operating expenses2
Income before income taxes
Income tax expense3
Net income
1$50,000
2$48,000
3$75,500

$180,000
35,000
145,000
(12,500)
(57,000)
75,500
(27,180)
$ 48,320

4 = $12,500
+ [$59,000 50,000]
x 36%

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CASES
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
companys future earnings. Sunbeams earnings management strategy produced a
1997 earnings figure that was not indicative of the companys future profit-generating
ability.

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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 longterm 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.

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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:
Sales price
Cost of goods sold
Gross profit
Gross profit percentage

Original sale
$2,000,000
1,200,000
$ 800,000

Trade-in sale
$2,380,000
1,500,000
$ 880,000

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.

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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.

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Research Case 5-5


(Note: This case requires the student to reference a journal article.]

1.
2.
3.
4.

Fifty-five firms reported the use of one of the two long-term contract accounting
methods.
Twenty-seven of the firms are manufacturing companies.
Only one company uses the completed contract method. That company reported
using both methods.
The most frequently used approach to estimating a percentage-of-completion is
the cost-to-cost method.

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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

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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.

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Judgment Case 5-8


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

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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 enterprises 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 sellers price to the buyer is substantially fixed or determinable at the
date of sale.
b. The buyer has paid the seller and the obligation is not contingent on resale
of the product.
c.
The buyers obligation to the seller would not be changed in the event of
theft or physical destruction or damage of the product.
d. The buyer acquiring the product for resale has economic substance apart
from that provided by the seller.
e.
The seller does not have significant obligations for future performance 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.

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Case 5-9 (concluded)


Requirement 5
The two revenue recognition policies differ with respect to AMDs 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 AMDs 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, AMDs sales to distributors might be contingent on resale of the
product to end users, one of the six criteria that must be met before revenue can be
recognized when the right of return exists.

Judgment Case 5-10


1.
2.
3.
4.

Delta should recognize the $425 as revenue on May 15, the date the flight
commences.
Revenue should be recognized evenly over the period beginning after
Thanksgiving and ending April 30.
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.
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.

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Judgment Case 5-11


Bills 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. Johns argument is that the important factor
is the earnings process and that revenue should be recognized as the process takes
place.
Johns 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.

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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

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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.

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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

Integrating Case 5-18


Balance Sheet
Assets
Cash
Accounts receivable (net)
Inventory
Prepaid expenses and other current assets
Current assets
Property, plant, and equipment (net)
Liabilities and Shareholders Equity
Accounts payable
Short-term notes
Current liabilities
Bonds payable
Shareholders equity

$ 15,000
12,000
30,000
3,000
60,000
140,000
$200,000

given
(e)
(d)
(i)
(h)
(j)
(b)

$ 25,000
5,000
30,000
20,000
150,000
$200,000

(g)
given
(f)
(l)
(k)
(b)

Income Statement
Sales
Cost of goods sold
Gross profit
Operating
expenses
Solutions Manual,
Vol.1, Chapter
5
Interest expense
Tax expense
Net income

$300,000 (a)
(180,000) (c)
120,000
(c)
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(2,000) (m)
(7,000) (n)
$ 15,000 given

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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

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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%

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