Chapter 6

Reporting and Analyzing Revenues and Receivables

Learning Objectives coverage by question
Miniexercises 14, 15, 17 LO1 Describe and apply the criteria for determining when revenue is recognized. LO2 Illustrate revenue and expense recognition when the transaction involves future deliverables. LO3 Illustrate revenue and expense recognition for long-term projects. 18, 19, 20, LO4 Estimate and account for uncollectible accounts receivable. LO5 Calculate return on capital employed, net operating profit after taxes, net operating profit margin, accounts receivable turnover, and average collection period. LO6 Discuss earnings management and explain how it affects analysis and interpretation of financial statements. LO7 Appendix 6A Describe and illustrate the reporting for nonrecurring items. 27, 32, 34 42, 43, 44 47, 48 21, 23 33, 34, 35, 36, 37 43, 44, 45 49 17, 24, 25 Exercises 26, 27, 32, 39 Problems Cases 47, 48, 49

39

46

48

13, 16

28, 29, 30

41

22

34, 38

44

49

31

40

47

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 6 6-1

QUESTIONS
Q6-1. Revenue must be realized or realizable and earned before it can be reported in the income statement. Realized or realizable means that the companys net assets have increased, that is, the company has received an asset (for example, cash or accounts receivable) or satisfied a liability as a result of the transaction. Earned means that the company has done everything it must do under the terms of the sale. For retailers, like Abercrombie & Fitch, revenue is generally earned when title to the merchandise passes to the buyer (e.g., when the buyer takes possession of the merchandise), because returns can be estimated. For companies operating under long-term contracts, the earning process is typically measured using the percentage-of-completion method, that is, by the percentage of costs incurred relative to total expected costs. Q6-2. Financial statement analysis is usually conducted for purposes of forecasting future financial performance of the company. Discontinued operations are, by definition, not expected to continue to affect the profits and cash flows of the company. Accordingly, the financial statements separately report discontinued operations from continuing operations to provide more useful measures of financial performance and financial income. For example, yielding an income measure that is more likely to persist into the future, and a net assets measure absent discontinued items. Q6-3. In order for an event to be classified as an extraordinary item, its occurrence must be both unusual and infrequent. Items that are considered to be both unusual and infrequent might be the destruction of property by natural disaster or the expropriation of assets by a foreign government in which the company operates. Gains and losses on early retirement of long-term bonds, once comprising the majority of extraordinary items, are no longer considered as such unless they meet the tests outlined above. Other events not likely to be included as extraordinary items include asset write-downs, gains and losses on the sales of assets, and costs related to an employee strike. Q6-4. Restructuring costs typically consist of two general categories: asset write-downs and accruals of liabilities . Asset write-downs reduce assets and are recognized in the income statement as an expense that reduces income and, thus, equity. Liability accruals create a liability, such as for anticipated severance costs and exit costs, and yield a corresponding expense that reduces income and equity. Big bath refers to an event in which companies are perceived as overestimating the amount of asset write-downs or liability accruals to deliberately reduce current period earnings so as to remove future costs from the balance sheet or to create reserves that can be used to increase future period earnings.
Cambridge Business Publishers, 2011 6-2 Financial Accounting, 3rd Edition

Q6-5. Earnings management may be motivated by a desire to reach or exceed previously stated earnings targets, to meet analysts expectations, or to maintain steady growth in earnings from year to year. This desire to achieve income goals may be motivated by the need to avoid violating covenants in loan indentures or to maximize incentive-based compensation. The tactics used to manage income involve transaction timing (recognizing a gain or loss) and estimations that increase (or decrease) income to achieve a target. Q6-6. Pro forma income adjusts GAAP income to eliminate (and sometimes add) various items that the company believes do not reflect its core operations. Such pro forma disclosures are only reported in earnings and press releases and are not part of the published 10-Ks or other annual reports provided for shareholders. The SEC requires that GAAP income be reported together with pro forma income. Yet, companies often report their GAAP income at the very end of the earnings or press release, thus obfuscating their comparison and focusing attention on the pro forma income. It is because of this potential to confuse the reader about the true financial performance of the company that the SEC has become concerned. Also, pro forma numbers are not subject to accepted standards (and, thus, we observe differing definitions across companies), are not subject to usual audit tests, and are subject to considerable management latitude in what is and is not included and how items are measured. Q6-7. Estimates are necessary in order to accurately measure and report income on a timely basis. For example, in order to record periodic depreciation of long-lived assets, one must estimate the useful life of the asset. Estimates allow accountants to match revenues and expenses incurred in different periods. For example, accountants estimate warranty costs so that the warranty expense is matched against the corresponding sales revenue. If the accounting process waited until no estimates were necessary, there would be a significant delay in the reporting of financial results. Q6-8. When analysts publish earnings forecasts, these forecasts become a benchmark against which some investors evaluate the companys performance. A company that fails to meet analysts forecasts may suffer a stock price decline, even though earnings are higher than previous years earnings and overall performance is good. Consequently, management may feel pressure to meet or slightly exceed analysts forecasts of earnings.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 6 6-3

Q6-9. Bad debts expense is recorded in the income statement when the allowance for uncollectible accounts is increased. If a company overestimates the allowance account, net income will be understated on the income statement and accounts receivable (net of the allowance account) will be underestimated on the balance sheet. In future periods, such a company will not need to add as much to its allowance account since it is already overestimated from that prior period (or, it can reverse the existing excess allowance balance). As a result, future net income will be higher. On the other hand, if a company underestimates its allowance account, then current net income will be overstated. In future periods, however, net income will be understated as the company must add to the allowance account and report higher bad debts expense. Q6-10. There are several possible explanations for a decrease in the allowance account. First, after an aging of accounts receivable, Wallace Company may have determined that a smaller percentage of its receivables are past due. Wallace Company may have changed its credit policy such that it is attracting lower-risk customers than in the past. Second, experience may have indicated that the percentages used to estimate uncollectibles was too high in previous years. By correcting the estimated percentage of defaults, the estimated uncollectibles would end up lower than in past years. Third, Wallace Company may be managing earnings. By lowering estimated uncollectibles, the company can increase current earnings, but may end up reporting a loss in a future year when write-offs exceed the balance in the allowance account. Q6-11. Minimizing uncollectible accounts is not necessarily the best objective for managing accounts receivable. That objective could be accomplished by not offering to sell to customers on credit. The purpose of offering credit to customers is to increase sales and profits. Losses from uncollectible accounts are a cost of doing business. As long as the benefit (greater contribution to profits due to increased sales) exceeds the cost (increased losses due to uncollectibles) then a higher-risk credit policy which increases the amount of uncollectible accounts would be a more profitable policy. Q6-12. The number of defaults tends to rise and fall with the economy. For example, in a recession, customers are more likely to default and companies take longer, on average, to pay their bills than during a healthy economy. This would result in higher estimated uncollectibles if the estimates are based on an aging of accounts receivable. For many companies, sales revenue also tends to decline during a recession. If estimated uncollectibles are estimated as a percentage of sales, then the estimate would tend to fall in a recession. This is contrary to the increase in the number of defaults that occurs during a recession. Therefore, the percentage of sales approach is not as sensitive to changing economic conditions as is accounts receivable aging.

Cambridge Business Publishers, 2011 6-4 Financial Accounting, 3rd Edition

MINI EXERCISES
M6-13 (15 minutes) Note: The completed contract method is not required but is presented for the purpose of comparison. Percentage-of-Completion Method Completed Contract Percent Revenue Income of total recognized (revenue Costs expected (percentage of costs Revenue Year incurred costs costs incurred incurred) recognized Income (rounded) total contract amount) 2009 2010 2011 $ 400,000 1,000,000 500,000 21%a 53%b 26%c $ 525,000 1,325,000 650,000 $2,500,000 $125,000 325,000 150,000 $600,000 0 0 0 0

$2,500,000 $600,000 $2,500,000 $600,000

Total $1,900,000
a b c

$400,000 / $1,900,000 $1,000,000/ $1,900,000 $500,000 / $1,900,000

M6-14 (20 minutes) Company GAP Merck Revenue recognition When merchandise is given to the customer and returns can be estimated (or the right of return period has expired). When merchandise is given to the customer and returns can be estimated (or the right of return period has expired). The company will also establish a reserve and recognize expense relating to uncollectible accounts receivable at the time the sale is recorded. When merchandise is given to the customer and the right of return period, if any, has expired. The company will also establish a reserve and recognize expense for uncollectible accounts receivable and anticipated warranty costs at the time the sale is recorded. Interest is earned by the passage of time. Each period, Bank of America accrues income on each of its loans and establishes a receivable on its balance sheet. Revenue is recognized under long-term contracts under the percentage-of-completion method.

Deere

Bank of America Johnson Controls

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 6 6-5

M6-15 (15 minutes) The Unlimited can only recognize revenues once they have been earned and the amount of returns can be estimated with sufficient accuracy. Assuming that happens at the time of sale, it must estimate the proportion of product that is likely to be returned and deduct that amount from gross sales for the period. In this case, it would report $4.9 million in net revenue (98% of $5 million) for the period. If The Unlimited does not have sufficient experience to estimate returns, then it should wait to recognize revenue until the right of return period has elapsed. M6-16 (20 minutes) a. Percentage-of-completion method: Year 2009 2010 Percent completed 30% 50% Revenue $12,000,000 $20,000,000 Construction costs 9,000,000 15,000,000 Gross profit $3,000,000 $5,000,000 b. Completed contract method: Year 2009 Revenue Construction costs Gross profit

2011 20% $8,000,000 6,000,000 $2,000,000

Total $40,000,000 30,000,000 $10,000,000

2010

2011 $40,000,000 30,000,000 $10,000,000

Total $40,000,000 30,000,000 $10,000,000

M6-17 (20 minutes) a. A.J. Smith should recognize the warranty revenue as it is earned. Since the warranties provide coverage for three years beginning in 2010, one-third of the revenue should be recognized in 2010, one-third in 2011, and the remaining third in 2012. 2010 $566,666 166,666 $400,000 2011 $566,667 166,667 $400,000 2012 $566,667 166,667 $400,000 Total $1,700,000 500,000 $1,200,000

b. Year Revenue Warranty expenses Gross profit

Cambridge Business Publishers, 2011 6-6 Financial Accounting, 3rd Edition

M6-17continued c. Total revenue from sales of the camera packages is $79,800 ($399 x 200). The revenue is allocated among the three elements of the sale (camera, printer and warranty) as follows: Element Camera Printer Warranty Total Retail price $300 125 75 $500 Proportion of total 60% ($300/$500) 25% ($125/$500) 15% ($75/$500) 100%

Using these proportions, the revenue is allocated among the three elements and recognized for each element as it is earned. In this case, the portion of the revenue allocated to the camera and printer are recognized immediately, while the revenue allocated to the warranty is deferred and recognized over the three-year warranty coverage period. Year 2010 2011 2012 2013 Total M6-18 (15 minutes) a. To bring the allowance to the desired balance of $2,100, the company will need to increase the allowance account by $1,600, resulting in bad debt expense of that same amount. b. The net amount of Accounts Receivable is calculated as follows: $98,000 $2,100 = $95,900. c.
- Allowance for Doubtful Accounts (XA) + 500 Balance 1,600 (a) 2,100 Balance (a) Balance + Bad Debt Expense (E) 1,600 1,600

Revenue $67,830 3,990 3,990 3,990 $79,800

($79,800 x .6 + $79,800 x .25) ($79,800 x .15 / 3)

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 6 6-7

M6-19 (15 minutes) a. Credit losses are incurred in the process of generating sales revenue. Specific losses may not be known until many months after the sale. A company sets up an allowance for uncollectible accounts to place the expense of uncollectible accounts in the same accounting period as the sale and to report accounts receivable at its estimated realizable value at the end of the accounting period. b. The balance sheet presentation shows the gross amount of accounts receivable, the allowance amount, and the difference between the two, the estimated net realizable value. The balance sheet, thus, reports the net amount that we expect to collect. That is the amount that is the most relevant to financial statement users. c. The matching concept requires that expenses (credit losses) related to a given revenue be matched with, and deducted from, the revenue in the determination of net income. This dictates the use of the allowance method. Recognition of expense only upon the write-off of the account would delay the reporting of our knowledge that losses are likely and, thereby, reduce the informativeness of the income statement. Accountants believe that providing more timely information justifies the use of estimates that may not be as precise as we would like. M6-20 (20 minutes) a. ($ millions) Accounts receivable (net).................................. Allowance for uncollectible accounts.............. Gross accounts receivable................................ Percentage of uncollectible accounts to gross accounts receivable..............................

2008 $4,704 129 $4,833 2.67% ($129/$4,833)

2007 $5,197 94 $5,291 1.78% ($94/$5,291)

b. The increase in the allowance for uncollectible accounts as a percentage of gross accounts receivable may indicate that the quality of the accounts receivable has declined, perhaps because the economy has deteriorated, the company is selling to a less creditworthy class of customers, or the companys management of accounts receivable is less effective. It may also indicate, however, that the receivables were under-reserved (e.g., allowance account was too low last year). This would result in lower reported profits in the current year because past profits were too high.

Cambridge Business Publishers, 2011 6-8 Financial Accounting, 3rd Edition

M6-21 (10 minutes) Bad debt expense of $2,400 ($120,000 0.02) would cause the allowance for uncollectibles to increase by the same amount. If the allowance increased by only $2,100 for the period, Sloan Company must have written off accounts totaling $300. Under accounts receivable, sales revenue increased the account by $120,000, and the write offs would decrease it by $300. If there was a net increase of $15,000 for the period, Sloan Company must have collected $104,700 in cash. ($104,700 = $120,000 - $300 - $15,000.) M6-22 (20 minutes) a. Accounts Receivable Turnover rates for 2009 Procter & Gamble Colgate-Palmolive $76,029 / [($5,836+$6,761)/2] = 12.07 $15,330 / [($1,592+$1,681)/2] = 9.37

b. P&G turns its accounts receivable much faster than Colgate-Palmolive. Receivable turns typically evolve to an equilibrium level for each industry that arises from the general business models used by industry competitors. Differences can arise due to variations in the product mix of competitors, the types of customers they sell to, their willingness to offer discounts for early payment, and their relative strength vis--vis the companies or individuals owing them money. Both of these companies sell a significant amount of their product to Wal-Mart. P&G is a sizable company, and may have greater bargaining power over Wal-Mart than does the smaller Colgate-Palmolive.

One other possibility is that the difference is due to the companies differing fiscal year-ends. If the receivable balance is not constant during the year due to some seasonality, then the receivable turnover ratio will depend on the choice of fiscal year.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 6 6-9

M6-23 (20 minutes) a. i. Accounts receivable (+A) Sales revenue (+R, +SE) ii. iii. iv. Bad debts expense (+E, -SE) Allowance for uncollectible accounts (+XA, -A) Allowance for uncollectible accounts (-XA, +A) Accounts receivable (-A) Accounts receivable (+A) Allowance for uncollectible accounts (+XA, -A) Cash (+A) Accounts receivable (-A)

3,200,000 3,200,000 42,000 42,000 39,000 39,000 12,000 12,000 12,000 12,000

The recovered receivable is reinstated, so that its payment may be properly recorded. b. Besides the $12,000 in recovery, the collections from customers can be summarized in the following entry: v. Cash (+A) Accounts receivable (-A) 2,926,000 2,926,000

(This amount includes payment of the recovered receivable for $12,000. The allowance increases by $15,000 over the period, so the fact that net receivables increased by $220,000 means that gross receivables must have increased by $235,000. That fact allows us to back out the cash received.) c.
(iv) (v) Cash (A) 12,000 2,926,000 2,938,000 + Accounts Receivable (A) 3,200,000 12,000 39,000 12,000 2,926,000 235,000 Allowance for Uncollectibles (XA) 42,000 39,000 12,000 15,000 + Sales Revenue (R) + 3,200,000 (i)

+ (ii) (iii) (iv) (v) + (ii) (iv)

(i) (iv)

Bad Debts Expense (E) 42,000

(iii)

Cambridge Business Publishers, 2011 6-10 Financial Accounting, 3rd Edition

d.
Balance Sheet
Transaction i. Sales on account. ii. Bad debt expense. Cash Asset Noncash + Assets +3,200,000 Accounts Receivabl e Contra Assets = Liabilities = + Contrib. Capital + Earned Capital +3,200,000 Retained Earnings -42,000 Retained Earnings

Income Statement
Revenues +3,200,000 Sales Revenue - Expenses = Net Income = +3,200,000

+42,000 - Allowance for = Uncollectible Accounts -39,000 -39,000 Accounts - Allowance for = Receivabl Uncollectible e Accounts +12,000 +12,000 Accounts - Allowance for Receivabl Uncollectible e Accounts +12,000 Cash -12,000 Accounts Receivabl e -2,926,000 Accounts Receivabl e

+42,000 Bad Debt = Expense

-42,000

iii. Write-off of uncollectible accounts. iv. Reinstate account previously written off.

Collect reinstated account. v. Collect cash on sales.

+2,926,000 Cash

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 6 6-11

M6-24 (15 minutes) a. Fiscal year 2007 2008 2009 2010 b. Fiscal year 2007 2008 2009 2010 c. Revenue 48,000 55,000 62,000 62,000 Unearned revenue liability (end of year) 20,000 24,000 26,000 25,000 Purchases = Revenue + Change in Unearned revenue liability 55,000 + 4,000 = 59,000 62,000 + 2,000 = 64,000 62,000 - 1,000 = 61,000 Growth in purchases Revenue 48,000 55,000 62,000 62,000 Revenue growth 14.6% 12.7% 0.0%

8.5% -4.7%

In both fiscal year 2009 and 2010, the growth in customer purchases is lower than the growth in reported revenues. The practice of deferring revenue recognition implies that reported revenues in a given period are the result of customer purchases over many periods, resulting in a smoothing of revenues. In the case of Finn Publishing, revenues in any given year are the result of newsstand and bookstore purchases during that year, plus part of the subscriptions from that year, plus part of the subscriptions from the previous year. That means that growth in annual revenues is a composite of growth in customer purchases over an even longer period of time. For 2009 and 2010, Finns growth in revenues exceeds the growth in purchases because the revenues are still reflecting growth from prior periods. Purchases are a leading indicator of revenues, and calculating purchase behavior can be useful in forecasting future revenue and identifying changes in customers attitudes about a companys current offerings.

M6-25 (20 minutes) This question is based on an actual situation, in which the accounting rules were influencing the product decisions. The rules for revenue deferral when there are multiple deliverables deterred the company from providing enhancements and upgrades that were available. If Commtechs customers (the wireless companies) had been willing to pay for the upgrades to its customers phones, that would have been allowed. (Its not clear what the wireless companies incentives would be, because they may want to encourage users to purchase new phones with a new service contract rather than improving their existing phones.)
Cambridge Business Publishers, 2011 6-12 Financial Accounting, 3rd Edition

M6-25continued. The question can generate a discussion about whether accounting should drive decisions. Whether it should or not, it does, so the question should evolve into what top management should do about this type of situation. Does the situation described in the problem require some managerial action, or not. Is the company foregoing sales because of its accounting? Within Commtech, the finance staff was skeptical of marketings predictions that the upgrades and enhancements would increase the sales of existing phone models. If the upgrades and enhancements are delivered, Commtech will have to change its accounting for revenue, with a resulting decrease in near-term profitability. How might the company communicate that change in a way that the investing public will understand as a net benefit to the company?

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 6 6-13

EXERCISES
E6-26 (20 minutes) Company The Limited Boeing Corporation SUPERVALU MTV Real estate developer Wells Fargo Revenue recognition When merchandise is given to the customer and returns can be estimated (or the right of return period has expired). Revenue is recognized under long-term contracts under the percentage-of-completion method. When merchandise is given to the customer and cash is received. When the content is aired by the TV stations. When title to the houses is transferred to the buyers. Interest is earned by the passage of time. Each period, Wells Fargo accrues income on each of its loans and establishes an account receivable on its balance sheet. When title to the motorcycles is transferred to the buyer. Harley will also set up a reserve for anticipated warranty costs and recognize the expected warranty cost expense when it recognizes the sales revenue. When the magazines are sent to subscribers.

HarleyDavidson

Time-Warner

E6-27 (20 minutes) Company Real Money Revenue recognition Recognize revenue ratably over the period of time that customers can access its Web site, not when the cash is received. The recognition of revenue is dependent upon Real Money providing updates. The fee to purchase the right to use the software can be recorded as revenue when the software is installed, unless that fee includes future deliverables like upgrades and support. (If such post-sale services are included in the fee, some portion must be deferred and recognized over the appropriate period.) Service revenue can only be recognized ratably over the period of time covered by the service contract. Recognize revenue when the software is sent to customers. The company must estimate potential warranty claims and establish a reserve for them when revenue is recorded. Record revenue after the 10-day right of return period has elapsed.

Oracle

Intuit

Computer game developer

Cambridge Business Publishers, 2011 6-14 Financial Accounting, 3rd Edition

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 6 6-15

E6-28 (20 minutes) a.

($ millions)

Year 2010 2011

Costs incurred $100 300 $400

Percentage-of-Completion Method Revenue recognized Percent Income (percentage of costs (revenue of total incurred total expected costs costs incurred) contract amount) 25% 75% $125 375 $500 $ 25 75 $100

Completed Contract Revenue recognized $ 0 500 $500

Income $ 0 100 $100

b.
($ millions)

Installment Method Revenue recognized $300 200 $500

Expense recognized [Revenue 1- gross profit margin (20%)]

Year 2010 2011

Cash collected $300 200 $500

Income (Revenue 20%) $ 60 40 $100

$240 160 $400

c. The percentage-of-completion method normally provides a reasonable estimate of the revenues, expenses, and income earned for each period. A key is obtaining good estimates of expected costs and costs to date. This method is also acceptable under GAAP for contracts spanning more than one accounting period, such as in the consulting and transportation industries.

Cambridge Business Publishers, 2011 6-16 Financial Accounting, 3rd Edition

E6-29 (20 minutes) a. ($ millions) Costs incurred $15 40 30 $85

($ millions)

Year 2010 2011 2012

Percentage-of-Completion Method Revenue recognized Percent Income (percentage of costs (revenue of total incurred total expected costs costs incurred) contract amount) (rounded) 18% $ 21.6 $ 6.6 ($15/$85) 47% 56.4 16.4 ($40/$85) 35% 42.0 12.0 ($30/$85) $120.0 $35.0 Installment Method Revenue recognized $30 50 40 $120
Expense recognized [Revenue 1- gross profit margin (29.17%)]

Completed Contract Revenue recognized $ 0 0 120 $120

Income $ 0 0 35 $ 35

Year 2010 2011 2012

Cash collected $30 50 40 $120

Income (Revenue 29.17%) $ 8.75 14.58 11.67 $35.00

$21.25 35.42 28.33 $85.00

b. The percentage-of-completion method provides a good estimate of the revenue and income earned in each period. This method is also acceptable under GAAP for contracts spanning more than one accounting period. Recognition of revenue and income is not affected by the cash received, except under the installment method. E6-30 (15 minutes) a. Year 2010 Revenue $1,000,000 Cost of software* 180,000 Gross profit $820,000

2011 $750,000 135,000 $615,000

2012 $500,000 90,000 $410,000

2013 $250,000 45,000 $205,000

Total $2,500,000 450,000 $2,050,000

* $180,000 = $450,000 x $1,000,000/$2,500,000 $135,000 = $450,000 x $750,000/$2,500,000 $90,000 = $450,000 x $500,000/$2,500,000 $45,000 = $450,000 x $250,000/$2,500,000
Cambridge Business Publishers, 2011 Solutions Manual, Chapter 6 6-17

E6-30continued. b. By 2012, Bryant had recognized gross profit of $1,435,000 ($820,000 + $615,000). However, only $315,000 ($180,000 + $135,000) of the software cost had been recognized. If none of the remaining cost was recoverable after the default, Bryant would recognize a loss equal to the remaining cost in 2012. Hence, Bryant would record a loss in 2012 of $135,000 ($90,000 + $45,000).

E6-31 (15 minutes) a.

Balance Sheet
Transaction
a. To record restructuring loss Cash Asset

Income Statement
Earned Capital

-159

LiabilContrib. + Noncash Assets = ities + Capital +

-186

+198

-543

Net Revenues - Expenses = Income

+ 543

-543

Plant Assets, etc.

Liability for Restructuring

Retained Earnings

Loss due to Restructuring

Loss due to restructuring 543 Plant assets, etc.* 186 Cash 159 Liability for restructuring 198 * The credit to plant assets would most likely be recorded in a contra asset account.
+ Cash (A) 159 + Plant Assets (A) 186

(a)

(a)

(a)

+ Loss Due to Restructuring (E) 543

- Liability for Restructuring (L) + 198

(a)

b. Restructuring charges should not be classified as discontinued operations. The term discontinued operations refers to discontinuing a component of the company with separately identifiable operations and cash flows. Restructuring charges generally do not meet this definition. However, restructuring charges are a transitory component of income and, if material, should be reported separately in the income statement (which PepsiCo does not).

Cambridge Business Publishers, 2011 6-18 Financial Accounting, 3rd Edition

E6-32 (15 minutes) In none of these cases should Simpyl Technologies recognize revenue. Each of the four settings touches on one of the four conditions for revenue recognition listed by the SEC. In part a, persuasive evidence of an exchange agreement does not yet exist, because the companys policies have defined a contract with authorized signatures to constitute persuasive evidence. In part b, delivery has not occurred. The product has been shipped, but not to the customer and not with the specified customizations that are required by the customer. In part c, the price is not yet fixed or determinable, because the negotiations over volume discounts have not been concluded. Finally, the distributor in part d does not have the means to pay for the items delivered, so collectibility cannot be reasonably assured (until the distributor sells the product to an end customer). The delivery should be viewed as a consignment arrangement, in which Simpyl recognizes revenue when the distributor sells the items to a third party. This problem is based on the restatements of Symbol Technologies, Inc.s 10K filing for fiscal year 2002, in which they detail the errors and irregularities in financial statements dating back to 1998. Symbol had made accounting entries that violated each of the SECs four criteria for revenue recognition. An article by Steve Lohr describing the incoming CEOs experiences at Symbol Technologies can be found in the New York Times, June 21, 2004. The title of the article is Day 2: I Learn the Books are Cooked. (Motorola, Inc., acquired Symbol Technologies in January 2007 for a price of $3.9 billion.) E6-33 (20 minutes) a. Prior to the aging of accounts, the balance in the Allowance for Uncollectible Accounts would be a credit of $520 (the opening balance of $4,350 less the amounts written off of $3,830). 2010 bad debt expense computation $250,000 0.5% $90,000 1% 20,000 2% 11,000 5% 6,000 10% 4,000 25% Less: Unused balance before adjustment Bad debt expense for 2010 = = = = = = $1,250 900 400 550 600 1,000 4,700 520 $4,180

b. Accounts receivable, net = $381,000 - $4,700 = $376,300 Reported in the balance sheet as follows:
Cambridge Business Publishers, 2011 Solutions Manual, Chapter 6 6-19

Accounts receivable, net of $4,700 in allowances............................... c.

+ (a) Bad Debts Expense (E) 4,180 -

$376,300

Allowance for Uncollectible Accounts (XA) + 4,350 Balance Write-offs 3,830 4,180 (a) 4,700 Balance

E6-34 (35 minutes) a. Allowance for doubtful accounts (-XA) Accounts receivable (-A) 400 400 773

Allowance for doubtful accounts (-XA) 773 Provision for doubtful accounts (-E,+SE)

The latter entry is the reverse of the normal one (and reversed from previous years). The provision for doubtful accounts (bad debt expense) has a credit entry that has the effect of increasing Ethan Allens reported income by $773 (thousand) for the year. b. and c. 2009 From the income statement: Net sales From the balance sheet: Accounts receivable, net From the disclosure on Allowance for doubtful accounts: Balance at beginning of period Additions (reductions) charged to income Adjustments or deductions Balance at end of period Gross receivables (net plus allowance) Allowance as a % of gross receivables Accounts receivable turnover (Sales Average AR, net) $674,277 13,086 2008 2007 $980,045 $1,005,312 12,672 14,602

2,535 (773) (400) 1,362 14,448 9.4% 52.4

2,042 493 2,535 15,207 16.7% 71.9

2,074 10 (42) 2,042 16,644 12.3%

Cambridge Business Publishers, 2011 6-20 Financial Accounting, 3rd Edition

Ethan Allens allowance was 16.7% of its gross receivables at the end of 2008. If that percentage were applied to the 2009 gross receivables, it would produce an allowance of $2,408 (14,44816.7%) which is $1,046 higher than the amount in Ethan Allens allowance at the end of 2009. Bad debt expense (provision for doubtful accounts) would have been higher by this amount if the same percentage were applied. d. Accounts receivable started with a balance of $15,207 and was increased by $674,277 in net sales. The account was decreased by write-offs of $400, and ended with a balance of $14,448. Therefore, the amount collected must have been $674,636 ($15,207 + $674,277 - $400 - $14,448). e. The patterns in Ethan Allens allowance account are unusual. In 2008, the company recorded a large bad debt expense relative to previous years, but wrote off no accounts. In 2009, the company wrote off some accounts (less than 3% of the opening balance), and then reduced its allowance by debiting it and crediting income. Perhaps the company was overly pessimistic about its collections in 2008 and became much more optimistic in 2009. That is not the experience of many companies in this time period. The very fast ART is probably due to the custom furniture aspect of Ethan Allens business. Many of their products are not produced until a customer places an order, so payment occurs very soon after delivery. E6-35 (20 minutes) Accounts receivable Less Allowance for uncollectible accounts Computations
Accounts Receivable Beginning balance Sales Collections Write-offs ($3,600 + $2,400 +$900) Provision for uncollectibles ($1,173,000 0.8%) $ 122,000 1,173,000 (1,150,000) (6,900) _________ $ 138,100 Allowance for Uncollectible Accounts $ 7,900 (6,900) 9,384 $ 10,384

$138,100 10,384

$127,716

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 6 6-21

E6-36 (20 minutes) a. Aging schedule at December 31, 2010 Current $304,000 1% = $ 3,040 060 days past due 44,000 5% = 2,200 61180 days past due 18,000 15% = 2,700 Over 180 days past due 9,000 40% = 3,600 Amount required 11,540 Balance of allowance 4,200 Provision $ 7,340 = 2010 bad debt expense Current Assets Accounts receivable Less: Allowance for uncollectible accounts
+ (a) Bad Debts Expense (E) 7,340 -

b.

$375,000 11,540

$363,460

c.
- Allowance for Uncollectible Accounts (XA) + 4,200 Balance 7,340 (a) 11,540 Balance

E6-37 (30 minutes) a. Year 2009 2010 2011 Total Sales $ 751,000 876,000 972,000 $2,599,000 Collections $ 733,000 864,000 938,000 $2,535,000 Accounts Written Off $ 5,300 5,800 6,500 $17,600

Accounts Receivable at the end of 2011 is: $46,400, computed as ($2,599,000 - $2,535,000 - $17,600). Bad Debts Expense is: 2009 2010 2011 2009-2011 $ 7,510 8,760 9,720 $25,990 computed as 1% computed as 1% computed as 1% computed as 1% $751,000 $876,000 $972,000 $2,599,000

Allowance for Uncollectible Accounts is: $8,390, computed as $25,990 total bad debts expense less $17,600 in total write-offs.
Cambridge Business Publishers, 2011 6-22 Financial Accounting, 3rd Edition

E6-37continued. b.
Accounts Receivable (A) Beg Bal 0 Sales 2009 Bal Sales 2010 Bal Sales 2011 Bal 751,000 12,700 876,000 18,900 972,000 46,400 6,500 938,000 Write offs Collections 8,390 2011 Bal Write offs 6,500 5,800 864,000 Write offs Collections 5,170 9,720 2010 Bal Bad debts expense Write offs 5,800 5,300 733,000 Write offs Collections 2,210 8,760 2009 Bal Bad debts expense Allowance for Uncollectibles (XA) 0 Beg Bal Bad debts Write offs 5,300 7,510 expense

There isnt any indication that the 1% rate is incorrect. If the rate is too high, we would expect the allowance to grow at a faster rate than receivables. If the rate is too low, the opposite would occur. In this case, the allowance percentage of receivables is 17%, 27% and 18% at the end of 2009, 2010 and 2011, respectively. So, there is no clear direction that would indicate an inappropriate estimate. E6-38 (20 minutes) a. Earnings from operation s Technology Solutions Group Personal Systems Group Imaging and Printing Group HP Financial Services $ 5,529 2,375 4,590 192 End. Assets Beg. Assets Avg. Assets ROCE

$ 63,008 16,4 51 14,20 3 9,17 4

$ 39,116 14,153 14,5 73 9,0 01

$ 51,062 15, 302 14, 388 9, 088

10.8% 15.5% 31.9% 2.1%

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 6 6-23

b. Earnings from operations Technology Solutions Group Personal Systems Group Imaging and Printing Group HP Financial Services c. NOPAT=(10.2)Earnings from Opns Revenues NOPM

$5,529 2,375 4,590 192

$4,423 1,900 3,672 154

$44,826 42,295 29,385 2,698

9.9% 4.5% 12.5% 5.7%

The most profitable group seems to be the Imaging and Printing Group, which represents HPs traditional strength. However, it is not growing very quickly (sales percentage increases in the single digits). The Personal Systems Group (commercial and personal PCs, workstations, etc.) has good ROCE, even though its NOPM is not high, because it has high asset turnover. The Technology Solutions Group (including the newly-acquired EDS consulting business) has substantial assets, which reduce the ROCE, but it is the area of highest growth.

E6-39 (20 minutes) a. Just like for-profit organizations, not-for-profit organizations cannot recognize revenue until it has been earned. In the case of The Lyric Opera, it cannot recognize the ticket revenue until the performances occur. (The Lyric does not issue quarterly reports, so we cannot observe how much of the revenue has been earned by six months through its fiscal year.) b. This entry is simplified by the fact the fiscal year-end is after the end of the current season and by assuming that all of The Lyrics deferred revenue relates to the following season (and none to any years after the following season). To record revenue for the fiscal year 2009 season: Deferred ticket and other revenue (-L) 17,246 Cash or Accounts receivable (+A) 10,805 Ticket sales (+R, +NA)

28,051

(As a not-for-profit, The Lyric Opera does not have shareholders equity, but rather net assets. Therefore, the recognition of revenue increases net assets (NA) on the balance sheet.) To record advance purchases for the fiscal year 2010 season: Cash or Accounts receivable (+A) 13,103 Deferred ticket and other revenue (+L) 13,103
Cambridge Business Publishers, 2011 6-24 Financial Accounting, 3rd Edition

c.

d.

Its likely that the downturn in the economy caused some subscribers not to renew (or to wait until after April 30 to renew). Its possible that the decline in advance purchases is a statement about the opera selections for the 2009-10 season. However, the loyal subscriber base (and the desire to keep ones assigned seating) makes the economy a more likely cause. The Lyric Opera usually operates at close to seating capacity. And, in a typical year, approximately 60% of its seats are sold by the April 30th preceding the season. So, the quantity of unsold seats will affect The Lyrics marketing efforts for subscribers who have not yet renewed, outreach to new potential subscribers and promotions for individual tickets which go on sale shortly before the season. Those efforts can be scaled up or down depending on the experience with advance sales.

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PROBLEMS
P6-40A (20 minutes) a. The following items might be considered to be operating: 1. Net Sales, cost of sales, R&D expenses, and SG&A expenses are typically designated as operating. 2. Amortization of intangible assets and restructuring charges would usually be considered to be operating under the assumptions that the acquisition that gave rise to the intangible assets is included as part of operations, and that the restructuring did not involve discontinuation of distinct parts of the business. 3. The asbestos-related credit would be considered to be operating since it is related to Dow Chemicals operating activities. The same is true of the goodwill impairment losses. (These items are both operating and transitory see b.) 4. Purchased in-process research and development charges and Acquisitionrelated expenses are caused by the companys investing activities, and would be considered nonoperating. 5. Equity in earnings of nonconsolidated affiliates would be considered operating under the assumption that the affiliates are related to Dows core operations, which is typically the case. 6. Sundry income would generally be considered nonoperating in the absence of a footnote clearly indicating its connection to the operating activities of the company. 7. Interest income (expense) is considered nonoperating 8. Minority interests share in income is nonoperating as it relates to equity that is nonoperating. Due to changes discussed in Chapter 12, Dows 2009 income statement will not show Minority interest in the determination of net income. b. The following items might be identified as transitory items: 1. Purchased in-process research and development and Acquisition-related expenses these are one-time (e.g., transitory) costs incurred in connection with the acquisition of another company and can properly be expensed under GAAP. 2. Asbestos-related credit this is a reversal of a previous accrual for litigation in connection with asbestos-related lawsuits. GAAP requires such an accrual if the loss is probable and can be reasonably estimated. Since it is a one-time occurrence, it can be considered to be a transitory item. 3. Goodwill impairment losses this loss results from changes in expectations of the performance of past acquisitions. It would be considered operating, but transitory. 4. Restructuring charges these relate to the companys actions due to the economic decline in 2008 and the expectations that future performance will
Cambridge Business Publishers, 2011 6-26 Financial Accounting, 3rd Edition

not meet prior expectations. Restructuring costs are considered special items, meaning that individually they are transitory, but as a category, they happen frequently. (Dow had restructuring charges from other causes of $578 million and $591 million in 2007 and 2006, respectively.) We would need to examine prior years income statements to discern if the other categories in Dows income statement are to be considered transitory. P6-41 (20 minutes) a. 1. Percentage-of-completion based on number of employees trained Year 2010 2011 2012 Total Number of employees trained 125 200 75 400 Revenues (# trained x $1,200) $150,000.00 $240,000.00 $90,000.00 $480,000.00 Expenses (# trained x $437.50)* 54,687.50 87,500.00 32,812.50 175,000.00 Gross Profit $95,312.50 $152,500.00 $57,187.50 $305,000.00 * $437.50 = $175,000 / 400 2. Percentage-of-completion based on costs incurred Year 2010 2011 2012 Costs incurred $60,000 $75,000 $40,000 Percentage completed 34.29% 42.86% 22.86% Revenues (% x $480,000) $164,571.43 $205,714.29 $109,714.29 Expenses 60,000.00 75,000.00 40,000.00 Gross Profit $104,571.43 $130,714.29 $69,714.29 3. Completed contract method Year Revenues Expenses Gross Profit 2010 $0 0 $0 2011 $0 0 $0 2012 $480,000 175,000 $305,000 Total $175,000 100.00% $480,000.00 175,000.00 $305,000.00 Total $480,000 175,000 $305,000

b. Assuming that (1) Philbrick has a noncancelable contract that specifies the price at $1,200 per employee, (2) the number of employees and the costs of training can be estimated with a reasonable degree of accuracy, and (3) Elliot Company is a reasonable credit risk, the best method would be to recognize revenues using the percentage-of-completion method based on the number of employees trained. The completed contract method should only be used if either of the first two conditions is not met.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 6 6-27

P6-42 (15 minutes) a. Management would have an incentive to shift $1 million of income from the current period into next. This might be accomplished by delaying revenue recognition or accelerating expenses. This would increase their bonus by $100,000 next year without decreasing the current bonus. b. Management would have an incentive to shift $3 million of income from next year into income reported this year. This would increase the current year bonus by $300,000 without reducing next years bonus. c. Management would have an incentive to shift income from the current year into next year. Even though this would reduce earnings this year, earnings are already so low that management does not expect to receive a bonus. Shifting earnings into a future period increases the bonus in that period. d. These incentives for earnings management would be mitigated if the kinks in the bonus formula were removed. Alternatively, some companies pay bonuses based on a three-year moving average of earnings to minimize the impact of earnings management. This problem can provide an opportunity to discuss the slippery slope of earnings management. For example, managements optimism about next year in part b may not turn out to be warranted. Suppose next years natural earnings turns out to be $20 million instead of $24 million. Managements action in the first year will have reduced next years $20 million to $17 million, and earnings management would again be required to meet the target. And, if meeting the target in one year causes the next years target to increase, things can get out of control very quickly.

Cambridge Business Publishers, 2011 6-28 Financial Accounting, 3rd Edition

P6-43 (30 minutes) a. 2007: $61,471 million $7,275 million = 8.45. 2006: $57,878 million $6,161 million = 9.39. Customers appear to be paying more slowly in 2007 than in 2006. In 2007, the average customer is taking about a month and a half to pay (and about 4 days longer than in 2006). b. c. Accounts receivable, net, is $8,054 million (=$8,624 million - $570 million). To record the bad debt provision: Bad debt provision (+E, -SE) Allowance for doubtful accounts (+XA, -A) To record write-offs of receivables: Allowance for doubtful accounts (-XA, +A) Accounts receivable (-A) d. 481 481 428 428

There are two items of information that conflict with the drop from 7.7% to 6.6%. First, the write-offs as a percentage of average receivables is going up from 5.1% to 5.9%. Second, the information on past due accounts (basically an aging analysis) indicates that the percentage of Targets receivables that are significantly past due has been increasing. In any normal aging of accounts analysis, that would lead to an increased allowance as a percentage of the receivables balance. There are quite a few reasons that might account of the disparity in part d. For example, it could be that Target has changed its credit policies in the middle of 2007. So, there is a holdover of late accounts, but Target expects that the remainder of the accounts will have a better rate of collection than they have experienced in the past. However, one must consider the possibility of earnings management. Targets pretax earnings were $4,625 million in 2007 and $4,497 million in 2006, an increase of $128 million. If Target had kept its allowance at 7.7% of gross accounts receivables, it would have needed an allowance of $664 million and an increase in its bad debt provision (and a decrease in pretax income) of $94 million ($664 million - $570 million), reducing the already modest increase in income. In fact, if the allowance were anything over about 8.1% of receivables, the change in pretax income would have been negative.

e.

Postscript: In fiscal year 2008, the estimates used for uncollectible accounts changed significantly. The 2008 bad debt provision was $1,251 million (a 160% increase over 2007), and the ending allowance for doubtful accounts was $1,010 (11.1% of ending accounts receivable).
Cambridge Business Publishers, 2011 Solutions Manual, Chapter 6 6-29

P6-44 (40 minutes)

(all in $ millions)

a.

Gross receivables as of 2002 are $5,667 + $2,379 = $8,046. Gross receivables as of 2001 are $6,054 + $1,889 = $7,943.

b. Estimated uncollectible accounts to gross accounts receivable are: 30% ($2,379/$8,046) in 2002 24% ($1,889/$7,943) in 2001 Gross receivables to sales are: 19.6% ($8,046/$40,961) in 2002 21.4% ($7,943/$37,166) in 2001 Although receivables are a lower percentage of sales in 2002, it appears that their collectibility is less certain. c. The receivables turnover rate is $40,961 / [($5,667 + $6,054)/2] = 6.99 Days sales in accounts receivable is $5,667/ ($40,961/365) = 50.5 days The AOL part of the business is mainly a cash basis operation and we would expect relatively minor receivables. The Time, Inc., portion of the business contains publishing, cable, film and music. Although the magazine publishing business does not carry significant receivables, the other lines of business do. On the whole, 50.5 days sales on average in accounts receivable for this type of business seems high, and our concern is increased by the relatively high levels of estimated uncollectible accounts. d. Time-Warner significantly increased its allowance for uncollectible accounts as a percentage of gross accounts receivable. There are two possible reasons for this, neither of which are particularly good for AOL: 1. The financial condition of its customers has deteriorated significantly, thus warranting a higher reserve, or 2. Time-Warner arbitrarily increased its allowance account. The second alternative would be consistent with the big bath theory. By increasing its allowance account more than necessary, it might have recorded more expense in 2002 than was warranted and created an allowance account that was higher than warranted. In future years, then, Time-Warner might have the ability to reverse this allowance account to immediately improve earnings, or it might just allow the allowance account to decline gradually as credit losses are recognized. In either case, future profits would be higher as TimeWarner would not have the current period expense to increase the allowance account.

Cambridge Business Publishers, 2011 6-30 Financial Accounting, 3rd Edition

A careful reader of the financial statements would keep an eye on these accounts in future years. Allowances as a percentage of gross receivables remained at 30% in 2003 and went to 28% in 2004, so there does not seem to be any significant reversal of the provisions taken in 2002. In retrospect, it appears that the first possible reason (deteriorating receivables) is the more likely of the two.

P6-45 (25 minutes) For the instructor: This problem covers the accounting for product returns, which is not covered in the chapter. The description of The Gaps practices should allow students to answer parts a and b. Part c is a bit of a stretch, because it requires that the allowance for returns, which is in gross profit terms, be grossed-up to revenue terms. a. Beginning balance + $700 million - $701 million = $21 million, so Beginning balance = $22 million. b. Sale and expected returns: (1) Record revenue. Cash (+A) Revenue (+R,+SE) (2) Record COGS. Cost of goods sold (+E,-SE) Inventory (-A) (3) Recognize Revenue contra, returns (+XR, -SE) expected returns. COGS contra, returns (+XE, +SE) Sales returns allowance (+L) 5,000 5,000 3,000 3,000 500 300 200

The sales returns allowance is equal to Gross sales ($5,000) times the probability of return (10%) times the gross profit margin (40%), or $200. For these ten units, the cost of goods was $300. Returns: (4) Process return transactions. DR Inventory (+A) DR Sales returns allowance (-L) CR Cash (-A) 300 200 500

At the conclusion of this transaction, the customers have their cash, the inventory costs have been adjusted to include the returned items, and the sales returns allowance liability has a balance of zero because the actual returns coincided with the expected returns. c. The Gaps reported gross profit is 37.5% of its net sales ($5,447million/$14,526 million). So, if The Gap expects returns of items with gross profit of $700 million, those items must have had sales prices of $1,867 million ($700 million/0.375) and cost of goods sold of $1,167 million ($1,867 million - $700
Cambridge Business Publishers, 2011 Solutions Manual, Chapter 6 6-31

million). The entry that would have reflected The Gaps accounting for these expected returns is the following: Recognize expected returns. Revenue contra, returns (+XR, -SE) COGS contra, returns (+XE, +SE) Sales returns allowance (+L) 1,867 1,167 700

The Gaps gross sales revenue would have been $16,393 million ($14,526 million + $1,867 million), and its expected returns as a percentage of sales would be 11.4% ($1,867 million/$16,393 million). The size of the allowance for 2008 ($700 million) relative to the end-of-year return liability ($21 million) means that the vast majority of these product returns occurred during the 2008 fiscal year, so it is more a reflection of actual experience than of managements estimates of future events. d. Under these circumstances, The Gap doesnt have to worry about accounting for expected returns, because it has not satisfied the requirements for revenue recognition. If the amount to be received (or in this case, the amount to be kept) is not yet fixed or determinable, the revenue should not be recognized until it is.

P6-46 (25 minutes) a. Fiscal year ending March 31 2005 2006 2007 2008 2009 b. Fiscal year ending March 31 2005 2006 2007 2008 2009 Net revenue 3,129 2,951 3,091 3,665 4,212 Net revenue 3,129 2,951 3,091 3,665 4,212 Deferred net revenue (liability) 0 9 32 387 261 Growth rate -5.7% 4.7% 18.6% 14.9% Purchases = Net revenue + Change in Deferred net revenue 3,129 2,960 3,114 4,020 4,086 Growth rate -5.4% 5.2% 29.1% 1.6%

Cambridge Business Publishers, 2011 6-32 Financial Accounting, 3rd Edition

When companies defer revenue, there is a lag between customers purchases and the recognition of revenue on the income statement. In 2006, 2007 and 2008, a growing portion of EAs sales to customers were deferred, as there was an increase in the rate of growth in purchases. So the growth in revenues was less than the growth in customer purchases. However, the growth in customer purchases for 2009 was not large only 1.6%. The substantial growth in revenue for 2009 is a vestige of the higher growth rates in previous years (particularly 2008). c. If customer purchases in 2009 are a leading indicator of customer purchases in 2010, we would predict a substantial drop in revenue growth for 2010 over 2009.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 6 6-33

CASES
C6-47A (60 minutes) a. i. SALES revenue is normally earned when title to the product passes to the customer who either purchases the product for cash or on credit terms. ii. SERVICES, OUTSOURCING AND RENTALS revenue from services is normally earned as the service is performed, usually ratably over the period of the service contract. The same applies to outsourcing and rentals. iii. FINANCE INCOME revenue from finance income (normally interest) is earned with the passage of time. For example, each period, Xerox accrues interest on its loans and leases. b. i. Restructuring costs typically fall within two general categories. (1) The write-off of assets, such as plant assets and goodwill, and (2) the accrual of liabilities for items, such as employee severance payments and exit costs. ii. These restructuring costs result in expenses that are recorded in their respective current periods despite the fact that the corresponding impaired assets may not be formerly written off and the employees not paid their severance until future periods. In any event, most analysts treat restructuring costs as transitory (one-time occurrences). Accordingly, they should impact the analysis, but are unlikely to impact the analysis to the degree of more persistent items such as recurring revenues and expenses. iii. Some companies report regularly recurring restructuring costs. In such cases, many analysts treat these recurring costs as operating expenses and do not consider them to be transitory items. This treatment implies that these costs are less transitory and more persistent in nature. In 2007, Xerox had a net credit on restructuring the result of a restructuring provision of $35 million and a reversal of prior restructuring accruals of $41 million. c. Companies are not required to separately disclose revenue and expense items unless they are deemed to be material. If not separately disclosed, these items are aggregated with other items that are also deemed not to be material. Such aggregation generally reduces the informativeness of income statements. More problematic is that revenues and expenses can be commingled in this Other category to yield a small number that further obscures the importance of the individual items comprising this category.

Cambridge Business Publishers, 2011 6-34 Financial Accounting, 3rd Edition

In Xeroxs case, the significantly higher amount in Other expenses, net, is due to a $774 million pretax charge for litigation losses. These would not be expected to recur in future years. d. The following items might be considered to be operating: Sales and service, outsourcing and rental revenue would be considered operating; cost of sales, cost of service, outsourcing and rentals, R&D and engineering expenses, and SG&A expenses are typically designated as operating. Restructuring and asset impairment charges would usually be considered to be operating. Equity in earnings of unconsolidated affiliates would be considered operating under the assumption that the affiliates are related to Xeroxs core operations, which is typically the case. Finance income and equipment financing interest expense would be classified as operating, because financing customers purchases is one of Xeroxs lines of business. However, it would be useful to consider it as a separate line of business for forecasting purposes. Other expenses would generally be considered nonoperating in the absence of a footnote clearly indicating its connection to the operating activities of the company (such as the litigation losses described above). The following items might be identified as transitory items: If Xerox had income from discontinued operations or extraordinary items, those would be considered transitory. Those items did not appear in its 2006, 2007 or 2008 income statement. The restructuring and impairment charges appear regularly, but in varying amounts, and the MD&A reports that a significant share of the Other expenses, net is due to litigation charges that are probably transitory (but related to operations). One other item that has transitory factors is the companys income tax expenses for the year. For reasons that will be discussed in Chapter 10, Xeroxs tax expense as a percentage of pretax income was (35.6%), 27.8% and 202.6% in 2006, 2007 and 2008, respectively. Given that the U.S corporate tax rate is 35%, it is clear that there are some transitory effects going on in this line item.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 6 6-35

C6-48 (30 minutes) a. When Dell sells other companies software products, it is often as part of a multiple-element sales agreement. For example, the customer may purchase hardware, software, and customer support for one price. This is an example of a bundled sale. Dell must allocate the sales price based on the relative fair market value of each element. Revenue is recognized for each specific element when it is clear that the element has been delivered and the revenue is earned. There are at least two possibilities for earnings management here. First, Dell could misallocate the sales price. By allocating more of the price to hardware and less to software, Dell may be able to manage when earnings are reported. Second, Dell may be aggressive in applying the earned and realizable criteria to each element, thereby prematurely recognizing revenue. From the information provided, it appears that Dell was recognizing revenue on software resales at the time of sale. However, most software is not truly sold. Instead, the customer purchases a license to use the software. As a result, Dell should have deferred part of the revenue and recognized it ratably over the license period. b. Extended warranties are typically sold separately from other products. Therefore, the revenue should be deferred and recognized ratably over the warranty contract period. Dell employees were apparently recording revenue at the time of sale, or were recognizing the revenue over a shorter time period than the contract period. As a result, revenues and income were overstated. c. It is common for managers to have performance targets based on revenues and earnings. This provides an incentive for these employees to take actions to accelerate revenue recognition when it appears that targets may not be met. On the other hand, in periods when revenues and earnings exceed the targets, managers may delay revenue recognition until a future period. In this way, they can store up revenues and earnings to meet future targets. The key to preventing this type of abuse is the periodic audit of divisional revenues and earnings. In addition, businesses spend a large amount of resources trying to design incentive compensation plans that do not encourage this type of abuse.

Cambridge Business Publishers, 2011 6-36 Financial Accounting, 3rd Edition

C6-49 (45 minutes) a. i. ii. Bad debt expense (+E, -SE) Allowance for doubtful accounts (+XA, -A) Allowance for doubtful accounts (-XA, +A) Accounts receivable (-A) 2,095,000 2,095,000 1,562,000 1,562,000

+ Accounts Receivable (A) ($000) Balance 110,069 Sales 761,865 1,562 Balance 124,430 *

(ii)

- Allowance for Doubtful Accounts (XA) ($000) + 3,609 Balance 2,095 (i) (ii) 1,562 4,142 Balance

*This accounts receivable T-account above is incomplete; it is missing a credit for sales returns and a credit for cash collections. Both are discussed and illustrated below.)

b. If sales returns are material in amount and can be estimated with a reasonable degree of accuracy, they should be estimated just as bad debts are estimated. Sales revenue is debited for the estimated returns while an allowance for returns is credited. One important difference is that with sales returns (unlike bad debts) the customer returns the product to the company and it is often returned to inventory. Hence, the amount of estimated returns is equal to the estimated gross profit on expected returns. Using Oakleys gross profit margin of 54.2% (= $412,751 / $761,865) the following entries would be required in 2006: iii. iv. Sales revenue (est. sales returns) (-R, -SE) Allowance for returns (+XA, -A) Allowance for returns (-XA, +A) Inventory (+A) Accounts receivable* (-A) 7,547,000 7,547,000 6,993,000 5,909,000 12,902,000
- Allowance for Returns (XA) ($000) + 6,683 Balance 7,547 (iii) (iv) 6,993 7,237 Balance

+ Accounts Receivable (A) ($000) Balance 110,069 Sales 761,865 1,562 (ii) 12,902 (iv) 733,040 Collections Balance 124,430

* $6,993,000 / 0.542 = $12,902,000

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 6 6-37

Note that an alternative entry for b(iii) would be the following, where the income statement adjustment for estimated returns affects both revenue and cost of gods sold. The T-accounts just above would not be affected. iii. Sales revenue (est. sales returns) (-R, -SE) Allowance for returns (+XA, -A) Cost of goods sold (-E, +SE) 13,924,000 7,547,000 6,377,000

($13,924,000 = $7,547,000/0.542.) However, if the sales returns cannot be resold, then the amount of estimated returns is equal to the estimated expected returned sales (not the gross profit on sales). This would be the case if sales returns were primarily returns of defective merchandise. If this is the case for Oakley, the appropriate journal entries and Taccounts would be as follows: iii. iv. Sales revenue (est. sales returns) (-R, -SE) Allowance for returns (+XA, -A) Allowance for returns (-XA, +A) Accounts receivable (-A) 7,547,000 7,547,000 6,993,000 6,993,000
- Allowance for Returns (XA) ($000) + 6,683 Balance 7,547 (iii) (iv) 6,993 7,237 Balance

+ Accounts Receivable (A) ($000) Balance 110,069 Sales 761,865 1,562 (ii) 6,993 (iv) 738,949 Collections Balance 124,430

Note that our calculation of the amount of cash collections on account (calculated as a plug amount) is contingent upon what assumption we make about Oakleys returns. If returned merchandise is returned to inventory and resold, then cash collections are approximately $733,040,000. On the other hand, if sales returns are not returned to inventory for resale (i.e., because the merchandise is defective) the cash collections are calculated as $738,949,000. These different scenarios represent not just different accounting, but substantively different situations. If Oakley can return the items to inventory, their reporting implies that customers will return (and not pay for) items totaling almost $13 million in sales. If returned products are always defective, then Oakleys reporting implies that customers will return items totaling about $7.5 million in sales. Obviously, only one of these amounts is correct, but it is impossible to tell from Oakleys financial statements. (The authors believe that Oakleys returns are largely related to performance warranties and returned goods are deemed defective and not returned to inventory. Hence the second set of journal

Cambridge Business Publishers, 2011 6-38 Financial Accounting, 3rd Edition

entries would be correct.) The amount of cash collected is included in the accounts receivable T-accounts above to be complete. c. Accounts receivable turnover: $761,865 / [($109,168 + $99,430)/2] = 7.3 times.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 6 6-39