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Module 5

Reporting and Analyzing


Operating Income

QUESTIONS
Q5-1. Revenue must be realized or realizable and earned before it can be reported in the
income statement. Realized or realizable means that the company’s 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), and the right of return period has passed. 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.
Q5-2. Financial statement analysis is usually conducted for purposes of forecasting
future financial performance of the company. Extraordinary items are, by
definition, not expected to continue to affect the profits and cash flows of the
company. Accordingly, the financial statements separately report extraordinary
items from continuing operations to yield an income measure that is more likely to
persist into the future.
Q5-3. In order for an item to be classified as extraordinary, it must be both unusual and
infrequent. Examples include the destruction of property by natural disaster or
the expropriation of assets by a foreign government. Gains and losses on early
retirement of long-term bonds, once the most common type of extraordinary item,
are no longer considered extraordinary 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.

©Cambridge Business Publishers, 2008


Solutions Manual, Module 5 5-1
M5-13 (20 minutes)

Company Revenue recognition


GAP When the customer takes the merchandise and the right of return
period has expired.

Merck When the customer takes the merchandise and the right of return
period, if any, has expired. The company will also establish a
reserve and recognize expense for uncollectible accounts
receivable at the time the sale is recorded.

John When the customer takes the merchandise and the right of return
Deere 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.

Bank of Interest is earned by the passage of time. Each period, Bank of


America America accrues income on each of its loans and establishes an
account receivable on its balance sheet.

Johnson Revenue is recognized for long-term contracts under the


Controls percentage-of-completion method.

M5-14 (15 minutes)

Two potential revenue recognition problems for a company with operations


similar to BannerAD follow:

1. Sales on consignment: BannerAD earns revenue as an agent for the


seller. It does not take title to the inventory and, as a result, cannot
characterize the gross revenues as sales. Rather, it should disclose the
consignment arrangement and identify its revenues as commissions
rather than sales. Thus, one potential problem could arise if BannerAd
records these commissions before the sale is actually made to the final
buyer.

2. Gross vs. Net: Many dotcom’s recorded commission sales at gross


amount, rather than the net commission that represented the true
earnings for the agent on the sale of the inventory. Grossing up the
sales inflates top line growth, often a key indicator of Internet site value.

©Cambridge Business Publishers, 2008


5-6 Financial Accounting for MBAs, 3rd Edition
M5-15 (15 minutes)

The GAP can only recognize revenues once they have been earned. That is,
not until after the right of return period has elapsed. At the time of sale, the
company 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 record $4.9 million in net sales (98% of $5 million) for the
period. The company would create an allowance for sales returns on the
balance sheet to offset the 2% of cash sales that they expect to have to
refund.

M5-16 (10 minutes)

a. $1,821 / $22,338 = 8.2%. To assess Abbott’s R&D expenditure level, we


would gather R&D expenditure data for Abbott’s competitors to gain a
sense of the appropriateness of Abbott’s R&D expenditures. As well, we
could gather information about R&D spending for all public companies
to assess whether economy-wide factors are at play.

b. Under current U.S. GAAP, all R&D costs must be expensed when
incurred. This policy applies to depreciable assets that would otherwise
be capitalized, unless the assets have alternative future uses. As a
result, the balance sheet does not reflect the costs incurred for long-
term R&D assets. In addition, under current GAAP, operating expenses
are increased, retained earnings are reduced and thus stockholders’
equity is lower.

M5-17 (15 minutes)

a. 2005: Sales decreased by 1% in 2005. This sales decrease is the net


result of a 2% sales decrease from the volume of goods sold and by a
1% sales increase attributable to foreign currency fluctuations.
2004: Sales increased by 4% in 2004. This 4% sales increase is entirely
attributable to foreign currency fluctuations.

b. Foreign exchange fluctuations increased sales in both years. This is


consistent with a weakening of the $US. As the $US weakens, foreign
sales are translated to larger amounts in $US terms. This means that
revenues and expenses both increase. If the company’s foreign
operations are profitable, net income in $US also increases. (Notice that
the weakening of the $US was less pronounced in 2005.)

©Cambridge Business Publishers, 2008


Solutions Manual, Module 5 5-7
M5-20 (20 minutes)

a. Koonce should record one-sixth of the season ticket receipts (or


$70,000) after each production.

b.
Balance Sheet Income Statement
Cash Noncash Liabil- Contrib. Earned Rev- Expen- Net
Transaction + = + + – =
Asset Assets ities Capital Capital enues ses Income
Cash 420,000
UR 420,000
Receive cash
Cash +420,000 +420,000
in advance for
420,000 Cash = Unearned – =
season
Revenue
tickets
UR
420,000
UR 70,000
Rev 70,000
UR
Recognize
70,000 -70,000 +70,000 +70,000
revenue for +70,000
= Unearned Retained Revenues – =
first
Rev Revenue Earnings
production
70,000

M5-21 (20 minutes)

a. When Target receives the cash it increases a liability called deferred


revenue or unearned revenue. The company will classify this as is a
current liability on the balance sheet if its experience is that all cards are
used within a year. But if historically, a portion of the cards sold
routinely expires or is used after a year, then Target would classify that
portion as a non-current liability

b. Target recognizes revenue when the card is used, or when it expires two
years later, whichever comes first.

©Cambridge Business Publishers, 2008


5-10 Financial Accounting for MBAs, 3rd Edition
EXERCISES

E5-22 (20 minutes)

Company Revenue recognition


The Limited When the customer takes the merchandise and the right of
return period has expired.

Boeing Revenue is recognized under long-term contracts under the


Corporation percentage-of-completion method.

Supervalu When the customer takes the merchandise and cash is


received.

MTV When the content is aired by the TV stations

Real estate When title to the houses is transferred to the buyers.


developer

Bank of Interest is earned by the passage of time. Each period, Bank of


America America accrues income on each of its loans and establishes
an account receivable on its balance sheet.

Harley- When title to the motorcycles is transferred to the buyer. Harley


Davidson will also set up a reserve for anticipated warranty costs and
recognize the expected warranty cost expense when it
recognizes the sales revenue.

Time-Warner When the magazines are sent to subscribers. Subscriptions


received in advance are deferred revenue (a liability) until the
magazines are mailed.

©Cambridge Business Publishers, 2008


Solutions Manual, Module 5 5-11
E5-25 (20 minutes)

a.
($ millions) 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
total contract
amount)
2005 $15 18% $ 21.6 $ 6.6 $ 0 $ 0
($15/$85)

2006 40 47% 56.4 16.4 0 0


($40/$85)

2007 30 35% 42.0 12.0 120 35


($30/$85)

$85 $120.0 $35.0 $120 $35

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. Note that recognition of revenue and income is not
affected by the cash received.

©Cambridge Business Publishers, 2008


Solutions Manual, Module 5 5-13