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
Trang 1Question 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 5-6
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
QUESTIONS FOR REVIEW OF KEY TOPICS
Trang 2© The McGraw-Hill Companies, Inc., 2007
Answers to Questions (continued)
Question 5-7
Sometimes a company arranges for another company to sell its product under consignment
The “consignor” physically transfers the goods to the other company (the consignee), but the consignor retains legal title If the consignee can’t find a buyer within an agreed-upon time, the consignee returns the goods to the consignor However, if a buyer is found, the consignee remits the selling price (less commission and approved expenses) to the consignor
Because the consignor retains the risks and rewards of ownership of the product and title does not pass to the consignee, the consignor does not record revenue (and related costs) until the consignee sells the goods and title passes to the eventual customer
Question 5-8
For service revenue, if there is one final service that is critical to the earnings process, revenues and costs are deferred and recognized after this service has been performed On the other hand, in many instances, service revenue activities occur over extended periods and recognizing revenue at any single date within that period would be inappropriate Instead, it’s more meaningful to recognize revenue over time in proportion to the performance of the activity
Question 5-10
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
Trang 3Answers to Questions (continued)
Question 5-13
Specific guidelines for revenue recognition of the initial franchise fee are provided by SFAS
45 A key to these guidelines is the concept of substantial performance It requires that
substantially all of the initial services of the franchisor required by the franchise agreement be performed before the initial franchise fee can be recognized as revenue The term “substantial” requires professional judgment on the part of the accountant In situations when the initial franchise fee is collectible in installments, even after substantial performance has occurred, the installment sales or cost recovery method should be used for profit recognition, if a reasonable estimate of uncollectibility cannot be made
Question 5-14
Receivables turnover ratio = Net sales
Average accounts receivable (net)
Inventory turnover ratio = Cost of goods sold
Average inventory
Asset turnover ratio = Net sales
Average total assets
Activity ratios are designed to provide information about a company’s effectiveness in managing assets Activity or turnover of certain assets measures the frequency with which those assets are replaced The greater the number of times an asset turns over, the less cash a company must devote to that asset, and the more cash it can commit to other purposes
Trang 4© The McGraw-Hill Companies, Inc., 2007
Answers to Questions (concluded)
Question 5-15
Net sales
Average total assets
A fundamental element of an analyst’s task is to develop an understanding of a firm’s profitability Profitability ratios provide information about a company’s ability to earn an adequate return relative to sales or resources devoted to operations Resources devoted to operations can be defined as total assets or only those assets provided by owners, depending on the evaluation objective
Question 5-16
These perspectives are referred to as the discrete and integral part approaches Current interim reporting requirements and existing practice generally view interim reports as integral parts of annual statements However, the discrete approach is applied to some items Most revenues and expenses are recognized in interim periods as incurred However, if an expenditure clearly benefits more than just the period in which it is incurred, the expense should be spread among the periods benefited Examples include annual repair expenses, property tax expense, and advertising expenses incurred in one quarter that clearly benefit later quarters These are assigned to each quarter through the use of accruals and deferrals On the other hand, major events such as discontinued operations, extraordinary items, and unusual or infrequent items should be reported separately in the interim period in which they occur
Trang 5= 40% (gross profit % = 60%)
$3,000,000
2006 gross profit = 2006 cash collection of $150,000 x 60% = $90,000
2007 gross profit = 2007 cash collection of $150,000 x 60% = $90,000
Brief Exercise 5-3
No gross profit will be recognized in either 2006 or 2007 Gross profit will not
be recognized until the entire $1,200,000 cost of the land is recovered In this case, gross profit recognition will equal 100% of the cash collected beginning with the ninth installment payment ($1,200,000 ÷ $150,000 = 8 payments to recover the cost of the land)
Brief Exercise 5-4
Initial deferred gross profit ($3,000,000 – 1,200,000) $1,800,000 Less gross profit recognized in 2006 ($150,000 x 60%) (90,000) Less gross profit recognized in 2007 ($150,000 x 60%) (90,000) Deferred gross profit at the end of 2007 $1,620,000 BRIEF EXERCISES
Trang 6© The McGraw-Hill Companies, Inc., 2007
Brief Exercise 5-5
The seller must meet certain criteria before revenue can be recognized in situations when the right of return exists The most critical of these criteria is that the seller must be able to make reliable estimates of future returns If Meyer’s management can make reliable estimates of the furniture that will be returned, revenue can be recognized when the product is delivered, assuming the company has no additional obligations to the buyer If reliable estimates cannot be made because of significant uncertainty, revenue and related cost recognition is delayed until the uncertainty is resolved
Brief Exercise 5-6
% of completion = $6 million ÷ $15 million = 40%
Total estimated gross profit ($20 million – 15 million) = $5,000,000
multiplied by the % of completion 40%
Gross profit recognized the first year $2,000,000
First year revenue = $20,000,000 x 40% = $8,000,000
Brief Exercise 5-7
Assets:
Accounts receivable ($7 million – 5 million) $2,000,000
Cost plus profit ($6 million + $2 million*)
in excess of billings ($7 million) 1,000,000
* Total estimated gross profit ($20 million – 15 million) = $5,000,000
multiplied by the % of completion 40%
Gross profit recognized in the first year $2,000,000
Brief Exercise 5-8
Trang 7© The McGraw-Hill Companies, Inc., 2007
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 = Net sales
Average accounts receivable (net)
Trang 8© The McGraw-Hill Companies, Inc., 2007
Trang 9Average total assets
$800,000
Return on shareholders’
Average shareholders’ equity
$522,500*
Shareholders’ equity, beginning of period $500,000
Shareholders’ equity, end of period $545,000
*Average shareholders equity = ($500,000 + 545,000) ÷ 2 = $522,500
Trang 10© The McGraw-Hill Companies, Inc., 2007
Brief Exercise 5-13
Inventory turnover ratio = Cost of goods sold ÷ Average inventory
6.0 = x ÷ $75,000
Cost of goods sold = $75,000 x 6.0 = $450,000
Sales - Cost of goods sold = Gross profit
$600,000 - $450,000 = $150,000
Trang 112006 deferred gross profit balance:
2006 initial gross profit ($360,000 - 234,000) $126,000
Balance in deferred gross profit account $73,500
2007 deferred gross profit balance:
2006 initial gross profit ($360,000 - 234,000) $ 126,000
Gross profit recognized in 2007 (35,000)
2007 initial gross profit ($350,000 - 245,000) 105,000
Balance in deferred gross profit account $107,500 EXERCISES
Trang 12© The McGraw-Hill Companies, Inc., 2007
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
Trang 14© The McGraw-Hill Companies, Inc., 2007
Trang 15Deferred gross profit 180,000
To record cash collection from installment sale
Cash 75,000
Installment receivables 75,000
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
Deferred gross profit 45,000
Realized gross profit 45,000
Trang 16© The McGraw-Hill Companies, Inc., 2007
Deferred gross profit 180,000
To record cash collection from installment sale
Deferred gross profit 30,000
Realized gross profit 30,000
Exercise 5-5
Requirement 1
Cost of goods sold ($1,000,000 - 600,000) $400,000
Add: Gross profit if use cost recovery method 100,000
Trang 17April 1, 2006 To record cash collection from installment sale
Trang 18© The McGraw-Hill Companies, Inc., 2007
April 1, 2006 To record cash collection from installment sale
Cash 120,000
Installment receivables 120,000
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
Trang 19Exercise 5-7
Requirement 1
Estimated costs to complete 1,200,000 - 0 -
Gross profit (estimated in 2006) $ 500,000 $ 125,000
Gross profit recognition:
2006: $ 300,000
= 20% x $500,000 = $100,000
$1,500,000 2007: $125,000 - $100,000 = $25,000
Trang 20© The McGraw-Hill Companies, Inc., 2007
Trang 21Exercise 5-8
Requirement 1
Estimated gross profit (actual in 2008) $ 60 $ 40 $ 50
Gross profit (loss) recognition:
Trang 22© The McGraw-Hill Companies, Inc., 2007
Exercise 5-9
Requirement 1
Actual costs to date 2,000,000 4,500,000 8,300,000
Estimated costs to complete 4,000,000 3,600,000 - 0 -
Total estimated costs 6,000,000 8,100,000 8,300,000
Estimated gross profit (loss)
Trang 23Billings on construction contract 2,500,000 2,750,000
To record progress billings
To record expected loss
Trang 24© The McGraw-Hill Companies, Inc., 2007
Trang 25Billings on construction contract 2,500,000 2,750,000
To record progress billings
To record cash collections
To record an expected loss
Trang 26© The McGraw-Hill Companies, Inc., 2007
Trang 27Exercise 5-11
Situation 1 - Percentage-of-Completion
Actual costs to date 1,500,000 3,600,000 4,500,000
Estimated costs to complete 3,000,000 900,000 - 0 -
Total estimated costs 4,500,000 4,500,000 4,500,000
Estimated gross profit
Situation 1 - Completed Contract
Trang 28© The McGraw-Hill Companies, Inc., 2007
Exercise 5-11 (continued)
Situation 2 - Percentage-of-Completion
Actual costs to date 1,500,000 2,400,000 4,800,000
Estimated costs to complete 3,000,000 2,400,000 - 0 -
Total estimated costs 4,500,000 4,800,000 4,800,000
Estimated gross profit
Situation 2 - Completed Contract
Trang 29Exercise 5-11 (continued)
Situation 3 - Percentage-of-Completion
Actual costs to date 1,500,000 3,600,000 5,200,000
Estimated costs to complete 3,000,000 1,500,000 - 0 -
Total estimated costs 4,500,000 5,100,000 5,200,000
Estimated gross profit (loss)
2008: $(200,000) - (100,000) = $(100,000)
Situation 3 - Completed Contract
Trang 30© The McGraw-Hill Companies, Inc., 2007
Exercise 5-11 (continued)
Situation 4 - Percentage-of-Completion
Actual costs to date 500,000 3,500,000 4,500,000
Estimated costs to complete 3,500,000 875,000 - 0 -
Total estimated costs 4,000,000 4,375,000 4,500,000
Estimated gross profit
Situation 4 - Completed Contract
Trang 31Exercise 5-11 (continued)
Situation 5 - Percentage-of-Completion
Actual costs to date 500,000 3,500,000 4,800,000
Estimated costs to complete 3,500,000 1,500,000 - 0 -
Total estimated costs 4,000,000 5,000,000 4,800,000
Estimated gross profit
2008: $200,000 - 0 = $200,000
Situation 5 - Completed Contract
Trang 32© The McGraw-Hill Companies, Inc., 2007
Exercise 5-11 (concluded)
Situation 6 - Percentage-of-Completion
Actual costs to date 500,000 3,500,000 5,300,000
Estimated costs to complete 4,600,000 1,700,000 - 0 -
Total estimated costs 5,100,000 5,200,000 5,300,000
Estimated gross profit (loss)
Situation 6 - Completed Contract
Trang 33Let A = Actual cost incurred + Estimated cost to complete
Actual cost incurred
x (Contract price - A) = Profit recognized
Trang 34© The McGraw-Hill Companies, Inc., 2007
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:
Trang 35Exercise 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
Trang 36© The McGraw-Hill Companies, Inc., 2007
Exercise 5-16
h 1 Inventory turnover a Net income divided by net sales
d 2 Return on assets b Defers recognition until cash collected equals
g 3 Return on shareholders' equity c Defers recognition until project is complete
a 4 Profit margin on sales d Net income divided by assets
b 5 Cost recovery method e Risks and rewards of ownership retained
i 6 Percentage-of-completion method f Contra account to construction in progress
c 7 Completed contract method g Net income divided by shareholders' equity
k 8 Asset turnover h Cost of goods sold divided by inventory
l 9 Receivables turnover i Recognition is in proportion to work completed
m 10 Right of return j Recognition is in proportion to cash received
f 11 Billings on construction contract k Net sales divided by assets
j 12 Installment sales method l Net sales divided by accounts receivable
e 13 Consignment sales m Could cause the deferral of revenue recognition
Trang 37However, to evaluate the adequacy of this ratio it should be compared with some norm such as the industry average That indicates whether inventory management practices are in line with the competition
It’s just one piece in the puzzle, though Other points of reference should be considered For instance, a high turnover can be achieved by maintaining too low inventory levels and restocking only when absolutely necessary This can be costly in terms of stockout costs
The ratio also can be useful when assessing the current ratio The more liquid inventory is, the lower the norm should be against which the current ratio should be compared
Inventory turnover ratio = Cost of goods sold
Average inventory
[$690,000 + 630,000] ÷ 2
Trang 38© The McGraw-Hill Companies, Inc., 2007
Exercise 5-18
Turnover ratios for Anderson Medical Supply Company for 2006:
The company turns its inventory over 6 times per year compared to the industry average of 5 times per year The asset turnover ratio also is slightly better than the industry average (2 times per year versus 1.8 times) These ratios indicate that Anderson is able to generate more sales per dollar invested in inventory and in total assets than the industry averages However, Anderson takes slightly longer to collect its accounts receivable (27.4 days compared to the industry average of 25 days)
Trang 39Retained earnings beginning of period $100,000
280,000 Less: Retained earnings end of period 150,000
Exercise 5-20
1 c Revenue is recognized when (1) realized or realizable and (2) earned On May
28, $500,000 of the sales price was realized while the remaining $500,000 was realizable in the form of a receivable The revenue was earned on May 28 since the title of the goods passed to the purchaser The cost-recovery method is not used because the receivable was not deemed uncollectible until June 10
2 d Based on the revenue recognition principle, revenue is normally recorded at the
time of the sale or, occasionally, at the time cash is collected However,
sometimes neither the sales basis nor the cash basis is appropriate, such as when
a construction contract extends over several accounting periods As a result, contractors ordinarily recognize revenue using the percentage-of-completion method so that some revenue is recognized each year over the life of the
contract Hence, this method is an exception to the general principle of revenue recognition, primarily because it better matches revenues and expenses
3 b Given that one-third of all costs have already been incurred ($6,000,000), the
company should recognize revenue equal to one-third of the contract price, or
$8,000,000 Revenues of $8,000,000 minus costs of $6,000,000 equals a gross profit of $2,000,000
Exercise 5-21
Quarter
Trang 40© The McGraw-Hill Companies, Inc., 2007
Cumulative income before taxes $50,000 $90,000 $190,000
Estimated annual effective tax rate 34% 30% 36%
Less: Income tax reported earlier 0 17,000 27,000
Tax expense to be reported $17,000 $10,000 $ 41,400
Exercise 5-22
Incentive compensation $300 million ÷ 4 = $ 75 million
Depreciation expense $60 million ÷ 4 = 15 million