CHAPTER 4: REVENUE RECOGNITION PROBLEM SOLUTIONS
Assessing Your Recall
4.1ROI measures performance through expressing the return from an
investment as a proportion of the average amount invested. In order to measure return, businesses need to determine the change in assets and liabilities from one period to the next. This is accomplished through the income statement.
4.2CashAcquisition ofSelling
inventoryActivities
CollectionDelivery of
product
Warranty
Service
The cash-to-cash cycle of a retail company includes the following:
a) Cash: initial cash is obtained from investors (shareholders) and creditors (banks and other lenders)
b) Acquisition of inventory: inventory is purchased from suppliers.
c) Selling activity: includes all activities to promote and sell the product
d) Delivery of product: product is delivered to the customer
e) Collection: collection of cash depends upon price allowances, cash
discounts, uncollectibles, etc.
f) Warranty service: period during which the seller is responsible for
replacement or repair of the product. Future costs incurred to repair or replace products affects the ultimate amount of cash available at the end of the cycle.
4.3The three main criteria are that the revenue be earned, that the amount earned can be measured and that there is reasonable assurance that the amounts earned will be collected.
4.4The “earned” criterion consists of two interrelated factors. The first is
that the major revenue generating activities of the company are essentially complete. The second factor is that the company has incurred the majority of the costs it will incur in its cash-to-cash cycle and that those remaining are subject to reasonable estimation. The “realizable” criterion means that the revenues must have been collected in cash by the company or that the collection of the receivables from credit sales is subject to reasonable estimation by the company.
4.5The percentage-of-completion method recognizes revenues (and the
related expenses) based on the fraction of work that is done during the current period. The fraction of work completed during the period is usually estimated by the costs incurred relative to the total estimated costs to complete the project. The completed contracts method, on the other hand, postpones the recognition of revenue (and expense) until the project is completed. All revenues and expenses are then recognized at the end of the construction period when the project is delivered to the customer.
4.6The instalment method recognizes income as cash is collected. The amount of income is determined by multiplying the cash collected by the overall profit margin. Thus with each payment some of the cost is recovered and some profit is recognized. It is rarely used in practice because companies can usually estimate the collectibility of instalment sales and therefore recognize revenue prior to the actual cash collection.
4.7The matching principle simply states that when revenues are recognized, all costs necessary to generate those revenues should be matched with the revenues as expenses on the income statement.
4.8When a deposit is made by a customer for the future delivery of inventory, no revenue is recognized. The company has not completed its part of the agreement, namely, the delivery of the inventory. With respect to the revenue recognition criteria, although it can measure the potential revenue and the collectibility is assured (it already has the cash), it has not yet earned the revenue.
Applying Your Knowledge
4.9 Advertising revenue is recognized as soon as the advertisement is printed in an issue of the magazine. At this point, the company has completed its commitment to the customer; it printed the advertisement. It knows how much it has earned and it can estimate the collectibility of the amount.
The subscription revenue is recognized as each issue is sent. At this point, the company has completed its part of the contract; it sent the issue. It has probably already collected the subscription amount from the customer so both the amount and collectibility are know.
4.10a)
Return$18.80
Average investment($430 + $490 + $590)/3$503.33
ROI3.74%
b)
Return5 x $0.3 + (($84.50-$79.40) x 5)$27
Average investment5 x $79.4$397
ROI6.80%
c)
Return$1,266 - $1,200$66
Average investment$1,200
ROI5.5%
d)
Return$22,900
Average investment($635,900 + $670,300)/2$653,100
ROI3.51%
e)
Return$75.75 - $70.42$5.33
Average investment$70.42
ROI7.57%
4.11a)
Return$2,000
Average investment$90,000
ROI2.22%
b)
Return$3.75 x 5,000$18,750
Average investment$15,000
ROI125%
c)
Return(10 x $14.75) – (10 x $7.50)$72.50
Average investment10 x $7.5$75
ROI96.67%
d)
Return$112,000
Average investment($1,340,000 + $1,150,000)/12$1,245,000
ROI9.00%
e)
Return$210,000 - $160,000$50,000
Average investment$160,000
ROI31.25%
4.12
Jones Sales Company
Income Statement
For the Year ending December 31, 2000
Sales / $221,000Cost of Goods Sold / $0 + $126,500 - $12,200 / (114,300)
Gross Profit / 106,700
Investment income
Net income / 500
$107,200
4.13
Tinder Box Furnace Company
Income Statement
For the Year ending December 31, 2001
Sales / $1,230,000 - $65,000 / $1,165,000Cost of Goods Sold / $580,000 + $245,000 / (825,000)
Gross Profit / 340,000
Warranty expense
Net income / 65,000
$275,000
4.14
a)Percentage of completion
Year /Revenue
/ Expense / Profit1 / (4,750 / 16,250) x
20,000,000 / $5,846,154 / $4,750,000 / $1,096,154
2 / (5,000 / 16,250) x
20,000,000 / $6,153,846 / $5,000,000 / $1,153,846
3 / (3,500 / 16,250) x
20,000,000 / $4,307,692 / $3,500,000 / $807,692
4 / (3,000 / 16,250) x
20,000,000 / $3,692,308 / $3,000,000 / $692,308
$20,000,000 / $16,250,000 / $3,750,000
b) Completed contract method
Year / Revenue / Expense / Profit1 / 0 / 0 / 0
2 / 0 / 0 / 0
3 / 0 / 0 / 0
4 / $20,000,000 / $16,250,000 / $3,750,000
$20,000,000 / $16,250,000 / $3,750,000
4.15Gross profit % = ($250 - $180) / $250 = 28%
$60 x 5 = $300; $300 - $250 = $50 = Interest revenue
Year / Accounts Receivable / Interest revenue / Profit1 / $200,000 / $10,000 / 28% x 50,000 / $14,000
2 / $150,000 / $10,000 / 28% x 50,000 / $14,000
3 / $100,000 / $10,000 / 28% x 50,000 / $14,000
4 / $ 50,000 / $10,000 / 28% x 50,000 / $14,000
5 / $0 / $10,000 / 28% x 50,000 / $14,000
4.16a) It would be reasonable for Superior to recognize all of the profit on the sale in the first year if Superior has reasonable assurance regarding the ultimate collection of the sale price from Imperial. In addition, no significant costs should remain to be incurred on the part of Superior, and the risks of ownership should be transferred to Imperial.
b) It would be appropriate to postpone revenue recognition until the actual cash is received if there is doubt that the receivable from Imperial will be collected, or the amount of bad debt expense relating to the sale cannot be estimated.
c)
Year / Accounts Receivable / Interest revenue / Profit1 / $900,000 / $105,000 / $1,500 - $975 / $525,000
2 / $500,000 / $105,000 / 0
3 / $150,000 / $105,000 / 0
4 / $0 / $105,000 / 0
4.17a)
- Percentage of completion method
Year / Revenue (millions) / Expense (millions) / Profit (millions)
1 / (21.2 / 96) x 120 / $ 26.5 / $21.2 / $ 5.3
2 / (36.4 / 96) x 120 / $ 45.5 / $36.4 / $ 9.1
3 / (26.0 / 96) x 120 / $ 32.5 / $26.0 / $ 6.5
4 / (12.4 / 96) x 120 / $ 15.5 / $12.4 / $ 3.1
$120.0 / $96.0 / $24.0
- Completed contract method
Year / Revenue (millions) / Expense (millions) / Profit (millions)
1 / 0 / 0 / 0
2 / 0 / 0 / 0
3 / 0 / 0 / 0
4 / $120 / $96 / $24
$120 / $96 / $24
b) The percentage of completion method should be used to indicate the
performance of Cruise Shipping Inc. under the contract because the revenue is earned over the course of the contract rather than all at once, upon completion. Since the work is done over a four year period, the percentage of completion method is most appropriate. If the collectibility of the amount was in question, using the completed contract method would be more appropriate.
4.18a)
1) Percentage of completion method
Period / Revenue (millions) / Expense (millions) / Profit (millions)1 / (140 / 750) x 1,000,000 / $ 186,667 / $140,000 / $ 46,667
2 / (210 / 750) x 1,000,000 / $ 280,000 / $210,000 / $ 70,000
3 / (240.5 / 750) x 1,000,000 / $ 320,667 / $240,500 / $ 80,167
4 / (90 / 750) x 1,000,000 / $ 120,000 / $ 90,000 / $ 30,000
5 / (69.5 / 750) x 1,000,000 / $ 92,666 / $ 69,500 / $ 23,166
$1,000,000 / $750,000 / $250,000
2) Completed contract method
Period / Revenue (millions) / Expense (millions) / Profit (millions)1 / 0 / 0 / 0
2 / 0 / 0 / 0
3 / 0 / 0 / 0
4 / 0 / 0 / 0
5 / $1,000,000 / $750,000 / $250,000
$1,000,000 / $750,000 / $250,000
b) The percentage of completion method should be used because the
revenue is earned over the course of the contract rather than all at once, upon completion. Since the work is done over several periods, the percentage of completion method is most appropriate. If the collectibility of the amount earned was in question, using the completed contract method would be more appropriate.
4.19Percentage of completion method
Year / Revenue (millions) / Expense (millions) / Profit (millions)2000 / (110.75 / 325) x 500,000 / $170,385 / $110,750 / $ 59,635
2001 / Loss = (511,250 - 500,000) +
59,635 / $ 29,615 / $100,500 / $ (70,885)
2002 / No profit or loss remains to
be recognized / $200,000 / $200,000 / $0
2003 / No profit or loss remains to
be recognized / $100,000 / $100,000 / $0
$500,000 / $$511,250 / ($11,250)
4.20
Year / Revenue / Interest / Expense / Accounts Receivable / Profit1 / 75,000 / $6,0001 / $60,000 / $25,0002 / $15,000
2 / 0 / $3,0003 / $0 / $04 / $0
1$3,600 + $2,400 = $6,000
2$75,000 - $30,000 - $20,000 = $25,000
3$1,800 + $1,200 = $3,000
4$25,000 - $15,000 - $10,000 = $0
4.21 a) Percentage of Completion Method ( answers in thousands)
Estimated Costs:
Year 2000$3,532.5
Year 20012,747.5
Year 2002 1,570.0
Total Estimated Costs$7,850.0
Contract Revenues$10,000
Estimated Cost 7,850
Profit$2,150
YearDegree of CompletionRevenue1Expense2Profit
2000$3,532.5/$7,850 = 45%$4,500$3,532.5$967.5
2001$2,747.5/$7,850 = 35%3,5002,747.5752.5
2002$1,570/$7,850 = 20%2,0001,570.0430.0
100%$10,000$7,850.0$2,150.0
1 Degree of Completion x Contract Price; Contract Price = $10,000 2 Cost incurred during period
b) Completed Contract Method (answers in thousands)
YearRevenueExpenseProfit
2000------
2001------
2002------
2003$10,000$7,850$2,150
$10,000$7,850$2,150
4.22a) Sonya’s cash-to-cash cycle begins when she pays cash for trees that she
plants on a plot of land, continues through six growing seasons with the outlay of cash for their care, and ends with the outlay of more cash for their harvesting so they can finally be sold to create a cash inflow. As she plants a new plot each year, she has six continuing cycles.
b)The general revenue recognition options that are open to Sonya, as
discussed in this chapter, are revenue recognition at the time of sale, at the time of contract signing, at the time of production, and at the time of collection. Because of the uncertainties involved in the planting, growing, harvesting, and sale of Christmas trees over such a long period of time, Sonya should use the time of sale to recognize revenues. Recognition of revenues at the time of collection would probably not be relevant if her sales are cash sales.
c)Recognizing revenues at the time of sale implies that all costs of growing
the trees should be deferred as inventory assets until the tees are harvested and sold, when they would be recognized as expenses and matched to the resulting revenues. To be able to match her costs to specific trees, Sonya would have to keep track of all costs incurred for each plot of land separately. Essentially this would mean that Sonya would keep track of six groups of inventory.
4.23a) Terry has two separate cash-to-cash cycles. The speculative design
business has cash outflows while the games are being developed, then has cash inflows only if the games are sold. The custom design business has a much shorter cash-to-cash cycle, with monthly cash outflows and monthly or less frequent cash inflows coming in after the invoices for the work are sent out.
b) Terry could recognize revenues at the time of sale, at the time of contract
signing, at the time of production, or at the time of collection of cash. For the speculative design, the time of sale basis would providing the best information. For hourly rate custom design, the percentage of completion basis (production) may be appropriate as Terry has a paying customer up front and the revenue is earned on an hourly basis as the work is done. However, if this work is normally completed within a short period of time, recognizing revenue when the work is complete would be appropriate.
c)Accounting for costs incurred would depend on the kind of business. For
speculative games, all costs incurred would be deferred as inventory assets until the games are sold, at which time the costs would be recognized as expenses to match to the revenues being earned. If Terry finds that any speculative games are found not to be salable, the cost associated with those games would be recognized as expenses. For custom designs, Terry would either recognize costs as they are incurred (for the hourly rate contracts) or defer the costs until the project is completed (for the fixed fee contracts). In all cases, costs should be matched with revenue.
d)The main difficulties with this business appear to be the requirement
that a stream of games be continually produced and that the cash flows need to be controlled. We should recommend that Terry produce a cash budget showing all expected cash inflows and outflows, as a continual supply of cash will be needed to be able to assure a continual flow of new games that can be marketed. We might recommend that Terry try to achieve a steady custom design business to produce the cash needed to produce the games for the speculative designs. Terry might also try to convince Kim to accept the same type of contract that Sandy has for the speculative game design in order to reduce the required cash outflows for wages.
Management Perspective Problems
4.24The “quality” of earnings refers to how certain an analyst is that the earnings reported in a company’s income statement will result in actual cash flows. If two companies were in the same industry and one of them recognized revenues earlier in the cash to cash cycle than the other then its earnings would likely have lower quality in the eyes of the analyst. The reason for this is that the earlier in the cycle that revenues are recognized the more uncertainty there is as to their actual collection. The relative quality of earnings for two companies in very different industries may be hard to judge due the differences in their cash to cash cycles.
4.25If a company is thinking of going public, it might have an incentive to
misstate its income statement via its revenue recognition policies. For example, if it recognizes revenue earlier in the cash-to-cash cycle, it can increase its net income, and attract a higher price from the share issuance. If a company did change its revenue recognition policy in order to enhance earnings, investors should realize what it is doing from its financial statements and related notes. Changes in accounting policy as well as the effects of such changes on net income must be disclosed in the notes to the financial statements, according to GAAP.
4.26Meeting your sales target is influenced by the revenue recognition principles
of the company because the earlier in the cash-to-cash cycle that revenue is recognized, the closer you can be to achieving the sales target. For example, if a large order is placed near the year-end, but the products are not shipped until the next year, recognizing this revenue in the current period can help you to meet your sales target.
4.27If the products sold in Brazil are priced in reals then you run the risk of each sale being worth less in dollar terms as the exchange rate increases unless, of course, you can fully adjust the real to compensate for the changing exchange rate. If you can, then you would want to sell more units earlier in the year as real earned in the last portion of the year are worth less in dollar terms than those at the beginning of the year. Another possibility would be to enter into some exchange rate hedging agreement to protect the dollar level of sales from extreme fluctuation in the exchange rate
Another possible solution to mitigate the exchange risk would be to price your goods in dollar terms. Therefore, as the exchange rate changes you still receive the same dollar amount for each sale. This puts the exchange risk on the customer. Depending on the market this may or may not be acceptable to the customer.
4.28Typically a company would want to choose a revenue recognition method for tax purposes that would delay the recognition of revenue. This postpones the payment of taxes on the revenue and is usually in the best interests of the taxpayer. On the other hand, for financial reporting purposes shareholders will want to see a more up-to-date and accurate picture of what has been sold and would prefer that revenues be recognized earlier than they might be for tax purposes. Management, in particular, might like to see revenues recognized as early as possible since their management compensation plan may be tied to reported net income.
4.29It might be appropriate for the toy company to recognize revenue at the time of shipment as long as it could reliably estimate the impact of returns. Just as you would estimate bad debts, the toy company must estimate and record an allowance for sales returns. To record revenues without any recognition of the effect of sales returns would not be appropriate since all of the revenues would not have been earned. If there is high uncertainty as to the amount of toys that might be returned then the uncertainties of realizing the revenues would be such that the company should not record revenues at time of shipment. Consignment sales are typical of this nature where title does not pass to the buyer but resides with the seller until the goods are ultimately sold the final consumer.
4.30Goods in transit are a problem for both the buyer and the seller. The issue comes down to who owns the goods at year-end. The sale contract typically specifies exactly when title passes to the goods and therefore determines when the risk of ownership passes from the seller to the buyer. The FOB terms are important. For instance, if the goods were shipped FOB shipping point, then the goods would belong to the Australian customer once they had left the dock in Vancouver. On the other hand, if they were shipped FOB destination then they would belong to the Vancouver exporter until they are delivered on the dock to the Australian customer. In some cases title may pass at sea when the ship crosses a certain geographic landmark.
4.31The selling company still bears the risks of owning the accounts receivable, because the purchaser has recourse if it is unable to collect. Therefore, the transaction should be treated as a borrowing of funds, rather than as an outright sale of accounts receivable.
4.32Since ESPN has not performed its part of the bargain, i.e. to run the advertisements and the customers has only put down a 20% deposit, this contract should probably be treated as mutually unexecuted and no revenues should be recognized until the commercials are aired. The $2,000,000 should be treated as a liability for customer deposits (or unearned revenues) in the financial statements on December 31.
4.33Although the cash has been received, the criteria for revenue recognition have not been satisfied because the GAP still bears the risks of owning the merchandise and must fulfill its obligation to holders of the gift certificates. Thus, the gift certificates should be recognized in the financial statements as unearned revenue.
4.34 The question here is whether the software company has “earned” its
revenues at the time the software is delivered to the customer. Because the software requires customization to the buyer’s system and the problem states that this can take several months it is likely that this is a major part of the earnings process for the company (i.e. the customization service). Therefore, you can argue that the revenues from the product should be deferred and recognized rationally over the customization period. Recognition at time of shipment would not seem appropriate since if no customization is done the product is highly likely to be returned to the company.
4.35Old inventory suggests that it is either damaged or obsolete. In either case it