Intermediate Accounting 7e, Chapter 5 Solutions

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© The McGraw-Hill Companies, Inc., 2013

Solutions Manual, Vol.1, Chapter 5 5–1

AACSB assurance of learning standards in accounting and business education require documentation of outcomes assessment. Although schools, departments, and faculty may approach assessment and its documentation differently, one approach is to provide specific questions on exams that become the basis for assessment. To aid faculty in this endeavor, we have labeled each question, exercise, and problem in Intermediate Accounting, 7e, with the following AACSB learning skills:

Questions AACSB Tags

5–1 Reflective thinking 5–2 Reflective thinking 5–3 Reflective thinking 5–4 Reflective thinking 5–5 Reflective thinking 5–6 Reflective thinking 5–7 Reflective thinking 5–8 Reflective thinking 5–9 Reflective thinking 5–10 Reflective thinking 5–11 Diversity, Reflective thinking 5–12 Reflective thinking 5–13 Reflective thinking 5–14 Reflective thinking 5–15 Diversity, Reflective thinking 5–16 Reflective thinking 5–17 Reflective thinking 5–18 Reflective thinking 5–19 Reflective thinking 5–20 Reflective thinking 5–21 Diversity, Reflective thinking 5–22 Reflective thinking 5–23 Reflective thinking 5–24 Reflective thinking 5–25 Reflective thinking 5–26 Reflective thinking 5–27 Reflective thinking Brief Exercises AACSB Tags 5–1 Analytic 5–2 Reflective thinking 5–3 Analytic 5–4 Analytic 5–5 Analytic 5–6 Reflective thinking, Communications 5–7 Analytic 5–8 Analytic 5–9 Analytic 5–10 Diversity, Analytic 5–11 Analytic

5–12 Reflective thinking, Analytic 5–13 Diversity, Reflective thinking,

Analytic 5–14 Analytic 5–15 Analytic 5–16 Analytic 5–17 Analytic 5–18 Analytic 5–19 Reflective thinking 5–20 Reflective thinking 5–21 Reflective thinking 5–22 Analytic 5–23 Analytic 5–24 Reflective thinking 5–25 Analytic

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5–2 Intermediate Accounting, 7/e

Exercises AACSB Tags

5–1 Reflective thinking, Analytic 5–2 Reflective thinking, Analytic 5–3 Analytic 5–4 Analytic 5–5 Analytic 5–6 Analytic 5–7 Analytic 5–8 Analytic 5–9 Analytic 5–10 Reflective thinking, Communications 5–11 Analytic 5–12 Diversity, Analytic 5–13 Analytic 5–14 Analytic 5–15 Analytic 5–16 Analytic 5–17 Reflective thinking, Communications 5–18 Analytic 5–19 Analytic 5–20 Diversity, Analytic 5–21 Analytic 5–22 Reflective thinking 5–23 Analytic, Communications 5–24 Analytic, Communications 5–25 Analytic 5–26 Analytic 5–27 Analytic 5–28 Analytic 5–29 Analytic 5–30 Diversity, Analytic 5–31 Reflective thinking, Analytic 5–32 Reflective thinking, Analytic 5–33 Reflective thinking 5–34 Reflective thinking, Analytic 5–35 Analytic

5–36 Reflective thinking 5–37 Reflective thinking 5–38 Analytic

CPA/CMA AACSB Tags

1 Analytic 2 Analytic 3 Analytic 4 Reflective thinking 5 Analytic 6 Analytic 7 Diversity, Reflective thinking 8 Diversity, Analytic 9 Diversity, Reflective thinking 10 Diversity, Reflective thinking 1 Analytic 2 Reflective thinking 3 Analytic Problems 5–1 Analytic 5–2 Analytic 5–3 Analytic 5–4 Analytic, Communications 5–5 Analytic 5–6 Analytic 5–7 Diversity, Analytic 5–8 Analytic 5–9 Analytic, Communications 5–10 Analytic, Communications 5–11 Analytic 5–12 Analytic, Communications 5–13 Analytic 5–14 Analytic, Communications 5–15 Analytic

5–16 Reflective thinking, Analytic 5–17 Reflective thinking,

Communications 5–18 Analytic 5–19 Analytic

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Question 5–1

The realization principle requires that two criteria be satisfied before revenue can be recognized:

1. The earnings process is judged to be complete or virtually complete.

2. There is reasonable certainty as to the collectibility of the asset to be received (usually cash).

Question 5–2

At the time production is completed, there usually exists significant uncertainty as to the collectibility of the asset to be received. We don’t know if the product will be sold, nor the selling price, nor the buyer if eventually the product is sold. Because of these uncertainties, revenue recognition usually is delayed until the point of product delivery.

Question 5–3

A principal has primary responsibility for delivering a product or service, and recognizes as revenue the gross amount received from a customer. An agent doesn’t primarily deliver goods or services, but acts as a facilitator that earns a commission for helping sellers to transact with buyers, and recognizes as revenue only the commission it receives for facilitating the sale.

Question 5–4

If the installment sale creates a situation where there is significant uncertainty concerning cash collection and it is not possible to make an accurate assessment of future bad debts, revenue and cost recognition should be delayed beyond the point of delivery.

Question 5–5

The installment sales method recognizes gross profit by applying the gross profit percentage on the sale to the amount of cash actually received each period. The cost recovery method defers all gross profit recognition until cash has been received equal to the cost of the item sold.

Question 5–6

Deferred gross profit is a contra installment receivable account. The balance in this account is subtracted from gross installment receivables to arrive at installment receivables, net. The net amount of the receivables represents the portion of remaining payments that represent cost recovery.

QUESTIONS FOR REVIEW OF KEY TOPICS

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Question 5–7

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.

Question 5–8

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 5–9

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 completed contract method of recognizing revenues and costs on long-term construction contracts is equivalent to recognizing revenue at point of delivery, i.e., when the construction project is complete. The percentage-of-completion method assigns a fair share of the project’s expected revenues and costs to each period in which the earnings process takes place, i.e., the construction period. The “fair share” typically is estimated as the project's costs incurred each period as a percentage of the project's total estimated costs. The completed contract method should only be used when the lack of dependable estimates or inherent hazards cause forecasts of future costs to be doubtful.

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Question 5–11

The completed contract method recognizes revenue, cost of construction, and gross profit at the end of the contract, after the contract has been completed. The cost recovery method will recognize an amount of revenue equal to the amount of cost that can be recovered, which typically is an amount that exactly offsets costs until all costs have been recovered, and then will recognize the remaining revenue and gross profit. Therefore, revenue and cost are recognized earlier under the cost recovery method than under the completed contract method, but gross profit recognition is delayed until late in the contract for both approaches. Assuming that the final costs are incurred just prior to completion of the contract, both approaches should recognize gross profit at the same time.

Question 5–12

The billings on construction contract account is a contra account to the construction in progress asset. 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 in the balance sheet as an asset. Conversely, if the net amount is a credit, it is reported as a liability.

Question 5–13

An estimated loss on a long-term contract must be fully recognized in the first period the loss is anticipated, regardless of the revenue recognition method used.

Question 5–14

This guidance requires that if an arrangement includes multiple elements, the revenue from the arrangement should be allocated to the various elements based on the relative fair values of the individual elements. If part of an arrangement does not qualify for separate accounting, revenue recognition is delayed until revenue is recognized for the other parts.

Question 5–15

IFRS has less specific guidance for recognizing revenue for multiple-deliverable arrangements.

IAS No. 18 simply states that: “…in certain circumstances, it is necessary to apply the recognition

criteria to the separately identifiable components of a single transaction in order to reflect the substance of the transaction” and gives a couple of examples, whereas U.S. GAAP provides more restrictive guidance concerning how to allocate revenue to various components and when revenue from components can be recognized.

Question 5–16

Specific guidelines for revenue recognition of the initial franchise fee are provided by FASB ASC 952–605–25–1. 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.

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Question 5–17

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.

Question 5–18

Profit margin on sales = Net income

Net sales

Return on assets = Net income

Average total assets Return on shareholders' = Net income

equity Average shareholders' equity

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.

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Question 5–19

Return on equity = Profit margin X Asset turnover X Equity multiplier Net income

Avg. total equity

= Net income Total sales

X Total sales Avg. total assets

X Avg. total assets Avg. total equity The DuPont framework shows return on equity as being driven by profit margin (reflecting a company’s ability to earn income from sales), asset turnover (reflecting a company’s effectiveness in using assets to generate sales), and the equity multiplier (reflecting the extent to which a company has used debt to finance its assets).

Question 5–20

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.

Question 5–21

U.S. GAAP views interim reports as an integral part of the annual report, so amounts that affect multiple interim periods are accrued or deferred and then charged to each of the periods they affect. IFRS takes much more of a discrete-period approach than does U.S. GAAP, such that costs for repairs, property taxes, advertising, etc., that do not meet the definition of an asset at the end of an interim period are expensed entirely in the period in which they occur.

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SUPPLEMENT QUESTIONS FOR REVIEW

OF KEY TOPICS

Question 5–22

The five key steps in recognizing revenue under the new standard are: 1. Identify a contract(s) with a customer.

2. Identify the separate performance obligation(s) in the contract. 3. Determine the transaction price.

4. Allocate the transaction price to the separate performance obligations.

5. Recognize revenue when (or as) the entity satisfies each performance obligation. Question 5–23

Under the proposed ASU, a good or service is a separate performance obligation if it is distinct, which is the case if either:

1. The seller regularly sells the good or service separately, or

2. A buyer could use the good or service on its own or in combination with goods or services the buyer could obtain elsewhere.

Question 5–24

Under the proposed ASU, if an entity grants a customer the option to acquire additional goods or services, that promise gives rise to a separate performance obligation in the contract only if the option provides a material right to the customer that the customer would not receive without entering into the contract. If the option provides a material right, the customer in effect pays the entity in advance for future goods or services and the entity recognizes revenue when those future goods or services are transferred or when the option expires.

Question 5–25

Under the proposed ASU, if an arrangement has multiple separate performance obligations, the seller allocates the transaction price to the separate performance obligations in proportion to the stand-alone selling prices of the goods or services underlying those performance obligations. If the seller can’t observe actual stand-alone selling prices, the seller should estimate them.

Question 5–26

Under the proposed ASU, a performance obligation for a good is satisfied when control of the good is transferred to the buyer. Four key indicators that control of a good has passed from the seller to the buyer are:

1. Buyer has an unconditional obligation to pay. 2. Buyer has legal title.

3. Buyer has physical possession.

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Question 5–27

Under the proposed ASU, if a seller provides the service of integrating products and services into one asset (for example, as is done in the construction industry), the risks of providing the goods and services are not separable, so that arrangement is treated as a single service-related performance obligation. The performance obligation is viewed as satisfied over time if at least one of two criteria is met:

1. The seller is creating or enhancing an asset that the buyer controls as the service is performed.

2. The seller is not creating an asset that the buyer controls or that has alternative use to the seller, and at least one of the following conditions hold:

a. The customer receives and consumes a benefit as the seller performs.

b. Another seller would not need to reperform the tasks performed to date if that other seller were to fulfill the remaining obligation.

c. The seller has the right to payment for performance even if the customer could cancel the contract at the customer’s discretion.

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BRIEF

EXERCISES

Brief Exercise 5–1

2013 gross profit = $3,000,000 – 1,200,000 = $1,800,000

2014 gross profit = 0

Brief Exercise 5–2

Indicators that the seller is a principal (recognizing gross revenue) as opposed to an agent (recognizing net revenue) include the following:

 The company is primarily responsible for providing the product or service to the customer.

 The company has general inventory risk, meaning that the company owns inventory prior to a customer ordering it and after a customer returns it.

 The company has discretion in setting prices and identifying suppliers.

In this transaction, Amazon never bears inventory risk, and is paid a fixed commission such that it has no discretion in setting prices. Therefore, Amazon appears to be an agent, and would only recognize revenue on the transaction equal to the amount of the commission it receives.

Brief Exercise 5–3

2013 Cost recovery % = Cost  Sales: $1,200,000

= 40% (implying a gross profit % = 60%) $3,000,000

2013 gross profit = 2013 cash collection of $150,000 x 60% = $90,000

2014 gross profit = 2014 cash collection of $150,000 x 60% = $90,000

Brief Exercise 5–4

No gross profit will be recognized in either 2013 or 2014. Gross profit will not be recognized until the entire $1,200,000 cost of the land is recovered. In this case, it will take eight payments to recover the cost of the land ($1,200,000  $150,000 = 8), so

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gross profit recognition will equal 100% of the cash collected beginning with the ninth installment payment.

Brief Exercise 5–5

Initial deferred gross profit ($3,000,000 – 1,200,000) $1,800,000 Less gross profit recognized in 2013 ($150,000 x 60%) (90,000) Less gross profit recognized in 2014 ($150,000 x 60%) (90,000)

Deferred gross profit at the end of 2014 $1,620,000

Brief Exercise 5–6

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 5–7

Total estimated cost to complete = $6 million + 9 million = $15 million % 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

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Brief Exercise 5–8

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 5–9

Year 1 = 0

Year 2 = $4 million

Revenue $20,000,000 Less: Costs in year 1 (6,000,000)

Costs in year 2 (10,000,000) Actual profit $ 4,000,000

Brief Exercise 5–10

Year 1: Revenue: $6 million Cost: $6 million Gross profit: $0 Year 2:

Revenue: $14 million ($20 million total – 6 million in year 1) Cost: $10 million

Gross profit: $ 4 million

Brief Exercise 5–11

The anticipated loss of $3 million ($30 million contract price less total estimated costs of $33 million) must be recognized in the first year applying either method.

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Brief Exercise 5–12

Orange has separate sales prices for the two parts of LearnIt-Plus, so that vendor-specific objective evidence (VSOE) allows them to allocate revenue to those parts according to their relative selling prices. LearnIt will be allocated $200 x [$150 ÷ ($150 + 100)] = $120, and that revenue will be recognized upon delivery of the LearnIt software. LearnIt Office Hours will be allocated $200 x [$100 ÷ ($150 + 100)] = $80, and that revenue will be deferred and recognized over the life of the one-year period in which the Office Hours are delivered.

If LearnIt were not sold separately, Orange would not have VSOE for all of the parts of the contract. In that case, revenue would be delayed until the later part was delivered. In this case, the $200 would be deferred and recognized over the life of the one-year period in which the Office Hours are delivered.

Brief Exercise 5–13

Orange has separate sales prices for the two parts of LearnIt-Plus, so the company can base its estimates of the fair value of those parts according to their relative selling prices. LearnIt will be allocated $200 x [$150 ÷ ($150 + 100)] = $120, and that revenue will be recognized upon delivery of the LearnIt software. LearnIt Office Hours will be allocated $200 x [$100 ÷ ($150 + 100)] = $80, and that revenue will be deferred and recognized over the life of the one-year period in which the Office Hours are delivered.

If LearnIt were not sold separately, the accounting would be the same. Orange would estimate the fair value of LearnIt Office Hours to be $100 and allocate revenue in the same fashion as it did when that product was sold separately. (VSOE is not required under IFRS).

Brief Exercise 5–14

Specific conditions for revenue recognition of the initial franchise fee are provided by FASB ASC 952–605–25–1. 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.

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Brief Exercise 5–15

*$600,000 – 200,000

Receivables turnover ratio ₌ Net sales

Average accounts receivable (net)

Receivables turnover ratio ₌ $600,000

[$100,000 + 120,000] ÷ 2

= 5.45 times

Inventory turnover ratio ₌ Cost of goods sold

Average inventory

Inventory turnover ratio ₌ $400,000*

[$80,000 + 60,000] ÷ 2

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Brief Exercise 5–16

_{Profit margin} ₌ Net income

Sales

₌ $65,000

$420,000

₌ 15.5%

Return on assets = Net income

Average total assets

₌ $65,000

$800,000

₌ 8.1%

Return on shareholders’

equity = Net income

Average shareholders’ equity

= $65,000

$522,500*

= 12.4%

Shareholders’ equity, beginning of period $500,000

Add: Net income 65,000

Deduct: Dividends (20,000)

Shareholders’ equity, end of period $545,000

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Brief Exercise 5–17

Return on

equity

= Profit margin

X Asset turnover X Equity multiplier

Net income Avg. total equity = Net income Total sales X Total sales

Avg. total assets

X Avg. total assets Avg. total equity

Return on shareholders’

equity = Net income

Average shareholders’ equity

= $65,000

$522,500

= 12.4%

Profit margin = Net income

Sales

₌ $65,000

$420,000

₌ 15.5%

Asset turnover = Sales

Average total assets

₌ $420,000

$800,000

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Brief Exercise 5–17 (concluded)

Equity multiplier = Average total assets Average shareholders’ equity

= $800,000

$522,500

= 1.53

Check: 12.4% ROE = 15.5% profit margin x .525 times asset turnover x 1.53 equity multiplier.

Brief Exercise 5–18

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

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SUPPLEMENT

BRIEF

EXERCISES

Brief Exercise 5–19

An agreement needs to have the following five characteristics to qualify as a contract for revenue recognition purposes under the proposed ASU:

1. Commercial substance. The contract is expected to affect the seller’s future cash flows.

2. Approval. Each party to the contract has approved the contract and is committed to satisfying their respective obligations.

3. Rights. Each party’s rights are specified with respect to the goods and services to be transferred.

4. Payment terms. The terms and manner of payment are specified.

5. Performance. A contract does not exist if either party can terminate a wholly unperformed contract without penalty.

The Richter agreement does not satisfy characteristic number 4, and may not satisfy characteristics 3 and 5 as well. Therefore, it does not qualify as a contract for purposes of recognizing revenue.

Brief Exercise 5–20

Yes, these are separate performance obligations, because each good is sold separately to individual customers.

Brief Exercise 5–21

Yes, they are separate. The renewal option is a material right because it allows the customer to renew at a better price than could be obtained without the right.

Brief Exercise 5–22

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Brief Exercise 5–23

Based on relative stand-alone selling prices, the software comprises 80% of the total fair values ($80,000 ÷ ($20,000 + 80,000)), and the technical support comprises 20% ($20,000 ÷ ($20,000 + 80,000)). Therefore, the seller would recognize $72,000 ($90,000  80%) in revenue up front when the software is delivered, and defer the remaining $18,000 ($90,000  20%) and recognize it ratably over the next six months as the technical support service is provided, making the following journal entry:

Cash 90,000

Revenue 72,000

Unearned revenue 18,000

Brief Exercise 5–24

A performance obligation is satisfied over time if at least one of two criteria is met: 1. The seller is creating or enhancing an asset that the buyer controls as the service

is performed.

2. The seller is not creating an asset that the buyer controls or that has alternative use to the seller, and at least one of the following conditions hold:

a. The customer receives and consumes a benefit as the seller performs the service.

b. Another seller would not need to reperform the tasks performed to date if that other seller were to fulfill the remaining obligation.

c. The seller has the right to payment for performance even if the customer could cancel the contract at the customer’s discretion.

Under Estate’s construction agreement with CyberB, if for some reason Estate could not complete construction, CyberB would own the partially completed building and could retain another construction company to complete the job. A new construction contractor would not need to reperform Estate’s work if the new contractor completed the job. Therefore, criterion 2b is satisfied.

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Brief Exercise 5–25

Patterson initially would record the payment as unearned revenue. Then Patterson would accrue interest expense of $10,000 x 5% = $500 in year one of the contract, and interest expense of ($10,000 + 500) x 5% = $525 in year two of the contract, in each case debiting interest expense and crediting unearned revenue. Therefore, at the point in time Patterson delivers the novel, it would have unearned revenue totaling $10,000 + 500 + 525 = $11,025, and would recognize that amount as revenue.

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Exercise 5–1

Requirement 1

Alpine West should recognize revenue over the ski season on an anticipated usage basis, in this case equally throughout the season. The fact that the $450 price is nonrefundable is not relevant to the revenue recognition decision. Revenue should be recognized as it is earned, in this case as the services are provided during the ski season.

Requirement 2

November 6, 2013

Cash ... 450

Unearned revenue ... 450

To record the cash collection

December 31, 2013

Unearned revenue ($450 x 1/5) ... 90

Revenue ... 90

To recognize revenue earned in December (no revenue earned in November, as season starts on December 1).

Requirement 3

$90 is included in revenue in the 2013 income statement. The $360 remaining balance in unearned revenue is included in the current liability section of the 2013 balance sheet.

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Exercise 5–2

When other parties are involved in providing goods or services to a seller’s customer, the seller has to determine whether its performance obligation is to provide the goods or services itself, making the seller a principal, or the seller arranges for another party to provide those goods or services, making the seller an agent. That determination affects whether the seller recognizes revenue in the amount of consideration received in exchange for those goods or services (if principal) or in the amount of any fee or commission received in exchange for arranging for the other party to provide the goods or services (if agent).

Requirement 1

AuctionCo is a principal because it obtained control of the used bicycle before the bicycle was sold. Therefore, AuctionCo should recognize revenue of $30.

Requirement 2

AuctionCo is an agent because it never controlled the product before it was sold. Therefore, AuctionCo should recognize revenue for the commission fees of $10 retained upon sending $20 to the original owner.

Requirement 3

In this case it appears that AuctionCo is acting as an agent, given that the bicycles are shipped directly from the owner to the customer. However, additional aspects of the arrangement could make it more appropriate to treat AuctionCo as a principal. For example, if AuctionCo must pay the bicycle owner the $20 wholesale price regardless of whether the bicycle is sold, then AuctionCo would appear to have purchased the bicycle and should be treated as a principal.

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Exercise 5–3

Requirement 1 2013 cost recovery %: $234,000 = 65% (gross profit % = 35%) $360,000 2014 cost recovery %: $245,000 = 70% (gross profit % = 30%) $350,000 2013 gross profit:

Cash collection from 2013 sales of $150,000 x 35% = $52,500

2014 gross profit:

Cash collection from 2013 sales of $100,000 x 35% = $ 35,000 + Cash collection from 2014 sales of $120,000 x 30% = 36,000

Total 2014 gross profit $71,000

Requirement 2

2013 deferred gross profit balance:

2013 initial gross profit ($360,000 – 234,000) $126,000

Less: Gross profit recognized in 2013 (52,500)

Balance in deferred gross profit account $73,500

2014 deferred gross profit balance:

2013 initial gross profit ($360,000 – 234,000) $ 126,000

Gross profit recognized in 2014 (35,000)

2014 initial gross profit ($350,000 – 245,000) 105,000

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Exercise 5–4

2013

Installment receivables ... 360,000

Inventory ... 234,000

Deferred gross profit ... 126,000

To record installment sales

2013

Cash ... 150,000

To record cash collections from installment sales

2013

Realized gross profit ... 52,500

To recognize gross profit from installment sales

2014

To record installment sales

2014

Cash ... 220,000

To record cash collections from installment sales

2014

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Exercise 5–5

Requirement 1

Year Income recognized

2013 $180,000 ($300,000 – 120,000) 2014 - 0 - 2015 - 0 - 2016 - 0 - Total $180,000 Requirement 2 Cost recovery %: $120,000 --- = 40% (gross profit % = 60%) $300,000

Year Cash Collected Cost Recovery(40%) Gross Profit(60%)

2013 $ 75,000 $ 30,000 $ 45,000 2014 75,000 30,000 45,000 2015 75,000 30,000 45,000 2016 75,000 30,000 45,000 Totals $300,000 $120,000 $180,000 Requirement 3

Year Cash Collected Cost Recovery Gross Profit

2013 $ 75,000 $ 75,000 - 0 -

2014 75,000 45,000 $ 30,000

2015 75,000 - 0 - 75,000

2016 75,000 - 0 - 75,000

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Exercise 5–6

Requirement 1

July 1, 2013

Sales revenue ... 300,000

To record installment sale

Cost of goods sold ... 120,000

Inventory ... 120,000 To record cost of installment sale

Cash ... 75,000

To record cash collection from installment sale

July 1, 2014

Cash ... 75,000

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Exercise 5–6 (continued)

Requirement 2

July 1, 2013

Cash ... 75,000

To recognize gross profit from installment sale

July 1, 2014

Cash ... 75,000

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Exercise 5–6 (concluded)

Requirement 3

July 1, 2013

Cash ... 75,000

July 1, 2014

Cash ... 75,000

Exercise 5–7

Requirement 1

Cost of goods sold ($1,000,000 – 600,000) $400,000 Add: Gross profit if using cost recovery method 100,000

Cash collected $500,000

Requirement 2

$ 600,000

Gross profit percentage = = 60% $1,000,000

Cash collected x Gross profit percentage = Gross profit recognized $500,000 x 60% = $300,000 gross profit

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Exercise 5–8

October 1, 2013

Installment receivable ... 4,000,000 Inventory ... 1,800,000

Deferred gross profit ... 2,200,000

To record the installment sale

Cash ... 800,000

Installment receivable ... 800,000

To record the cash down payment from installment sale

Deferred gross profit ($800,000 x 55%*) ... 440,000

October 1, 2014

Repossessed inventory (fair value) ... 1,300,000 Deferred gross profit (balance) ... 1,760,000 Loss on repossession (difference) ... 140,000

Installment receivable (balance) ... 3,200,000 To record the default and repossession ...

(30)

Exercise 5–9

Requirement 1

April 1, 2013

Installment receivables ... 2,400,000

Land ... 480,000 Gain on sale of land ... 1,920,000

April 1, 2013

Cash ... 120,000

April 1, 2014

Cash ... 120,000

Requirement 2

April 1, 2013

Installment receivables ... 2,400,000

Land ... 480,000 Deferred gain ... 1,920,000

(31)

When payments are received, gain on sale of land is recognized, calculated by applying the gross profit percentage ($1,920,000 ÷ $2,400,000 = 80%) to the cash collected (80% x $120,000).

April 1, 2013

Cash ... 120,000

Deferred gain ... 96,000

Gain on sale of land (80% x $120,000) ... 96,000

To recognize profit from installment sale

April 1, 2014

Cash ... 120,000

Deferred gain ... 96,000

Gain on sale of land (80% x $120,000) ... 96,000

(32)

Exercise 5–10

The FASB Accounting Standards Codification represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is:

1. When a provision for loss is recognized for a percentage-of-completion contract:

FASB ASC 605–35–25–46: “Revenue Recognition–Construction–Type and Production–Type Contracts–Recognition–Provisions for Losses on Contracts.” 2. Circumstances indicating when the installment method or cost recovery

method is appropriate for revenue recognition:

FASB ASC 605–10–25–4: “Revenue Recognition–Overall–Recognition– Installment and Cost Recovery Methods of Revenue Recognition.” (Note: ASC 605–10–25–3 also provides some guidance, as it indicates when installment method is not acceptable).

3. Criteria determining when a seller can recognize revenue at the time of sale from a sales transaction in which the buyer has the right to return the

product:

FASB ASC 605–15–25–1: “Revenue Recognition–Products–Recognition– General–Sales of Product when Right of Return Exists.”

(33)

Exercise 5–11

Requirement 1

2013 2014

Contract price $2,000,000 $2,000,000

Actual costs to date 300,000 1,875,000

Estimated costs to complete 1,200,000 - 0 -

Total estimated costs 1,500,000 1,875,000

Gross profit (estimated in 2013) $ 500,000 $ 125,000

Gross profit recognition:

2013: $ 300,000 = 20% x $500,000 = $100,000 $1,500,000 2014: $125,000 – 100,000 = $25,000 Requirement 2 2013 $ - 0 - 2014 $125,000 Requirement 3 Balance Sheet At December 31, 2013 Current assets: Accounts receivable $ 130,000

Costs and profit ($400,000*) in excess

of billings ($380,000) 20,000

(34)

Exercise 5–11 (concluded) Requirement 4 Balance Sheet At December 31, 2013 Current assets: Accounts receivable $ 130,000 Current liabilities:

(35)

Exercise 5–12

Requirement 1

($ in millions) 2013 2014 2015

Contract price $220 $220 $220

Actual costs to date 40 120 170

Estimated costs to complete 120 60 - 0 -

Total estimated costs 160 180 170

Estimated gross profit (actual in 2015) $ 60 $ 40 $ 50

Gross profit (loss) recognition:

2013: $40 = 25% x $60 = $15 $160 2014: $120 = 66.67% x $40 = $26.67 – 15 = $11.67 $180 2015: $220 – 170 = $50 – (15 + 11.67) = $23.33 Requirement 2 2013: $220 x 25% = $55 2014: $220 x 66.67% = $146.67 – 55 = $91.67 2015: $220 – 146.67 = $73.33 Requirement 3

Year Gross profit (loss) recognized

2013 - 0 -

2014 - 0 -

2015 50

(36)

Exercise 5–12 (concluded) Requirement 4 2013: Revenue: $40 Cost: 40 Gross profit: $ 0 2014: Revenue: $80 Cost: 80 Gross profit: $ 0 2015:

Revenue: $100 ($220 contract price – 40 – 80) Cost: 50 Gross profit: $ 50 Requirement 5 2014: $120 = 60% x $20* = $12 – 15 = $(3) loss $200 *$220 – (40 + 80 + 80) = $20

(37)

Exercise 5–13

Requirement 1

2013 2014 2015

Contract price $8,000,000 $8,000,000 $8,000,000

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)

(actual in 2015) $2,000,000 $ (100,000) $ (300,000)

Gross profit (loss) recognition:

2013: $2,000,000

= 33.3333% x $2,000,000 = $666,667

$6,000,000

2014: $(100,000) – 666,667 = $(766,667)

(38)

Requirement 2

2013 2014

Construction in progress 2,000,000 2,500,000

Various accounts 2,000,000 2,500,000

To record construction costs

Accounts receivable 2,500,000 2,750,000

Billings on construction contract 2,500,000 2,750,000

To record progress billings

Cash 2,250,000 2,475,000

To record cash collections

Construction in progress

(gross profit) 666,667

Cost of construction 2,000,000

Revenue from long-term contracts

(33.3333% x $8,000,000) _2,666,667

To record gross profit

Cost of construction (2) 2,544,000

Revenue from long-term contracts (1) _1,777,333

Construction in progress (loss) 766,667

To record expected loss

(1) and (2):

Percent complete = $4,500,000 ÷ $8,100,000 = 55.55% Revenue recognized to date:

55.55% x $8,000,000 = $4,444,000

Less: Revenue recognized in 2013 (above) (2,666,667) Revenue recognized in 2014 1,777,333 (1) Plus: Loss recognized in 2014 (prior page) 766,667 Cost of construction, 2014 $2,544,000 (2)

(39)

Requirement 3

Balance Sheet 2013 2014

Current assets:

Accounts receivable $250,000 $525,000

Costs and profit ($2,666,667*) in

excess of billings ($2,500,000) 166,667

Current liabilities:

Billings ($5,250,000) in excess

of costs less loss ($4,400,000**) $850,000

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

(40)

Exercise 5–14

Requirement 1

2013 - 0 -

2014 $(100,000)

2015 (200,000)

Total project loss $(300,000)

Requirement 2

2013 2014

Construction in progress 2,000,000 2,500,000

Various accounts 2,000,000 2,500,000

To record construction costs

Billings on construction contract 2,500,000 2,750,000

To record progress billings

Cash 2,250,000 2,475,000

To record cash collections

Loss on long-term contract 100,000

Construction in progress 100,000

(41)

Exercise 5–14 (concluded) Requirement 3 Balance Sheet 2013 2014 Current assets: Accounts receivable $250,000 $525,000 Current liabilities:

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

($2,000,000) _$500,000

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

loss ($4,400,000*) $850,000

(42)

Exercise 5–15

SUMMARY

Percentage-of-Completion Completed Contract

Situation 2013 2014 2015 2013 2014 2015 1 $166,667 $233,333 $100,000 $0 $0 $500,000 2 $166,667 $(66,667) $100,000 $0 $0 $200,000 3 $166,667 $(266,667) $(100,000) $0 $(100,000) $(100,000) 4 $125,000 $375,000 $0 $0 $0 $500,000 5 $125,000 $(125,000) $200,000 $0 $0 $200,000 6 $(100,000) $(100,000) $(100,000) $(100,000) $(100,000) $(100,000)

(43)

Situation 1 - Percentage-of-Completion

2013 2014 2015

Contract price $5,000,000 $5,000,000 $5,000,000

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

(actual in 2015) $ 500,000 $ 500,000 $ 500,000

Gross profit (loss) recognized:

2013: $1,500,000 = 33.3333% x $500,000 = $166,667 $4,500,000 2014: $3,600,000 = 80.0% x $500,000 = $400,000 – 166,667 = $233,333 $4,500,000 2015: $500,000 – 400,000 = $100,000

Situation 1 - Completed Contract

Year Gross profit recognized

2013 - 0 -

2014 - 0 -

2015 $500,000

(44)

2013 2014 2015

Contract price $5,000,000 $5,000,000 $5,000,000

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

(actual in 2015) $ 500,000 $ 200,000 $ 200,000

2013: $1,500,000 = 33.3333% x $500,000 = $166,667 $4,500,000 2014: $2,400,000 = 50.0% x $200,000 = $100,000 – 166,667 = $(66,667) $4,800,000 2015: $200,000 – 100,000 = $100,000

2013 - 0 -

2014 - 0 -

2015 $200,000

(45)

2013 2014 2015

Contract price $5,000,000 $5,000,000 $5,000,000

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)

(actual in 2015) $ 500,000 $ (100,000) $ (200,000)

2013: $1,500,000

= 33.3333% x $500,000 = $166,667

$4,500,000

2014: $(100,000) – 166,667 = $(266,667)

2015: $(200,000) – (100,000) = $(100,000)

2013 - 0 -

2014 $(100,000)

2015 (100,000)

(46)

2013 2014 2015

Contract price $5,000,000 $5,000,000 $5,000,000

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

(actual in 2015) $1,000,000 $ 625,000 $ 500,000

2013: $ 500,000 = 12.5% x $1,000,000 = $125,000 $4,000,000 2014: $3,500,000 = 80.0% x $625,000 = $500,000 – 125,000 = $375,000 $4,375,000 2015: $500,000 – 500,000 = $ - 0 -

2013 - 0 -

2014 - 0 -

2015 $500,000

(47)

2013 2014 2015

Contract price $5,000,000 $5,000,000 $5,000,000

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

(actual in 2015) $1,000,000 $ - 0 - $ 200,000

2013: $ 500,000

= 12.5% x $1,000,000 = $125,000

$4,000,000

2014: $0 – 125,000 = $(125,000)

2015: $200,000 – 0 = $200,000

2013 - 0 -

2014 - 0 -

2015 $200,000

(48)

2013 2014 2015

Contract price $5,000,000 $5,000,000 $5,000,000

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)

(actual in 2015) $ (100,000) $ (200,000) $ (300,000)

2013: $(100,000)

2014: $(200,000) – (100,000) = $(100,000)

2015: $(300,000) – (200,000) = $(100,000)

2013 $(100,000)

2014 (100,000)

2015 (100,000)

(49)

Exercise 5–16

Requirement 1

Construction in progress = Costs incurred + Profit recognized $100,000 = ? + $20,000

Actual costs incurred in 2013 = $80,000 Requirement 2

Billings = Cash collections + Accounts receivable $94,000 = ? + $30,000

Cash collections in 2013 = $64,000 Requirement 3

Let A = Actual cost incurred + Estimated cost to complete Actual cost incurred

x (Contract price – A) = Profit recognized A $80,000 ($1,600,000 – A) = $20,000 A $128,000,000,000 – 80,000A = $20,000A $100,000A = $128,000,000,000 A = $1,280,000

Estimated cost to complete = $1,280,000 – 80,000 = $1,200,000 Requirement 4

$80,000

= 6.25%

(50)

Exercise 5–17

Requirement 1

The specific citation that specifies the the circumstances and conditions under which it is appropriate to use the percentage-of-completion method is: FASB ASC 605–35– 25–57: “Revenue Recognition–Construction–Type and Production–Type Contracts– Recognition–Circumstances Appropriate for Using the Percentage-of-Completion Method.”

Requirement 2

FASB ASC 605–35–25–57 reads as follows:

“The percentage-of-completion method is considered preferable as an accounting policy in circumstances in which reasonably dependable estimates can be made and in which all the following conditions exist:

a. Contracts executed by the parties normally include provisions that clearly specify the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement.

b. The buyer can be expected to satisfy all obligations under the contract. c. The contractor can be expected to perform all contractual obligations.”

(51)

Exercise 5–18

Requirement 1

Revenue should be recognized as follows:

Software – date of shipment, July 1, 2013

Technical support – evenly over the 12 months of the agreement Upgrade – date of shipment, January 1, 2014

The amounts are determined by an allocation of total contract price in proportion to the individual fair values of the components if sold separately: Software $210,000 ÷ $270,000 x $243,000 = $189,000 Technical support $30,000 ÷ $270,000 x $243,000 = 27,000 Upgrade $30,000 ÷ $270,000 x $243,000 = 27,000 Total $243,000 Requirement 2 July 1, 2013 Cash ... 243,000 Revenue ... 189,000 Unearned revenue ($27,000 + 27,000) ... 54,000

(52)

Exercise 5–19

Requirement 1 Conveyer ($20,000 ÷ $50,000) x $45,000 = $18,000 Labeler ($10,000 ÷ $50,000) x $45,000 = 9,000 Filler ($15,000 ÷ $50,000) x $45,000 = 13,500 Capper ($5,000 ÷ $50,000) x $45,000 = 4,500 Total $45,000 Requirement 2

All $45,000 of revenue is delayed until installation of the conveyer, because the usefulness of the other elements of the multi-part arrangement is

(53)

Exercise 5–20

Requirement 1 Conveyer ($20,000 ÷ $50,000) x $45,000 = $18,000 Labeler ($10,000 ÷ $50,000) x $45,000 = 9,000 Filler ($15,000 ÷ $50,000) x $45,000 = 13,500 Capper ($5,000 ÷ $50,000) x $45,000 = 4,500 Total $45,000 Requirement 2

Under IFRS, it is likely that Richardson would recognize revenue the same as in Requirement 1, because (a) revenue for each part can be estimated reliably and (b) the receipt of economic benefits is probable.

(54)

Exercise 5–21

October 1, 2013

Cash (10% x $300,000) ... 30,000 Note receivable ... 270,000

Unearned franchise fee revenue ... 300,000

To record franchise agreement and down payment

January 15, 2014

Unearned franchise fee revenue ... 300,000

Franchise fee revenue ... 300,000

To recognize franchise fee revenue

Exercise 5–22

List A List B

h 1. Inventory turnover a. Net income divided by net sales.

d 2. Return on assets b. Defers recognition until cash collected equals

cost.

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

by seller.

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

(55)

Exercise 5–23

Requirement 1

Requirement 2

By itself, this one ratio provides very little information. In general, the higher the inventory turnover, the lower the investment must be for a given level of sales. It indicates how well inventory levels are managed and the quality of inventory, including the existence of obsolete or overpriced inventory.

However, to evaluate the adequacy of this ratio it should be compared with some norm such as the industry average. That indicates whether inventory management practices are in line with the competition.

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

= $1,840,000

[$690,000 + 630,000] ÷ 2

(56)

Exercise 5–24

Turnover ratios for Anderson Medical Supply Company for 2013:

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).

Inventory turnover ratio ₌ $4,800,000

[$900,000 + 700,000] ÷ 2

= 6 times

Receivables turnover ratio ₌ $8,000,000

[$700,000 + 500,000] ÷ 2

= 13.33 times

Average collection period ₌ 365

13.33

= 27.4 days

Asset turnover ratio ₌ $8,000,000

[$4,300,000 + 3,700,000] ÷ 2

(57)

Exercise 5–25

Requirement 1

a. Profit margin on sales $180 ÷ $5,200 = 3.5%

b. Return on assets $180 ÷ [($1,900 + 1,700) ÷ 2] = 10% c. Return on shareholders’ equity $180 ÷ [($550 + 500) ÷ 2] = 34.3%

Requirement 2

Retained earnings beginning of period $100,000

Add: Net income 180,000

280,000 Less: Retained earnings end of period 150,000

Dividends paid $130,000

Exercise 5–26

Requirement 1

a. Profit margin on sales $180 ÷ $5,200 = 3.46%

b. Asset turnover $5,200 ÷ [($1,900 + 1,700) ÷ 2] = 2.89 c. Equity multiplier [($1,900 + 1,700) ÷ 2] ÷ [($550 + 500) ÷ 2] = 3.43 d. Return on shareholders’ equity $180 ÷ [($550 + 500) ÷ 2] = 34.3%

Requirement 2

Profit margin x Asset turnover x Equity multiplier = ROE 3.46% x 2.89 x 3.43 = 34.3%

Exercise 5–27

Quarter

First Second Third

Cumulative income before taxes $50,000 $90,000 $190,000 Estimated annual effective tax rate 34% 30% 36%

17,000 27,000 68,400

Less: Income tax reported earlier - 0 - 17,000 27,000