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Chapter 05 - Income Measurement and Profitability Analysis

Question 5-1The 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 5-2At the time production is completed, there usually exists significant uncertainty as to the

collectibility of the asset to be received. We dont know if the product will be sold, nor the selling

price, nor the buyer if eventually the product is sold. Because of these uncertainties, revenuerecognition usually is delayed until the point of product delivery.

Question 5-3If 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 costrecognition should be delayed beyond the point of delivery.

Question 5-4The 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 methoddefers algross profit recognition until cash has been received equal to the cost of the item sold.

Question 5-5Deferred gross profit is a contra installment receivable account. The balance in this account i

subtracted from gross installment receivables to arrive at installment receivables, net. The netamount of the receivables represents the portion of remaining payments that represent cost recovery.

5-1

Chapter 5 Income Measurement and Profitability Analysis

QUESTIONS FOR REVIEW OF KEY TOPICS

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Question 5-10The 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 wilrecognize 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 theremaining revenue and gross profit. Therefore, revenue and cost are recognized earlier under thecost recovery method than under the completed contract method, but gross profit recognition isdelayed until late in the contract for both approaches. Assuming that the final costs are incurred justprior to completion of the contract, both approaches should recognize gross profit at the same time.

Question 5-11The 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 arcompared. If the net amount is a debit, it is reported in the balance sheet as an asset. Conversely, ithe net amount is a credit, it is reported as a liability.

Question 5-12An 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 5-13This 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 theindividual elements. If part of an arrangement does not qualify for separate accounting, revenuerecognition is delayed until revenue is recognized for the other parts.

Question 5-14

IFRS has less specific guidance for recognizing revenue for multiple-deliverable arrangementsIAS No. 18 simply states that: in certain circumstances, it is necessary to apply the recognitioncriteria to the separately identifiable components of a single transaction in order to reflect thesubstance of the transaction and gives a couple of examples, whereas U.S. GAAP provides morerestrictive guidance concerning how to allocate revenue to various components and when revenuefrom components can be recognized.

Question 5-15Specific guidelines for revenue recognition of the initial franchise fee are provided by FASB

ASC 952605251. A key to these guidelines is the concept of substantial performance. Itrequires 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 termsubstantial requires professional judgment on the part of the accountant. In situations when theinitial 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 reasonableestimate of uncollectibility cannot be made.

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Question 5-16

Receivables turnover ratio = Net sales

Average accounts receivable (net)

Inventory turnover ratio = Cost of goods soldAverage inventory

Asset turnover ratio = Net salesAverage total assets

Activity ratios are designed to provide information about a companys effectiveness inmanaging assets. Activity or turnover of certain assets measures the frequency with which thoseassets are replaced. The greater the number of times an asset turns over, the less cash a companymust devote to that asset, and the more cash it can commit to other purposes.

Question 5-17

Profit margin on sales = Net incomeNet sales

Return on assets = Net incomeAverage total assets

Return on shareholders' = Net incomeequity Average shareholders' equity

A fundamental element of an analysts task is to develop an understanding of a firmsprofitability. Profitability ratios provide information about a companys ability to earn an adequatereturn relative to sales or resources devoted to operations. Resources devoted to operations can bedefined as total assets or only those assets provided by owners, depending on the evaluationobjective.

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Question 5-18

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

Net incomeAve. total equity = Net incomeTotal sales X Total salesAve. total assets X Ave. total assetsAve. total equity

The DuPont framework shows return on equity as being driven by profit margin (reflecting acompanys ability to earn income from sales), asset turnover (reflecting a companys effectivenessin using assets to generate sales), and the equity multiplier (reflecting the extent to which a companyhas used debt to finance its assets).

Question 5-19These 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 ofannual statements. However, the discrete approach is applied to some items. Most revenues andexpenses are recognized in interim periods as incurred. However, if an expenditure clearly benefitsmore than just the period in which it is incurred, the expense should be spread among the periodsbenefited. Examples include annual repair expenses, property tax expense, and advertising expensesincurred in one quarter that clearly benefit later quarters. These are assigned to each quarter throughthe use of accruals and deferrals. On the other hand, major events such as discontinued operationsextraordinary items, and unusual or infrequent items should be reported separately in the interimperiod in which they occur.

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BRIEF EXERCISES

2011 gross profit = $3,000,000 1,200,000 = $1,800,000

2012 gross profit = 0

2011 Cost recovery % = Cost Sales:$1,200,000

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

2011 gross profit = 2011 cash collection of $150,000 x 60% = $90,0002012 gross profit = 2012 cash collection of $150,000 x 60% = $90,000

No gross profit will be recognized in either 2011 o2012. Gross profit will not be recognized until the entire

$1,200,000 cost of the land is recovered. In this case, it will take 8 payments torecover the cost of the land ($1,200,000 $150,000 = 8), so gross profit recognitionwill equal 100% of the cash collected beginning with the ninth installment payment.

Initial deferred gross profit ($3,000,000 1,200,000)

$1,800,000Less gross profit recognized in 2011 ($150,000 x 60%) (90,000)Less gross profit recognized in 2012 ($150,000 x 60%) (90,000)

Deferred gross profit at the end of 2012 $1,620,000The seller must meet certain criteria before revenue can

be recognized in situations when the right of return existsThe most critical of these criteria is that the seller must be

able to make reliable estimates of future returns. If Meyers management can makereliable estimates of the furniture that will be returned, revenue can be recognizedwhen the product is delivered, assuming the company has no additional obligations to

the buyer. If reliable estimates cannot be made because of significant uncertaintyrevenue and related cost recognition is delayed until the uncertainty is resolved.

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

% of completion = $6 million $15 million = 40%

5-6

Brief Exercise 5-1

Brief Exercise 5-2

Brief Exercise 5-3

Brief Exercise 5-4

Brief Exercise 5-5

Brief Exercise 5-6

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Total estimated gross profit ($20 million 15 million) = $5,000,000multiplied 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

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

Year 1 = 0Year 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

Year 1:Revenue: $6 millionCost: $6 millionGross profit: $0

Year 2:Revenue: $14 million ($20 million total $6 million in year 1)Cost: $10 million

Gross profit: $ 4 millionThe anticipated loss of $3 million ($30 million contract

price less total estimated costs of $33 million) must berecognized in the first year applying either method.

Orange has separate sales pricesfor the two parts of LearnIt-Plus,so that vendor-specific objective

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Brief Exercise 5-7

Brief Exercise 5-8

Brief Exercise 5-9

Brief Exercise 5-10

Brief Exercise 5-11

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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 $500,000Add: Net income 65,000

Deduct: Dividends (20,000)Shareholders equity, end of period $545,000

*Average shareholders equity = ($500,000 + 545,000) 2 = $522,500

5-9

Brief Exercise 5-15

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Brief Exercise 5-16

Return onequity

= Profitmargin

X Asset turnover X Equity multiplier

Net incomeAve. total

equity

= Net incomeTotal sales

X Total salesAve. total assets

X Ave. total assetsAve. total equity

Return on shareholders

equity = Net income


=$65,000

$522,500

= 12.4%

Profit margin = Net income

Sales

= $65,000

$420,000

Asset Turnover =Sales

Averagetotal assets

= $420,000

$800,000

5-10

= 15.5%

= 52.5%

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Brief Exercise 5-16 (concluded)

Equity Multiplier = Average total assets


= $800,000

$522,500

= 1.53

Inventory turnover ratio = Cost of goods sold Average inventory6.0 = 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

5-11

Check: 12.4% ROE = 15.5% profit margin x 52.5% asset turnover x 1.53 equity

multiplier.

Brief Exercise 5-17

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Requirement 1Alpine 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 isnonrefundable is not relevant to the revenue recognition decision. Revenue should berecognized as it is earned, in this case as the services are provided during the skiseason.

Requirement 2

November 6, 2011 To record the cash collectionCash................................................................................ 450

Unearned revenue....................................................... 450

December 31, 2011 To recognize revenue earned in December (norevenue earned in November, as season starts on December 1).Unearned revenue ($450 x 1/5)........................................ 90

Revenue...................................................................... 90

Requirement 3$90 is included in revenue in the 2011 income statement. The $360 remaining

balance in unearned revenue is included in the current liability section of the 2011balance sheet.

Requirement 12011 Cost recovery %:

$234,000= 65% (gross profit % = 35%)

$360,000

2012 Cost recovery %:$245,000

= 70% (gross profit % = 30%)$350,000

5-12

EXERCISESExercise 5-1

Exercise 5-2

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2011 gross profit:Cash collection from 2011 sales of $150,000 x 35% = $52,500

2012 gross profit:Cash collection from 2011 sales of $100,000 x 35% = $ 35,000

+ Cash collection from 2012 sales of $120,000 x 30% = 36,000Total 2012 gross profit $71,000

Requirement 22011 deferred gross profit balance:2011 initial gross profit ($360,000 234,000) $126,000Less: Gross profit recognized in 2011 (52,500)Balance in deferred gross profit account $73,500

2012 deferred gross profit balance:2011 initial gross profit ($360,000 234,000) $ 126,000Less: Gross profit recognized in 2011 (52,500)

Gross profit recognized in 2012 (35,000)

2012 initial gross profit ($350,000 245,000) 105,000Less: Gross profit recognized in 2012 (36,000)Balance in deferred gross profit account $107,500

2011To record installment salesInstallment receivables................................................... 360,000

Inventory..................................................................... 234,000Deferred gross profit................................................... 126,000

2011 To record cash collections from installment salesCash................................................................................ 150,000

Installment receivables............................................... 150,000

2011 To recognize gross profit from installment salesDeferred gross profit....................................................... 52,500Realized gross profit................................................... 52,500

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Exercise 5-3

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2012 To record installment salesInstallment receivables................................................... 350,000




2012 To recognize gross profit from installment salesDeferred gross profit....................................................... 71,000

Realized gross profit................................................... 71,000

Requirement 1

Year Income recognized2011 $180,000 ($300,000 120,000)2012 - 0 -2013 - 0 -2014 - 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%)2011 $ 75,000 $ 30,000 $ 45,0002012 75,000 30,000 45,0002013 75,000 30,000 45,000

2014 75,000 30,000 45,000Totals $300,000 $120,000 $180,000

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Exercise 5-4

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Requirement 3

5-15

Year Cash Collected Cost Recovery Gross Profit2011 $ 75,000 $ 75,000 - 0 -

2012 75,000 45,000 $ 30,0002013 75,000 - 0 - 75,0002014 75,000 - 0 - 75,000Totals $300,000 $120,000 $180,000

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Exercise 5-5

Requirement 1

July 1, 2011 To record installment saleInstallment receivables................................................... 300,000Sales revenue.............................................................. 300,000

Cost of goods sold.......................................................... 120,000Inventory..................................................................... 120,000

To record cash collection from installment saleCash................................................................................ 75,000


July 1, 2012 To record cash collection from installment saleCash................................................................................ 75,000


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Exercise 5-5 (continued)

Requirement 2

July 1, 2011 To record installment saleInstallment receivables................................................... 300,000




To recognize gross profit from installment sale

Deferred gross profit....................................................... 45,000Realized gross profit................................................... 45,000

July 1, 2012 To record cash collection from installment saleCash................................................................................ 75,000


To recognize gross profit from installment saleDeferred gross profit....................................................... 45,000


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Exercise 5-5 (concluded)

Requirement 3

July 1, 2011 To record installment saleInstallment receivables................................................... 300,000




July 1, 2012 To record cash collection from installment sale

Cash................................................................................ 75,000Installment receivables............................................... 75,000

To recognize gross profit from installment saleDeferred gross profit....................................................... 30,000


Requirement 1

Cost of goods sold ($1,000,000 600,000)$400,000Add: Gross profit if using cost recovery method 100,000Cash 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% = $300,000gross profit

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Exercise 5-6

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October 1, 2011............To record the installment sale

Installment receivable.....................................................4,000,000Inventory..................................................................... 1,800,000Deferred gross profit................................................... 2,200,000

To record the cash down payment from installment saleCash................................................................................ 800,000

Installment receivable................................................. 800,000

To recognize gross profit from installment saleDeferred gross profit ($800,000 x 55%*)....................... 440,000


October 1, 2012To record the default and repossession

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

Installment receivable (balance)................................. 3,200,000

*$2,200,000 $4,000,000 = 55% gross profit percentage

Requirement 1

April 1, 2011 To record installment saleInstallment receivables................................................... 2,400,000

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

April 1, 2011 To record cash collection from installment saleCash................................................................................ 120,000

5-19

Exercise 5-7

Exercise 5-8

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Requirement 2

April 1, 2011 To record installment saleInstallment receivables................................................... 2,400,000

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

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When payments are received, gain on sale of land is recognized, calculated byapplying the gross profit percentage ($1,920,000 $2,400,000 = 80%) to the cash

collected (80% x $120,000).



To recognize profit from installment saleDeferred gain.................................................................. 96,000

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



To recognize profit from installment saleDeferred gain.................................................................. 96,000

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

Requirement 12011 2012

Contract price $2,000,000 $2,000,000Actual costs to date 300,000 1,875,000Estimated costs to complete 1,200,000 - 0 -Total estimated costs 1,500,000 1,875,000Gross profit (estimated in 2011) $ 500,000 $ 125,000

Gross profit recognition:2011: $ 300,000 = 20% x $500,000 = $100,000$1,500,000

2012: $125,000 $100,000 = $25,000

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Exercise 5-9

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Requirement 22011 $ - 0 -2012 $125,000

Requirement 3

Balance SheetAt December 31, 2011

Current assets:Accounts receivable $ 130,000Costs and profit ($400,000*) in excess

of billings ($380,000) 20,000

* Costs ($300,000) + profit ($100,000)

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Requirement 4


Current assets:Accounts receivable $ 130,000

Current liabilities:Billings($380,000) in excess of costs ($300,000) $ 80,000

Requirement 1

($ in millions) 2011 20122013

Contract price $220 $220$220Actual costs to date 40 120 170Estimated costs to complete 120 60 - 0 -Total estimated costs 160 180 170Estimated gross profit (actual in 2013) $ 60 $ 40 $ 50

Gross profit (loss) recognition:

2011: $40 = 25% x $60 = $15$160

2012: $120 = 66.67% x $40 = $26.67 $15 = $11.67$180

2013: $220 170 = $50 ($15 + 11.67) = $23.33

Requirement 22011: $220 x 25% = $552012: $220 x 66.67% = $146.67 55 = $91.672013: $220 146.67 = $73.33

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Exercise 5-10

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Requirement 3

Year Gross profit (loss) recognized2011 - 0 -2012 - 0 -2013 50

Total project income $50

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Requirement 4

2011:

Revenue: $40Cost: $40Gross profit: $ 0

2012:Revenue: $80Cost: $80Gross profit: $ 0

2013:Revenue: $100 ($220 contract price $40 $80)Cost: $ 50Gross profit: $ 50

Requirement 5

2012: $120 = 60% x $20* = $12 15 = $(3) loss$200

*$220 ($40 + 80 + 80) = $20

Requirement 12011 2012 2013

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

Actual costs to date 2,000,000 4,500,000 8,300,000Estimated costs to complete 4,000,000 3,600,000 - 0 -Total estimated costs 6,000,000 8,100,000 8,300,000Estimated gross profit (loss)

(actual in 2013) $2,000,000 $ (100,000 ) $ (300,000 )


2011: $2,000,000 = 33.3333% x $2,000,000 = $666,667$6,000,000

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Exercise 5-11

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2012: $(100,000) 666,667 = $(766,667)

2013: $(300,000) (100,000) = $(200,000)

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Requirement 2

2011 2012

Construction in progress 2,000,000 2,500,000Various accounts 2,000,000 2,500,000

To record construction costs.

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

To record progress billings.

Cash 2,250,000 2,475,000Accounts receivable 2,250,000 2,475,000

To record cash collections.

Construction in progress(gross profit) 666,667

Cost of construction 2,000,000Revenue from long-term contracts

(33.3333% x $8,000,000) 2,666,667To record gross profit.

Cost of construction (2) 2,544,000Revenue from long-term contracts (1) 1,777,333Construction 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 2011 (above) (2,666,667)Revenue recognized in 2012 1,777,333 (1)Plus: Loss recognized in 2012 (above) 766,667

Cost of construction, 2012 $2,544,000 (2)

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Requirement 3

Balance Sheet 2011 2012

Current assets:Accounts receivable $250,000 $525,000Costs 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)** Costs ($2,000,000 + $2,500,000) loss ($100,000 = $766,667 $666,667)

Requirement 1Year Gross profit (loss) recognized2011 - 0 -2012 $(100,000)2013 (200,000 )

Total project loss $(300,000 )

Requirement 2

2011 2012Construction in progress 2,000,000 2,500,000

Various accounts 2,000,000 2,500,000To record construction costs.

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


Cash 2,250,000 2,475,000Accounts receivable 2,250,000 2,475,000


Loss on long-term contract 100,000

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Exercise 5-12

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Construction in progress 100,000To record an expected loss.

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Requirement 3

Balance Sheet 2011 2012Current 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 lessloss ($4,400,000*) $850,000

* Costs ($2,000,000 + $2,500,000) loss ($100,000)

Situation 1 - Percentage-of-Completion

2011 2012 2013Contract price $5,000,000 $5,000,000 $5,000,000Actual 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 4,500,000Estimated gross profit

(actual in 2013) $ 500,000 $ 500,000 $ 500,000

Gross profit (loss) recognized:

2011: $1,500,000= 33.3333% x $500,000 = $166,667

$4,500,000

2012: $3,600,000= 80.0% x $500,000 = $400,000 166,667 =$233,333

$4,500,000

2013: $500,000 400,000 = $100,000

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Exercise 5-13

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Situation 1 - Completed Contract

Year Gross profit recognized2011 - 0 -2012 - 0 -2013 $500,000

Total gross profit $500,000

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2011 2012 2013Contract price $5,000,000 $5,000,000 $5,000,000Actual costs to date 1,500,000 2,400,000 4,800,000Estimated costs to complete 3,000,000 2,400,000 - 0 -Total estimated costs 4,500,000 4,800,000 4,800,000Estimated gross profit

(actual in 2013) $ 500,000 $ 200,000 $ 200,000


2011: $1,500,000= 33.3333% x $500,000 = $166,667

$4,500,000

2012: $2,400,000= 50.0% x $200,000 = $100,000 166,667 =$(66,667)

$4,800,000

2013: $200,000 100,000 = $100,000




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2011 2012 2013Contract price $5,000,000 $5,000,000 $5,000,000Actual costs to date 1,500,000 3,600,000 5,200,000Estimated costs to complete 3,000,000 1,500,000 - 0 -Total estimated costs 4,500,000 5,100,000 5,200,000Estimated gross profit (loss)

(actual in 2013) $ 500,000 $ (100,000 ) $ (200,000 )


2011: $1,500,000= 33.3333% x $500,000 = $166,667

$4,500,000

2012: $(100,000) 166,667 = $(266,667)

2013: $(200,000) (100,000) = $(100,000)


Year Gross profit (loss) recognized2011 - 0 -2012 $(100,000)2013 (100,000 )


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2011 2012 2013Contract price $5,000,000 $5,000,000 $5,000,000Actual costs to date 500,000 3,500,000 4,500,000Estimated costs to complete 3,500,000 875,000 - 0 -Total estimated costs 4,000,000 4,375,000 4,500,000Estimated gross profit

(actual in 2013) $1,000,000 $ 625,000 $ 500,000


2011: $ 500,000= 12.5% x $1,000,000 = $125,000

$4,000,000

2012: $3,500,000= 80.0% x $625,000 = $500,000 125,000 = $375,000

$4,375,000

2013: $500,000 500,000 = $ - 0 -




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2011 2012 2013Contract price $5,000,000 $5,000,000 $5,000,000Actual costs to date 500,000 3,500,000 4,800,000Estimated costs to complete 3,500,000 1,500,000 - 0 -Total estimated costs 4,000,000 5,000,000 4,800,000Estimated gross profit

(actual in 2013) $1,000,000 $ - 0 - $ 200,000


2011: $ 500,000= 12.5% x $1,000,000 = $125,000

$4,000,000

2012: $ 0 125,000 = $(125,000)

2013: $200,000 0 = $200,000




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2011 2012 2013Contract price $5,000,000 $5,000,000 $5,000,000Actual costs to date 500,000 3,500,000 5,300,000Estimated costs to complete 4,600,000 1,700,000 - 0 -Total estimated costs 5,100,000 5,200,000 5,300,000Estimated gross profit (loss)

(actual in 2013) $ (100,000 ) $ (200,000 ) $ (300,000 )


2011: $(100,000)

2012: $(200,000) (100,000) = $(100,000)

2013: $(300,000) (200,000) = $(100,000)


Year Gross profit (loss) recognized2011 $(100,000)2012 (100,000)2013 (100,000 )


Requirement 1Construction in progress = Costs incurred + Profit recognized

$100,000 = ? + $20,000

Actual costs incurred in 2011 = $80,000

Requirement 2Billings = Cash collections + Accounts Receivable

$94,000 = ? + $30,000

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Exercise 5-14

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Cash collections in 2011 = $64,000

Requirement 3Let A = Actual cost incurred + Estimated cost to complete

Actual cost incurred x (Contract price A) = Profit recognizedA

$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%$1,280,000

Requirement 1Revenue should be recognized as follows:

Software - date of shipment, July 1, 2011Technical support - evenly over the 12 months of the agreementUpgrade - date of shipment, January 1, 2012

The amounts are determined by an allocation of total contract price inproportion 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 = 27,000Upgrade $30,000 $270,000 x $243,000 = 27,000

Total $243,000

Requirement 2

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Exercise 5-15

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July 1, 2011 To record sale of software

Cash................................................................................ 243,000Revenue...................................................................... 189,000Unearned revenue ($27,000 + 27,000)............................ 54,000

Requirement 1

Conveyer ($20,000 $50,000) x $45,000 = $18,000Labeler ($10,000 $50,000) x $45,000 = 9,000

Filler ($15,000 $50,000) x $45,000 = 13,500Capper ($5,000 $50,000) x $45,000 = 4,500total $45,000

Requirement 2

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

contingent on its delivery.Requirement 1

Conveyer ($20,000 $50,000) x $45,000 = $18,000Labeler ($10,000 $50,000) x $45,000 = 9,000Filler ($15,000 $50,000) x $45,000 = 13,500Capper ($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 sameas in Requirement 1, because (a) revenue for each part can be estimatedreliably and (b) the receipt of economic benefits is probable.

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Exercise 5-16

Exercise 5-17

Exercise 5-18

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October 1, 2011 To record franchise agreementand down paymentCash (10% x $300,000)...................................................... 30,000

Note receivable............................................................... 270,000Unearned franchise fee revenue.................................. 300,000

January 15, 2012 To recognize franchise fee revenueUnearned franchise fee revenue...................................... 300,000

Franchise fee revenue................................................. 300,000

List AList 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

beyond delivery point.

Requirement 1

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Exercise 5-19

Exercise 5-20

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Requirement 2By 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. Itindicates how well inventory levels are managed and the quality of inventoryincluding the existence of obsolete or overpriced inventory.

However, to evaluate the adequacy of this ratio it should be compared with somenorm such as the industry average. That indicates whether inventory management

practices are in line with the competition.Its 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 lowinventory levels and restocking only when absolutely necessary. This can be costly interms of stockout costs.

The ratio also can be useful when assessing the current ratio. The more liquidinventory is, the lower the norm should be against which the current ratio should becompared.

Turnover ratios for Anderson Medical Supply Company for2011:

Thecompany

turns itsinventoryover 6

times per year compared to the industry average of 5 times per year. The assetturnover ratio also is slightly better than the industry average (2 times per year versus1.8 times). These ratios indicate that Anderson is able to generate more sales perdollar invested in inventory and in total assets than the industry averages. However

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Inventory turnover ratio = Cost of goods sold

Average inventory

= $1,840,000

[$690,000 + 630,000] 2

= 2.79 times

Exercise 5-21

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

= 2 times

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Anderson takes slightly longer to collect its accounts receivable (27.4 days comparedto the industry average of 25 days).

Requirement 1a. 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 2Retained earnings beginning of period $100,000Add: Net income 180,000

280,000Less: Retained earnings end of period 150,000Dividends paid $130,000

Requirement 1a. Profit margin on sales $180 $5,200 = 3.5%

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

Requirement 2Profit margin x Asset turnover x Equity multiplier = ROE

3.5% x 2.89 x 3.43 = 34.7% ~ 34.3% (difference due

to rounding)Quarter

First Second ThirdCumulative income before taxes $50,000 $90,000

$190,000Estimated annual effective tax rate 34% 30% 36%

17,000 27,000 68,400Less: Income tax reported earlier 0 17,000 27,000Tax expense to be reported $17,000 $10,000 $ 41,400

Incentive compensation $300 million 4 = $ 75 millionDepreciation expense $60 million 4 = 15 millionGain on sale 23 million

1st 2nd 3rd 4th

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Exercise 5-22

Exercise 5-23

Exercise 5-24

Exercise 5-25

Exercise 5-26

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Advertising $200,000 $200,000 $200,000 $200,000Property tax 87,500 87,500 87,500 87,500Equipment repairs 65,000 65,000 65,000 65,000Extraordinary casualty loss 0 185,000 0 0Research and development 0 32,000 32,000 32,000

Requirement 1

The specific citation that specifies the the circumstances and conditions under which itis appropriate to use the percentage-of-completion method is: Revenue RecognitionConstructionType and ProductionType ContractsRecognitionCircumstancesAppropriate for Using the Percentage-of-Completion Method.

Requirement 2

FASB ASC 605352557 reads as follows:

The percentage-of-completion method is considered preferable as an accounting

policy in circumstances in which reasonably dependable estimates can by 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.

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-completioncontract:

FASB ASC 605352546: Revenue RecognitionConstructionType and

ProductionType ContractsRecognitionProvisions for Losses on Contracts.

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Exercise 5-27

Exercise 5-28

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2. Circumstances indicating when the installment method or cost recovery

method is appropriate for revenue recognition:

FASB ASC 60510254: Revenue RecognitionOverallRecognition

Installment and Cost Recovery Methods of Revenue Recognition. (Note: ASC

60510253 also provides some guidance, as it indicates when installmentmethod 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 60515251: Revenue RecognitionProductsRecognition

GeneralSales of Product when Right of Return Exists.

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CPA Exam Questions

1. b. The earnings process is completed upon delivery of the product. Therefore,in 2011, revenue for 50,000 gallons at $3 each is recognized. The paymentterms do not affect revenue recognition.

2. d. The deferred gross profit in the balance sheet at December 31, 2012 shouldbe the balances in the accounts receivable accounts for 2011 and 2012multiplied times the appropriate gross profit percentage:

Accounts Receivable 2011 2012Total Sales 600,000 900,000Less: Collections (300,000) (300,000)Less: Write Offs (200,000) (50,000)

Accounts Receivable Balance 100,000 550,000x Gross Profit Rate x 30% x 40%Deferred Gross Profit12/31/2012

30,000 220,000

The Combined Deferred Gross Profit in the Balance Sheet is $250,000

($220,000 + $30,000).

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CPA / CMA REVIEW QUESTIONS

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CPA Review Questions (concluded)

3. a.Year of sale

2011 2012

a. Gross profit realized $240,000 $200,000 b. Percentage 30% 40%c. Collections on sales (a/b) $800,000 $500,000Total sales 1,000,000 2,000,000Balance uncollected $200,000 $1,500,000

The total uncollected balance is $1,700,000 ($200,000 + $1,500,000).

4. d. Construction-in-progress represents the costs incurred plus the cumulative

pro-rata share of gross profit under the percentage-of-completion method ofaccounting. Construction-in-progress does not include the cumulative effectof gross profit recognition under the completed contract method.

5. c.

2011 actual costs $20,000Total estimated costs 60,000Ratio = 1/3Contract Price x 100,000

Revenue 33,3332011 actual costs -20,000Gross profit $13,333

6. d. Since the total cost of the contract, $3,100,000 ($930,000 + $2,170,000) isprojected to exceed the contract price of $3,000,000, the excess cost of$100,000 must be recognized as a loss in 2011.

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CMA Exam Questions

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 realizablein the form of a receivable. The revenue was earned on May 28 since the title of thegoods passed to the purchaser. The cost-recovery method is not used because thereceivable was not deemed uncollectible until June 10.

2. d. Based on the revenue recognition principle, revenue is normally recorded at thetime of the sale or, occasionally, at the time cash is collected. However, sometimesneither the sales basis nor the cash basis is appropriate, such as when a constructioncontract extends over several accounting periods. As a result, contractors ordinarilyrecognize 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 exceptionto the general principle of revenue recognition, primarily because it better matchesrevenues and expenses.

3. b. Given that one-third of all costs have already been incurred ($6,000,000), thecompany 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 profitof $2,000,000.

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PROBLEMS

REAGAN CORPORATIONIncome Statement

For the Year Ended December 31, 2011

Income before income taxes andextraordinary item ....................................... [1]$3,680,000

Income tax expense ....................................... 1,472,000Income before extraordinary item ................. 2,208,000Extraordinary item:Gain from settlement of lawsuit (net of

$400,000 tax expense)................................. 600,000Net Income .................................................... $2,808,000

Income before extraordinary item ................. 2.21Extraordinary gain ......................................... 0 .60

Net income .................................................... $ 2 .81

[1] Income from continuing operations before income taxes:Unadjusted $4,200,000Add: Gain from sale of equipment 50,000Deduct: Inventory write-off (400,000)

Depreciation expense (2011) (50,000)

Overstated profit on installment sale (120,000 ) *Adjusted $3,680,000

* Profit recognized ($400,000 240,000) $160,000Profit that should have been recognized

(gross profit ratio of 40% x $100,000) (40,000 )Overstated profit $120,000

Requirement 12011 Cost recovery % :

$180,000 = 60% (gross profit % = 40%)$300,000

2012 Cost recovery %:

$280,000= 70% (gross profit % = 30%)

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Problem 5-1

Problem 5-2

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$400,000

2011 gross profit:

Cash collection from 2011 sales = $120,000 x 40% = $48,000

2012 gross profit:

Cash collection from 2011 sales = $100,000 x 40% = $ 40,000+ Cash collection from 2012 sales = $150,000 x 30% = 45,000

Total 2012 gross profit $85,000

Requirement 2







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Problem 5-2 (continued)

2012 To record installment sales

Installment receivables................................................... 400,000Inventory..................................................................... 280,000Deferred gross profit................................................... 120,000





Requirement 3

Date Cash Collected Cost Recovery Gross Profit

20112011 sales $120,000 $120,000 - 0 -

20122011 sales $100,000 $ 60,000 $40,0002012 sales 150,000 150,000 - 0 -2012 totals $250,000 $210,000 $40,000

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Problem 5-2 (concluded)

2011 To record installment sales

Installment receivables................................................... 300,000Inventory..................................................................... 180,000Deferred gross profit................................................... 120,000

2011 To record cash collection from installment salesCash................................................................................ 120,000




2012 To record cash collection from installment salesCash................................................................................ 250,000




Requirement 1Total profit = $500,000 300,000 = $200,000

Installment sales method: Gross profit % = $200,000 $500,000 = 40%

8/31/11 8/31/12 8/31/13 8/31/14 8/31/15

Cash collections $100,000 $100,000 $100,000 $100,000 $100,000

a. Point of delivery method $200,000 - 0 - - 0 - - 0 - - 0 -

b. Installment sales method (40% x cash collected) $ 40,000 $ 40,000 $ 40,000 $ 40,000 $40,000

c. Cost recovery method - 0 - - 0 - - 0 - $100,000 $100,000

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Problem 5-3

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Requirement 2

Point ofDelivery

InstallmentSales Cost Recovery

Installment receivable 500,000Sales revenue 500,000

Cost of goods sold 300,000Inventory 300,000

To record sale on 8/31/11.

Installment receivable 500,000 500,000Inventory 300,000 300,000Deferred gross profit

To record sale on 8/31/11.

200,000 200,000

Cash 100,000 100,000 100,000Installment receivable 100,000 100,000 100,000

Entry made each Aug. 31.

Deferred gross profit 40,000Realized gross profit

To record gross profit.(entry made each Aug. 31)

40,000

Deferred gross profit 100,000

Realized gross profitTo record gross profit.(entry made 8/31/14 & 8/31/15)

100,000

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Requirement 3

Point ofDelivery

InstallmentSales

CostRecovery

December 31, 2011AssetsInstallment receivablesLess: Deferred gross profitInstallment receivables, net

400,000 400,000(160,000)240,000

400,000(200,000)200,000

December 31, 2012

AssetsInstallment receivablesLess: Deferred gross profitInstallment receivables, net

300,000 300,000(120,000)180,000

300,000(200,000)100,000

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Requirement 1

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Problem 5-4All jobs consist of four equal payments: one payment when the job is completethree payments over the next three years.

Bluebird:Job completed in 2009, so down payment made in 2009, another payment inand two payments remain. $400,000 gross receivable at 1/1/2011 implies

payments of ($400,000 2) = $200,000 in 2011 and 2012. Four payments o$200,000 implies total revenue of 4 x $200,000 = $800,000 on the job. 25%

profit ratio implies cost of 75% x $800,000 = $600,000.

Cost recovery method gross profit: Payments in 2009 and 2010 have alreadyrecovered $400,000 of cost, so cost remaining to be recovered as of 1/1/2011$600,000 total $400,000 already recovered = $200,000. Therefore, the ent

2011 payment of $200,000 will be applied to cost recovery, and no gross prorecognized in 2011.

Installment sales method gross profit: $200,000 payment x 25% gross profit $50,000 of gross profit recognized in 2011.

PitStop:Job completed in 2008, so down payment made in 2008, another payment inanother in 2010, and one payment remains. $150,000 gross receivable at 1/1implies a single payment of $150,000 in 2011. Four payments of $150,000

implies total revenue of 4 x $150,000 = $600,000 on the job. 35% gross proratio implies cost of 65% x $600,000 = $390,000.

Cost recovery method gross profit: Payments in 2008, 2009 and 2010 of a to$450,000 have already recovered the entire $390,000 of cost and allowedrecognition of $60,000 of gross profit. Therefore, the entire 2011 payment o$150,000 will be applied to gross profit.

Installment sales method gross profit: $150,000 payment x 35% gross profit $52,500 of gross profit recognized in 2011.

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Requirement 2


Contract price $10,000,000 $10,000,000 $10,000,000Actual costs to date 2,400,000 6,000,000 8,200,000Estimated costs to complete 5,600,000 2,000,000 - 0 -Total estimated costs 8,000,000 8,000,000 8,200,000Estimated gross profit (loss)

(actual in 2013) $ 2,000,000 $ 2,000,000 $ 1,800,000


2011: $2,400,000

= 30.0% x $2,000,000 = $600,000$8,000,000

2012: $6,000,000 = 75.0% x $2,000,000 = $1,500,000 600,000 = $900,000$8,000,000

2013: $1,800,000 1,500,000 = $300,000

5-55

Totals:Cost recovery method: $0 (Bluebird) + $150,000 (PitStop) = $150,000.

Installment sales method: $50,000 (Bluebird) + $52,500 (PitStop) = $102,500.

If Dan is focused on 2011, he would not be happy with a switch to the installmentsales method, because that would produce gross profit of only $102,500, which is$47,500 less than he would show under the cost recovery method. It is true thatthe installment sales method recognizes gross profit faster than does the cost

recovery method, but the installment sales method also recognizes gross profitmore evenly than does the cost-recovery method. The timing of these jobs issuch that 2011 is a year in which almost all of the gross profit associated with thePitStop job gets recognized, so 2011 looks more profitable under the costrecovery method.

Problem 5-5

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Requirement 2

2011 2012 2013

Construction in progress 2,400,000 3,600,000 2,200,000Various accounts 2,400,000 3,600,000 2,200,000

To record construction costs.

Accounts receivable 2,000,000 4,000,000 4,000,000Billings on construction

contract2,000,000 4,000,000 4,000,000


Cash 1,800,000 3,600,000 4,600,000Accounts receivable 1,800,000 3,600,000 4,600,000


Construction in progress(gross profit)

600,000 900,000 300,000

Cost of construction(cost incurred)

2,400,000 3,600,000 2,200,000

Revenue from long-termcontracts (1)

3,000,000 4,500,000 2,500,000

To record gross profit.

(1) Revenue recognized:2011: 30% x $10,000,000 = $3,000,0002012: 75% x $10,000,000 = $7,500,000

Less: Revenue recognized in 2011 (3,000,000)Revenue recognized in 2012 $4,500,000

2013: 100% x $10,000,000 = $10,000,000Less: Revenue recognized in 2011 & 2012 (7,500,000)Revenue recognized in 2013 $2,500,000

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Requirement 3


Current assets:Accounts receivable $ 200,000 $600,000Construction in progress $3,000,000 $7,500,000Less: Billings (2,000,000 ) (6,000,000 )

Costs and profit in excessof billings 1,000,000 1,500,000


Costs incurred during the year $2,400,000 $3,800,000 $3,200,000Estimated costs to complete

as of year-end 5,600,000 3,100,000 -

2011 2012 2013Contract price $10,000,000 $10,000,000 $10,000,000Actual costs to date 2,400,000 6,200,000 9,400,000Estimated costs to complete 5,600,000 3,100,000 - 0 -Total estimated costs 8,000,000 9,300,000 9,400,000Estimated gross profit

(actual in 2013) $ 2,000,000 $ 700,000 $ 600,000

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Gross profit (loss) recognition:2011: $2,400,000

= 30.0% x $2,000,000 = $600,000$8,000,000

2012: $6,200,000 = 66.6667% x $700,000 = $466,667 600,000 = $(133,333)$9,300,000

2013: $600,000 466,667 = $133,333



as of year-end 5,600,000 4,100,000 -

2011 2012 2013Contract price $10,000,000 $10,000,000 $10,000,000Actual costs to date 2,400,000 6,200,000 10,100,000Estimated costs to complete 5,600,000 4,100,000 - 0 -

Total estimated costs 8,000,000 10,300,000 10,100,000Estimated gross profit (loss)

(actual in 2013) $ 2,000,000 $ (300,000 ) $ (100,000 )


2011: $2,400,000 = 30.0% x $2,000,000 = $600,000

$8,000,000

2012: $(300,000) 600,000 = $(900,000)

2013: $(100,000) (300,000) = $200,000

Requirement 1

Year Gross profit recognized2011 - 0 -

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2012 - 0 -2013 $1,800,000

Total gross profit $1,800,000

Requirement 2

2011 2012 2013Construction in progress 2,400,000 3,600,000 2,200,000

Various accounts 2,400,000 3,600,000 2,200,000To record construction costs.

Accounts receivable 2,000,000 4,000,000 4,000,000Billings on construction

contract

2,000,000 4,000,000 4,000,000





1,800,000

Cost of construction(costs incurred)

8,200,000

Revenue from long-termcontracts(contract price)

10,000,000


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Requirement 3


Current assets:Accounts receivable $ 200,000 $ 600,000Construction in progress $2,400,000 $6,000,000Less: Billings (2,000,000) (6,000,000)

Costs in excess of billings 400,000 - 0 -



as of year-end 5,600,000 3,100,000 -





as of year-end 5,600,000 4,100,000 -

Year Gross profit (loss) recognized2011 - 0 -

2012 $(300,000)2013 200,000


Requirement 1

Year Gross profit recognized

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2011 - 0 -2012 - 0 -2013 $1,800,000

Total gross profit $1,800,000

Requirement 2

2011 2012 2013Construction in progress 2,400,000 3,600,000 2,200,000

Various accounts 2,400,000 3,600,000 2,200,000To record construction costs.

Accounts receivable 2,000,000 4,000,000 4,000,000

Billings on constructioncontract

2,000,000 4,000,000 4,000,000





1,800,000

Cost of construction(costs incurred)

2,400,000 3,600,000 2,200,000

Revenue from long-termcontracts(contract price)

2,400,000 3,600,000 4,000,000


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Requirement 3


Current assets:Accounts receivable $ 200,000 $ 600,000Construction in progress $2,400,000 $6,000,000Less: Billings (2,000,000) (6,000,000)

Costs in excess of billings 400,000 - 0 -



as of year-end 5,600,000 3,100,000 -





as of year-end 5,600,000 4,100,000 -

Year Gross profit (loss) recognized2011 - 0 -

2012 $(300,000)2013 200,000



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Contract price $4,000,000 $4,000,000 $4,000,000Actual costs to date 350,000 2,500,000 4,250,000Estimated costs to complete 3,150,000 1,700,000 - 0 -Total estimated costs 3,500,000 4,200,000 4,250,000Estimated gross profit (loss)

(actual in 2013) $ 500,000 $ (200,000) $ (250,000)

Year Gross profit (loss) recognized2011 - 0 -2012 $(200,000)2013 (50,000 )


Requirement 2


2011: 10% x $500,000 = $50,000

2012: $(200,000) 50,000 = $(250,000)

2013: $(250,000) (200,000) = $(50,000)

Requirement 3


Current assets:Costs less loss ($2,300,000*) in

excess of billings ($2,170,000) $ 130,000

Current liabilities:Billings ($720,000)in excess

of costs and profit ($400,000) $ 320,000

*Cumulative costs ($2,500,000) less cumulative loss recognized ($200,000) = $2,300,000

Requirement 1The completed contract method of recognizing revenues and

costs on long-term construction contracts is equivalent to recognizing revenue at thepoint of delivery, i.e., when the construction project is complete. The percentage-ofcompletion method assigns a share of the projects expected revenues and costs toeach period in which the earnings process takes place, i.e., the construction period.The share is estimated based on the project's costs incurred each period as a

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percentage of the project's total estimated costs. The completed contract methodshould only be used when a lack of dependable estimates or inherent hazards make itdifficult to forecast future costs and profits.

Requirement 2 2011 2012Contract price $20,000,000 $20,000,000Actual costs to date 4,000,000 13,500,000Estimated costs to complete 12,000,000 4,500,000Total estimated costs 16,000,000 18,000,000Estimated gross profit $ 4,000,000 $ 2,000,000

a. Gross profit recognition:Under the completed contract method Citation would not report gross profit until

the project is competed. Citation would have to report an overall gross loss onthe contract in whatever period it first revises the estimates to determine that anoverall loss will eventually occur. Citation never estimates the Altamont contractwill earn a gross loss, so never has to recognize one.

b. Under the completed contract method Citation would not report any revenue inthe 2011 or 2012 income statements.

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c.

Balance SheetAt December 31, 2011Current assets:

Accounts receivable $ 200,000Costs ($4,000,000*) in excess

of billings ($2,000,000) 2,000,000

* Under the completed contract method, this account would only include costs of$4,000,000

Requirement 32011 2012

Contract price $20,000,000 $20,000,000Actual costs to date 4,000,000 13,500,000Estimated costs to complete 12,000,000 4,500,000Total estimated costs 16,000,000 18,000,000Estimated gross profit $ 4,000,000 $ 2,000,000

a. Gross profit recognition:2011: $ 4,000,000

= 25% x $4,000,000 = $1,000,000

$16,000,000

2012: $13,500,000 = 75% x $2,000,000 = $1,500,000$18,000,000

Less: 2011 gross profit 1,000,0002012 gross profit$ 500,000

b. 2011: $20,000,000 x 25% = $5,000,000

2012: $20,000,000 x 75% = $15,000,000Less: 2011 revenue (5,000,000)

$10,000,000

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c.


Current assets:Accounts receivable $ 200,000Costs and profit ($5,000,000*) in excess

of billings ($2,000,000) 3,000,000

* Costs ($4,000,000) + profit ($1,000,000)

Requirement 4

2011 2012Contract price $20,000,000 $20,000,000Actual costs to date 4,000,000 13,500,000Estimated costs to complete 12,000,000 9,000,000Total estimated costs 16,000,000 22,500,000Estimated gross profit $ 4,000,000 ($ 2,500,000 )

a. Gross profit recognition:

2012: Overall loss of ($2,500,000) previously recognized gross profit of$1,000,000 = $3,500,000.

b. 2012: Easiest to solve using a journal entry:

Cost of construction (to balance) $10,500,000Revenue from long-term contracts* $7,000,000Construction in progress (loss) $3,500,000

*Total revenue recognized to date = (percentage complete)(total revenue)

= ($13,500,000 $22,500,000) x ($20,000,000)= (60%) x ($20,000,000)= $12,000,000

Revenue recognized this period = total revenue recognized in prior periods= $12,000,000 $5,000,000 = $7,000,000

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c.

Balance Sheet

At December 31, 2012Current assets:

Accounts receivable

Current liabilities:

$ 1,600,000

Billings ($12,000,000) in excess of costsand profit ($11,000,000*) 1,000,000

* 2011 costs ($4,000,000) + 2011 profit ($1,000,000) + 2012 costs ($9,500,000)

2012 loss ($3,500,000)

Requirement 5Citation should recognize revenue at the point of delivery, when the homes are

completed and title is transferred to the buyer. This is equivalent to the completedcontract method for long-term contracts. The percentage-of-completion method is notappropriate in this case. There is no contract in place and until the completion of thehome, the transfer of title, and the receipt of the full sales price, the earnings process isnot virtually complete and there is still significant uncertainty as to cash collectionAlso, the sales price is not fixed.

Requirement 6Income statement:

Sales revenue (3 x $600,000) $1,800,000Cost of goods sold (3 x $450,000) 1,350,000Gross profit $ 450,000

Balance sheet:

Current assets:Inventory (work in process) $2,700,000

Current liabilities:Customer deposits (or unearned revenue) 300,000*

*$600,000 x 10% = $60,000 x 5 = $300,000

Requirement 1

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Problem 5-10

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a. January 30, 2011

Cash ............................................................................... 200,000Note receivable .............................................................. 1,000,000

Unearned franchise fee revenue.................................. 1,200,000

b. September 1, 2011

Unearned franchise fee revenue...................................... 1,200,000Franchise fee revenue ................................................ 1,200,000

c. September 30, 2011

Accounts receivable ($40,000 x 3%)................................ 1,200Service revenue .......................................................... 1,200

d. January 30, 2012

Cash................................................................................ 100,000Note receivable .......................................................... 100,000

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Requirement 2a. January 30, 2011

Cash ............................................................................... 200,000Note receivable .............................................................. 1,000,000

Deferred franchise fee revenue................................... 1,200,000

Note: Could also show as:Cash ............................................................................... 200,000

Note receivable .............................................................. 1,000,000Deferred franchise fee revenue................................... 1,000,000Unearned franchise fee revenue.................................. 200,000

b. September 1, 2011

Deferred franchise fee revenue ...................................... 200,000Franchise fee revenue(cash collected)........................... 200,000

c. September 30, 2011

Accounts receivable ($40,000 x 3%)................................ 1,200Service revenue .......................................................... 1,200

d. January 30, 2012

Cash................................................................................ 100,000Note receivable .......................................................... 100,000

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Deferred franchise fee revenue ...................................... 100,000Franchise fee revenue ................................................ 100,000

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Requirement 3


Current assets:Installment notes receivable($1,000,000) less deferred franchise feerevenue ($1,000,000)

Current liabilities:

$ -0-

Unearned franchise fee revenue $200,000

Explanation: Revenue recognition on the entire note receivable is deferred. Inaddition, $200,000 of unearned revenue must be shown as a liability.

1. Inventory turnover ratio$6,300 [($800 + 600) 2] = 9.02. Average days in inventory365 9.0 = 40.56 days

3. Receivables turnover ratio $9,000 [($600 + 400) 2] = 18.04. Average collection period 365 18.0 = 20.28 days5. Asset turnover ratio $9,000 [($4,000 + 3,600) 2] = 2.376. Profit margin on sales $300 $9,000 = 3.33%7. Return on assets $300 [($4,000 + 3,600) 2] = 7.89%

or: 3.33% x 2.37 times = 7.89%8. Return on

shareholders equity $300 [($1,500 + 1,350) 2] = 21.1%9. Equity multiplier [($4,000 + 3,600) 2] [($1,500 + 1,350) 2] = 2.6710. DuPont framework 3.33% x 2.37 x 2.67 = 21.1%

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Problem 5-11

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Requirement 1

On average, J&Jcollects itsreceivables in 14

days less thanPfizer.

On average, J&Jsells its inventorytwice as fast asPfizer.

5-72

Problem 5-12Receivables turnover = Net sales

Accounts receivable

J&J = $41,862 = 6.37 times$6,574

Pfizer = $45,188 = 5.15 times

$8,775

Average collection period = 365

Receivables turnover

J&J = 365 = 57 days

6.37

Pfizer = 365 = 71 days

5.15

Inventory turnover = Cost of goods sold

Inventories

J&J = $12,176 = 3.39 times

$3,588

Pfizer = $9,832 = 1.68 times

$5,837

Average days in inventory = 365

Inventory turnover

J&J = 365 = 108 days

3.39

Pfizer = 365 = 217 days

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Requirement 2

The return on

assets indicates acompany's overal

profitability,ignoring specificsources offinancing. In thisregard, J&Js

profitability is significantly higher than that of Pfizer.

Requirement 3

Profitability can be achieved by a high profit margin, high turnover, or acombination of the two.

Rate of return on assets = Profit margin x Asset

on sales turnover

= Net income x Net sales

Net sales Total assets

J&J = $ 7,197 x $41,862$41,862 $48,263

= 17.19% x .867 times = 14.9%

Pfizer = $ 1,639 x $45,188

$45,188 $116,775

= 3.63% x .387 times = 1.4%

J&Js profit margin is much higher than that of Pfizer, as is its asset turnover.These differences combine to produce a significantly higher return on assets forJ&J.

5-73

Rate of return on assets = Net income

Total assets

J&J = $7,197 = 14.9%

$48,263

Pfizer = $1,639 = 1.4%

$116,775

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Requirement 4

J&J provided a

much greaterreturn toshareholders.

Requirement 5

The twocompanies havevirtually identicalequity multipliersindicating that theyare using leverageto the same extentto earn a return on

equity that is higher than their return on assets.a. Times interest earned ratio = (Net income + Interest + Taxes)

Interest = 17(Net income + $2 + 12) $2 = 17

Net income + $14 = 17 x $2Net income = $20

b. Return on assets = Net income Total assets = 10%Total assets = $20 10% = $200

c. Profit margin on sales = Net income Sales = 5%Sales = $20 5% = $400

d. Gross profit margin = Gross profit Sales = 40%Gross profit = $400 x 40% = $160

Cost of goods sold = Sales Gross profit = $400 160 = $240e. Inventory turnover ratio = Cost of goods sold Inventory = 8

Inventory = $240 8 = $30

f. Receivables turnover ratio = Sales Accounts receivable = 20Accounts receivable = $400 20 = $20

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Rate of return on = Net income

shareholders equity Shareholders equity

J&J = $7,197 = 26.8%$26,869

Pfizer = $1,639 = 2.5%

$65,377

Equity multiplier = Total Assets


J&J = $48,263 = 1.80$26,869

Pfizer = $116,775 = 1.79

$65,377

Problem 5-13

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g. Current ratio = Current assets Current liabilities = 2.0Acid-test ratio = Quick assets Current liabilities = 1.0

Current assets 2 = Current liabilitiesQuick assets 1 = Current liabilitiesCurrent assets 2 = Quick assets 1Current assets = 2 x Quick assetsCash + accts. rec. + Inventory = 2 x (Cash + Accounts receivable)Cash + $20 + $30 = (2 x Cash) + (2 x $20)Cash + $50 = Cash + Cash + $40Cash = $10

h. Acid-test ratio = (Cash + Accounts receivable) Current liabilities = 1.0Current liabilities = ($10 + 20) 1.0 = $30

i. Noncurrent assets = Total assets Current assets

= $200 ($10+20+30) = $140j. Return on shareholders equity = Net income Shareholders equity = 20%

Shareholders equity = $20 20% = $100

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k. Debt to equity ratio = Total liabilities Shareholders equity = 1.0Total liabilities = $100 x 1.0 = $100

Long-term liabilities = Total liabilities Current liabilities = $100 30 = $70

Requirement 1

The returnon assetsindicates a

company'soverall

profitability,ignoring specificsources offinancing. In thisregard,Metropolitans

profitabilityexceeds that of

Republic.

Requirement 2Profitability can be achieved by a high profit margin, high turnover, or a

combination of the two.

Rate of return on assets = Profit margin x Asset

on sales turnover

= Net income x Net sales

Net sales Total assets

Metropolitan= $ 593.8 x $5,698.0

$5,698.0 $4,021.5

= 10.4% x 1.42 times = 14.8%

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CADUX CANDY COMPANYBalance Sheet

At December 31, 2011

AssetsCurrent assets:Cash $ 10Accounts receivable (net) 20

Inventories 30Total current assets 60

Property, plant, and equipment (net) 140Total assets $200

Liabilities and Shareholders EquityCurrent liabilities $ 30Long-term liabilities 70Shareholders equity 100

Total liabilities and shareholders' equity $200

Problem 5-14

Rate of return on assets = Net income

Total assets

Metropolitan = $ 593.8 = 14.8%

$4,021.5

Republic = $ 424.6 = 10.6%

$4,008.0

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Republic = $ 424.6 x $7,768.2

$7,768.2 $4,008.0

= 5.5% x 1.94 times = 10.7%

Republics profit margin is much less than that of Metropolitan, but partiallymakes up for it with a higher turnover.

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Requirement 3

Republic provides a greater return to common shareholders.

Requirement 4

When the return on shareholders equity is greater than the return on assets,management is using debt funds to enhance the earnings for stockholders. Both firmsdo this. Republics higher leverage has been used to provide a higher return toshareholders than Metropolitan, even though its return on assets is less. Republicincreased its return to shareholders 4.07 times (43.6% 10.7%) the return on assetsMetropolitan increased its return to shareholders 2.34 times (34.6% 14.8%) the

return on assets.

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Rate of return on = Net income


Metropolitan = $593.8 = 34.6%$144.9 + 2,476.9 904.7

Republic = $424.6 = 43.6%

$335.0 + 1,601.9 964.1

Equity multiplier = Total assets

Shareholders equity

Metropolitan = $4,021.5 = 2.34$144.9 + 2,476.9 904.7

Republic = $4,008.0 = 4.12$335.0 + 1,601.9 964.1

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Requirement 5

The current ratios of the two firms are comparable and within the range of therule-of-thumb standard of 1 to 1. The more robust acid-test ratio reveals thatMetropolitan is more liquid than Republic.

Requirement 6

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Current ratio = Current assets

Current liabilities

Metropolitan = $1,203.0 = .94$1,280.2

Republic = $1,478.7 = .83

$1,787.1

Acid-test ratio = Quick assets

Current liabilities

Metropolitan = $1,203.0 466.4 134.6 = .47$1,280.2

Republic = $1,478.7 635.2 476.7 = .21

$1,787.1

Receivables turnover ratio = Sales

Accounts receivable

Metropolitan = $5,698.0 = 13.5 times$422.7

Republic = $7,768.2 = 23.9 times

$325.0

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Problem 5-14

Documents

Chap005 (3)