Chap 005

Chapter 5 Income Measurement and Profitability Analysis
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, 5e with the following AACSB learning
skills:
Questions AACSB Tags Exercises AACSB Tags

(cont.)
5-1 Reflective thinking 5-9 Analytic
5-10 Reflective thinking 5-18 Reflective thinking
5-11 Reflective thinking, Communications 5-19 Analytic, Communications
5-18 Reflective thinking
Brief CPA/CMA
Exercises
5-1 Analytic 5-1 Analytic
5-4 Analytic 5-4 Reflective thinking
5-5 Reflective thinking, Communications 5-5 Analytic
5-10 Reflective thinking Problems
5-14 Analytic 5-4 Communications, Analytic
Exercises 5-6 Analytic
© The McGraw-Hill Companies, Inc., 2009
Solutions Manual, Vol.1, Chapter 5 5-1
5-2 Analytic 5-8 Analytic, Reflective thinking
Exercises Problems
(cont.) (cont.)
QUESTIONS FOR REVIEW OF KEY TOPICS

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
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 5-4
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 5-5
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.

5-2 Intermediate Accounting, 5/e
Question 5-6
Because the return of merchandise can retroactively negate the benefits of having made a sale,
the seller must meet certain criteria before revenue is recognized in situations when the right of
return exists. The most critical of these criteria is that the seller must be able to make reliable
estimates of future returns. In certain situations, these criteria are not satisfied at the point of
delivery of the product.
Question 5-7
Sometimes a company arranges for another company to sell its product under consignment.
The “consignor” physically transfers the goods to the other company (the consignee), but the
consignor retains legal title. If the consignee can’t find a buyer within an agreed-upon time, the
consignee returns the goods to the consignor. However, if a buyer is found, the consignee remits the
selling price (less commission and approved expenses) to the consignor.
Because the consignor retains the risks and rewards of ownership of the product and title does
not pass to the consignee, the consignor does not record revenue (and related costs) until the
consignee sells the goods and title passes to the eventual customer.
Question 5-8
For service revenue, if there is one final service that is critical to the earnings process, revenues and
costs are deferred and recognized after this service has been performed. On the other hand, in many
instances, service revenue activities occur over extended periods and recognizing revenue at any
single date within that period would be inappropriate. Instead, it’s more meaningful to recognize
revenue over time in proportion to the performance of the activity.
Question 5-9
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.

Question 5-10
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 that exactly offsets costs until all costs have been incurred, and then
will recognize revenue and gross profit. Therefore, revenue and cost are recognized earlier under
the cost recovery method than under the completed contract method. 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 5-11
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 on the balance sheet as an asset. Conversely, if
the net amount is a credit, it is reported as a liability.
Question 5-12
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 5-13
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 5-14
Specific guidelines for revenue recognition of the initial franchise fee are provided by SFAS
45. A key to these guidelines is the concept of substantial performance. It requires that
substantially all of the initial services of the franchisor required by the franchise agreement be
performed before the initial franchise fee can be recognized as revenue. The term “substantial”
requires professional judgment on the part of the accountant. In situations when the initial franchise
fee is collectible in installments, even after substantial performance has occurred, the installment
sales or cost recovery method should be used for profit recognition, if a reasonable estimate of
uncollectibility cannot be made.

Question 5-15
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 5-16
Profit margin on sales = Net income

Net sales
Return on assets = Net income

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.

Question 5-17
Return on equity = Profit margin X Asset turnover X Equity multiplier
Net income = Net income X Total sales X Ave. total assets

Ave. total equity Total sales Ave. total assets Ave. 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 5-18
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.
BRIEF EXERCISES
Brief Exercise 5-1
2009 gross profit = $3,000,000 – 1,200,000 = $1,800,000
2010 gross profit = 0
Brief Exercise 5-2 2009 Cost recovery % = Cost ÷ Sales:

$1,200,000
= 40% (implying a gross profit % = 60%)
$3,000,000
2009 gross profit = 2009 cash collection of $150,000 x 60% = $90,000

2010 gross profit = 2010 cash collection of $150,000 x 60% = $90,000
Brief Exercise 5-3 No gross profit will be recognized in either 2009 or

2010. 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 to
recover the cost of the land ($1,200,000 ÷ $150,000 = 8), so gross profit recognition
will equal 100% of the cash collected beginning with the ninth installment payment.
Brief Exercise 5-4 Initial deferred gross profit ($3,000,000 – 1,200,000)

$1,800,000
Less gross profit recognized in 2009 ($150,000 x 60%) (90,000)
Less gross profit recognized in 2010 ($150,000 x 60%) (90,000)
Deferred gross profit at the end of 2010 $1,620,000
The seller must meet certain criteria before revenue can
Brief Exercise 5-5be recognized in situations when the right of return exists.
The most critical of these criteria is that the seller must be
able to make reliable estimates of future returns. If Meyer’s management can make
reliable estimates of the furniture that will be returned, revenue can be recognized
when the product is delivered, assuming the company has no additional obligations to
the buyer. If reliable estimates cannot be made because of significant uncertainty,
revenue and related cost recognition is delayed until the uncertainty is resolved.
Brief Exercise 5-6 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
First year revenue = $20,000,000 x 40% = $8,000,000
Brief Exercise 5-7 Assets:

Accounts receivable ($7 million – 5 million)$2,000,000
Cost plus profit ($6 million + $2 million*)
in excess of billings ($7 million) 1,000,000
* Total estimated gross profit ($20 million – 15 million) = $5,000,000

multiplied by the % of completion 40%
Gross profit recognized in the first year $2,000,000
Brief Exercise 5-8 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 5-9 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
The anticipated loss of $3 million ($30 million contract
Brief Exercise 5-10price less total estimated costs of $33 million) must be
recognized in the first year applying either method.
Specific conditions for revenue recognition of the
Brief Exercise 5-11initial franchise fee are provided by SFAS 45. A key to
these conditions is the concept of substantial performance. It
requires that substantially all of the initial services of the franchisor required by the
franchise agreement be performed before the initial franchise fee can be recognized as
revenue. The term “substantial” requires professional judgment on the part of the
accountant. Often, substantial performance is considered to have occurred when the
franchise opens for business.
Continuing franchise fees are recognized over time as the services are performed.
BriefReceivables
Exerciseturnover
5-12 ratio = Net sales
Inventory turnover ratio = Costaccounts
Average of goodsreceivable
sold
(net) Average inventory
Receivables
Inventory turnover
turnoverratio
ratio = $400,000*
$600,000
[$100,000
[$80,000 + 60,000]
120,000]÷÷22
= 5.45 times
5.71
*$600,000 – 200,000
Brief Exercise 5-13

Profit margin = Net income
Sales
= $65,000
$420,000
= 15.5%
Return on assets = Net income

= $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
*Average shareholders equity = ($500,000 + 545,000) ÷ 2 = $522,500
Brief Exercise 5-14
Return on = Profit X Asset turnover X Equity multiplier

equity margin
Net income = Net income X Total sales X Ave. total assets

Ave. total Total sales Ave. total assets Ave. total equity
equity
Return on shareholders’
equity = Net income
= $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

= 52.5%Brief Exercise 5-14 (concluded)
Equity Multiplier =
= $800,000
$522,500
= 1.53
Check: 12.4% ROE = 15.5% profit margin x 52.5% asset turnover x 1.53 equity
multiplier.
Brief Exercise 5-15

Inventory turnover ratio = Cost of goods sold ÷ Average inventory
6.0 = x ÷ $75,000
Cost of goods sold = $75,000 x 6.0 = $450,000
Sales - Cost of goods sold = Gross profit

$600,000 - $450,000 = $150,000

EXERCISES
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, 2009 To record the cash collection

Cash................................................................................ 450
Unearned revenue....................................................... 450
December 31, 2009 To recognize revenue earned in December (no

revenue 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 2009 income statement. The $360 remaining
balance in unearned revenue is included in the current liability section of the 2009
balance sheet.
Requirement 1
Exercise 5-2 2009 Cost recovery %:
$234,000
= 65% (gross profit % = 35%)
$360,000
2010 Cost recovery %:

$245,000
= 70% (gross profit % = 30%)
$350,000

2009 gross profit:
Cash collection from 2009 sales of $150,000 x 35% = $52,500
2010 gross profit:

Cash collection from 2009 sales of $100,000 x 35% = $ 35,000
+ Cash collection from 2010 sales of $120,000 x 30% = 36,000
Total 2010 gross profit $71,000
Requirement 2
2009 deferred gross profit balance:
2009 initial gross profit ($360,000 - 234,000) $126,000
Less: Gross profit recognized in 2009 (52,500)
Balance in deferred gross profit account $73,500
2010 deferred gross profit balance:

2009 initial gross profit ($360,000 - 234,000) $ 126,000
Gross profit recognized in 2010 (35,000)
2010 initial gross profit ($350,000 - 245,000) 105,000

Balance in deferred gross profit account $107,500
Exercise 5-3
2009To record installment sales
Installment receivables................................................... 360,000
Inventory..................................................................... 234,000
Deferred gross profit................................................... 126,000
2009 To record cash collections from installment sales

Cash................................................................................ 150,000
Installment receivables............................................... 150,000
2009 To recognize gross profit from installment sales

Deferred gross profit....................................................... 52,500
Realized gross profit................................................... 52,500

2010 To record installment sales
Inventory..................................................................... 245,000

Cash................................................................................ 220,000

Requirement 1
Exercise 5-4 Year Income recognized
2009 $180,000 ($300,000 - 120,000)
2010 -0-
2011 -0-
2012 -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%)

2009 $ 75,000 $ 30,000 $ 45,000
2010 75,000 30,000 45,000
2011 75,000 30,000 45,000
2012 75,000 30,000 45,000
Totals $300,000 $120,000 $180,000
Requirement 3

Year Cash Collected Cost Recovery Gross Profit
2009 $ 75,000 $ 75,000 -0-
2010 75,000 45,000 $ 30,000
2011 75,000 -0- 75,000
2012 75,000 -0- 75,000
Totals $300,000 $120,000 $180,000
Requirement 1
Exercise 5-5
July 1, 2009 To record installment sale
Sales revenue.............................................................. 300,000
Cost of goods sold.......................................................... 120,000

Inventory..................................................................... 120,000
To record cash collection from installment sale

Cash................................................................................ 75,000
July 1, 2010 To record cash collection from installment sale

Cash................................................................................ 75,000

Exercise 5-5 (continued)
Requirement 2

Inventory..................................................................... 120,000

Cash................................................................................ 75,000
To recognize gross profit from installment sale


Cash................................................................................ 75,000


Exercise 5-5 (concluded)
Requirement 3

Inventory..................................................................... 120,000

Cash................................................................................ 75,000

Cash................................................................................ 75,000

Requirement 1
Exercise 5-6 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
Exercise 5-7

October 1, 2009
To record the installment sale
Installment receivable.....................................................4,000,000
Inventory..................................................................... 1,800,000
Deferred gross profit................................................... 2,200,000
To record the cash down payment from installment sale

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

Deferred gross profit ($800,000 x 55%*)....................... 440,000
October 1, 2010
To record the default and repossession
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
*$2,200,000 ÷ $4,000,000 = 55% gross profit percentage
Requirement 1
Exercise 5-8
April 1, 2009 To record installment sale
Installment receivables................................................... 2,400,000
Land............................................................................ 480,000
Gain on sale of land.................................................... 1,920,000
April 1, 2009 To record cash collection from installment sale

Cash................................................................................ 120,000

Cash................................................................................ 120,000
Requirement 2
April 1, 2009 To record installment sale

Installment receivables................................................... 2,400,000
Land............................................................................ 480,000
Deferred gain.............................................................. 1,920,000

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).

Cash................................................................................ 120,000
To recognize profit from installment sale

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

Cash................................................................................ 120,000
To recognize profit from installment sale

Deferred gain.................................................................. 96,000
Gain on sale of land (80% x $120,000).......................... 96,000
Requirement 1
Exercise 5-9 2009 2010
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 2009) $ 500,000 $ 125,000
Gross profit recognition:

2009: $ 300,000
= 20% x $500,000 = $100,000
$1,500,000
2010: $125,000 - $100,000 = $25,000

Requirement 2
2009 $ -0-
2010 $125,000
Requirement 3
Balance Sheet
At December 31, 2009
Current assets:
Accounts receivable $ 130,000
Costs and profit ($400,000*) in excess
of billings ($380,000) 20,000
* Costs ($300,000) + profit ($100,000)

Requirement 4
Balance Sheet
Current assets:
Current liabilities:
Billings ($380,000) in excess of costs ($300,000) $ 80,000
Requirement 1
($ in millions) 2009 2010
2011
Exercise 5-10 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 2011) $ 60 $ 40 $ 50
Gross profit (loss) recognition:
2009: $40
= 25% x $60 = $15
$160
2010: $120
= 66.67% x $40 = $26.67 - $15 = $11.67
$180
2011: $220 – 170 = $50 – ($15 + 11.67) = $23.33
Requirement 2
2009: $220 x 25% = $55
2010: $220 x 66.67% = $146.67 – 55 = $91.67
2011: $220 – 146.67 = $73.33

Requirement 3
Year Gross profit (loss) recognized

2009 -0-
2010 -0-
2011 50
Total project income $50

Requirement 4
2009:
Revenue: $40
Cost: $40
Gross profit: $ 0
2010:
Revenue: $80
Cost: $80
Gross profit: $ 0
2011:
Revenue: $100 ($220 contract price - $40 - $80)
Cost: $ 50
Gross profit: $ 50
Requirement 5
2010: $120
= 60% x $20* = $12 - 15 = $(3) loss
$200
*$220 – ($40 + 80 + 80) = $20
Requirement 1
2009 2010 2011
Contract price $8,000,000 $8,000,000
Exercise 5-11 $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 2011) $2,000,000 $ (100,000) $ (300,000)
2009: $2,000,000
= 33.3333% x $2,000,000 = $666,667
$6,000,000
2010: $(100,000) - 666,667 = $(766,667)
2011: $(300,000) - (100,000) = $(200,000)

Requirement 2
2009 2010
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 2009 (above) (2,666,667)
Revenue recognized in 2010 1,777,333 (1)
Plus: Loss recognized in 2010 (above) 766,667
Cost of construction, 2010 $2,544,000 (2)

Requirement 3
Balance Sheet 2009 2010
Current assets:
Accounts receivable $250,000 $525,000
Costs and profit ($2,666,667*) in
excess of billings ($2,500,000) 166,667
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 1
Exercise 5-12 Year Gross profit (loss) recognized
2009 -0-
2010 $(100,000)
2011 (200,000)
Total project loss $(300,000)
Requirement 2
2009 2010
Construction in progress 2,000,000 2,500,000
Various accounts 2,000,000 2,500,000

Billings on construction contract 2,500,000 2,750,000
Cash 2,250,000 2,475,000

Loss on long-term contract 100,000

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

Requirement 3

Current assets:
Accounts receivable $250,000 $525,000
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
* Costs ($2,000,000 + $2,500,000) - loss ($100,000)
Situation 1 - Percentage-of-Completion
Exercise 5-13
2009 2010 2011
Contract price $5,000,000 $5,000,000 $5,000,000
Estimated costs to complete 3,000,000 900,000 -0-
Estimated gross profit
(actual in 2011) $ 500,000 $ 500,000 $ 500,000
Gross profit (loss) recognized:
2009: $1,500,000
= 33.3333% x $500,000 = $166,667
$4,500,000
2010: $3,600,000
= 80.0% x $500,000 = $400,000 - 166,667 = $233,333
$4,500,000
2011: $500,000 - 400,000 = $100,000

Situation 1 - Completed Contract
Year Gross profit recognized

2009 -0-
2010 -0-
2011 $500,000
Total gross profit $500,000

2009 2010 2011

Contract price $5,000,000 $5,000,000 $5,000,000
(actual in 2011) $ 500,000 $ 200,000 $ 200,000
2009: $1,500,000
= 33.3333% x $500,000 = $166,667
$4,500,000
2010: $2,400,000
= 50.0% x $200,000 = $100,000 - 166,667 = $(66,667)
$4,800,000
2011: $200,000 - 100,000 = $100,000

2009 -0-
2010 -0-
2011 $200,000

2009 2010 2011

Contract price $5,000,000 $5,000,000 $5,000,000
(actual in 2011) $ 500,000 $ (100,000) $ (200,000)
2009: $1,500,000
= 33.3333% x $500,000 = $166,667
$4,500,000
2010: $(100,000) - 166,667 = $(266,667)
2011: $(200,000) - (100,000) = $(100,000)

2009 -0-
2010 $(100,000)
2011 (100,000)

2009 2010 2011

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-
(actual in 2011) $1,000,000 $ 625,000 $ 500,000
2009: $ 500,000
= 12.5% x $1,000,000 = $125,000
$4,000,000
2010: $3,500,000
= 80.0% x $625,000 = $500,000 - 125,000 = $375,000
$4,375,000
2011: $500,000 - 500,000 = $ - 0 -

2009 -0-
2010 -0-
2011 $500,000

2009 2010 2011

Contract price $5,000,000 $5,000,000 $5,000,000
(actual in 2011) $1,000,000 $ -0- $ 200,000
2009: $ 500,000
= 12.5% x $1,000,000 = $125,000
$4,000,000
2010: $ 0 - 125,000 = $(125,000)
2011: $200,000 - 0 = $200,000

2009 -0-
2010 -0-
2011 $200,000

2009 2010 2011

Contract price $5,000,000 $5,000,000 $5,000,000
(actual in 2011) $ (100,000) $ (200,000) $ (300,000)
2009: $(100,000)
2010: $(200,000) - (100,000) = $(100,000)
2011: $(300,000) - (200,000) = $(100,000)

2009 $(100,000)
2010 (100,000)
2011 (100,000)
Requirement 1
Exercise 5-14 Construction in progress = Costs incurred + Profit recognized
$100,000 = ? + $20,000
Actual costs incurred in 2009 = $80,000

Requirement 2
Billings = Cash collections + Accounts Receivable
$94,000 = ? + $30,000
Cash collections in 2009 = $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%
$1,280,000
Requirement 1
Exercise 5-15 Revenue should be recognized as follows:
Software - date of shipment, July 1, 2009
Technical support - evenly over the 12 months of the agreement
Upgrade - date of shipment, January 1, 2010
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, 2009 To record sale of software
Cash................................................................................ 243,000
Revenue...................................................................... 189,000
Unearned revenue ($27,000 + 27,000)............................ 54,000
Requirement 1
Exercise 5-16
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
contingent on its delivery.
Exercise 5-17
October 1, 2009To record franchise agreement and
down payment
Cash (10% x $300,000)...................................................... 30,000
Note receivable............................................................... 270,000
Unearned franchise fee revenue.................................. 300,000
January 15, 2010 To recognize franchise fee revenue

Unearned franchise fee revenue...................................... 300,000
Franchise fee revenue................................................. 300,000
Exercise 5-18
Solutions Manual, Vol.1, Chapter 5
5-37
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
beyond delivery point.
Requirement 1
Exercise 5-19
Average inventory
= $1,840,000
[$690,000 + 630,000] ÷ 2
= 2.79 times
Requirement 2
By itself, very little. 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.
Exercise 5-20 Turnover ratios for Anderson Medical Supply Company for
2009:
Inventory turnover ratio = $4,800,000

Receivables turnover ratio = $8,000,000
[$900,000 + 700,000] ÷ 2
Average collection period = [$700,000 +365
500,000] ÷ 2
Asset turnover ratio = $8,000,000
613.33
times
= [$4,300,000
13.33+times
3,700,000] ÷ The
2 = 27.4 days company
turns its
= 2 times 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).
Requirement 1
Exercise 5-21 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 5-22Requirement 1
a. Profit margin on sales $180 ÷ $5,200 = 3.5%
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
3.5% x 2.89 x 3.43 = 34.7% ~ 34.3% (difference due
to rounding)
Quarter
First Second Third
Exercise 5-23 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
Tax expense to be reported $17,000 $10,000 $ 41,400
Incentive compensation $300 million ÷ 4 = $ 75 million
Exercise 5-24 Depreciation expense $60 million ÷ 4 = 15 million
Gain on sale 23 million
1st 2nd 3rd 4th

Advertising $200,000 $200,000 $200,000
$200,000
Exercise 5-25 Property tax 87,500 87,500 87,500
87,500
Equipment repairs 65,000 65,000 65,000 65,000
Extraordinary casualty loss 0 185,000 0 0
Research and development 0 32,000 32,000 32,000
CPA / CMA REVIEW QUESTIONS

CPA Exam Questions
1. b. The earnings process is completed upon delivery of the product. Therefore,
in 2009, revenue for 50,000 gallons at $3 each is recognized. The payment
terms do not affect revenue recognition.
2. d. The deferred gross profit on the balance sheet at December 31, 2010 should
be the balances in the accounts receivable accounts for 2009 and 2010
multiplied times the appropriate gross profit percentage:
Accounts Receivable 2009 2010

Total Sales 600,000 900,000
Less: Collections (300,000) (300,000)
Less: Write Offs (200,000) (50,000)
Accounts Receivable Balance 100,000 550,000
x Gross Profit Rate x 30% x 40%
Deferred Gross Profit 12/31/10 30,000 220,000
The Combined Deferred Gross Profit on the Balance Sheet is $250,000

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

CPA Review Questions (concluded)
3. a.
Year of sale
2009 2010
a. Gross profit realized $240,000 $200,000
b. Percentage 30% 40%
c. Collections on sales (a/b) $800,000 $500,000
Total sales 1,000,000 2,000,000
Balance 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 of
accounting. Construction-in-progress does not include the cumulative effect
of gross profit recognition under the completed contract method.
5. c.
2009 actual costs $20,000

Total estimated costs ÷ 60,000
Ratio = 1/3
Contract Price x 100,000
Revenue 33,333
2009 actual costs -20,000
Gross profit $13,333
6. d. Since the total cost of the contract, $3,100,000 ($930,000 + $2,170,000) is

projected to exceed the contract price of $3,000,000, the excess cost of
$100,000 must be recognized as a loss in 2009.

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 realizable
in the form of a receivable. The revenue was earned on May 28 since the title of the
goods passed to the purchaser. The cost-recovery method is not used because the
receivable was not deemed uncollectible until June 10.
2. d. Based on the revenue recognition principle, revenue is normally recorded at the

time of the sale or, occasionally, at the time cash is collected. However, sometimes
neither the sales basis nor the cash basis is appropriate, such as when a construction
contract extends over several accounting periods. As a result, contractors ordinarily
recognize revenue using the percentage-of-completion method so that some revenue is
recognized each year over the life of the contract. Hence, this method is an exception
to the general principle of revenue recognition, primarily because it better matches
revenues and expenses.
3. b. Given that one-third of all costs have already been incurred ($6,000,000), the
company should recognize revenue equal to one-third of the contract price, or
$8,000,000. Revenues of $8,000,000 minus costs of $6,000,000 equals a gross profit
of $2,000,000.
PROBLEMS
Problem 5-1
REAGAN CORPORATION
Income Statement
For the Year Ended December 31, 2009
Income before income taxes and
extraordinary item ....................................... [1] $3,680,000
Income tax expense ....................................... 1,472,000
Income before extraordinary item ................. 2,208,000
Extraordinary item:
Gain from settlement of lawsuit (net of
$400,000 tax expense) ................................. 600,000
Net Income .................................................... $2,808,000
Income before extraordinary item ................. 2.21
Extraordinary gain ......................................... 0.60
Net income .................................................... $ 2.81
[1] Income from continuing operations before income taxes:

Unadjusted $4,200,000
Add: Gain from sale of equipment 50,000
Deduct: Inventory write-off (400,000)
Depreciation expense (2009) (50,000)
Overstated profit on installment sale (120,000) *
Adjusted $3,680,000
* Profit recognized ($400,000 - 240,000) $160,000
Profit that should have been recognized
(gross profit ratio of 40% x $100,000) (40,000)
Overstated profit $120,000
Problem 5-2Requirement 1
2009 Cost recovery % :
$180,000
= 60% (gross profit % = 40%)
$300,000
2010 Cost recovery %:
$280,000
= 70% (gross profit % = 30%)
$400,000
2009 gross profit:
Cash collection from 2009 sales = $120,000 x 40% = $48,000
2010 gross profit:
Cash collection from 2009 sales = $100,000 x 40% = $ 40,000
+ Cash collection from 2010 sales = $150,000 x 30% = 45,000
Total 2010 gross profit $85,000
Requirement 2

Inventory..................................................................... 180,000

Cash................................................................................ 120,000


Problem 5-2 (continued)

Inventory..................................................................... 280,000

Cash................................................................................ 250,000

Requirement 3
Date Cash Collected Cost Recovery Gross Profit
2009
2009 sales $120,000 $120,000 -0-
2010
2009 sales $100,000 $ 60,000 $40,000
2010 sales 150,000 150,000 -0-
2010 totals $250,000 $210,000 $40,000

Problem 5-2 (concluded)

Inventory..................................................................... 180,000
2009 To record cash collection from installment sales

Cash................................................................................ 120,000

Inventory..................................................................... 280,000
2010 To record cash collection from installment sales

Cash................................................................................ 250,000

Requirement 1
Problem 5-3Total profit = $500,000 - 300,000 = $200,000
Installment sales method: Gross profit % = $200,000 ÷ $500,000 = 40%
8/31/09 8/31/10 8/31/11 8/31/12 8/31/13
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

Requirement 2
Point of Installment
Delivery Sales Cost Recovery
Installment receivable 500,000
Sales revenue 500,000
Cost of goods sold 300,000
Inventory 300,000
To record sale on 8/31/09.
Installment receivable 500,000 500,000

Inventory 300,000 300,000
Deferred gross profit 200,000 200,000
To record sale on 8/31/09.
Cash 100,000 100,000 100,000

Installment receivable 100,000 100,000 100,000
Entry made each Aug. 31.
Deferred gross profit 40,000

Realized gross profit 40,000
(entry made each Aug. 31)
Deferred gross profit 100,000

Realized gross profit 100,000
(entry made 8/31/12 & 8/31/13)

Requirement 3
Point of Installment Cost

Delivery Sales Recovery
December 31, 2009
Assets
Installment receivables 400,000 400,000 400,000
Less: Deferred gross profit (160,000) (200,000)
Installment receivables, net 240,000 200,000
December 31, 2010

Assets
Installment receivables 300,000 300,000 300,000
Less: Deferred gross profit (120,000) (200,000)
Installment receivables, net 180,000 100,000

All jobs consist of four equal payments: one payment when the job is completed and
three payments over the next three years.
Bluebird:
Job completed in 2007, so down payment made in 2007, another payment in 2008,
and two payments remain. $400,000 gross receivable at 1/1/09 implies payments
of ($400,000 ÷ 2) = $200,000 in 2009 and 2010. Four payments of $200,000
implies total revenue of 4 x $200,000 = $800,000 on the job. 25% gross profit
ratio implies cost of 75% x $800,000 = $600,000.
Cost recovery method gross profit: Payments in 2007 and 2008 have already
recovered $400,000 of cost, so cost remaining to be recovered as of 1/1/09 is
$600,000 total - $400,000 already recovered = $200,000. Therefore, the entire
2009 payment of $200,000 will be applied to cost recovery, and no gross profit is
recognized in 2009.
Installment sales method gross profit: $200,000 payment x 25% gross profit ratio =
$50,000 of gross profit recognized in 2009.
PitStop:
Job completed in 2006, so down payment made in 2006, another payment in 2007,
another in 2008, and one payment remains. $150,000 gross receivable at 1/1/09
implies a single payment of $150,000 in 2009. Four payments of $150,000
implies total revenue of 4 x $150,000 = $600,000 on the job. 35% gross profit
ratio implies cost of 65% x $600,000 = $390,000.
Cost recovery method gross profit: Payments in 2006, 2007 and 2008 of a total of
$450,000 have already recovered the entire $390,000 of cost and allowed
recognition of $60,000 of gross profit. Therefore, the entire 2009 payment of
$150,000 will be applied to gross profit.
Installment sales method gross profit: $150,000 payment x 35% gross profit ratio =
$52,500 of gross profit recognized in 2009.
Totals:
Requirement 2
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 2009, he would not be happy with a switch to the installment
sales 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 that
the installment sales method recognizes gross profit faster than does the cost
recovery method, but the installment sales method also recognizes gross profit
more evenly than does the cost-recovery method. The timing of these jobs is
such that 2009 is a year in which almost all of the gross profit associated with the
PitStop job gets recognized, so 2009 looks more profitable under the cost
recovery method.
Requirement 1
Problem 5-5 2009 2010 2011
Contract price $10,000,000 $10,000,000 $10,000,000
(actual in 2011) $ 2,000,000 $ 2,000,000 $ 1,800,000
2009: $2,400,000
= 30.0% x $2,000,000 = $600,000
$8,000,000
2010: $6,000,000
= 75.0% x $2,000,000 = $1,500,000 - 600,000 = $900,000
$8,000,000
2011: $1,800,000 - 1,500,000 = $300,000

Requirement 2
2009 2010 2011
Construction in progress 2,400,000 3,600,000 2,200,000

Various accounts 2,400,000 3,600,000 2,200,000
Accounts receivable 2,000,000 4,000,000 4,000,000

Billings on construction 2,000,000 4,000,000 4,000,000
contract
Cash 1,800,000 3,600,000 4,600,000

Construction in progress 600,000 900,000 300,000

(gross profit)
Cost of construction 2,400,000 3,600,000 2,200,000
(cost incurred)
Revenue from long-term 3,000,000 4,500,000 2,500,000
contracts (1)
(1) Revenue recognized:

2009: 30% x $10,000,000 = $3,000,000
2010: 75% x $10,000,000 = $7,500,000
Less: Revenue recognized in 2009 (3,000,000)
Revenue recognized in 2010 $4,500,000
2011: 100% x $10,000,000 = $10,000,000
Less: Revenue recognized in 2009 & 2010 (7,500,000)
Revenue recognized in 2011 $2,500,000

Requirement 3
Current assets:
Accounts receivable $ 200,000 $600,000
Construction in progress $3,000,000 $7,500,000
Less: Billings (2,000,000) (6,000,000)
Costs and profit in excess
of billings 1,000,000 1,500,000
Requirement 4
2009 2010 2011
Costs incurred during the year $2,400,000 $3,800,000 $3,200,000
Estimated costs to complete
as of year-end 5,600,000 3,100,000 -
2009 2010 2011

Contract price $10,000,000 $10,000,000 $10,000,000
(actual in 2011) $ 2,000,000 $ 700,000 $ 600,000


2009: $2,400,000
= 30.0% x $2,000,000 = $600,000
$8,000,000
2010: $6,200,000
= 66.6667% x $700,000 = $466,667 - 600,000 = $(133,333)
$9,300,000
2011: $600,000 - 466,667 = $133,333
Requirement 5
2009 2010 2011
as of year-end 5,600,000 4,100,000 -
2009 2010 2011

Contract price $10,000,000 $10,000,000 $10,000,000
(actual in 2008) $ 2,000,000 $ (300,000) $ (100,000)
2009: $2,400,000
= 30.0% x $2,000,000 = $600,000
$8,000,000
2010: $(300,000) - 600,000 = $(900,000)
2011: $(100,000) - (300,000) = $200,000
2009 -0-
2010 -0-
2011 $1,800,000
Total gross profit $1,800,000
Requirement 2
2009 2010 2011

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

Billings on construction 2,000,000 4,000,000 4,000,000
contract
Cash 1,800,000 3,600,000 4,600,000

Construction in progress 1,800,000

(gross profit)
Cost of construction 8,200,000
(costs incurred)
Revenue from long-term 10,000,000
contracts (contract price)

Requirement 3

Current assets:
Accounts receivable $ 200,000 $ 600,000
Construction in progress $2,400,000 $6,000,000
Less: Billings (2,000,000) (6,000,000)
Costs in excess of billings 400,000 -0-
Requirement 4
2009 2010 2011
as of year-end 5,600,000 3,100,000 -

2009 -0-
2010 -0-
2011 $600,000
Requirement 5
2009 2010 2011
as of year-end 5,600,000 4,100,000 -

2009 -0-
2010 $(300,000)
2011 200,000
2009 2010 2011

Contract price $4,000,000 $4,000,000 $4,000,000
(actual in 2011) $ 500,000 $ (200,000) $ (250,000)

2009 -0-
2010 $(200,000)
2011 (50,000)
Requirement 2
2009: 10% x $500,000 = $50,000
2010: $(200,000) - 50,000 = $(250,000)
2011: $(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
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 1
Problem 5-8 The completed contract method of recognizing revenues and
costs on long-term construction contracts is equivalent to recognizing revenue at the
point of delivery, i.e., when the construction project is complete. The percentage-of-
completion method assigns a 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 share is estimated based on 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 a lack of dependable estimates or inherent hazards make it
difficult to forecast future costs and profits.
Requirement 2
2009 2010
Contract price $20,000,000 $20,000,000
Actual costs to date 4,000,000 13,500,000
Estimated costs to complete 12,000,000 4,500,000
Estimated 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 on
the contract in whatever period it first revises the estimates to determine that an
overall loss will eventually occur. Citation never estimates the Altamont contract
will earn a gross loss, so never has to recognize one.
b. Under the completed contract method Citation would not report any revenue in
the 2009 or 2010 income statements.

c.
Balance Sheet
Current assets:
Costs ($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 3
2009 2010
Contract price $20,000,000 $20,000,000
Estimated gross profit $ 4,000,000 $ 2,000,000
2009: $ 4,000,000
= 25% x $4,000,000 = $1,000,000
$16,000,000
2010: $13,500,000
= 75% x $2,000,000 = $1,500,000
$18,000,000
Less: 2009 gross profit 1,000,000
2010 gross profit$ 500,000
b. 2009: $20,000,000 x 25% = $5,000,000
2010: $20,000,000 x 75% = $15,000,000

Less: 2009 revenue (5,000,000)
$10,000,000

c.
Balance Sheet
Current assets:
Costs 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
2009 2010
Contract price $20,000,000 $20,000,000
Estimated gross profit $ 4,000,000 ($ 2,500,000)
2010: Overall loss of ($2,500,000) – previously recognized gross profit of

$1,000,000 = $3,500,000.
b. 2010: Easiest to solve using a journal entry:
Cost of construction (to balance) $10,500,000

Revenue from long-term contracts* $7,000,000
Construction 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

c.
Balance Sheet
Current assets:
Billings ($12,000,000) in excess of costs
and profit ($11,000,000*) 1,000,000
* 2009 costs ($4,000,000) + 2009 profit ($1,000,000) + 2010 costs ($9,500,000)

– 2010 loss ($3,500,000)
Requirement 5
Citation 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 completed
contract method for long-term contracts. The percentage-of-completion method is not
appropriate in this case. There is no contract in place and until the completion of the
home, the transfer of title, and the receipt of the full sales price, the earnings process is
not virtually complete and there is still significant uncertainty as to cash collection.
Also, the sales price is not fixed.
Requirement 6
Income statement:
Sales revenue (3 x $600,000) $1,800,000
Cost of goods sold (3 x $450,000) 1,350,000
Gross profit $ 450,000
Balance sheet:
Current assets:
Inventory (work in process) $2,700,000
Customer deposits (or unearned revenue) 300,000*
*$600,000 x 10% = $60,000 x 5 = $300,000
Problem 5-9 Requirement 1

a. January 30, 2009
Cash ............................................................................... 200,000

Note receivable .............................................................. 1,000,000
Unearned franchise fee revenue.................................. 1,200,000
b. September 1, 2009
Unearned franchise fee revenue...................................... 1,200,000

Franchise fee revenue ................................................ 1,200,000
c. September 30, 2009
Accounts receivable ($40,000 x 3%) ................................ 1,200

Service revenue .......................................................... 1,200
d. January 30, 2010
Cash................................................................................ 100,000
Note receivable .......................................................... 100,000

Requirement 2
a. January 30, 2009
Cash ............................................................................... 200,000

Note receivable .............................................................. 1,000,000
Deferred franchise fee revenue................................... 1,200,000
Note: Could also show as:

Cash ............................................................................... 200,000
Note receivable .............................................................. 1,000,000
Deferred franchise fee revenue................................... 1,000,000
Unearned franchise fee revenue.................................. 200,000
b. September 1, 2009
Deferred franchise fee revenue ...................................... 200,000

Franchise fee revenue (cash collected)........................... 200,000
c. September 30, 2009
Accounts receivable ($40,000 x 3%) ................................ 1,200

Service revenue .......................................................... 1,200
d. January 30, 2010
Cash................................................................................ 100,000
Note receivable .......................................................... 100,000

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

Requirement 3
Balance Sheet
Current assets:
Installment notes receivable $ -0-
($1,000,000) less deferred franchise fee
revenue ($1,000,000)
Unearned franchise fee revenue $200,000
Explanation: Revenue recognition on the entire note receivable is deferred. In

addition, $200,000 of unearned revenue must be shown as a liability.
Problem 5-101. Inventory turnover ratio$6,300 ÷ [($800 + 600) ÷ 2] = 9.0

2. Average days in inventory365 ÷ 9.0 = 40.56 days
3. Receivables turnover ratio $9,000 ÷ [($600 + 400) ÷ 2] = 18.0
4. Average collection period 365 ÷ 18.0 = 20.28 days
5. Asset turnover ratio $9,000 ÷ [($4,000 + 3,600) ÷ 2] = 2.37
6. 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. Receivables
Return on turnover = Net sales
shareholders’ equity $300receivable
Accounts ÷ [($1,500 + 1,350) ÷ 2] = 21.1%
9. Equity multiplier [($4,000 + 3,600) ÷ 2] ÷ [($1,500 + 1,350) ÷ 2] = 2.67
J&J
10. DuPont framework = $41,862 3.33% = 6.37
x 2.37times
x 2.67 = 21.1%
$6,574
Problem 5-11 Requirement 1
Pfizer $45,188
= = 5.15 times
On average, J&J collects its receivables in 14 days less than Pfizer.
$8,775
On average,
Inventory
Average J&J sells
turnover
collection its inventory
period == twice
Cost
365ofasgoods
fast assold
Pfizer.
Inventories
Receivables turnover
5-66 J&J == $12,176
365 = 3.39 times
57 days Intermediate Accounting, 5/e
$3,588
6.37
Pfizer == $9,832
365 = 1.68 times
71 days
Requirement 2
Rate of return on assets = Net income The return on

Total assets assets indicates a
company's overall
J&J = $7,197 = 14.9% profitability,
$48,263 ignoring specific
sources of
Pfizer = $1,639 = 1.4% financing. In this
$116,775 regard, J&J’s
profitability is significantly higher than that of Pfizer.
Requirement 3
Profitability 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
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&J’s 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 for
J&J.

Requirement 4
Rate of return on = Net income J&J provided a

shareholders’ equity Shareholders’ equity much greater
return to
J&J = $7,197 = 26.8% shareholders.
$26,869
Pfizer $1,639
= = 2.5% Requirement 5
$65,377
Equity multiplier = Total Assets The two
shareholders’ equity Shareholders’ equity companies have
virtually identical
J&J = $48,263 = 1.80 equity multipliers,
$26,869 indicating that
they are using
Pfizer = $116,775 = 1.79% leverage to the
$65,377 same extent to
earn a return on equity that is higher than their return on assets.
a. Times interest earned ratio = (Net income + Interest + Taxes) ÷

Problem 5-12 Interest = 17
(Net income + $2 + 12) ÷ $2 = 17
Net income + $14 = 17 x $2
Net 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 = $240
e. Inventory turnover ratio = Cost of goods sold ÷ Inventory = 8
Inventory = $240 ÷ 8 = $30

f. Receivables turnover ratio = Sales ÷ Accounts receivable = 20
Accounts receivable = $400 ÷ 20 = $20
g. Current ratio = Current assets ÷ Current liabilities = 2.0
Acid-test ratio = Quick assets ÷ Current liabilities = 1.0
Current assets ÷ 2 = Current liabilities
Quick assets ÷ 1 = Current liabilities
Current assets ÷ 2 = Quick assets ÷ 1
Current assets = 2 x Quick assets
Cash + accts. rec. + Inventory = 2 x (Cash + Accounts receivable)
Cash + $20 + $30 = (2 x Cash) + (2 x $20)
Cash + $50 = Cash + Cash + $40
Cash = $10
h. Acid-test ratio = (Cash + Accounts receivable) ÷ Current liabilities = 1.0
Current liabilities = ($10 + 20) ÷ 1.0 = $30
i. Noncurrent assets = Total assets – Current assets
= $200 – ($10+20+30) = $140
j. Return on shareholders’ equity = Net income ÷ Shareholders’ equity = 20%
Shareholders’ equity = $20 ÷ 20% = $100

k. Debt to equity ratio = Total liabilities ÷ Shareholders’ equity = 1.0

Total liabilities = $100 x 1.0 = $100
Long-term liabilities = Total liabilities - Current liabilities = $100 - 30 = $70
CADUX CANDY COMPANY

Balance Sheet
Problem 5-13
Assets Requirement 1
Rate of return
Current assets:on assets = Net income
Cash Total assets $ 10 The
return
Accounts receivable (net) 20 on assets
Metropolitan
Inventories = $ 593.8 = 14.8%
30 indicates a
Total current assets $4,021.5 60 company's
Property, plant, and equipment (net) 140 overall
Republic
Total assets = $ 424.6 = 10.6%
$200 profitability,
$4,008.0 ignoring specific
Liabilities and Shareholders’ Equity sources of
Current liabilities $ 30 financing. In this
Long-term liabilities 70 regard,
Shareholders’ equity 100 Metropolitan’s
Total liabilities and shareholders' equity $200 profitability
exceeds that of
Republic.
Requirement 2
Profitability 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%

Republic = $ 424.6 x $7,768.2
$7,768.2 $4,008.0
= 5.5% x 1.94 times = 10.7%
Republic’s profit margin is much less than that of Metropolitan, but partially
makes up for it with a higher turnover.

Requirement 3
Rate of return on = Net income

shareholders’ equity Shareholders’ equity
Metropolitan = $593.8 = 34.6%
$144.9 + 2,476.9 - 904.7
Republic = $424.6 = 43.6%
$335.0 + 1,601.9 - 964.1
Republic provides a greater return to common shareholders.
Requirement 4
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
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 firms
do this. Republic’s higher leverage has been used to provide a higher return to
shareholders than Metropolitan, even though its return on assets is less. Republic
increased its return to shareholders 4.07 times (43.6% ÷ 10.7%) the return on assets.
Metropolitan increased its return to shareholders 2.34 times (34.6% ÷ 14.8%) the
return on assets.

Requirement 5
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
The current ratios of the two firms are comparable and within the range of the
rule-of-thumb standard of 1 to 1. The more robust acid-test ratio reveals that
Metropolitan is more liquid than Republic.
Requirement 6
Receivables turnover ratio = Sales

Accounts receivable
Metropolitan = $5,698.0 = 13.5 times
$422.7
Republic = $7,768.2 = 23.9 times
$325.0


Inventory
Metropolitan = $2,909.0 = 6.2 times
$466.4
Republic = $4,481.7 = 7.1 times
$635.2
Republic’s receivables turnover is more rapid than Metropolitan’s, perhaps

suggesting that its relative liquidity is not as bad as its acid-test ratio indicated.
Requirement 7
Times interest = Net income plus interest plus taxes
earned ratio Interest
Metropolitan = $593.8 + 56.8 + 394.7 = 18.4 times
$56.8
Republic = $424.6 + 46.6 + 276.1 = 16.0 times
$46.6
Both firms provide an adequate margin of safety.

Branson Electronics Company
Problem 5-14 Income Statement
Revenues $180,000
Cost of goods sold 35,000
Gross profit 145,000
Advertising expense1 (12,500)
Other operating expenses2 (57,000)
Income before income taxes 75,500
Income tax expense3 (27,180)
Net income $ 48,320
1$50,000 ÷ 4 = $12,500
2$48,000 + [$59,000 – 50,000]
3$75,500 x 36%
CASES
Real World Case 5-1
Requirement 1
A bill and hold strategy accelerates the recognition of revenue. In this case, sales
that would normally have occurred in 1998 were recorded in 1997. Assuming a
positive gross profit on these sales, earnings in 1997 is inflated.
Requirement 2
A customer would probably not be expected to pay for goods purchased using
this bill and hold strategy until the goods were actually received. Receivables would
therefore increase.
Requirement 3
Sales that would normally have been recorded in 1998 were recorded in 1997.
This bill and hold strategy shifted sales revenue and therefore earnings from 1998 to
1997.
Requirement 4
Earnings quality refers to the ability of reported earnings (income) to predict a
company’s future earnings. Sunbeam’s earnings management strategy produced a
1997 earnings figure that was not indicative of the company’s future profit-generating
ability.
Requirement 1
Judgment Case 5-2 While revenue often is earned during a period of time,
revenue usually is recognized at a point in time when both revenue recognition criteria
are satisfied. These criteria usually are satisfied at the point of delivery. The revenue
has been earned and there is reasonable certainty as to the collectibility of the asset
(cash) to be received.
Usually, significant uncertainties exist at the time products are produced. At
point of delivery, the product has been sold and the price and buyer are known. The
only remaining uncertainty involves the ultimate cash collection, which can usually be
accounted for by estimating and recording allowances for possible return of the
product and for uncollectibility of the cash.
Requirement 2
It would be useful to recognize revenue as the productive activity takes place
when the earnings process occurs over long periods of time. A good example is long-
term projects in the construction industry.
Requirement 3
Some revenue-producing activities call for revenue recognition after the product
has been delivered. These situations involve significant uncertainty as to the
collectibility of the cash to be received, caused either by the possibility of the product
being returned or, with credit sales, the possibility of bad debts. Usually, these
remaining uncertainties can be accounted for by estimating and recording allowances
for anticipated returns and bad debts, thus allowing revenue and related costs to be
recognized at point of delivery. But occasionally, an abnormal degree of uncertainty
causes point of delivery revenue recognition not to be appropriate. Revenue
recognition after delivery sometimes is appropriate for installment sales and when a
right of return exists.
Judgment Case 5-3 Mega should recognize revenue for the initial fee
equally over the estimated average period members will
continue to be members. Even though the fee is nonrefundable, it is not “earned” until
services are provided. Since there is no contractual period of service, it must be
estimated. Mega would be justified in recognizing only $3 of the initial fee
immediately to offset the cost of the membership card. The payment option chosen by
members does not affect the revenue recognition policy.
The monthly fee should be recognized as revenue upon billing, as long as
adequate provision is made for possible uncollectible amounts.
The revenue recognition policy is questionable. The

Judgment Case 5-4liberal trade-in policy causes gross profit to be overstated on
the original sale and understated on the trade-in sale. This
results from the granting of a trade-in allowance for the old computer that is greater
than the old computer's resale value. Using the company's recognition policy, gross
profit recognized on the two sales would be as follows:
Original sale Trade-in sale
Sales price $2,000,000 $2,380,000
Cost of goods sold 1,200,000 1,500,000
Gross profit $ 800,000 $ 880,000
Gross profit percentage 40% 37%
Of course, there is no guarantee that the customer will exercise the trade-in
option. If, however, a large percentage of customers do exercise the option, and the
distortion in gross profit is material, the company should adopt a revenue recognition
policy that results in a more stable gross profit percentage for the two transactions.
The critical question that student groups should

Communication Case 5-5address is how to match revenues and expenses.
There is no right or wrong answer. The process of
developing the proposed solutions will likely be more beneficial than the solutions
themselves. Students should benefit from participating in the process, interacting first
with other group members, then with the class as a whole.
Solutions could take one of two directions:
1. Deferral of revenue recognition. As each ice cream cone is sold, a portion of
the sales price is deferred and a liability is recorded. This liability will then be
reduced and revenue recognized when the free ice cream cone is awarded.
2. The accrual of estimated cost. This direction views the free ice cream cone as
a promotional expense. The estimated cost of the free cone should be
expensed as the ten required cones are sold. A corresponding liability is
recorded which should increase to an amount equal to the cost of the free
cone. When the free cone is awarded, the liability and inventory are reduced.
In either case, the accounting method must consider the fact that not all
customers will take advantage of the free cone award.
It is important that each student actively participate in the process. Domination
by one or two individuals should be discouraged. Students should be encouraged to
contribute to the group discussion by (a) offering information on relevant issues, and
(b) clarifying or modifying ideas already expressed, or (c) suggesting alternative
direction.
(Note: This case requires the student to reference a journal
Research Case 5-6article.]
1. Fifty-five firms reported the use of one of the two long-term contract accounting
methods.
2. Twenty-seven of the firms are manufacturing companies.
3. Only one company uses the completed contract method. That company reported
using both methods.
4. The most frequently used approach to estimating a percentage-of-completion is
the cost-to-cost method.
(Note: This case requires the student to reference a journal
Research Case 5-7article.]
1.
Abuse Expanation
1. Cutoff manipulation The company either closes their books early (so some
current-year revenue is postponed until next year) or
leaves them open too long (so some next-year
revenue is included in the current year).
2. Deferring too much The company has an arrangement under which
or too little revenue revenue should be deferred (for example, they should
be using the installment sales method), but they don’t
defer the revenue. Or, a company could defer too
much revenue to shift income into future periods.
3. Bill-and-hold sale The company records sales even though they haven’t
yet delivered the goods to the customer.
4. Right-of-return sale The company sells to distributors or other customers
and can’t estimate returns with sufficient accuracy
due to the nature of the selling relationship.
2. Manipulating estimates of percentage complete in order to manipulate gross

profit recognition.
3. These abuses tended to increase income (75% of the time), consistent with
management generally having an incentive to increase income.
4. The auditors tended to require adjustment (56% of the time), consistent with
auditors being concerned about income-increasing earnings management.
Discussion should include these elements.

Ethics Case 5-8
Facts:
Horizon Corporation, a computer manufacturer, reported profits from 2004
through 2007, but reported a $20 million loss in 2008 due to increased competition.
The chief financial officer (CFO) circulated a memo suggesting the shipment of
computers to J.B. Sales, Inc., in 2009 with a subsequent return of the merchandise to

Horizon in 2010. Horizon would record a sale for the computers in 2009 and avoid an
inventory write-off that would place the company in a loss position for that year.
The CFO is clearly asking Jim Fielding to recognize revenue in 2009 which he
knows will be reversed as a sales return in 2010.
Ethical Dilemma:
Is Jim's obligation to challenge the memo of the CFO and provide useful
information to users of the financial statements greater than the obligation to prevent a
company loss in 2009 that may lead to bankruptcy?
Who is affected?
Jim Fielding
CFO and other managers
Other employees
Shareholders
Potential shareholders
Creditors
Auditors
Requirement 1
Judgment Case 5-9 The three methods that could be used to recognize
revenue and costs for this situation are (1) point of delivery, (2) the installment sales
method, and (3) the cost recovery method.
2009 gross profit under the three methods:
(1) point of delivery:
$80,000 - 40,000 = $40,000
(2) installment sales method:
$40,000
= 50% = gross profit %
$80,000
50% x $30,000 (cash collected) = $15,000
(3) cost recovery method:
No gross profit recognized since cost ($40,000) exceeds cash collected ($30,000).
Requirement 2
Customers sometimes are allowed to pay for purchases in installments over long
periods of time. Uncertainty about collection of a receivable normally increases with
the length of time allowed for payment. In most situations, the increased uncertainty
concerning the collection of cash from installment sales can be accommodated
satisfactorily by estimating uncollectible amounts. In these situations, point of
delivery revenue recognition should be used.
If, however, the installment sale creates a situation where there is significant
uncertainty concerning cash collection making it impossible to make an accurate
assessment of future bad debts, revenue and cost recognition should be delayed. The
installment sales method and the cost recovery method are available to handle such
situations. These methods should be used only in situations involving exceptional
uncertainty. The cost recovery method is the more conservative of the two.
Question 1
No. In the SEC's view, it would be inappropriate for
Company M to recognize the membership fees as earned
Judgment Case 5-10revenue upon billing or receipt of the initial fee with a
corresponding accrual for estimated costs to provide the membership services. This
conclusion is based on Company M's remaining and unfulfilled contractual obligation
to perform services (i.e., make available and offer products for sale at a discounted
price) throughout the membership period. Therefore, the earnings process, irrespective
of whether a cancellation clause exists, is not complete.
In addition, the ability of the member to receive a full refund of the membership
fee up to the last day of the membership term raises an uncertainty as to whether the
fee is fixed or determinable at any point before the end of the term. Generally, the
SEC believes that a sales price is not fixed or determinable when a customer has the
unilateral right to terminate or cancel the contract and receive a cash refund.
Question 2
No. Products delivered to a consignee pursuant to a consignment arrangement are
not sales and do not qualify for revenue recognition until a sale occurs. The SEC
believes that revenue recognition is not appropriate because the seller retains the risks
and rewards of ownership of the product and title usually does not pass to the
consignee.
Question 3
Provided that the other criteria for revenue recognition are met, the SEC believes
that Company R should recognize revenue from sales made under its layaway
program upon delivery of the merchandise to the customer. Until then, the amount of
cash received should be recognized as a liability entitled such as "deposits received
from customers for layaway sales" or a similarly descriptive caption. Because
Company R retains the risks of ownership of the merchandise, receives only a deposit
from the customer, and does not have an enforceable right to the remainder of the
purchase price, the SEC would object to Company R recognizing any revenue upon
receipt of the cash deposit. This is consistent with item two (2) in the SEC's criteria
for bill-and-hold transactions that states that "the customer must have made a fixed
commitment to purchase the goods."
Requirement 2
Research Case 5-11 The standard lists the following factors that may
impair the ability to make a reasonable estimate:
a. The susceptibility of the product to significant external factors, such as
technological obsolescence or changes in demand.
b. Relatively long periods in which a particular product may be returned.
c. Absence of historical experience with similar types of sales of similar
products, or inability to apply such experience because of changing
circumstances, for example, changes in the selling enterprise’s marketing
policies or relationships with its customers.
d. Absence of a large volume of relatively homogeneous transactions.
Requirement 3
The six criteria are:
a. The seller’s price to the buyer is substantially fixed or determinable at the
date of sale.
b. The buyer has paid the seller and the obligation is not contingent on resale
of the product.
c. The buyer’s obligation to the seller would not be changed in the event of
theft or physical destruction or damage of the product.
d. The buyer acquiring the product for resale has economic substance apart
from that provided by the seller.
e. The seller does not have significant obligations for future performance to
directly bring about resale of the product by the buyer.
f. The amount of future returns can be reasonably estimated.
Requirement 4
Both companies recognize revenues from products sold when persuasive
evidence of an arrangement exists, the price is fixed or determinable, shipment is
made and collectibility is reasonably assured. However, for sales to distributors under
terms allowing the distributors certain rights of return and price protection on unsold

merchandise held by them, AMD defers recognition of revenue and related profits
until the merchandise is resold by the distributors.

Case 5-11 (concluded)
Requirement 5
The two revenue recognition policies differ with respect to AMD’s sales to
distributors. Revenue for these sales is deferred until the merchandise is resold by the
distributors. On the other hand, HP recognizes all sales when products are shipped
even though they offer price protection as well as the right of return to customers.
Estimates are recorded for customer returns, price protection, rebates and other
offerings. Reasons for the difference in policies could relate to the types of products
sold by the two companies, the distribution channels, and the actual agreements with
customers. AMD sells semiconductors, a highly volatile industry. It may be more
difficult for AMD to see through the distribution channels to reasonably estimate
returns. Also, the agreements with distributors of AMD’s products may be more
liberal than those of HP with respect to things like price protection and returns. For
example, AMD might offer a longer time period for customers to return product than
does HP. Also, AMD’s sales to distributors might be contingent on resale of the
product to end users, one of the six criteria that must be met before revenue can be
recognized when the right of return exists.
Requirement 1
Research Case 5-12 This topic is addressed in EITF Issue No. 99-19.
Requirement 2
The Issue lists the following indicators for use of the gross method:
1. The company is the primary obligor in the arrangement.
2. The company has general inventory risk (before customer order is placed or
upon customer return).
3. The company has latitude in establishing price.
4. The company changes the product or performs part of the service.
5. The company has discretion in supplier selection.
6. The company is involved in the determination of product or service
specifications.
7. The company has physical loss inventory risk (after customer order or during
shipping).
8. The company has credit risk.
The indicators for the use of the net method are:
1. The supplier (not the company) is the primary obligor in the arrangement.
2. The amount the company earns is fixed.
3. The supplier (and not the company) has credit risk.

Requirements 3 and 4
In its footnote on Fulfillment partner revenue, the company describes the reasons
for making the switch from the net to the gross method:
“Prior to July 1, 2003, the Company did not physically handle the merchandise
sold in these transactions, as the merchandise was shipped directly by a third party
vendor, who also handled all customer returns related to these fulfillment partner
sales. During that period, the Company recognized as revenue only the net portion of
the price customers paid for the purchased products since the Company acted as an
agent in such transactions. Beginning July 1, 2003, the Company took responsibility
for returned items relating to these sales and began accepting returned items relating to
these sales into the Company’s warehouse, and the Company now handles the
possible resale of returned items. As a result, beginning July 1, 2003, the Company is
considered to be the primary obligor for these sales transactions, and assumes the risk
of loss on returned items. As a consequence, the Company now records revenue from
sales transactions involving fulfillment partners on a gross basis, rather than on a net
basis as was recorded prior to July 1, 2003.”

Case 5-12 (concluded)
Requirement 5
For their AdSense program, Google’s 2006 10K states: “In accordance with
Emerging Issues Task Force (“EITF”) Issue No. 99-19 … we report our Google
AdSense revenues on a gross basis principally because we are the primary obligor to
our advertisors.” That is consistent with the first indicator for use of the gross method
listed under Requirement 2.
For Google Video, Google’s 2006 10K states: “We recognize as revenue the fees
we receive from end users to the extent we are the primary obligor to them; however,
to the extent we are not, we recognize as revenues the fees we receive from end users
net of the amounts we pay to our video content providers in accordance with EITF 99-
19.” That is also consistent with the primary obligor indicator.
1.
Delta should recognize the $425 as revenue on
Judgment Case 5-13 May 15, the date the flight commences.
2. Revenue should be recognized evenly over the
period beginning after Thanksgiving and ending April 30.
3. The $5,000 monthly charge is recognized as revenue each month. The
$12,000 fee must be recognized evenly over the 36-month lease period.
4. Janora Hawkins should recognize the $60,000 as revenue on August 28, the
date the case is settled successfully. This assumes reasonable certainty as to
the collection.
Bill’s argument is that the completed contract method
Judgment Case 5-14is preferable because it is analogous to point of delivery
revenue recognition. That is, no revenue is recognized
until the completed product is delivered. John’s argument is that the important factor
is the earnings process and that revenue should be recognized as the process takes
place.
John’s argument is correct. In situations when the earnings process takes place
over long periods of time, like long-term construction contracts, it is preferable to
recognize revenue during the earnings process, rather than to wait until the process is
complete.
Communication Case 5-15

Suggested Grading Concepts and Grading
Scheme:
Content (70%)
_________ 45 Income differences.
________ Percentage-of-completion recognizes gross profit during construction
based on an estimate of percent complete.
________ The completed contract method recognizes no gross profit until
project completion.
________ For both methods, estimated losses are fully recognized in the first period
the loss is anticipated.
_________ 10 Balance sheet differences.

The two methods are similar. However, for profitable projects, the
construction in progress account during construction will have a higher
balance when using the percentage-of-completion method due to the
inclusion of gross profit.
_________ 15 According to generally accepted accounting principles, the

percentage-of-completion method should be used in most situations. The completed
contract method distorts income when long-term projects span more than one
accounting period.
_______
_________ 70 points
Writing (30%)
_________ 6 Terminology and tone appropriate to the audience of a company
controller.
_________ 12 Organization permits ease of understanding.

_______ Introduction that states purpose.
_______ Paragraphs that separate main points.
_________ 12 English
_______ Sentences grammatically clear and well organized,
concise.
_______ Word selection.
_______ Spelling.
_______ Grammar and punctuation.
_______
_________ 30 points
Electrolux's revenue recognition policies for
International Case 5-16products and services are similar to revenue
recognition policies in the U.S. Sales of products are
recorded when goods have been put at the disposal of the customers in accordance
with agreed terms of delivery and when the risks and rewards of ownership have been
transferred to the buyer. The terminology is somewhat different, but the end results,
as compared to U.S. policies, should be similar in most cases.
A solution and extensive discussion

Trueblood Accounting Case 5-17materials can be obtained from the
Deloitte Foundation.
A solution and extensive discussion

Trueblood Accounting Case 5-18materials can be obtained from the
Deloitte Foundation.

Requirement 3
Real World Case 5-19 The following is from the 2006 10K of Jack in the
Box, Inc. The responses to the question will vary if the
company has since changed its revenue recognition policy.
a. These fees are recognized as revenue when the company has substantially
performed all of its contractual obligations. This policy agrees with SFAS No.
45 guidelines.
b. Continuing payments are based on a percentage of sales.
Requirement 4
Answers to this question will, of course, vary because students will research
financial statements of different companies. Likely candidates for comparison include
most of the fast-food chains such as McDonalds and Wendys.
This case encourages students to obtain hands-on

Analysis Case 5-20familiarity with an actual annual report and library sources
of industry data. They also must apply the techniques
learned in the chapter. You may wish to provide students with multiple copies of the
same annual reports and compare responses. Another approach is to divide the class
into teams who evaluate reports from a group perspective.
Apparently, a significant increase in assets occurred

Judgment Case 5-21during the last quarter. Total assets were $324 million and
now they total $450 million, as can be calculated as
follows:
Return on shareholders’ equity = Net income ÷ Shareholders’ equity = 14%
Shareholders’ equity = $21 million ÷ 14% = $150 million
Debt to equity ratio = Total liabilities ÷ Shareholders’ equity = 2
Total liabilities = $150 million x 2 = $300 million
Total assets = Total liabilities + Shareholders’ equity
= $300 million + 150 million = $450 million

Balance Sheet
Integrating Case 5-22 Case 5-22
Assets
Cash $ 15,000 given
Accounts receivable (net) 12,000 (e)
Inventory 30,000 (d)
Prepaid expenses and other current assets 3,000 (i)
Current assets 60,000 (h)
Property, plant, and equipment (net) 140,000 (j)
$200,000 (b)
Liabilities and Shareholders’ Equity
Accounts payable $ 25,000 (g)
Short-term notes 5,000 given
Current liabilities 30,000 (f)
Bonds payable 20,000 (l)
Shareholders’ equity 150,000 (k)
$200,000 (b)
Income Statement
Sales $300,000 (a)
Cost of goods sold (180,000) (c)
Gross profit 120,000 (c)
Operating expenses (96,000) (o)
Interest expense (2,000) (m)
Tax expense (7,000) (n)
Net income $ 15,000 given
(concluded)
Calculations ($ in 000s):
a. Profit margin on sales = Net income ÷ Sales = 5%
Sales = $15 ÷ 5% = $300
b. Return on assets = Net income ÷ Total assets = 7.5%
Total assets = $15 ÷ 7.5% = $200
c. Gross profit margin = Gross profit ÷ Sales = 40%
Gross profit = $300 x 40% = $120
Cost of goods sold = Sales – Gross profit = $300 – 120 = $180
d. Inventory turnover ratio = Cost of goods sold ÷ Inventory = 6
Inventory = $180 ÷ 6 = $30
e. Receivables turnover ratio = Sales ÷ Accounts receivable = 25
Accounts receivable = $300 ÷ 25 = $12
f. Acid-test ratio = Cash + AR + ST Investments ÷ Current liabilities = .9
Current liabilities = ($15 + 12 + 0) ÷.9 = $30
g. Accounts payable = Current liabilities – Short-term notes = $30 – 5 = $25
h. Current ratio = Current assets ÷ Current liabilities = 2
Current assets = $30 x 2 = $60
i. Prepaid expenses and other current assets =
Current assets – (Cash + AR + Inventory) = $60 – ($15 + 12 + 30) = $3
j. Property, plant, and equipment = Total assets – Current assets = $200 – 60 = $140
k. Return on shareholders’ equity = Net income ÷ Shareholders’ equity =10%
Shareholders’ equity = $15 ÷ 10% = $150
l. Debt to equity ratio = Total liabilities ÷ Shareholders’ equity = 1/3
Total liabilities = $150 x 1/3 = $50
Bonds payable = Total liabilities - Current liabilities = $50 - 30 = $20
m. Interest expense = 8% x (Short-term notes + Bonds )
Interest expense = 8% x ($5 + 20) = $2
n Times interest earned ratio = (Net income + Interest +Taxes) ÷ Interest = 12
Times interest earned ratio = ($15 + 2 + Taxes) ÷ 2 = 12
Times interest earned ratio = ($15 + 2 + Taxes) = 24
Tax expense = $24 – ($15 + 2) = $7
o. Operating expenses = (Sales – Cost of goods sold – Interest expense – Tax
expense) – Net income = ($300 - 180 - 2 - 7) - 15 = $96


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Chapter 5 Income Measurement and Profitability Analysis

AACSB assurance of learning standards in accounting and business education require

Questions AACSB Tags Exercises AACSB Tags

QUESTIONS FOR REVIEW OF KEY TOPICS

© The McGraw-Hill Companies, Inc., 2009

© The McGraw-Hill Companies, Inc., 2009

© The McGraw-Hill Companies, Inc., 2009

Receivables turnover ratio = Net sales

Inventory turnover ratio = Cost of goods sold

Asset turnover ratio = Net sales

Activity ratios are designed to provide information about a company’s effectiveness in

Profit margin on sales = Net income

Return on assets = Net income

Return on shareholders' = Net income

A fundamental element of an analyst’s task is to develop an understanding of a firm’s

© The McGraw-Hill Companies, Inc., 2009

Net income = Net income X Total sales X Ave. total assets

Brief Exercise 5-2 2009 Cost recovery % = Cost ÷ Sales:

2009 gross profit = 2009 cash collection of $150,000 x 60% = $90,000

Brief Exercise 5-3 No gross profit will be recognized in either 2009 or

Brief Exercise 5-4 Initial deferred gross profit ($3,000,000 – 1,200,000)

Brief Exercise 5-6 Total estimated cost to complete = $6 million + $9

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

First year revenue = $20,000,000 x 40% = $8,000,000

Brief Exercise 5-7 Assets:

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

Brief Exercise 5-8 Year 1 = 0

Brief Exercise 5-9 Year 1:

Brief Exercise 5-13

Return on assets = Net income

Shareholders’ equity, beginning of period $500,000

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

Brief Exercise 5-14

Return on = Profit X Asset turnover X Equity multiplier

Net income = Net income X Total sales X Ave. total assets

Profit margin = Net income

= 15.5% Asset Turnover =

© The McGraw-Hill Companies, Inc., 2009

Brief Exercise 5-15

Sales - Cost of goods sold = Gross profit

© The McGraw-Hill Companies, Inc., 2009

November 6, 2009 To record the cash collection

December 31, 2009 To recognize revenue earned in December (no

2010 Cost recovery %:

© The McGraw-Hill Companies, Inc., 2009

2010 gross profit:

2010 deferred gross profit balance:

2010 initial gross profit ($350,000 - 245,000) 105,000

2009 To record cash collections from installment sales

2009 To recognize gross profit from installment sales

© The McGraw-Hill Companies, Inc., 2009

2010 To record cash collections from installment sales

2010 To recognize gross profit from installment sales

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

© The McGraw-Hill Companies, Inc., 2009

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

To record cash collection from installment sale

July 1, 2010 To record cash collection from installment sale

© The McGraw-Hill Companies, Inc., 2009

July 1, 2009 To record installment sale

To record cash collection from installment sale

To recognize gross profit from installment sale

July 1, 2010 To record cash collection from installment sale

To recognize gross profit from installment sale