Chapter 6
Reporting and Analyzing Revenues and
Receivables
Learning Objectives – coverage by question
Miniexercises
14, 15, 17
LO1 – Describe and apply the
criteria for determining when revenue
is recognized.
LO2 – Illustrate revenue and
expense recognition when the
transaction involves future
deliverables.
Exercises
Problems
26, 27, 32,
Cases
47, 48, 49
39
17, 24, 25
39
46
48
13, 16
28, 29, 30
41
18, 19, 20,
33, 34, 35,
43, 44, 45
49
21, 23
36, 37
22
34, 38
44
49
27, 32, 34
42, 43, 44
47, 48
31
40
47
LO3 – Illustrate revenue and
expense recognition for long-term
projects.
LO4 – Estimate and account for
uncollectible accounts receivable.
LO5 – Calculate return on capital
employed, net operating profit after
taxes, net operating profit margin,
accounts receivable turnover, and
average collection period.
LO6 –Discuss earnings management
and explain how it affects analysis
and interpretation of financial
statements.
LO7 Appendix 6A – Describe and
illustrate the reporting for
nonrecurring items.
©Cambridge Business Publishers, 2011
Solutions Manual, Chapter 6
6-1
QUESTIONS
Q6-1. Revenue must be realized or realizable and earned before it can be
reported in the income statement. Realized or realizable means that the
company’s net assets have increased, that is, the company has received an
asset (for example, cash or accounts receivable) or satisfied a liability as a
result of the transaction. Earned means that the company has done
everything it must do under the terms of the sale.
For retailers, like Abercrombie & Fitch, revenue is generally earned when
title to the merchandise passes to the buyer (e.g., when the buyer takes
possession of the merchandise), because returns can be estimated. For
companies operating under long-term contracts, the earning process is
typically measured using the percentage-of-completion method, that is, by
the percentage of costs incurred relative to total expected costs.
Q6-2. Financial statement analysis is usually conducted for purposes of
forecasting future financial performance of the company. Discontinued
operations are, by definition, not expected to continue to affect the profits
and cash flows of the company. Accordingly, the financial statements
separately report discontinued operations from continuing operations to
provide more useful measures of financial performance and financial
income. For example, yielding an income measure that is more likely to
persist into the future, and a net assets measure absent discontinued
items.
Q6-3. In order for an event to be classified as an extraordinary item, its
occurrence must be both unusual and infrequent.
Items that are
considered to be both unusual and infrequent might be the destruction of
property by natural disaster or the expropriation of assets by a foreign
government in which the company operates. Gains and losses on early
retirement of long-term bonds, once comprising the majority of
extraordinary items, are no longer considered as such unless they meet the
tests outlined above. Other events not likely to be included as
extraordinary items include asset write-downs, gains and losses on the
sales of assets, and costs related to an employee strike.
Q6-4. Restructuring costs typically consist of two general categories: asset writedowns and accruals of liabilities. Asset write-downs reduce assets and are
recognized in the income statement as an expense that reduces income
and, thus, equity. Liability accruals create a liability, such as for anticipated
severance costs and exit costs, and yield a corresponding expense that
reduces income and equity.
Big bath refers to an event in which companies are perceived as
overestimating the amount of asset write-downs or liability accruals to
deliberately reduce current period earnings so as to remove future costs
from the balance sheet or to create ‘reserves’ that can be used to increase
future period earnings.
©Cambridge Business Publishers, 2011
6-2
Financial Accounting, 3rd Edition
Q6-5. Earnings management may be motivated by a desire to reach or exceed
previously stated earnings targets, to meet analysts’ expectations, or to
maintain steady growth in earnings from year to year. This desire to
achieve income goals may be motivated by the need to avoid violating
covenants in loan indentures or to maximize incentive-based
compensation.
The tactics used to manage income involve transaction timing (recognizing
a gain or loss) and estimations that increase (or decrease) income to
achieve a target.
Q6-6. Pro forma income adjusts GAAP income to eliminate (and sometimes add)
various items that the company believes do not reflect its core operations.
Such pro forma disclosures are only reported in earnings and press
releases and are not part of the published 10-Ks or other annual reports
provided for shareholders. The SEC requires that GAAP income be
reported together with pro forma income. Yet, companies often report their
GAAP income at the very end of the earnings or press release, thus
obfuscating their comparison and focusing attention on the pro forma
income.
It is because of this potential to confuse the reader about the true financial
performance of the company that the SEC has become concerned. Also,
pro forma numbers are not subject to accepted standards (and, thus, we
observe differing definitions across companies), are not subject to usual
audit tests, and are subject to considerable management latitude in what is
and is not included and how items are measured.
Q6-7. Estimates are necessary in order to accurately measure and report income
on a timely basis. For example, in order to record periodic depreciation of
long-lived assets, one must estimate the useful life of the asset. Estimates
allow accountants to match revenues and expenses incurred in different
periods. For example, accountants estimate warranty costs so that the
warranty expense is matched against the corresponding sales revenue. If
the accounting process waited until no estimates were necessary, there
would be a significant delay in the reporting of financial results.
Q6-8. When analysts publish earnings forecasts, these forecasts become a
benchmark against which some investors evaluate the company’s
performance. A company that fails to meet analysts’ forecasts may suffer a
stock price decline, even though earnings are higher than previous years’
earnings and overall performance is good. Consequently, management
may feel pressure to meet or slightly exceed analysts’ forecasts of
earnings.
©Cambridge Business Publishers, 2011
Solutions Manual, Chapter 6
6-3
Q6-9. Bad debts expense is recorded in the income statement when the
allowance for uncollectible accounts is increased. If a company
overestimates the allowance account, net income will be understated on
the income statement and accounts receivable (net of the allowance
account) will be underestimated on the balance sheet. In future periods,
such a company will not need to add as much to its allowance account
since it is already overestimated from that prior period (or, it can reverse
the existing excess allowance balance). As a result, future net income will
be higher.
On the other hand, if a company underestimates its allowance account,
then current net income will be overstated. In future periods, however, net
income will be understated as the company must add to the allowance
account and report higher bad debts expense.
Q6-10. There are several possible explanations for a decrease in the allowance
account. First, after an aging of accounts receivable, Wallace Company may
have determined that a smaller percentage of its receivables are past due.
Wallace Company may have changed its credit policy such that it is attracting
lower-risk customers than in the past. Second, experience may have
indicated that the percentages used to estimate uncollectibles was too high
in previous years. By correcting the estimated percentage of defaults, the
estimated uncollectibles would end up lower than in past years. Third,
Wallace Company may be managing earnings. By lowering estimated
uncollectibles, the company can increase current earnings, but may end up
reporting a loss in a future year when write-offs exceed the balance in the
allowance account.
Q6-11. Minimizing uncollectible accounts is not necessarily the best objective for
managing accounts receivable. That objective could be accomplished by not
offering to sell to customers on credit. The purpose of offering credit to
customers is to increase sales and profits. Losses from uncollectible
accounts are a cost of doing business. As long as the benefit (greater
contribution to profits due to increased sales) exceeds the cost (increased
losses due to uncollectibles) then a higher-risk credit policy which increases
the amount of uncollectible accounts would be a more profitable policy.
Q6-12. The number of defaults tends to rise and fall with the economy. For example,
in a recession, customers are more likely to default and companies take
longer, on average, to pay their bills than during a healthy economy. This
would result in higher estimated uncollectibles if the estimates are based on
an aging of accounts receivable.
For many companies, sales revenue also tends to decline during a recession.
If estimated uncollectibles are estimated as a percentage of sales, then the
estimate would tend to fall in a recession. This is contrary to the increase in
the number of defaults that occurs during a recession. Therefore, the
percentage of sales approach is not as sensitive to changing economic
conditions as is accounts receivable aging.
©Cambridge Business Publishers, 2011
6-4
Financial Accounting, 3rd Edition
MINI EXERCISES
M6-13 (15 minutes)
Note: The completed contract method is not required but is presented for the
purpose of comparison.
Percentage-of-Completion Method
Completed Contract
Percent
Revenue
Income
of total
recognized
(revenue
Costs
expected
(percentage of
– costs
Revenue
Year
incurred
costs
incurred)
recognized
Income
costs incurred 
(rounded)
total contract
amount)
2009
$ 400,000
21%a
$ 525,000
$125,000
0
0
2010
1,000,000
53%b
1,325,000
325,000
0
0
2011
500,000
26%c
650,000
150,000
$2,500,000 $600,000
$2,500,000
$600,000
$2,500,000 $600,000
Total $1,900,000
a
b
c
$400,000 / $1,900,000
$1,000,000/ $1,900,000
$500,000 / $1,900,000
M6-14 (20 minutes)
Company
GAP
Merck
Deere
Bank of
America
Johnson
Controls
Revenue recognition
When merchandise is given to the customer and returns can be
estimated (or the right of return period has expired).
When merchandise is given to the customer and returns can be
estimated (or the right of return period has expired). The company will
also establish a reserve and recognize expense relating to
uncollectible accounts receivable at the time the sale is recorded.
When merchandise is given to the customer and the right of return
period, if any, has expired. The company will also establish a reserve
and recognize expense for uncollectible accounts receivable and
anticipated warranty costs at the time the sale is recorded.
Interest is earned by the passage of time. Each period, Bank of
America accrues income on each of its loans and establishes a
receivable on its balance sheet.
Revenue is recognized under long-term contracts under the
percentage-of-completion method.
©Cambridge Business Publishers, 2011
Solutions Manual, Chapter 6
6-5
M6-15 (15 minutes)
The Unlimited can only recognize revenues once they have been earned and the
amount of returns can be estimated with sufficient accuracy. Assuming that
happens at the time of sale, it must estimate the proportion of product that is
likely to be returned and deduct that amount from gross sales for the period. In
this case, it would report $4.9 million in net revenue (98% of $5 million) for the
period. If The Unlimited does not have sufficient experience to estimate returns,
then it should wait to recognize revenue until the right of return period has
elapsed.
M6-16 (20 minutes)
a. Percentage-of-completion method:
Year
Percent completed
Revenue
Construction costs
Gross profit
2009
30%
$12,000,000
9,000,000
$3,000,000
2010
50%
$20,000,000
15,000,000
$5,000,000
2011
20%
$8,000,000
6,000,000
$2,000,000
$40,000,000
30,000,000
$10,000,000
b. Completed contract method:
Year
2009
2010
2011
Total
$40,000,000
30,000,000
$10,000,000
$40,000,000
30,000,000
$10,000,000
Revenue
Construction costs
Gross profit
Total
M6-17 (20 minutes)
a.
A.J. Smith should recognize the warranty revenue as it is earned. Since the
warranties provide coverage for three years beginning in 2010, one-third of
the revenue should be recognized in 2010, one-third in 2011, and the
remaining third in 2012.
b.
Year
Revenue
Warranty expenses
Gross profit
2010
$566,666
166,666
$400,000
2011
$566,667
166,667
$400,000
2012
$566,667
166,667
$400,000
Total
$1,700,000
500,000
$1,200,000
©Cambridge Business Publishers, 2011
6-6
Financial Accounting, 3rd Edition
M6-17—continued
c. Total revenue from sales of the camera packages is $79,800 ($399 x 200). The
revenue is allocated among the three elements of the sale (camera, printer and
warranty) as follows:
Element
Camera
Printer
Warranty
Total
Retail price
$300
125
75
$500
Proportion of total
60% ($300/$500)
25% ($125/$500)
15% ($75/$500)
100%
Using these proportions, the revenue is allocated among the three elements
and recognized for each element as it is earned. In this case, the portion of
the revenue allocated to the camera and printer are recognized immediately,
while the revenue allocated to the warranty is deferred and recognized over
the three-year warranty coverage period.
Year
2010
2011
2012
2013
Total
Revenue
$67,830
3,990
3,990
3,990
$79,800
($79,800 x .6 + $79,800 x .25)
($79,800 x .15 / 3)
M6-18 (15 minutes)
a. To bring the allowance to the desired balance of $2,100, the company will need
to increase the allowance account by $1,600, resulting in bad debt expense of
that same amount.
b. The net amount of Accounts Receivable is calculated as follows: $98,000 
$2,100 = $95,900.
c.
- Allowance for Doubtful Accounts (XA) +
500
Balance
1,600
(a)
2,100
Balance
(a)
Balance
+ Bad Debt Expense (E) 1,600
1,600
©Cambridge Business Publishers, 2011
Solutions Manual, Chapter 6
6-7
M6-19 (15 minutes)
a. Credit losses are incurred in the process of generating sales revenue. Specific
losses may not be known until many months after the sale. A company sets up
an allowance for uncollectible accounts to place the expense of uncollectible
accounts in the same accounting period as the sale and to report accounts
receivable at its estimated realizable value at the end of the accounting period.
b. The balance sheet presentation shows the gross amount of accounts
receivable, the allowance amount, and the difference between the two, the
estimated net realizable value. The balance sheet, thus, reports the net amount
that we expect to collect. That is the amount that is the most relevant to
financial statement users.
c. The matching concept requires that expenses (credit losses) related to a given
revenue be matched with, and deducted from, the revenue in the
determination of net income. This dictates the use of the allowance method.
Recognition of expense only upon the write-off of the account would delay the
reporting of our knowledge that losses are likely and, thereby, reduce the
informativeness of the income statement. Accountants believe that providing
more timely information justifies the use of estimates that may not be as
precise as we would like.
M6-20 (20 minutes)
a.
($ millions)
2008
2007
Accounts receivable (net) .......................................... $4,704
Allowance for uncollectible accounts ......................
$5,197
129
94
Gross accounts receivable ........................................ $4,833
$5,291
Percentage of uncollectible accounts to
2.67%
gross accounts receivable .....................................
($129/$4,833)
1.78%
($94/$5,291)
b. The increase in the allowance for uncollectible accounts as a percentage of
gross accounts receivable may indicate that the quality of the accounts
receivable has declined, perhaps because the economy has deteriorated, the
company is selling to a less creditworthy class of customers, or the
company’s management of accounts receivable is less effective. It may also
indicate, however, that the receivables were under-reserved (e.g., allowance
account was too low last year). This would result in lower reported profits in
the current year because past profits were too high.
©Cambridge Business Publishers, 2011
6-8
Financial Accounting, 3rd Edition
M6-21 (10 minutes)
Bad debt expense of $2,400 ($120,000 × 0.02) would cause the allowance for
uncollectibles to increase by the same amount. If the allowance increased by
only $2,100 for the period, Sloan Company must have written off accounts
totaling $300. Under accounts receivable, sales revenue increased the
account by $120,000, and the write offs would decrease it by $300. If there
was a net increase of $15,000 for the period, Sloan Company must have
collected $104,700 in cash. ($104,700 = $120,000 - $300 - $15,000.)
M6-22 (20 minutes)
a.
Accounts Receivable Turnover rates for 2009
Procter & Gamble
$76,029 / [($5,836+$6,761)/2] = 12.07
Colgate-Palmolive
$15,330 / [($1,592+$1,681)/2] = 9.37
b. P&G turns its accounts receivable much faster than Colgate-Palmolive.
Receivable turns typically evolve to an equilibrium level for each industry that
arises from the general business models used by industry competitors.
Differences can arise due to variations in the product mix of competitors, the
types of customers they sell to, their willingness to offer discounts for early
payment, and their relative strength vis-à-vis the companies or individuals
owing them money. Both of these companies sell a significant amount of their
product to Wal-Mart. P&G is a sizable company, and may have greater
bargaining power over Wal-Mart than does the smaller Colgate-Palmolive.
One other possibility is that the difference is due to the companies’
differing fiscal year-ends. If the receivable balance is not constant
during the year due to some seasonality, then the receivable turnover
ratio will depend on the choice of fiscal year.
©Cambridge Business Publishers, 2011
Solutions Manual, Chapter 6
6-9
M6-23 (20 minutes)
a.
i.
Accounts receivable (+A) ………………………………………
Sales revenue (+R, +SE) …………………………………
ii.
iii.
iv.
3,200,000
3,200,000
Bad debts expense (+E, -SE) …………………………………
Allowance for uncollectible accounts (+XA, -A)…
42,000
Allowance for uncollectible accounts (-XA, +A) ……
Accounts receivable (-A) …………………………………
39,000
Accounts receivable (+A) ………………………………………
Allowance for uncollectible accounts (+XA, -A)
12,000
Cash (+A)
………………………………………………………
Accounts receivable (-A) …………………………………
12,000
42,000
39,000
12,000
12,000
The recovered receivable is reinstated, so that its payment may be properly
recorded.
b. Besides the $12,000 in recovery, the collections from customers can be
summarized in the following entry:
v.
Cash (+A)
Accounts receivable (-A)
2,926,000
2,926,000
(This amount includes payment of the recovered receivable for $12,000. The
allowance increases by $15,000 over the period, so the fact that net
receivables increased by $220,000 means that gross receivables must have
increased by $235,000. That fact allows us to “back out” the cash received.)
c.
+
(iv)
(v)
(i)
(iv)
(iii)
Cash (A) 12,000
2,926,000
2,938,000
+ Accounts Receivable (A) 3,200,000
12,000
39,000
12,000
2,926,000
235,000
Allowance for Uncollectibles (XA)
42,000
39,000
12,000
15,000
-
+
(ii)
Sales Revenue (R) +
3,200,000
Bad Debts Expense (E)
42,000
(i)
-
(iii)
(iv)
(v)
+
(ii)
(iv)
©Cambridge Business Publishers, 2011
6-10
Financial Accounting, 3rd Edition
d.
Balance Sheet
Transaction
Cash
Asset
i. Sales on
account.
Noncash
+ Assets
+3,200,000
Accounts Receivable
ii. Bad debt
expense.
iv. Reinstate
account
previously
written off.
v. Collect
cash on
sales.
Liabil=
ities
=
+42,000
- Allowance for =
Uncollectible
Accounts
iii. Write-off
of
uncollectible
accounts.
Collect
reinstated
account.
Contra
Assets
+12,000
Cash
+2,926,000
Cash
Income Statement
+
Contrib.
Capital
Earned
+
Capital
+3,200,000
Retained
Earnings
- Expenses = Net Income
+3,200,000
Sales
Revenue
-
= +3,200,000
-
+42,000
Bad Debt =
Expense
-39,000
-39,000
Accounts - Allowance for =
Receivable
Uncollectible
Accounts
-
=
+12,000
+12,000
Accounts - Allowance for
Uncollectible
Receivable
Accounts
-
=
-12,000
Accounts Receivable
-
=
-
=
-2,926,000
Accounts Receivable
=
-42,000
Retained
Earnings
Revenues
©Cambridge Business Publishers, 2011
Solutions Manual, Chapter 6
6-11
-42,000
M6-24 (15 minutes)
a.
Fiscal year
2007
2008
2009
2010
Revenue
48,000
55,000
62,000
62,000
Revenue growth
14.6%
12.7%
0.0%
b.
Fiscal Revenue
year
2007
2008
2009
2010
c.
48,000
55,000
62,000
62,000
Unearned revenue Purchases = Revenue + Change Growth in
liability (end of
in Unearned revenue liability
purchases
year)
20,000
24,000
55,000 + 4,000 = 59,000
26,000
62,000 + 2,000 = 64,000
8.5%
25,000
62,000 - 1,000 = 61,000
-4.7%
In both fiscal year 2009 and 2010, the growth in customer purchases is
lower than the growth in reported revenues. The practice of deferring
revenue recognition implies that reported revenues in a given period are
the result of customer purchases over many periods, resulting in a
smoothing of revenues. In the case of Finn Publishing, revenues in any
given year are the result of newsstand and bookstore purchases during
that year, plus part of the subscriptions from that year, plus part of the
subscriptions from the previous year. That means that growth in annual
revenues is a composite of growth in customer purchases over an even
longer period of time.
For 2009 and 2010, Finn’s growth in revenues exceeds the growth in
purchases because the revenues are still reflecting growth from prior
periods. Purchases are a “leading indicator” of revenues, and calculating
purchase behavior can be useful in forecasting future revenue and
identifying changes in customers’ attitudes about a company’s current
offerings.
M6-25 (20 minutes)
This question is based on an actual situation, in which the accounting rules were
influencing the product decisions. The rules for revenue deferral when there are
multiple deliverables deterred the company from providing enhancements and
upgrades that were available. If Commtech’s customers (the wireless companies)
had been willing to pay for the upgrades to its customer’s phones, that would
have been allowed. (It’s not clear what the wireless companies’ incentives would
be, because they may want to encourage users to purchase new phones – with a
new service contract – rather than improving their existing phones.)
©Cambridge Business Publishers, 2011
6-12
Financial Accounting, 3rd Edition
M6-25—continued.
The question can generate a discussion about whether accounting should drive
decisions. Whether it should or not, it does, so the question should evolve into
what top management should do about this type of situation. Does the situation
described in the problem require some managerial action, or not. Is the company
foregoing sales because of its accounting? Within Commtech, the finance staff
was skeptical of marketing’s predictions that the upgrades and enhancements
would increase the sales of existing phone models. If the upgrades and
enhancements are delivered, Commtech will have to change its accounting for
revenue, with a resulting decrease in near-term profitability. How might the
company communicate that change in a way that the investing public will
understand as a net benefit to the company?
©Cambridge Business Publishers, 2011
Solutions Manual, Chapter 6
6-13
EXERCISES
E6-26 (20 minutes)
Company
The Limited
Boeing
Corporation
SUPERVALU
MTV
Real estate
developer
Wells Fargo
HarleyDavidson
Time-Warner
Revenue recognition
When merchandise is given to the customer and returns can be
estimated (or the right of return period has expired).
Revenue is recognized under long-term contracts under the
percentage-of-completion method.
When merchandise is given to the customer and cash is received.
When the content is aired by the TV stations.
When title to the houses is transferred to the buyers.
Interest is earned by the passage of time. Each period, Wells
Fargo accrues income on each of its loans and establishes an
account receivable on its balance sheet.
When title to the motorcycles is transferred to the buyer. Harley
will also set up a reserve for anticipated warranty costs and
recognize the expected warranty cost expense when it recognizes
the sales revenue.
When the magazines are sent to subscribers.
E6-27 (20 minutes)
Company
Real Money
Oracle
Intuit
Computer
game
developer
Revenue recognition
Recognize revenue ratably over the period of time that
customers can access its Web site, not when the cash is
received. The recognition of revenue is dependent upon Real
Money providing updates.
The fee to purchase the right to use the software can be
recorded as revenue when the software is installed, unless that
fee includes future deliverables like upgrades and support. (If
such post-sale services are included in the fee, some portion
must be deferred and recognized over the appropriate period.)
Service revenue can only be recognized ratably over the period
of time covered by the service contract.
Recognize revenue when the software is sent to customers. The
company must estimate potential warranty claims and establish
a reserve for them when revenue is recorded.
Record revenue after the 10-day right of return period has
elapsed.
©Cambridge Business Publishers, 2011
6-14
Financial Accounting, 3rd Edition
E6-28 (20 minutes)
a.
($ millions)
Year
Costs
incurred
Percentage-of-Completion Method
Revenue recognized
Percent
Income
(percentage of costs (revenue
of total
incurred  total
expected
– costs
contract amount)
costs
incurred)
Completed Contract
Revenue
recognized
2010
$100
25%
$125
$ 25
2011
300
75%
375
75
500
100
$500
$100
$500
$100
$400
$
0
Income
$
0
b.
($ millions)
Year
Installment Method
Cash
collected
Revenue
recognized
Expense recognized
[Revenue  1- gross
profit margin (20%)]
Income
(Revenue  20%)
2010
$300
$300
$240
$ 60
2011
200
200
160
40
$500
$500
$400
$100
c. The percentage-of-completion method normally provides a reasonable
estimate of the revenues, expenses, and income earned for each period. A key
is obtaining good estimates of expected costs and costs to date. This method
is also acceptable under GAAP for contracts spanning more than one
accounting period, such as in the consulting and transportation industries.
©Cambridge Business Publishers, 2011
Solutions Manual, Chapter 6
6-15
E6-29 (20 minutes)
a.
($ millions)
Year
Costs
incurred
2010
$15
2011
40
2012
30
$85
Percentage-of-Completion Method
Revenue recognized
Percent
Income
(percentage of costs (revenue
of total
incurred  total
expected
– costs
contract amount)
costs
incurred)
(rounded)
18%
$ 21.6
$ 6.6
($15/$85)
47%
56.4
16.4
($40/$85)
35%
42.0
12.0
($30/$85)
$120.0
$35.0
($ millions)
Year
Completed Contract
Revenue
recognized
$
Income
0
$
0
0
0
120
35
$120
$ 35
Installment Method
Cash
collected
Revenue
recognized
Expense recognized
[Revenue  1- gross
profit margin (29.17%)]
Income
(Revenue  29.17%)
2010
$30
$30
$21.25
$ 8.75
2011
50
50
35.42
14.58
2012
40
40
28.33
11.67
$120
$120
$85.00
$35.00
b. The percentage-of-completion method provides a good estimate of the
revenue and income earned in each period. This method is also acceptable
under GAAP for contracts spanning more than one accounting period.
Recognition of revenue and income is not affected by the cash received,
except under the installment method.
E6-30 (15 minutes)
a.
Year
2010
Revenue
$1,000,000
Cost of
software*
180,000
Gross profit
$820,000
2011
$750,000
2012
$500,000
2013
$250,000
Total
$2,500,000
135,000
$615,000
90,000
$410,000
45,000
$205,000
450,000
$2,050,000
* $180,000 = $450,000 x $1,000,000/$2,500,000
$135,000 = $450,000 x $750,000/$2,500,000
$90,000 = $450,000 x $500,000/$2,500,000
$45,000 = $450,000 x $250,000/$2,500,000
©Cambridge Business Publishers, 2011
6-16
Financial Accounting, 3rd Edition
E6-30—continued.
b. By 2012, Bryant had recognized gross profit of $1,435,000 ($820,000 +
$615,000). However, only $315,000 ($180,000 + $135,000) of the software cost
had been recognized. If none of the remaining cost was recoverable after the
default, Bryant would recognize a loss equal to the remaining cost in 2012.
Hence, Bryant would record a loss in 2012 of $135,000 ($90,000 + $45,000).
E6-31 (15 minutes)
a.
Balance Sheet
Transaction
Cash
Asset
a. To record
restructuring loss
-159
Income Statement
Noncash
LiabilContrib.
+
=
+
+
Assets
ities
Capital
Earned
Capital
Net
Revenues - Expenses =
Income
-186
+198
-543
+ 543
Plant
Assets, etc.
Liability
for
Restructuring
Retained
Earnings
Loss due to
Restructuring
=
-
-543
=
Loss due to restructuring
543
Plant assets, etc.*
186
Cash
159
Liability for restructuring
198
* The credit to plant assets would most likely be recorded in a contra asset
account.
+ Cash (A) 159
(a)
+ Loss Due to Restructuring (E) 543
(a)
+ Plant Assets (A) 186
(a)
- Liability for Restructuring (L) +
198
(a)
b. Restructuring charges should not be classified as discontinued operations.
The term discontinued operations refers to discontinuing a component of the
company with separately identifiable operations and cash flows.
Restructuring charges generally do not meet this definition. However,
restructuring charges are a transitory component of income and, if material,
should be reported separately in the income statement (which PepsiCo does
not).
©Cambridge Business Publishers, 2011
Solutions Manual, Chapter 6
6-17
E6-32 (15 minutes)
In none of these cases should Simpyl Technologies recognize revenue. Each
of the four settings touches on one of the four conditions for revenue
recognition listed by the SEC. In part a, “persuasive evidence of an exchange
agreement” does not yet exist, because the company’s policies have defined a
contract with authorized signatures to constitute persuasive evidence. In part
b, delivery has not occurred. The product has been shipped, but not to the
customer and not with the specified customizations that are required by the
customer. In part c, the price is not yet fixed or determinable, because the
negotiations over volume discounts have not been concluded. Finally, the
distributor in part d does not have the means to pay for the items delivered, so
collectibility cannot be reasonably assured (until the distributor sells the
product to an end customer).
The delivery should be viewed as a
consignment arrangement, in which Simpyl recognizes revenue when the
distributor sells the items to a third party.
This problem is based on the restatements of Symbol Technologies, Inc.’s 10K filing for fiscal year 2002, in which they detail the errors and irregularities in
financial statements dating back to 1998. Symbol had made accounting
entries that violated each of the SEC’s four criteria for revenue recognition.
An article by Steve Lohr describing the incoming CEO’s experiences at
Symbol Technologies can be found in the New York Times, June 21, 2004. The
title of the article is “Day 2: I Learn the Books are Cooked.” (Motorola, Inc.,
acquired Symbol Technologies in January 2007 for a price of $3.9 billion.)
E6-33 (20 minutes)
a. Prior to the aging of accounts, the balance in the Allowance for Uncollectible
Accounts would be a credit of $520 (the opening balance of $4,350 less the
amounts written off of $3,830).
2010 bad debt expense computation
$250,000 × 0.5%
$90,000  1%
20,000  2%
11,000  5%
6,000  10%
4,000  25%
Less: Unused balance before adjustment
Bad debt expense for 2010
=
=
=
=
=
=
$1,250
900
400
550
600
1,000
4,700
520
$4,180
b. Accounts receivable, net = $381,000 - $4,700 = $376,300
Reported in the balance sheet as follows:
Accounts receivable, net of $4,700 in allowances ..............................
$376,300
©Cambridge Business Publishers, 2011
6-18
Financial Accounting, 3rd Edition
c.
+
(a)
Bad Debts Expense (E)
-
4,180
-
Allowance for Uncollectible Accounts (XA)
+
4,350
Balance
Write-offs
3,830
4,180
(a)
4,700
Balance
E6-34 (35 minutes)
a.
Allowance for doubtful accounts (-XA)
Accounts receivable (-A)
400
400
Allowance for doubtful accounts (-XA)
773
Provision for doubtful accounts (-E,+SE)
773
The latter entry is the reverse of the normal one (and reversed from previous
years). The provision for doubtful accounts (bad debt expense) has a credit
entry that has the effect of increasing Ethan Allen’s reported income by $773
(thousand) for the year.
b. and c.
2009
From the income statement:
Net sales
From the balance sheet:
Accounts receivable, net
$674,277
2008
2007
$980,045 $1,005,312
13,086
12,672
14,602
2,535
(773)
(400)
1,362
2,042
493
–
2,535
2,074
10
(42)
2,042
Gross receivables (net plus allowance)
14,448
15,207
16,644
Allowance as a % of gross receivables
9.4%
16.7%
12.3%
52.4
71.9
From the disclosure on Allowance for doubtful
accounts:
Balance at beginning of period
Additions (reductions) charged to income
Adjustments or deductions
Balance at end of period
Accounts receivable turnover (Sales ÷ Average
AR, net)
©Cambridge Business Publishers, 2011
Solutions Manual, Chapter 6
6-19
Ethan Allen’s allowance was 16.7% of its gross receivables at the end of 2008.
If that percentage were applied to the 2009 gross receivables, it would produce
an allowance of $2,408 (14,448×16.7%) which is $1,046 higher than the amount
in Ethan Allen’s allowance at the end of 2009. Bad debt expense (provision for
doubtful accounts) would have been higher by this amount if the same
percentage were applied.
d. Accounts receivable started with a balance of $15,207 and was increased by
$674,277 in net sales. The account was decreased by write-offs of $400, and
ended with a balance of $14,448. Therefore, the amount collected must have
been $674,636 ($15,207 + $674,277 - $400 - $14,448).
e. The patterns in Ethan Allen’s allowance account are unusual. In 2008, the
company recorded a large bad debt expense relative to previous years, but
wrote off no accounts. In 2009, the company wrote off some accounts (less
than 3% of the opening balance), and then reduced its allowance by debiting it
and crediting income. Perhaps the company was overly pessimistic about its
collections in 2008 and became much more optimistic in 2009. That is not the
experience of many companies in this time period.
The very fast ART is probably due to the custom furniture aspect of Ethan
Allen’s business. Many of their products are not produced until a customer
places an order, so payment occurs very soon after delivery.
E6-35 (20 minutes)
Accounts receivable
Less Allowance for uncollectible accounts
$138,100
10,384
$127,716
Computations
Accounts
Receivable
Beginning balance
Sales
Collections
Write-offs ($3,600 + $2,400 +$900)
Provision for uncollectibles ($1,173,000  0.8%)
$ 122,000
1,173,000
(1,150,000)
(6,900)
_________
$ 138,100
Allowance for
Uncollectible Accounts
$ 7,900
(6,900)
9,384
$ 10,384
©Cambridge Business Publishers, 2011
6-20
Financial Accounting, 3rd Edition
E6-36 (20 minutes)
a.
Aging schedule at December 31, 2010
Current $304,000  1% =
$ 3,040
0–60 days past due 44,000  5% =
2,200
61–180 days past due 18,000  15% =
2,700
Over 180 days past due 9,000  40% =
3,600
Amount required
11,540
Balance of allowance
4,200
Provision
$ 7,340 = 2010 bad debt expense
b.
Current Assets
Accounts receivable
Less: Allowance for uncollectible accounts
$375,000
11,540
$363,460
c.
+
(a)
Bad Debts Expense (E)
7,340
-
- Allowance for Uncollectible Accounts (XA) +
4,200
Balance
7,340
(a)
11,540
Balance
E6-37 (30 minutes)
a.
Year
2009
2010
2011
Total
Sales
$ 751,000
876,000
972,000
$2,599,000
Collections
$ 733,000
864,000
938,000
$2,535,000
Accounts Written Off
$ 5,300
5,800
6,500
$17,600
Accounts Receivable at the end of 2011 is:
$46,400, computed as ($2,599,000 - $2,535,000 - $17,600).
Bad Debts Expense is:
2009
2010
2011
2009-2011
$ 7,510
8,760
9,720
$25,990
computed as 1%  $751,000
computed as 1%  $876,000
computed as 1%  $972,000
computed as 1%  $2,599,000
Allowance for Uncollectible Accounts is:
$8,390, computed as $25,990 total bad debts expense less $17,600 in total
write-offs.
©Cambridge Business Publishers, 2011
Solutions Manual, Chapter 6
6-21
E6-37—continued.
b.
Accounts Receivable (A)
Beg Bal
0
Sales
751,000
5,300
733,000
2009 Bal
Sales
Allowance for Uncollectibles (XA)
0
Beg Bal
Bad debts
Write offs
5,300 7,510
expense
Write offs
Collections
12,700
876,000
2,210
5,800
864,000
2010 Bal
18,900
Sales
972,000
2011 Bal
46,400
Write offs
Write offs
5,800
8,760
Collections
5,170
6,500
938,000
2009 Bal
Bad debts
expense
Write offs
Write offs
6,500
9,720
2010 Bal
Bad debts
expense
Collections
8,390
2011 Bal
There isn’t any indication that the 1% rate is incorrect. If the rate is too high,
we would expect the allowance to grow at a faster rate than receivables. If
the rate is too low, the opposite would occur. In this case, the allowance
percentage of receivables is 17%, 27% and 18% at the end of 2009, 2010 and
2011, respectively. So, there is no clear direction that would indicate an
inappropriate estimate.
E6-38 (20 minutes)
a.
Earnings
from
operations
Technology Solutions
Group
Personal Systems
Group
Imaging and Printing
Group
HP Financial Services
$
End.
Assets
Beg.
Assets
Avg.
Assets
ROCE
5,529
$ 63,008
$ 39,116
$ 51,062
10.8%
2,375
16,451
14,153
15,302
15.5%
4,590
14,203
14,573
14,388
31.9%
192
9,174
9,001
9,088
2.1%
©Cambridge Business Publishers, 2011
6-22
Financial Accounting, 3rd Edition
b.
Earnings
from
operations
Technology Solutions
Group
Personal Systems
Group
Imaging and Printing
Group
HP Financial Services
c.
NOPAT=(10.2)×Earnings
from Opns
Revenues
NOPM
$5,529
$4,423
$44,826
9.9%
2,375
1,900
42,295
4.5%
4,590
3,672
29,385
12.5%
192
154
2,698
5.7%
The most profitable group seems to be the Imaging and Printing Group,
which represent’s HP’s traditional strength. However, it is not growing
very quickly (sales percentage increases in the single digits). The Personal
Systems Group (commercial and personal PCs, workstations, etc.) has
good ROCE, even though its NOPM is not high, because it has high asset
turnover. The Technology Solutions Group (including the newly-acquired
EDS consulting business) has substantial assets, which reduce the ROCE,
but it is the area of highest growth.
E6-39 (20 minutes)
a.
Just like for-profit organizations, not-for-profit organizations cannot
recognize revenue until it has been earned. In the case of The Lyric Opera,
it cannot recognize the ticket revenue until the performances occur. (The
Lyric does not issue quarterly reports, so we cannot observe how much of
the revenue has been earned by six months through its fiscal year.)
b.
This entry is simplified by the fact the fiscal year-end is after the end of the
current season and by assuming that all of The Lyric’s deferred revenue
relates to the following season (and none to any years after the following
season).
To record revenue for the fiscal year 2009 season:
Deferred ticket and other revenue (-L)
17,246
Cash or Accounts receivable (+A)
10,805
Ticket sales (+R, +NA)
28,051
(As a not-for-profit, The Lyric Opera does not have shareholders’ equity,
but rather “net assets.” Therefore, the recognition of revenue increases
net assets (NA) on the balance sheet.)
To record advance purchases for the fiscal year 2010 season:
Cash or Accounts receivable (+A)
13,103
Deferred ticket and other revenue (+L)
13,103
©Cambridge Business Publishers, 2011
Solutions Manual, Chapter 6
6-23
c.
d.
It’s likely that the downturn in the economy caused some subscribers not
to renew (or to wait until after April 30 to renew). It’s possible that the
decline in advance purchases is a statement about the opera selections for
the 2009-10 season. However, the loyal subscriber base (and the desire to
keep one’s assigned seating) makes the economy a more likely cause.
The Lyric Opera usually operates at close to seating capacity. And, in a
typical year, approximately 60% of its seats are sold by the April 30th
preceding the season. So, the quantity of unsold seats will affect The
Lyric’s marketing efforts for subscribers who have not yet renewed,
outreach to new potential subscribers and promotions for individual tickets
which go on sale shortly before the season. Those efforts can be scaled
up or down depending on the experience with advance sales.
©Cambridge Business Publishers, 2011
6-24
Financial Accounting, 3rd Edition
PROBLEMS
P6-40A (20 minutes)
a. The following items might be considered to be operating:
1. Net Sales, cost of sales, R&D expenses, and SG&A expenses are typically
designated as operating.
2. Amortization of intangible assets and restructuring charges would usually be
considered to be operating under the assumptions that the acquisition that
gave rise to the intangible assets is included as part of operations, and that
the restructuring did not involve discontinuation of distinct parts of the
business.
3. The asbestos-related credit would be considered to be operating since it is
related to Dow Chemical’s operating activities. The same is true of the
goodwill impairment losses. (These items are both operating and transitory –
see b.)
4. Purchased in-process research and development charges and Acquisitionrelated expenses are caused by the company’s investing activities, and would
be considered nonoperating.
5. Equity in earnings of nonconsolidated affiliates would be considered
operating under the assumption that the affiliates are related to Dow’s core
operations, which is typically the case.
6. Sundry income would generally be considered nonoperating in the absence of
a footnote clearly indicating its connection to the operating activities of the
company.
7. Interest income (expense) is considered nonoperating
8. Minority interests’ share in income is nonoperating as it relates to equity that
is nonoperating. Due to changes discussed in Chapter 12, Dow’s 2009 income
statement will not show Minority interest in the determination of net income.
b. The following items might be identified as transitory items:
1. Purchased in-process research and development and Acquisition-related
expenses – these are one-time (e.g., transitory) costs incurred in connection
with the acquisition of another company and can properly be expensed under
GAAP.
2. Asbestos-related credit – this is a reversal of a previous accrual for litigation
in connection with asbestos-related lawsuits. GAAP requires such an accrual
if the loss is probable and can be reasonably estimated. Since it is a one-time
occurrence, it can be considered to be a transitory item.
3. Goodwill impairment losses – this loss results from changes in expectations
of the performance of past acquisitions. It would be considered operating, but
transitory.
4. Restructuring charges – these relate to the company’s actions due to the
economic decline in 2008 and the expectations that future performance will
©Cambridge Business Publishers, 2011
Solutions Manual, Chapter 6
6-25
not meet prior expectations. Restructuring costs are considered “special
items,” meaning that individually they are transitory, but as a category, they
happen frequently. (Dow had restructuring charges – from other causes – of
$578 million and $591 million in 2007 and 2006, respectively.)
We would need to examine prior years’ income statements to discern if the other
categories in Dow’s income statement are to be considered transitory.
P6-41 (20 minutes)
a.
1. Percentage-of-completion based on number of employees trained
Year
2010
2011
2012
Total
Number of employees
trained
125
200
75
400
Revenues (# trained x
$1,200)
$150,000.00 $240,000.00 $90,000.00 $480,000.00
Expenses (# trained x
$437.50)*
54,687.50
87,500.00
32,812.50
175,000.00
Gross Profit
$95,312.50 $152,500.00 $57,187.50 $305,000.00
* $437.50 = $175,000 / 400
2. Percentage-of-completion based on costs incurred
Year
2010
2011
2012
Costs incurred
$60,000
$75,000
$40,000
Percentage completed
34.29%
42.86%
22.86%
Revenues (% x
$480,000)
$164,571.43 $205,714.29 $109,714.29
Expenses
60,000.00
75,000.00
40,000.00
Gross Profit
$104,571.43 $130,714.29 $69,714.29
3. Completed contract method
Year
Revenues
Expenses
Gross Profit
2010
$0
0
$0
2011
$0
0
$0
2012
$480,000
175,000
$305,000
Total
$175,000
100.00%
$480,000.00
175,000.00
$305,000.00
Total
$480,000
175,000
$305,000
b. Assuming that (1) Philbrick has a noncancelable contract that specifies the
price at $1,200 per employee, (2) the number of employees and the costs of
training can be estimated with a reasonable degree of accuracy, and (3) Elliot
Company is a reasonable credit risk, the best method would be to recognize
revenues using the percentage-of-completion method based on the number of
employees trained. The completed contract method should only be used if
either of the first two conditions is not met.
©Cambridge Business Publishers, 2011
6-26
Financial Accounting, 3rd Edition
P6-42 (15 minutes)
a. Management would have an incentive to shift $1 million of income from the
current period into next. This might be accomplished by delaying revenue
recognition or accelerating expenses. This would increase their bonus by
$100,000 next year without decreasing the current bonus.
b. Management would have an incentive to shift $3 million of income from next
year into income reported this year. This would increase the current year
bonus by $300,000 without reducing next year’s bonus.
c. Management would have an incentive to shift income from the current year
into next year. Even though this would reduce earnings this year, earnings
are already so low that management does not expect to receive a bonus.
Shifting earnings into a future period increases the bonus in that period.
d. These incentives for earnings management would be mitigated if the “kinks”
in the bonus formula were removed. Alternatively, some companies pay
bonuses based on a three-year moving average of earnings to minimize the
impact of earnings management.
This problem can provide an opportunity to discuss the “slippery slope” of
earnings management. For example, management’s optimism about next year in
part b may not turn out to be warranted. Suppose next year’s “natural” earnings
turns out to be $20 million instead of $24 million. Management’s action in the
first year will have reduced next year’s $20 million to $17 million, and earnings
management would again be required to meet the target. And, if meeting the
target in one year causes the next year’s target to increase, things can get out of
control very quickly.
©Cambridge Business Publishers, 2011
Solutions Manual, Chapter 6
6-27
P6-43 (30 minutes)
a.
2007: $61,471 million ÷ $7,275 million = 8.45.
2006: $57,878 million ÷ $6,161 million = 9.39.
Customers appear to be paying more slowly in 2007 than in 2006. In 2007,
the average customer is taking about a month and a half to pay (and about 4
days longer than in 2006).
b.
Accounts receivable, net, is $8,054 million (=$8,624 million - $570 million).
c.
To record the bad debt provision:
Bad debt provision (+E, -SE)
Allowance for doubtful accounts (+XA, -A)
481
To record write-offs of receivables:
Allowance for doubtful accounts (-XA, +A)
Accounts receivable (-A)
428
481
428
d.
There are two items of information that conflict with the drop from 7.7% to
6.6%. First, the write-offs as a percentage of average receivables is going up
from 5.1% to 5.9%. Second, the information on past due accounts (basically
an aging analysis) indicates that the percentage of Target’s receivables that
are significantly past due has been increasing. In any normal aging of
accounts analysis, that would lead to an increased allowance as a
percentage of the receivables balance.
e.
There are quite a few reasons that might account of the disparity in part d.
For example, it could be that Target has changed its credit policies in the
middle of 2007. So, there is a “holdover” of late accounts, but Target
expects that the remainder of the accounts will have a better rate of
collection than they have experienced in the past.
However, one must consider the possibility of earnings management.
Target’s pretax earnings were $4,625 million in 2007 and $4,497 million in
2006, an increase of $128 million. If Target had kept its allowance at 7.7% of
gross accounts receivables, it would have needed an allowance of $664
million and an increase in its bad debt provision (and a decrease in pretax
income) of $94 million ($664 million - $570 million), reducing the already
modest increase in income. In fact, if the allowance were anything over
about 8.1% of receivables, the change in pretax income would have been
negative.
Postscript:
In fiscal year 2008, the estimates used for uncollectible accounts changed
significantly. The 2008 bad debt provision was $1,251 million (a 160%
increase over 2007), and the ending allowance for doubtful accounts was
$1,010 (11.1% of ending accounts receivable).
©Cambridge Business Publishers, 2011
6-28
Financial Accounting, 3rd Edition
P6-44 (40 minutes)
(all in $ millions)
a. Gross receivables as of 2002 are $5,667 + $2,379 = $8,046.
Gross receivables as of 2001 are $6,054 + $1,889 = $7,943.
b. Estimated uncollectible accounts to gross accounts receivable are:
30% ($2,379/$8,046) in 2002
24% ($1,889/$7,943) in 2001
Gross receivables to sales are:
19.6% ($8,046/$40,961) in 2002
21.4% ($7,943/$37,166) in 2001
Although receivables are a lower percentage of sales in 2002, it appears that
their collectibility is less certain.
c. The receivables turnover rate is $40,961 / [($5,667 + $6,054)/2] = 6.99
Days sales in accounts receivable is $5,667/ ($40,961/365) = 50.5 days
The AOL part of the business is mainly a cash basis operation and we would
expect relatively minor receivables. The Time, Inc., portion of the business
contains publishing, cable, film and music. Although the magazine publishing
business does not carry significant receivables, the other lines of business
do.
On the whole, 50.5 days sales on average in accounts receivable for this type
of business seems high, and our concern is increased by the relatively high
levels of estimated uncollectible accounts.
d. Time-Warner significantly increased its allowance for uncollectible accounts
as a percentage of gross accounts receivable. There are two possible reasons
for this, neither of which are particularly good for AOL:
1. The financial condition of its customers has deteriorated significantly, thus
warranting a higher reserve, or
2. Time-Warner arbitrarily increased its allowance account.
The second alternative would be consistent with the “big bath” theory. By
increasing its allowance account more than necessary, it might have recorded
more expense in 2002 than was warranted and created an allowance account
that was higher than warranted. In future years, then, Time-Warner might have
the ability to reverse this allowance account to immediately improve earnings,
or it might just allow the allowance account to decline gradually as credit
losses are recognized. In either case, future profits would be higher as TimeWarner would not have the current period expense to increase the allowance
account.
©Cambridge Business Publishers, 2011
Solutions Manual, Chapter 6
6-29
A careful reader of the financial statements would keep an eye on these
accounts in future years. Allowances as a percentage of gross receivables
remained at 30% in 2003 and went to 28% in 2004, so there does not seem to
be any significant reversal of the provisions taken in 2002. In retrospect, it
appears that the first possible reason (deteriorating receivables) is the more
likely of the two.
P6-45 (25 minutes)
For the instructor:
This problem covers the accounting for product returns, which is not
covered in the chapter. The description of The Gap’s practices should allow
students to answer parts a and b. Part c is a bit of a stretch, because it
requires that the allowance for returns, which is in gross profit terms, be
“grossed-up” to revenue terms.
a. Beginning balance + $700 million - $701 million = $21 million, so Beginning
balance = $22 million.
b. Sale and expected returns:
(1) Record revenue.
Cash (+A)
Revenue (+R,+SE)
(2) Record COGS.
Cost of goods sold (+E,-SE)
Inventory (-A)
(3) Recognize
Revenue contra, returns (+XR, -SE)
expected returns.
COGS contra, returns (+XE, +SE)
Sales returns allowance (+L)
5,000
5,000
3,000
3,000
500
300
200
The sales returns allowance is equal to Gross sales ($5,000) times the probability
of return (10%) times the gross profit margin (40%), or $200. For these ten units,
the cost of goods was $300.
Returns:
(4) Process return
transactions.
DR Inventory (+A)
DR Sales returns allowance (-L)
CR Cash (-A)
300
200
500
At the conclusion of this transaction, the customers have their cash, the
inventory costs have been adjusted to include the returned items, and the
sales returns allowance liability has a balance of zero because the actual
returns coincided with the expected returns.
c. The Gap’s reported gross profit is 37.5% of its net sales ($5,447million/$14,526
million). So, if The Gap expects returns of items with gross profit of $700
million, those items must have had sales prices of $1,867 million ($700
million/0.375) and cost of goods sold of $1,167 million ($1,867 million - $700
©Cambridge Business Publishers, 2011
6-30
Financial Accounting, 3rd Edition
million). The entry that would have reflected The Gap’s accounting for these
expected returns is the following:
Recognize expected
returns.
Revenue contra, returns (+XR, -SE)
COGS contra, returns (+XE, +SE)
Sales returns allowance (+L)
1,867
1,167
700
The Gap’s gross sales revenue would have been $16,393 million ($14,526
million + $1,867 million), and its expected returns as a percentage of sales
would be 11.4% ($1,867 million/$16,393 million).
The size of the allowance for 2008 ($700 million) relative to the end-of-year
return liability ($21 million) means that the vast majority of these product
returns occurred during the 2008 fiscal year, so it is more a reflection of actual
experience than of management’s estimates of future events.
d. Under these circumstances, The Gap doesn’t have to worry about accounting
for expected returns, because it has not satisfied the requirements for revenue
recognition. If the amount to be received (or in this case, the amount to be
kept) is not yet “fixed or determinable,” the revenue should not be recognized
until it is.
P6-46 (25 minutes)
a.
b.
Fiscal year
ending
March 31
2005
2006
2007
2008
2009
Fiscal year
ending March
31
2005
2006
2007
2008
2009
Net revenue
Growth rate
3,129
2,951
3,091
3,665
4,212
–
-5.7%
4.7%
18.6%
14.9%
Net
revenue
Deferred net
revenue (liability)
3,129
2,951
3,091
3,665
4,212
0
9
32
387
261
Purchases = Net
revenue + Change in
Deferred net revenue
3,129
2,960
3,114
4,020
4,086
Growth
rate
–
-5.4%
5.2%
29.1%
1.6%
©Cambridge Business Publishers, 2011
Solutions Manual, Chapter 6
6-31
When companies defer revenue, there is a lag between customers’ purchases
and the recognition of revenue on the income statement. In 2006, 2007 and
2008, a growing portion of EA’s sales to customers were deferred, as there
was an increase in the rate of growth in purchases. So the growth in revenues
was less than the growth in customer purchases. However, the growth in
customer purchases for 2009 was not large – only 1.6%. The substantial
growth in revenue for 2009 is a vestige of the higher growth rates in previous
years (particularly 2008).
c. If customer purchases in 2009 are a leading indicator of customer purchases
in 2010, we would predict a substantial drop in revenue growth for 2010 over
2009.
©Cambridge Business Publishers, 2011
6-32
Financial Accounting, 3rd Edition
CASES
C6-47A (60 minutes)
a. i. SALES – revenue is normally earned when title to the product passes to the
customer who either purchases the product for cash or on credit terms.
ii. SERVICES, OUTSOURCING AND RENTALS – revenue from services is normally
earned as the service is performed, usually ratably over the period of the
service contract. The same applies to outsourcing and rentals.
iii. FINANCE INCOME – revenue from finance income (normally interest) is earned
with the passage of time. For example, each period, Xerox accrues interest
on its loans and leases.
b. i. Restructuring costs typically fall within two general categories. (1) The
write-off of assets, such as plant assets and goodwill, and (2) the accrual of
liabilities for items, such as employee severance payments and exit costs.
ii. These restructuring costs result in expenses that are recorded in their
respective current periods despite the fact that the corresponding impaired
assets may not be formerly written off and the employees not paid their
severance until future periods. In any event, most analysts treat
restructuring costs as transitory (one-time occurrences). Accordingly, they
should impact the analysis, but are unlikely to impact the analysis to the
degree of more persistent items such as recurring revenues and expenses.
iii. Some companies report regularly recurring restructuring costs. In such
cases, many analysts treat these recurring costs as operating expenses
and do not consider them to be transitory items. This treatment implies that
these costs are less transitory and more persistent in nature.
In 2007, Xerox had a net credit on restructuring – the result of a
restructuring provision of $35 million and a reversal of prior restructuring
accruals of $41 million.
c. Companies are not required to separately disclose revenue and expense items
unless they are deemed to be material. If not separately disclosed, these items
are aggregated with other items that are also deemed not to be material. Such
aggregation generally reduces the informativeness of income statements.
More problematic is that revenues and expenses can be commingled in this
“Other” category to yield a small number that further obscures the importance
of the individual items comprising this category.
©Cambridge Business Publishers, 2011
Solutions Manual, Chapter 6
6-33
In Xerox’s case, the significantly higher amount in Other expenses, net, is due
to a $774 million pretax charge for litigation losses. These would not be
expected to recur in future years.
d. The following items might be considered to be operating:
Sales and service, outsourcing and rental revenue would be considered
operating; cost of sales, cost of service, outsourcing and rentals, R&D and
engineering expenses, and SG&A expenses are typically designated as
operating.
Restructuring and asset impairment charges would usually be considered to
be operating.
Equity in earnings of unconsolidated affiliates would be considered operating
under the assumption that the affiliates are related to Xerox’s core operations,
which is typically the case.
Finance income and equipment financing interest expense would be classified
as operating, because financing customers’ purchases is one of Xerox’s lines
of business. However, it would be useful to consider it as a separate line of
business for forecasting purposes.
Other expenses would generally be considered nonoperating in the absence
of a footnote clearly indicating its connection to the operating activities of the
company (such as the litigation losses described above).
The following items might be identified as transitory items:
If Xerox had income from discontinued operations or extraordinary items,
those would be considered transitory. Those items did not appear in its 2006,
2007 or 2008 income statement. The restructuring and impairment charges
appear regularly, but in varying amounts, and the MD&A reports that a
significant share of the Other expenses, net is due to litigation charges that
are probably transitory (but related to operations).
One other item that has transitory factors is the company’s income tax
expenses for the year. For reasons that will be discussed in Chapter 10,
Xerox’s tax expense as a percentage of pretax income was (35.6%), 27.8% and
202.6% in 2006, 2007 and 2008, respectively. Given that the U.S corporate tax
rate is 35%, it is clear that there are some transitory effects going on in this
line item.
©Cambridge Business Publishers, 2011
6-34
Financial Accounting, 3rd Edition
C6-48 (30 minutes)
a. When Dell sells other companies’ software products, it is often as part of a
multiple-element sales agreement. For example, the customer may purchase
hardware, software, and customer support for one price. This is an example
of a bundled sale. Dell must allocate the sales price based on the relative fair
market value of each element. Revenue is recognized for each specific
element when it is clear that the element has been delivered and the revenue
is earned.
There are at least two possibilities for earnings management here. First, Dell
could misallocate the sales price. By allocating more of the price to hardware
and less to software, Dell may be able to manage when earnings are reported.
Second, Dell may be aggressive in applying the “earned and realizable”
criteria to each element, thereby prematurely recognizing revenue.
From the information provided, it appears that Dell was recognizing revenue
on software “resales” at the time of sale. However, most software is not truly
sold. Instead, the customer purchases a license to use the software. As a
result, Dell should have deferred part of the revenue and recognized it ratably
over the license period.
b. Extended warranties are typically sold separately from other products.
Therefore, the revenue should be deferred and recognized ratably over the
warranty contract period. Dell employees were apparently recording revenue
at the time of sale, or were recognizing the revenue over a shorter time period
than the contract period. As a result, revenues and income were overstated.
c. It is common for managers to have performance targets based on revenues
and earnings. This provides an incentive for these employees to take actions
to accelerate revenue recognition when it appears that targets may not be met.
On the other hand, in periods when revenues and earnings exceed the targets,
managers may delay revenue recognition until a future period. In this way,
they can “store up” revenues and earnings to meet future targets.
The key to preventing this type of abuse is the periodic audit of divisional
revenues and earnings. In addition, businesses spend a large amount of
resources trying to design incentive compensation plans that do not
encourage this type of abuse.
©Cambridge Business Publishers, 2011
Solutions Manual, Chapter 6
6-35
C6-49 (45 minutes)
a.
i.
ii.
Bad debt expense (+E, -SE)
Allowance for doubtful accounts (+XA, -A)
2,095,000
Allowance for doubtful accounts (-XA, +A)
Accounts receivable (-A)
1,562,000
+ Accounts Receivable (A) ($000) Balance
110,069
Sales
761,865
1,562
Balance
124,430
*
(ii)
2,095,000
1,562,000
- Allowance for Doubtful Accounts (XA) ($000) +
3,609
Balance
2,095
(i)
(ii)
1,562
4,142
Balance
*This accounts receivable T-account above is incomplete; it is missing a credit for sales returns
and a credit for cash collections. Both are discussed and illustrated below.)
b. If sales returns are material in amount and can be estimated with a reasonable
degree of accuracy, they should be estimated just as bad debts are estimated.
Sales revenue is debited for the estimated returns while an allowance for
returns is credited. One important difference is that with sales returns (unlike
bad debts) the customer returns the product to the company and it is often
returned to inventory. Hence, the amount of estimated returns is equal to the
estimated gross profit on expected returns. Using Oakley’s gross profit
margin of 54.2% (= $412,751 / $761,865) the following entries would be
required in 2006:
iii.
iv.
Sales revenue (est. sales returns) (-R, -SE)
Allowance for returns (+XA, -A)
7,547,000
Allowance for returns (-XA, +A)
Inventory (+A)
Accounts receivable* (-A)
6,993,000
5,909,000
+ Accounts Receivable (A) ($000) Balance
110,069
Sales
761,865
1,562
(ii)
12,902
(iv)
733,040 Collections
Balance
124,430
7,547,000
12,902,000
- Allowance for Returns (XA) ($000) +
6,683
Balance
7,547
(iii)
(iv)
6,993
7,237
Balance
* $6,993,000 / 0.542 = $12,902,000
©Cambridge Business Publishers, 2011
6-36
Financial Accounting, 3rd Edition
Note that an alternative entry for b(iii) would be the following, where the
income statement adjustment for estimated returns affects both revenue and
cost of gods sold. The T-accounts just above would not be affected.
iii.
Sales revenue (est. sales returns) (-R, -SE)
Allowance for returns (+XA, -A)
Cost of goods sold (-E, +SE)
13,924,000
7,547,000
6,377,000
($13,924,000 = $7,547,000/0.542.)
However, if the sales returns cannot be resold, then the amount of estimated
returns is equal to the estimated expected returned sales (not the gross profit on
sales). This would be the case if sales returns were primarily returns of defective
merchandise. If this is the case for Oakley, the appropriate journal entries and Taccounts would be as follows:
iii.
iv.
Sales revenue (est. sales returns) (-R, -SE)
Allowance for returns (+XA, -A)
7,547,000
Allowance for returns (-XA, +A)
Accounts receivable (-A)
6,993,000
+ Accounts Receivable (A) ($000) Balance
110,069
Sales
761,865
1,562
(ii)
6,993
(iv)
738,949 Collections
Balance
124,430
7,547,000
6,993,000
- Allowance for Returns (XA) ($000) +
6,683
Balance
7,547
(iii)
(iv)
6,993
7,237
Balance
Note that our calculation of the amount of cash collections on account
(calculated as a “plug” amount) is contingent upon what assumption we make
about Oakley’s returns. If returned merchandise is returned to inventory and
resold, then cash collections are approximately $733,040,000. On the other hand,
if sales returns are not returned to inventory for resale (i.e., because the
merchandise is defective) the cash collections are calculated as $738,949,000.
These different scenarios represent not just different accounting, but
substantively different situations. If Oakley can return the items to inventory,
their reporting implies that customers will return (and not pay for) items totaling
almost $13 million in sales. If returned products are always defective, then
Oakley’s reporting implies that customers will return items totaling about $7.5
million in sales.
Obviously, only one of these amounts is correct, but it is impossible to tell from
Oakley’s financial statements. (The authors believe that Oakley’s returns are
largely related to performance warranties and returned goods are deemed
“defective” and not returned to inventory. Hence the second set of journal
©Cambridge Business Publishers, 2011
Solutions Manual, Chapter 6
6-37
entries would be correct.) The amount of cash collected is included in the
accounts receivable T-accounts above to be complete.
c. Accounts receivable turnover: $761,865 / [($109,168 + $99,430)/2] = 7.3 times.
©Cambridge Business Publishers, 2011
6-38
Financial Accounting, 3rd Edition