Revenue Recog

Chapter 8 Revenue Recognition MULTIPLE CHOICE

1.

An adjusting adjusting entry in which revenue is recognized recognized and a receivable is established established indicates that revenue has been Earned

Collected

a. Yes  b. Yes c. No d. No ANS: A PTS: 1 TOP: AICPA FN-Measurement

No Yes Yes No

DIF: Easy OBJ: LO 1 MSC: AACSB Analytic

2.

Which of the following best describes describes the the condition(s) condition(s) that must must be present for the recognition of  revenue? a. The revenue must be earned, earned, measurable, and collected.  b. The revenue must be earned, measurable, and collectible. collectible. c. The revenue must be earned and collectible. d. The revenue must be measurable and collectible. ANS: B PTS: 1 DIF: Easy OBJ: LO 1 TOP: AICPA FN-Measurement MSC: AACSB Analytic 3.

A company providing maintenance services on equipment for a fixed periodic fee would would a. recognize an equal amount amount of service revenue revenue for each act.  b. recognize service revenue over over the fixed period by the straight-line straight-line method. c. recognize service revenue in proportion to the direct direct costs to the provider provider of the services to  perform each act. d. recognize service service revenue only when the fixed period period has ended. ANS: B PTS: 1 DIF: Medium OBJ: LO 4 TOP: AICPA FN-Measurement MSC: AACSB Analytic 4.

Which of the following types of service transactions transactions is most most likely to require require the proportional  performance method of revenue recognition recognition based on the the seller's direct costs to perform perform each act? a. Processing of monthly mortgage payments by a mortgage banker.  b. Providing lessons, examinations, examinations, and grading by a correspondence school. c. Providing maintenance services on equipment equipment for a fixed periodic periodic fee. d. Delivering freight (by a trucking firm). ANS: B PTS: 1 DIF: Medium OBJ: LO 4 TOP: AICPA FN-Measurement MSC: AACSB Analytic

Chapter 8/Revenue Recognition  237 5.

Dilla Construction Company's projects extend over several several years years and collection of receivables receivables is is reasonably certain. Each project has a contract that specifies a price and the rights and obligations of all parties. Both the contractor and the customer are expected to fulfill their contractual obligations on each project. Reliable estimates can be made of the extent of progress and cost to complete each project. The method that the company should use to account for construction revenue is a. installment sales.  b. percentage-of-completion. c. completed-contract. d. cost recovery. ANS: B PTS: 1 DIF: Easy OBJ: LO 2 TOP: AICPA FN-Measurement MSC: AACSB Analytic 6.

How should the balances balances of Progress Billings Billings and Construction Construction in in Progress be shown shown at reporting dates prior to the completion of a long-term contract? a. Progress Billings Billings as income, income, Construction Construction in Progress as inventory. inventory.  b. Net, as income from construction construction if credit balance, and loss from construction if debit  balance. c. Progress Billings Billings as deferred income, income, Construction Construction in Progress as a current asset. d. Net, as a current asset if debit balance balance and current liability liability if credit credit balance. ANS: D PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Reporting MSC: AACSB Reflective Thinking 7.

If the the percentage-of-completion percentage-of-completion method method is used, used, what is the basis for determining determining the the gross profit to be recognized in the second year of a three-year contract? a. Cumulative actual costs incurred only.  b. Incremental cost for the second year year only. c. Cumulative actual costs and estimated costs to complete. d. No gross gross profit would be recognized recognized in year 2. 2. ANS: C PTS: 1 DIF: Easy OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic 8.

If the the completed-contract completed-contract method is used, used, what is the basis for determining determining the income income to be recognized in the second year of a three-year contract? a. Cumulative actual costs incurred only.  b. Incremental cost for the second year year only. c. Latest available estimated costs. d. No income income would be recognized recognized in year 2. ANS: D PTS: 1 DIF: Easy OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic

Chapter 8/Revenue Recognition  237 5.

Dilla Construction Company's projects extend over several several years years and collection of receivables receivables is is reasonably certain. Each project has a contract that specifies a price and the rights and obligations of all parties. Both the contractor and the customer are expected to fulfill their contractual obligations on each project. Reliable estimates can be made of the extent of progress and cost to complete each project. The method that the company should use to account for construction revenue is a. installment sales.  b. percentage-of-completion. c. completed-contract. d. cost recovery. ANS: B PTS: 1 DIF: Easy OBJ: LO 2 TOP: AICPA FN-Measurement MSC: AACSB Analytic 6.

How should the balances balances of Progress Billings Billings and Construction Construction in in Progress be shown shown at reporting dates prior to the completion of a long-term contract? a. Progress Billings Billings as income, income, Construction Construction in Progress as inventory. inventory.  b. Net, as income from construction construction if credit balance, and loss from construction if debit  balance. c. Progress Billings Billings as deferred income, income, Construction Construction in Progress as a current asset. d. Net, as a current asset if debit balance balance and current liability liability if credit credit balance. ANS: D PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Reporting MSC: AACSB Reflective Thinking 7.

If the the percentage-of-completion percentage-of-completion method method is used, used, what is the basis for determining determining the the gross profit to be recognized in the second year of a three-year contract? a. Cumulative actual costs incurred only.  b. Incremental cost for the second year year only. c. Cumulative actual costs and estimated costs to complete. d. No gross gross profit would be recognized recognized in year 2. 2. ANS: C PTS: 1 DIF: Easy OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic 8.

If the the completed-contract completed-contract method is used, used, what is the basis for determining determining the income income to be recognized in the second year of a three-year contract? a. Cumulative actual costs incurred only.  b. Incremental cost for the second year year only. c. Latest available estimated costs. d. No income income would be recognized recognized in year 2. ANS: D PTS: 1 DIF: Easy OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic

238  Chapter 8/Revenue Recognition 9.

Which of the following following would be used in the calculation of the gross profit profit recognized recognized in the third and final year of a construction contract that is accounted for using the percentage-of-completion method? Actual Income Contract Total Previously Price Costs Recognized a. Yes Yes No  b. Yes Yes Yes c. Yes No Yes d. No Yes Yes ANS: B PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic 10.

The installment method of recognizing revenue a. should be used only in cases in which no reasonable basis basis exists for estimating estimating the collectibility of receivables.  b. is not a generally accepted accounting accounting principle under any circumstances. c. should be used for book book purposes only if it is used used for tax purposes. d. is an acceptable acceptable alternative alternative accounting principle for a firm that makes installment installment sales. ANS: A PTS: 1 DIF: Easy OBJ: LO 5 TOP: AICPA FN-Measurement MSC: AACSB Analytic 11.

Assume the percentage-of-completion method of revenue recognition is used on a long-term long-term construction contract. Under this method, revenues that are earned but unbilled at the balance sheet date should be disclosed a. as a long-term receivable in the noncurrent noncurrent assets section of the balance sheet.  b. only as a footnote disclosure disclosure until the customer customer is billed for the percentage percentage of work  completed. c. as construction construction in progress progress in the the current assets assets section of the balance balance sheet. d. as construction construction in progress progress in the the noncurrent assets section of the balance balance sheet. ANS: C PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Reporting MSC: AACSB Reflective Thinking 12.

When using the installment sales method, a. gross profit is deferred until until all cash is received, received, but revenues and costs costs are recognized recognized in  proportion to the cash collected collected from the sale.  b. gross profit is recognized recognized only after the amount of cash collected collected exceeds the cost of the the item sold. c. revenue, costs, and gross profit are recognized proportionally proportionally as the cash is is received from the sale of product. d. total revenues and costs are recognized recognized at the point point of sale, but but gross profit is deferred in  proportion to the cash that is uncollected from the sale. sale. ANS: D PTS: 1 DIF: Medium OBJ: LO 5 TOP: AICPA FN-Measurement MSC: AACSB Analytic

Chapter 8/Revenue Recognition  239 13.

The completed-contract method of accounting for long-term construction-type construction-type contracts is  preferable when a. a contractor contractor is involved in numerous projects.  b. the contracts are of a relatively long long duration. c. estimates of of costs to complete and extent of progress progress toward completion are reasonably dependable. d. there are inherent uncertainties uncertainties in the contract beyond beyond normal normal business risks. ANS: D PTS: 1 DIF: Easy OBJ: LO 2 TOP: AICPA FN-Measurement MSC: AACSB Analytic 14.

Which of the following is not an element identified by the AICPA as being necessary in order to use percentage-of-completion accounting? a. The construction period can be reasonably estimated.  b. The buyer can be expected to satisfy satisfy obligations under under the contract. c. Dependable estimates estimates can be made of the extent of progress toward toward completion. completion. d. Dependable estimates can be made of contract contract costs. costs. ANS: A PTS: 1 DIF: Easy OBJ: LO 2 TOP: AICPA FN-Measurement MSC: AACSB Analytic 15.

Which of the following is not a difference between the percentage-of completion and completedcontract methods of accounting for long-term construction contracts? a. They report different amounts for inventory during the construction construction period. period.  b. They report different amounts amounts for progress billings billings during the construction construction period. c. They cause cause a different cash inflow inflow during during the the construction construction period. d. They report different different amounts for accounts receivable during the construction construction period. period. ANS: C PTS: 1 DIF: Medium OBJ: LO 2 TOP: AICPA FN-Measurement MSC: AACSB Analytic 16.

The theoretical support for using the percentage-of-completion method of accounting for longterm construction projects is that it a. is more conservative than the completed-contract method.  b. reports a lower Net Income figure than than the completed-contract method. c. more closely conforms to the cost principle. d. produces a realistic matching of expenses with revenues. ANS: D PTS: 1 DIF: Easy OBJ: LO 2 TOP: AICPA FN-Measurement MSC: AACSB Analytic 17.

If a company uses the completed-contract method of accounting accounting for long-term construction contracts, then during the period of construction, financial information related to a long-term contract will a. appear on both both the income income statement and balance sheet during the construction construction period.  b. appear only on the income income statement during the period of construction. c. appear only on the balance sheet sheet during the period of construction. construction. d. not appear on the financial statements. ANS: C PTS: 1 DIF: Medium OBJ: LO 2 TOP: AICPA FN-Reporting MSC: AACSB Reflective Thinking

240  Chapter 8/Revenue Recognition 18.

When the percentage-of-completion method of accounting for long-term construction projects is used, why is Construction in Progress increased by the annual recognized gross profit on longterm construction contracts? a. The cost of the contract has increased.  b. The project's value has increased above cost. c. The economy experiences inflation over the construction period. d. Construction in Progress is not increased by the annual recognized profit. ANS: B PTS: 1 DIF: Medium OBJ: LO 2 TOP: AICPA FN-Measurement MSC: AACSB Analytic 19.

When comparing the percentage-of-completion and completed-contract methods of accounting for long-term construction contracts, both methods will report a. the same balances each period in the Progress Billings account.  b. the same expense for cost of construction each year. c. the same amount of income in the year of completion. d. the same inventory carrying value each year during the construction period. ANS: A PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Reporting MSC: AACSB Reflective Thinking 20.

The cost recovery method a. is used only when circumstances surrounding a sale are so uncertain that earlier recognition is impossible.  b. is the most common method of accounting for real estate sales. c. is similar to percentage-of-completion accounting. d. is never acceptable under generally accepted accounting principles. ANS: A PTS: 1 DIF: Medium OBJ: LO 5 TOP: AICPA FN-Measurement MSC: AACSB Analytic 21.

Franchise fees are properly recognized as revenue a. when received in cash.  b. when a contractual agreement has been signed. c. after the franchise business has begun operations. d. after the franchiser has substantially performed its service. ANS: D PTS: 1 DIF: Easy OBJ: LO 4 TOP: AICPA FN-Measurement MSC: AACSB Analytic 22.

Goods on consignment should be included in the inventory of  a. the consignor but not the consignee.  b. both the consignor and the consignee. c. the consignee but not the consignor. d. neither the consignor nor the consignee. ANS: A PTS: 1 DIF: Medium OBJ: LO 2 TOP: AICPA FN-Reporting MSC: AACSB Reflective Thinking

Chapter 8/Revenue Recognition  241 23.

In accounting for sales on consignment, sales revenue and the related cost of goods sold should  be recognized by the a. consignor when the goods are shipped to the consignee.  b. consignee when the goods are shipped to the third party. c. consignor when notification is received the consignee has sold the goods. d. consignee when cash is received from the customer. ANS: C PTS: 1 DIF: Medium OBJ: LO 2 TOP: AICPA FN-Measurement MSC: AACSB Analytic 24.

A company uses the percentage-of-completion method to account for a four year construction contract. Progress billings sent in the second year that were collected in the third year would a. be included in the calculation of the income recognized in the second year.  b. be included in the calculation of the income recognized in the third year. c. be included in the calculation of the income recognized in the fourth year. d. not be included in the calculation of the income recognized in any year. ANS: D PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic 25.

In accounting for a long-term construction contract for which there is a projected profit, the  balance in the Construction in Progress account at the end of the first year of work using the  percentage-of-completion method would be a. zero.  b. the same as the completed-contract method. c. higher than the completed-contract method. d. lower than the completed-contract method. ANS: C PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Reporting MSC: AACSB Reflective Thinking 26.

On May 1, 2008, Green Construction Company entered into a fixed-price contract to construct an apartment building for $3,000,000. Green appropriately accounts for this contract under the  percentage-of-completion method. Information relating to the contract is as follows:

At December 31: Percentage of completion ........ Estimated costs at completion ... Income recognized (cumulative) ..

2008

2009

20% $2,250,000 $ 150,000

60% $2,400,000 $ 360,000

What is the amount of contract costs incurred during the year ended December 31, 2009? a. $600,000  b. $960,000 c. $990,000 d. $1,440,000 ANS: C PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic

242  Chapter 8/Revenue Recognition 27.

C & J Construction, Inc. has consistently used the percentage-of-completion method of  recognizing income. Last year C & J started work on a $4,500,000 construction contract, which was completed this year. The accounting records disclosed the following data for last year: Progress billings ......................... ............ Costs incurred ............................ ............ Collections .......................... ................. Estimated cost to complete ........................ ....

$1,650,000 1,350,000 1,050,000 2,700,000

How much income should C & J have recognized on this contract last year? a. $105,000  b. $150,000 c. $300,000 d. $350,000 ANS: B PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic 28.

Jessup Construction, Inc. has consistently used the percentage-of-completion method of  recognizing income. During 2008, Jessup started work on a $1,500,000 fixed-price construction contract. The accounting records disclosed the following data for the year ended Decem ber 31, 2008: Costs incurred ............................ ............ Estimated cost to complete ......................... ... Progress billings ......................... ............ Collections .......................... .................

$ 465,000 1,085,000 550,000 350,000

How much loss should Jessup have recognized in 2008? a. $15,000  b. $35,000 c. $50,000 d. $115,000 ANS: C PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic 29.

Shepard Construction Company has consistently used the percentage-of- completion method. On January 10, 2008, Shepard began work on a $3,000,000 construction contract. At the inception date, the estimated cost of construction was $2,250,000. The following data relate to the progress of the contract: Gross profit recognized at December 31, 2008 .......... Costs incurred Jan. 10, 2008, through Dec. 31, 2009 ... Estimated cost to complete at December 31, 2009 .......

$ 300,000 1,800,000 600,000

How much gross profit should Shepard recognize for the year ended December 31, 2009? a. $150,000  b. $262,500 c. $300,000 d. $450,000 ANS: A PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic

Chapter 8/Revenue Recognition  243 30.

For a construction firm using the completed-contract method, if costs exceed billings on some contracts by $1,000,000 and billings exceed costs by $800,000 on others, the contracts should ordinarily be reported as a a. current asset of $200,000.  b. current liability of $200,000. c. current asset of $1,000,000 less a contra-current asset of $800,000. d. current asset of $1,000,000 and a current liability of $800,000. ANS: D PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Reporting MSC: AACSB Reflective Thinking 31.

Salmon Construction Company uses the percentage-of-completion method of accounting. In 2008, Salmon began work on a project which had a contract price of $1,600,000 and estimated costs of $1,200,000. Additional information is as follows:

Costs incurred during the year ............ Estimated costs to complete, as of 12/31/08 ................................ Billings during the year .................. Collections during the year ...............

2008 $240,000 960,000

2009 $1,060,000

290,000 250,000

1,310,000 1,200,000

The amount of gross profit Salmon should recognize on this contract during 2008 is a. $40,000.  b. $80,000. c. $100,000. d. $200,000. ANS: B PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic 32.

Brown Construction Company uses the percentage-of-completion method for long-term construction contracts. A specific job was begun in 2008 and c ompleted in 2010. The contract  price was $1,400,000 and cost information as of each year-end is given below:

End of year estimated cost to complete ...................... Annual cost incurred ............

2008

2009

$400,000 400,000

$200,000 400,000

2010 $

0 120,000

Assuming Brown correctly recorded gross profit in 2008, how much gross profit should the company record in 2009? a. $0  b. $20,000 c. $300,000 d. $320,000 ANS: B PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic

244  Chapter 8/Revenue Recognition The following data relate to a construction job started by Worthington Co. during 2008: Total contract price ........................... ....... Actual costs incurred during 2008 ..................... Estimated remaining costs .......................... ... Billed to customer during 2008 ........................ Received from customer during 2009 ....................

$300,000 60,000 120,000 90,000 30,000

33.

See Worthington Co. information above. Under the completed-contract method, how much should Worthington recognize as gross profit for 2008? a. $0  b. $30,000 c. $40,000 d. $90,000 ANS: A PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic 34.

See Worthington Co. information above. Under the percentage-of-completion method, how much should Worthington recognize as gross profit for 2008? a. $0  b. $40,000 c. $80,000 d. $100,000 ANS: B PTS: 1 DIF: Easy OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic 35.

Rainbow Construction Company uses the percentage-of-completion method for long-term construction contracts. The company started a project with a contract price of $2,750 in 2008. Given the following data, what is the balance in Construction in Progress for this contract at the end of 2008?

Costs incurred this year .................. Total estimated costs remaining at end of year ..

a. $150  b. $400 c. $550 d. $1,750 ANS: C PTS: 1 TOP: AICPA FN-Measurement

DIF: Easy OBJ: LO 3 MSC: AACSB Analytic

2008 $ 400 1,600

2009 $ 500 1,000

Chapter 8/Revenue Recognition  245 36.

Lake Construction Company uses the percentage-of-completion method for long-term construction contracts. The company has a project with a c ontract price of $7,000 on which $600 of gross profit has been recognized in prior years. Information for the current year is as follows: Total cost incurred through current year ............... Estimated costs remaining at end of current year .......

$5,000 2,800

What is the loss that Lake should recognize in the current year? a. $600  b. $800 c. $1,400 d. No loss should be recognized. ANS: C PTS: 1 DIF: Easy OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic 37.

Brooke Company began operations on January 1, 2008, and uses the installment sales method of  accounting. The company has the following information available for 2008 and 2009:

Installment sales ......................... Gross profit on sales ..................... Cash collections on 2008 sales ............ Cash collections on 2009 sales ............

2008 $4,500,000 30% 1,500,000

2009 $5,400,000 40% 3,600,000 4,200,000

The realized gross profit for 2009 would be a. $1,680,000.  b. $2,760,000. c. $3,120,000. d. $4,320,000. ANS: B PTS: 1 DIF: Medium OBJ: LO 5 TOP: AICPA FN-Measurement MSC: AACSB Analytic 38.

Lake Construction Company uses the completed-contract method for long-term construction contracts. The information for a specific contract as of January 1, 2008, is shown below. Costs incurred to date ......................... ....... Contract price ............................ ............ Estimated remaining cost to complete ..................

$ 700,000 2,000,000 800,000

$600,000 of cost was incurred during 2008 and on December 31, 2008, the estimated remaining cost to complete was still $800,000. The correct balance for the Construction in Progress at December 31, 2008 is a. $600,000.  b. $700,000. c. $1,200,000. d. $1.300,000. ANS: C PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic

246  Chapter 8/Revenue Recognition 39.

In 2008, Aldous Corp. began construction work under a three-year contract. The contract price is $800,000. Aldous used the percentage-of-completion method for financial accounting purposes. The income to be recognized each year is based on the proportion of costs incurred to total estimated costs for completing the contract. The financial presentations relating to this contract at December 31, 2008, appear below. Balance Sheet Accounts receivable--construction contract billings ........................... ....... Construction in progress .................... Less contract billings ...................... Cost of uncompleted contract in excess of billings ........................... .......

$15,000 $50,000 (47,000)

Income Statement Income (before tax) on the contract recognized in year 1 ......................

3,000

$10,000

How much cash was collected in 2008 on this contract? a. $32,000  b. $35,000 c. $47,000 d. $50,000 ANS: A PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic 40.

Paral Company began operations on January 2, 2008, and appropriately used the installment sales method of accounting. The following data are available for 2008 and 2009:

Installment sales ...................... Gross profit on sales .................. Cash collections from: 2008 sales ......................... .. 2009 sales ......................... ..

The realized gross profit for 2009 is a. $1,440,000.  b. $1,040,000. c. $920,000. d. $780,000. ANS: C PTS: 1 DIF: Medium OBJ: LO 5 TOP: AICPA FN-Measurement MSC: AACSB Analytic

2008 $3,000,000 30%

2009 $3,600,000 40%

$1,000,000 --

$1,200,000 $1,400,000

Chapter 8/Revenue Recognition  247 41.

Wedtec Enterprises, which began operations on January 1, appropriately uses the installment method of accounting. The following information is available for its first year: Gross profit on sales .......................... ....... Deferred gross profit at December 31 .................. Cash collected, including down payments ...............

40% $120,000 $225,000

What is the total amount of Wedtec's installment sales for the first year? a. $300,000  b. $345,000 c. $425,000 d. $525,000 ANS: D PTS: 1 DIF: Medium OBJ: LO 5 TOP: AICPA FN-Measurement MSC: AACSB Analytic 42.

Leno Distributing, which began operating on January 1, appropriately uses the installment method of accounting. The following information pertains to Leno's operations for the first year: Installment sales ......................... ............. Cost of installment sales .......................... .... General and administrative expenses .................... Collections on installment sales .......................

$1,000,000 600,000 100,000 200,000

The balance in the deferred gross profit account at December 31 should be a. $400,000.  b. $320,000. c. $240,000. d. $200,000. ANS: B PTS: 1 DIF: Medium OBJ: LO 5 TOP: AICPA FN-Measurement MSC: AACSB Analytic 43.

On January 3, 2008, Lincoln Services, Inc., signed an agreement authorizing Lisa Company to operate as a franchisee over a 20-year period for an initial franchise fee of $100,000 received when the agreement was signed. Lisa commenced operations on J uly 1, 2008, at which date all of  the initial services required of Lincoln had been performed. The agreement also provides that Lisa must pay a continuing franchise fee equal to 5% of the revenue from the franchise annually to Lincoln. Lisa's franchise revenue for 2008 was $800,000. For the year ended December 31, 2008, how much should Lincoln record as revenue from franchise fees in respect of the Lisa franchise? a. $140,000  b. $90,000 c. $45,000 d. $42,500 ANS: A PTS: 1 DIF: Medium OBJ: LO 2 TOP: AICPA FN-Measurement MSC: AACSB Analytic

248  Chapter 8/Revenue Recognition 44.

Assume the Randall Corporation sold $30,000 worth of merchandise on the installment basis. The cost of the merchandise was $24,000, and collectibility of the receivable is uncertain. Collection in the current year on the account is $8,000. How much gross profit should be reported as realized? a. $1,600  b. $2,000 c. $6,000 d. $8,000 ANS: A PTS: 1 DIF: Easy OBJ: LO 5 TOP: AICPA FN-Measurement MSC: AACSB Analytic 45.

On November 30, Northrup Company consigned 90 freezers to Watson Company for sale at $1,600 each and paid $1,200 in transportation costs. A report of sales was received on December  30 from Watson reporting the sale of 20 freezers, together with a remittance of the $27,200  balance due. The remittance was net of the agreed 15% commission. How much, and in what month, should Northrup recognize as consignment sales revenue?  November

December 

a. $0 $32,000  b. $0 $27,200 c. $144,000 $0 d. $142,800 $0 ANS: A PTS: 1 DIF: Medium OBJ: LO 2 TOP: AICPA FN-Measurement MSC: AACSB Analytic 46.

Layton Construction Company has consistently used the percentage-of completion method of  recognizing income. During 2008, Layton entered into a fixed-price contract to construct an office building for $10,000,000. Information relating to the contract is as follows:

Percentage of completion .............. Estimated total cost at completion .... Income recognized (cumulative) ........

December 31 2008 2009 20% 60% $7,500,000 $8,000,000 500,000 1,200,000

Contract costs incurred during 2009 were a. $3,200,000.  b. $3,300,000. c. $3,500,000. d. $4,800,000. ANS: B PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic

Chapter 8/Revenue Recognition  249 47.

Hillson Company began operations on January 1, 2008, and appropriately uses the installment method of accounting. The following data are available for 2008 and 2009:

Installment sales ..................... Cash collections from: 2008 sales ......................... . 2009 sales ......................... . Gross profit on sales .................

2008 $1,200,000

2009 $1,500,000

400,000 -30%

500,000 600,000 40%

The realized gross profit for 2009 is a. $240,000.  b. $390,000. c. $440,000. d. $600,000. ANS: B PTS: 1 DIF: Challenging OBJ: TOP: AICPA FN-Measurement MSC: AACSB Analytic 48.

LO 5

Seahawks, Inc. had the following consignment transactions during December: Inventory shipped on consignment to Ashe Company ........ Freight paid by Seahawks ........................... ..... Inventory received on consignment from Fenn Company ..... Freight paid by Fenn .......................... ..........

$18,000 900 12,000 500

 No sales of consigned goods were made through December 31. Seahawks' December 31 balance sheet should include consigned inventory at a. $18,900.  b. $18,000. c. $12,500. d. $12,000. ANS: A PTS: 1 DIF: Medium OBJ: LO 2 TOP: AICPA FN-Measurement MSC: AACSB Analytic 49.

A construction company uses the percentage-of-completion method for long-term construction contracts. A particular job was begun in 2007 and completed in 2009. During 2008, it appeared that the project would cost 25 percent more than originally expected. Data at the end of each year  are given below: 2007

End-of-year estimated cost remaining Annual cost incurred

$

200,000 200,000

$

2008

2009

100,000 200,000

$ 60,000

The contract price was $700,000. Assuming the company properly recorded income in 2007, how much income should be recorded in 2008? a. $ 10,000  b. $ 42,000 c. $160,000 d. $192,000 ANS: A PTS: 1 TOP: AICPA FN-Measurement

DIF: Challenging OBJ: MSC: AACSB Analytic

LO 3

250  Chapter 8/Revenue Recognition

50.

Knudsen Company sold $300,000 to customers on account during 2008, and collected $187,500 during the year. The company properly uses the installment sales method of revenue recognition due to the uncertainty of collection of these installment receivables. The company has determined that cost of sales for the $300,000 of sales was $240,000.

What is the correct balance of the company’s Deferred Gross Profit account at the end of 2008, after the recognition of revenue for that year? a. $22,500.  b. $-0-. c. $60,000. d. $112,000. ANS: A PTS: 1 DIF: Medium OBJ: LO 5 TOP: AICPA FN-Measurement MSC: AACSB Analytic 51.

Grover, Inc., appropriately uses the installment sales method of revenue recognition. The company sold $1,500,000 on installment accounts during 2008. The cost of items sold was $900,000. At December 31, 2008, Grover reported a balance of $100,000 in the Deferred Gross Profit account. How much cash did Grover collect on installment contracts during 2008? a. $600,000.  b. $500,000. c. $250,000. d. $1,250,000. ANS: D PTS: 1 DIF: Medium OBJ: LO 5 TOP: AICPA FN-Measurement MSC: AACSB Analytic 52.

Superior Builders has a fixed -price contract providing $120,000 of revenue. Construction on the contract was begun in 2007 and was completed in 2008. Information relating to the contract is as follows: 2007 Cumulative cost incurred to the end of the year 

Expected costs to complete Billings to the end of the year Collections to the end of the year

$

40,000 60,000 38,000 46,000

2008

$

What amount of income should Superior recognize in 2008 assuming that the company appropriately uses the percentage-of-completion method of income recognition? a. $9,286.  b. $15,000. c. $17,000. d. $7,000. ANS: D PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic

105,000 120,000 120,000

Chapter 8/Revenue Recognition  251 53.

The completed-contract method (as opposed to the percentage-of-completion method) of  accounting for revenue from long-term construction contracts should be used in which of the following circumstances? a. The contractor has been in business for many years and has completed many contracts in the  past.  b. The contracts are of a relatively long duration. c. Reasonable accurate estimates of the degree of completion can be made based on past experience. d. Reasonably accurate estimates of the degree of completion cannot be made due to the lack of  experience with similar types of contracts. ANS: D PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic 54.

When a contractor determines that a contract will result in an overall loss, when should that loss  be recognized within the completed-contract and percentage-of-completion methods?

Completed-Contract Percentage-of-Completion a. Immediately Over the remainder of the contract  b. At the completion of the contract At the completion of the contract c. At the completion of the contract Immediately d. Immediately Immediately ANS: D PTS: 1 DIF: Easy OBJ: LO 3 TOP: AICPA FN-Measurement MSC: AACSB Analytic 55.

Under which of the following circumstances is the installment sales method appropriate for the recognition of revenue in the income statement? a. For any sales where collection is spread over a reasonable long period of time.  b. In any situation where management wishes to delay the recognition of revenue in order to smooth its income. c. For sales where collection is spread over a reasonable long period of time and significant doubt exists about the ultimate collection of the receivables. d. For sales where collection is spread over a reasonable long period of time and not significant doubt exists concerning ultimate collection of the receivables. ANS: C PTS: 1 DIF: Easy OBJ: LO 5 TOP: AICPA FN-Measurement MSC: AACSB Analytic 56.

When progress billings are made by a contractor on a long-term contract, what account is credited? a. Contract Revenue, a revenue account.  b. Contract Billings, a contra-asset account. c. Contract Receivable, an asset account. d. Contract Billings, a contra-revenue account. ANS: B PTS: 1 DIF: Medium OBJ: LO 3 TOP: AICPA FN-Reporting MSC: AACSB Reflective Thinking

252  Chapter 8/Revenue Recognition

PROBLEM

1.

In 2008, Fayette Engineering entered into an agreement to construct an office building at a contract price of $5,100,000. Construction data were as follows: 2008 2009 2010 Construction costs incurred Estimated costs to complete Progress billings Collections from client

$

750,000

$2,700,000

$

630,000

3,000,000

862,500

--

570,000 450,000

3,600,000 3,300,000

930,000 1,350,000

Prepare the necessary entries for each year, assuming the firm uses the: (1) (2)

completed-contract method percentage-of-completion method.

ANS: (1) 2008 Construction in Progress .................... Materials, Cash, etc. .....................

750,000

Accounts Receivable ......................... Progress Billings on Construction Contracts

570,000

Cash ........................ ................ Accounts Receivable .......................

450,000

750,000

570,000

450,000

2009 Construction in Progress .................... Materials, Cash, etc. .....................

2,700,000

Accounts Receivable ......................... Progress Billings on Construction Contracts

3,600,000

Cash ........................ ................ Accounts Receivable .......................

3,300,000

2,700,000

3,600,000

3,300,000

2010 Construction in Progress .................... Materials, Cash, etc. .....................

630,000

Accounts Receivable ......................... Progress Billings on Construction Contracts

930,000

Cash ........................ ................ Accounts Receivable .......................

1,350,000

Progress Billings on Construction Contracts . Revenue from Long-Term Construction Contracts .......................... .......

5,100,000

Cost of Long-Term Construction Contracts .... Construction in Progress ..................

4,080,000

630,000

930,000

1,350,000

5,100,000

4,080,000

Chapter 8/Revenue Recognition  253

(2) 2008 Construction in Progress .................... Materials, Cash, etc. .....................

750,000

Accounts Receivable ......................... Progress Billings on Construction Contracts

570,000

Cash ....................... ................. Accounts Receivable .......................

450,000

Cost of Long-Term Construction Contracts .... Construction in Progress .................... Revenue from Long-Term Construction Contracts .......................... .......

750,000 270,000

750,000

570,000

450,000

1,020,000

2009 Construction in Progress .................... Materials, Cash, etc. .....................

2,700,000

Accounts Receivable ......................... Progress Billings on Construction Contracts

3,600,000

Cash ........................ ................ Accounts Receivable .......................

3,300,000

Cost of Long-Term Construction Contracts .... Construction in Progress .................... Revenue from Long-Term Construction Contracts .......................... .......

2,700,000 360,000

2,700,000

3,600,000

3,300,000

3,060,000

2010 Construction in Progress .................... Materials, Cash, etc. .....................

630,000

Accounts Receivable ......................... Progress Billings on Construction Contracts

930,000

Cash ........................ ................ Accounts Receivable .......................

1,350,000

Cost of Long-Term Construction Contracts .... Construction in Progress .................... Revenue from Long-Term Construction Contracts .......................... .......

630,000 390,000

Progress Billings on Construction Contracts . Construction in Progress ..................

5,100,000

PTS: 1 DIF: Challenging MSC: AACSB Analytic

OBJ: LO 3

630,000

930,000

1,350,000

1,020,000

5,100,000

TOP: AICPA FN-Measurement

254  Chapter 8/Revenue Recognition 2.

Bywater Construction contracted to build a ship over a two year period. The contract price was $21,000,000 with an estimate total cost of $18,400,000. The following cost data relate to the construction period. Costs Incurred Estimated Cost Cash Year in Year to Complete Billings Collected 2008 2009 2010

$9,000,000 9,500,000 0

$10,000,000 0 0

$11,000,000 8,000,000 2,000,000

$7,500,000 9,000,000 4,500,000

Prepare the necessary journal entries for 2008, 2009, and 2010 assuming Bywater uses the  percentage-of-completion method. ANS: 2008 Construction in Progress .................... Materials, Cash, etc. .....................

9,000,000

Accounts Receivable ......................... Progress Billings on Construction Contracts

11,000,000

Cash ........................ ................ Accounts Receivable .......................

7,500,000

Cost of Long-Term Construction Contracts .... Construction in Progress

9,000,000

($9,000,000 / $19,000,000)  $2,000,000 ... Revenue from Long-Term Construction Contracts .......................... .......

947,368

9,000,000

11,000,000

7,500,000

9,947,368

2009 Construction in Progress .................... Materials, Cash, etc. .....................

9,500,000

Accounts Receivable ......................... Progress Billings on Construction Contracts

8,000,000

Cash ........................ ................ Accounts Receivable .......................

9,000,000

Cost of Long-Term Construction Contracts .... Construction in Progress ($21,000,000 $18,500,000 total costs) - $947,368 ........ Revenue from Long-Term Construction Contracts .......................... .......

9,500,000

9,500,000

8,000,000

9,000,000

1,552,632 11,052,632

2010 Accounts Receivable ......................... Progress Billings on Construction Contracts

2,000,000

Cash ........................ ................ Accounts Receivable .......................

4,500,000

Progress Billings on Construction Contracts . Construction in Progress ..................

21,000,000

PTS: 1 DIF: Medium MSC: AACSB Analytic

OBJ:

2,000,000

4,500,000

LO 3 TOP: AICPA FN-Measurement

21,000,000

Chapter 8/Revenue Recognition  255

3.

Lytherma Construction entered into a contract to construct a floating bridge across a lake. The contract price for the bridge is $7,500,000. During 2005, costs of $1,800,000 were incurred representing 30% of total expected costs. Prepare the necessary entries for 2008 to recognize gross profit for the year assuming the firm uses the (1) (2)

completed-contract method. percentage-of-completion method.

ANS: (1) Using the completed-contract method, no gross profit is recognized on the contract until the  bridge is completed. Thus, no entry is needed. (2) Cost of Long-Term Construction Contracts ... Construction in Progress ................... Revenue from Long-Term Construction Contracts.................................. $1,800,000 / 30% = $6,000,000 $7,500,000 - $6,000,000 = $1,500,000 $1,500,000

PTS: 1 DIF: Medium MSC: AACSB Analytic 4.



1,800,000 450,000 * 2,250,000

30% = $450,000

OBJ:

LO 3 TOP: AICPA FN-Measurement

Tappan Industrial sells machinery on the installment plan. On September 1, 2008, Tappan entered into an installment sale contract with Western Productions for a six-year period. Equal annual  payments under the installment sale are $187,500 and are due on August 31 of each year   beginning in 2009. Additional information: (a) (b)

The cost of the machinery sold to Western was $637,500. The implicit interest rate on the installment sale is 10%.

Compute the income or loss before taxes that Tappan should record for the year ended December  31, 2008, as a result of the above transaction, assuming that circumstances are such that the collection of the installments due under the contract (1) is reasonably assured. (2) cannot be reasonably assured. ANS: (1) Accrual basis: full gross profit recognized in the year of the sale.

256  Chapter 8/Revenue Recognition Determination of selling price: PVn = R(PVAFn/i) Table IV  PVn = $187,500  4.3553 n = 6, i = 10% PVn = $816,619 (rounded) Gross profit on sale: Sale ........................... .................... Cost of sales ........................... ........... Gross profit ............................ ........... Interest revenue--4 months: $816,619



10%



4/12 = ..

Total income for 2008 = $179,119 + $27,221 =

$816,619 637,500 $179,119 $ 27,221 $206,340

(2) Installment sale: Gross profit ($179,119/$816,619) = Gross profit earned in 2008 ($0  22%) ............... Interest revenue ......................... ............ Total income for 2008 .......................... ......

PTS: 1 DIF: Challenging MSC: AACSB Analytic 5.

OBJ: LO 5

22% (rounded) $ 0 27,221 $ 27,221

TOP: AICPA FN-Measurement

Kamus Medical Center uses the cost recovery method in accounting for recognizing revenue. The following information is available: 2008 Sales ................... Gross profit percentage . Cash collections: 2008 ................. 2009 ................. 2010 .................

2009

2010

$45,000 37%

$60,000 41%

$85,000 40%

$24,000

$19,000 40,000

$ 2,000 17,000 53,000

Determine the amount of gross profit to be recognized for 2008, 2009, and 2010. ANS: When the cost recovery method is used, gross profit is recognized only after all costs have been recovered. 2008 $45,000  63% = $28,350 $28,350 - $24,000 = $4,350

Cost of sale No gross profit is recognized in 2008. Costs still to be recovered.

Chapter 8/Revenue Recognition  257 2009 Relating to 2008 sales: $19,000 - $4,350 = Relating to 2009 sales:

$14,650

$60,000  59% = $35,400 $40,000 - $35,400 =

Gross profit recognized Cost of sale

4,600 $19,250

Gross profit recognized Recognized in 2009

2010 Relating to 2008 sales: Since all costs have been recovered, all cash collected is recognized as gross profit ...... Relating to 2009 sales: Since all costs have been recovered, all cash collected is recognized as gross profit ...... Relating to 2010 sales: $85,000  60% = $51,000 $53,000 - $51,000 = ..........

$ 2,000

17,000 Cost of sale 2,000 $21,000

PTS: 1 DIF: Challenging MSC: AACSB Analytic 6.

OBJ: LO 5

Gross profit recognized Recognized in 2010

TOP: AICPA FN-Measurement

The Winimucca Supply Company sells maintenance contracts to the purchasers of the equipment they sell. The cost of the contract is $1,450, payable at the signing of the contract. The contract covers a three-year period with regularly scheduled inspection visits (every six months) plus any emergency visits. Experience shows that, on the average, one emergency visit per contract is required each year. Assume that 2,200 contracts were sold in 2008 and that contract sales were made evenly over the year. Give the entries required for 2008 and 2009 to account for the 2,200 contracts.

258  Chapter 8/Revenue Recognition ANS: 2008 Cash ($1,450  2,200) ..................... Deferred Maintenance Contract Revenue ..

3,190,000

Deferred Maintenance Contract Revenue ..... Maintenance Contract Revenue ...........

354,444

*

3,190,000

354,444 *

First 1,100 contracts sold--one regularly scheduled inspection per contract ..... Average 1,100 contracts in force during 2008--one emergency visit per contract Total visits expected--2008 ...........

1,100 1,100 2,200

Total expected visits over life of contract (9 visits (2,200/19,800)





19,800

2,200) ........... $

$3,190,000 =

354,444

2009 Deferred Maintenance Contract Revenue ..... Maintenance Contract Revenue ..............

1,063,333 1,063,333 *

* Contracts in effect for the entire year  Average visits per year = Expected visits during 2009 2,200 contracts x 3 average visits = 6,600 Proportion of visits in 2009: 6,600/19,800 = 1/3 Recognized revenue: $3,190,000

PTS: 1 DIF: Medium MSC: AACSB Analytic 7.

OBJ:



1/3 = $1,063,333

LO 4 TOP: AICPA FN-Measurement

In 2008, Johnson Builders began construction work under a three-year contract at a price of  $7,525,000. The firm uses the percentage-of-completion method for financial accounting  purposes. The income to be recognized each year is based on the proportion of cost incurred to the total estimated costs for completing the contract. The financial statement presentations relating to this contract on December 31, 2008, are: Balance Sheet Accounts receivable ........................ Construction in progress ................... Less progress billings ..................... Income Statement Gross profit on construction contracts .....

$150,500 $602,000 562,000

40,000

$301,000

Chapter 8/Revenue Recognition  259 Determine the (1) cash collected in 2008. (2) estimated income on the construction contract. ANS: (1) Progress billings on construction contract ............ Less accounts receivable ........................... ... Cash collected in 2008 ......................... .......

$562,000 150,500 $411,500

(2) Gross profit from construction contract + Construction in progress = Revenue for 2008 $301,000 + $602,000 = $903,000 $903,000/$7,525,000 = 12% Percentage completed in 2008 $301,000/.12 = $2,508,333 Estimated income on construction contract

PTS: 1 DIF: Medium MSC: AACSB Analytic 8.

OBJ:

LO 3 TOP: AICPA FN-Measurement

Summit Electronics Company sends appliances to dealers on a consignment basis. The selling  price per unit is $920 and the dealer earns a 30% commission. The manufacturing cost of the appliance to Summit Electronics is $570. Assume that in 2008, 800 units were sent on consignment to Farley Hardware. Four hundred of these units were sold for cash, and by December 31, 2008, remittance had been made to Summit Electronics for 380 units. Prepare the required journal entries on the books of Summit Electronics Company and Farley Hardware for the transactions in 2008.

ANS: Summit Electronics Company Inventory on Consignment (800 @ $570) ............................ ... Finished Goods Inventory .................

456,000 456,000

Consignment Expense ($368,000  30%) ........................... Accounts Receivable--Consignee Sales ....... Sales Revenue--Consignment ($920



110,400 257,600 368,000

400) .............................

Cost of Consigned Goods Sold ($570  400) ............................... Inventory on Consignment .................

228,000

Cash [($920  70%)  380] .................. Accounts Receivable--Consignee Sales .....

244,720

228,000

244,720

260  Chapter 8/Revenue Recognition Farley Hardware No entry upon receipt of consigned merchandise. Cash ($920  400) .......................... Consignor Payable ........................ Commission Revenue .......................

368,000

Consignor Payable .......................... Cash ......................... ............

244,720

PTS: 1 DIF: Challenging MSC: AACSB Analytic 9.

OBJ: LO 2

257,600 110,400

244,720

TOP: AICPA FN-Measurement

The Abbott Corporation sells merchandise on the installment basis, and the uncertainties of cash collection make the use of the installment sales method of accounting acceptable. The following data relate to two years of operations.

Installment sales ........................ .... Cost of installment sales .................... Gross profit ......................... ........ Gross profit percentage ...................... Cash collections: 2008 Sales ......................... ........ 2009 Sales ......................... ........

2008

2009

$480,000 300,000 180,000 37.5%

$560,000 364,000 196,000 35%

$190,000 --

$210,000 235,000

Record the transactions related to installment sales for 2008 and 2009. ANS: 2008 Installment Accounts Receivable--2008 ........ Installment Sales ..........................

480,000

Cost of Installment Sales .................... Inventory .......................... ........

300,000

Cash ........................ ................. Installment Accounts Receivable--2008 ......

190,000

Installment Sales ......................... ... Cost of Installment Sales .................. Deferred Gross Profit--2008 ................

480,000

Deferred Gross Profit--2008 .................. Realized Gross Profit on Installment Sales

71,250

($190,000



37.5%) ........................

480,000

300,000

190,000

300,000 180,000

71,250

Chapter 8/Revenue Recognition  261 2009 Installment Accounts Receivable--2009 ........ Installment Sales ..........................

560,000

Cost of Installment Sales .................... Inventory .......................... ........

364,000

Cash ........................ ................. Installment Accounts Receivable--2008 ...... Installment Accounts Receivable--2009 ......

445,000

Installment Sales ......................... ... Cost of Installment Sales .................. Deferred Gross Profit--2009 ................

560,000

Deferred Gross Profit--2008 .................. Deferred Gross Profit--2009 .................. Realized Gross Profit on Installment Sales . 2008: $ 78,750 $210,000  37.5% =

78,750 82,250

2009:

$235,000



35% =

560,000

364,000

210,000 235,000

364,000 196,000

161,000

82,250 $161,000

PTS: 1 DIF: Challenging MSC: AACSB Analytic 10.

OBJ: LO 5

TOP: AICPA FN-Measurement

Ajax Dry Cleaners, Inc. charges an initial franchise fee of $195,000. When the agreement is signed, a payment of $75,000 is due, followed by four annual payments of $30,000 at the end of  each period. Ajax's normal borrowing rate is 12%. Prepare the entries to record the initial franchise fee on the books of Ajax under each of the following circumstances. (1) (2)

(3)

The franchiser has substantial services to perform and the collection of the note is extremely uncertain. The down payment is nonrefundable, collection of the note is reasonably assured, and the franchiser has performed substantially all of the ser vices required by the initial fee. The down payment is nonrefundable, collection of the note is reasonably assured, the franchiser has performed services equivalent to the down payment, but substantial services remain to be performed.

262  Chapter 8/Revenue Recognition ANS: (1) Cash ........................ ................. Unearned Franchise Fee ..................... (2) Cash ........................ ................. Note Receivable ........................... ... Discount on Note Receivable ................ Revenue from Franchise Fee .................

75,000 75,000

75,000 120,000 28,881 166,119

[$75,000 + ($30,000  3.0373)] = $166,119 (Table IV n = 4, i = 12%)

(3) Cash ........................ ................. Note Receivable ........................... ... Discount on Note Receivable ................ Revenue from Franchise Fee ................. Unearned Franchise Fee .....................

PTS: 1 DIF: Challenging MSC: AACSB Analytic 11.

OBJ: LO 2

75,000 120,000 28,881 75,000 91,119

TOP: AICPA FN-Measurement

On January 1, 2008 Rose Enterprises obtained a contract to construct a building. It was estimated at the beginning of the contract that it would take three years to complete the project at an expected cost of $200,000. The contract price was $250,000. The following information describes the status of the job at the close of production each year:

Actual costs incurred ........... Estimated costs to complete ..... Billings on contract ............ Collections on contract .........

2008

2009

$110,000 100,000 125,000 120,000

$120,000 20,000 125,000 120,000

2010 $15,000 0 0 10,000

Compute the items listed below for each year assuming the use of the percentage-of-completion cost-to-cost method. (Round all percentages to two decimals). 2008 1. Revenue recognized during the year .......................... 2. Gross profit recognized during the year ...................... 3. Balance in the construction in progress account at December 31 (after closing entries) ....... 4. Balance in the progress billings account at December 31 (after closing entries) ..............

2009

2010

Chapter 8/Revenue Recognition  263 ANS: 2008

2009

Contract price ................... Current year costs ............... Costs to date .................... Estimated cost to complete ....... Estimated total cost ............. Estimated total gross profit .....

$250,000 110,000 110,000 100,000 210,000 40,000

$250,000 115,000 225,000 20,000 245,000 5,000

$250,000 15,000 240,000 0 240,000 10,000

Percent complete ................. Revenue to date ..................

52% $130,000

92% $230,000

100% $250,000

To Date at Dec. 31

Previous Years

Current Year 

2008:

Revenue ............ Costs ............ Gross profit ............

$130,000 110,000 $ 20,000

2009:

Revenue ............ Costs ............ Gross profit ............

$230,000 225,000 $ 5,000

$130,000 110,000 $ 20,000

$100,000 115,000 $(15,000)

2010:

Revenue ............ Costs ............ Gross profit ............

$250,000 240,000 $ 10,000

$230,000 225,000 $ 5,000

$ 20,000 15,000 $ 5,000

2008 1. 2. 3. 4.

Revenue recognized during the year .................... Gross profit recognized during the year .................... Balance in the construction in progress account at Dec. 31 Balance in the progress billings account at Dec. 31

PTS: 1 DIF: Challenging MSC: AACSB Analytic 12.

2010

OBJ: LO 3

$130,000 20,000

$130,000 110,000 $ 20,000

2009

2010

$100,000

$20,000

(15,000)

5,000

130,000

230,000

0

125,000

250,000

0

TOP: AICPA FN-Measurement

On January 1, 2008, Edwards Inc. obtained a contract to construct a building. It was estimated at the beginning of the contract that it would take 3 years to complete the project at an expected cost of $200,000. The contract price was $250,000. The following information describes the status of  the job at the close of production each year: 2008 Actual costs incurred ............ Estimated costs to complete ...... Billings on contract ............. Collections on contract ..........

$150,000 90,000 110,000 100,000

2009 $100,000 20,000 120,000 120,000

2010 $15,000 0 20,000 30,000

264  Chapter 8/Revenue Recognition Compute the items listed below for each year assuming the use of the percentage-of- completion cost-to-cost method. (Round all percentages to two decimals.) 2008

2009

2010

1. Construction costs (expense) recognized during the year .... 2. Gross profit recognized during the year ...................... 3. Balance in the construction in progress account at Dec. 31 (after closing entries) ....... 4. Balance in accounts receivable at Dec. 31 (after closing entries) ......................

ANS: 2008 Contract price Current year costs Costs to date Estimated cost to complete Estimated total cost Estimated total gross profit Percent complete Revenue to date

$250,000 150,000 150,000 90,000 240,000 10,000

2009 $250,000 100,000 250,000 20,000 270,000 (20,000)

63%

93%

$157,500

$232,500

To Date at Dec. 31

Previous Years

2010 $250,000 15,000 265,000 0 265,000 (15,000) 100% $250,000

Current Year 

2008:

Revenue ............ Costs ............ Gross profit ............

$157,500 150,000 $ 7,500

2009:

Revenue ............ Costs ............ Gross profit ............

$232,500 252,500 $(20,000)

$157,500 150,000 $ 7,500

$ 75,000 102,500 $(27,500)

2010:

Revenue ............ Costs ............ Gross profit ............

$250,000 265,000 $(15,000)

$232,500 252,500 $(20,000)

$ 17,500 12,500 $ 5,000

1. Construction costs (expense) recognized during the year

$157,500 150,000 $ 7,500

2008

2009

$150,000

$102,500

2. Gross profit recognized during the year

7,500

3. Balance in the construction in progress account at Dec. 31 (after closing entries)

157,500

(27,500)

230,000

2010 $12,500

5,000

0

Chapter 8/Revenue Recognition  265 4. Balance in accounts receivable at Dec. 31 (after closing entries)

PTS: 1 DIF: Challenging MSC: AACSB Analytic 13.

OBJ: LO 3

10,000

10,000

0

TOP: AICPA FN-Measurement

The importance of revenue to a business enterprise has caused much discussion among accountants as to how the term "revenue" should be defined. The FASB in Statement of Financial   Accounting Concepts No. 6 , "Elements of Financial Statements," defines revenue as "inflows or  other enhancements of assets of an entity or settlements of its liabilities (or a combination of   both) from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations." Evaluate the soundness of the definition of the term "revenue" provided by the FASB in Statement of Financial Accounting Concepts No. 6.

ANS: Critics of the FASB's definition have suggested that the inflow concept used by the FASB in defining revenue confuses the measurement and timing of revenue with the actual revenue  process. Revenue is viewed by some as a product of the firm resulting from the creation of goods or services by an enterprise during a given period of time. Defining revenue in terms of inflows of  assets imposes upon revenues the measurement criteria for assets. The concept of revenue is  broader than the measurement criteria for some other financial statement element. The inflow approach requires a careful statement of which inflows are to be considered revenues and which are not. Assets may increase and liabilities may decrease for a number of reasons other  than revenues. Exceptions to the inflow criteria also must be clearly stated. Revenue may be reported prior to a sale occurring with the associated inflow of assets. PTS: 1 DIF: Medium OBJ: MSC: AACSB Reflective Thinking 14.

LO 1 TOP: AICPA FN-Measurement

Measuring progress toward completion of long-term construction projects can be accomplished in a number of ways. Nonetheless, all of these measurements can be classified into two basic groups: input measures and output measures. Input measures attempt to measure the effort devoted to a project to date compared to the total effort expected to be required in order to complete the project. A common input measure is the ratio of costs incurred to date to total estimated costs for the project. Output measures attempt to measure the results to date compared to total results when the project is completed. A common output measure would be the number of  stories of a building completed compared to the total number of stories to be built. Identify the general problems associated with input and output measures in determining the level of completion of a long-term construction project.

266  Chapter 8/Revenue Recognition ANS: Several general problems exist with input and output measures generally, regardless of the specific methods used to operationalize these measures. Input measures are misleading if a relatively constant relationship does not exist between the input measure and productivity. A construction company building a large multi-story building may first need to excavate 100 feet into the ground in order to construct the appropriate foundation for the building. The excavation may proceed quite smoothly for the first 50 feet but may become more difficult as hard bedrock is encountered. Costs per foot of excavation may increase. If the higher excavation cost associated with greater depths was not included in the original cost estimates, then the use of a cost as a measure of progress will overstate the progress actually made. Cost incurred also poses problems as a measure of progress when large amounts of expenditures for materials and supplies are made at the inception of the project for use throughout the project. A distinction thus should be made  between costs incurred and cost actually contributing to progress. Costs incurred also may pose a  problem due to the learning curve effect: As more units are produced, construction can become less costly because the contractor learns the most efficient procedures and methods of  construction for the project. Use of the cost of earlier units to measure the cost of all units may also tend to overstate the actual cost of the progress made. Output measures also pose problems, particularly when different output units require different amounts of input effort to complete. The first floor of a multi-story building may require more input effort to complete as a result of foundation and subsurface construction than the second floor. Use of floors completed may understate the actual rate of progress. PTS: 1 DIF: Medium OBJ: MSC: AACSB Reflective Thinking 15.

LO 2 TOP: AICPA FN-Measurement

The percentage-of-completion method is used to recognize revenue and gross profit for  construction and other types of projects that extend beyond one accounting period. A problem similar to long-term construction projects exists in accounting for service revenue that is earned for more than one performance act where such activity extends beyond one accounting period. Provide examples of service activities that might extend beyond one accounting period and  propose means of recognizing revenues for such activities.

ANS: A proportional measurement approach similar to the percentage-of-completion approach may be adopted for recognizing service revenues. Under the proportional measurement approach, revenue is recognized on the proportional performance of each act. Service transactions may take several different forms, however. If the service transaction involves a specified number of identical or  similar acts, then an equal amount of revenue should be recorded for each act performed. A refuse disposal company, for example, would recognize an equal amount of revenue for each weekly removal of a customer's garbage. A service transaction may involve a specified number of defined but not identical or similar acts. In this case, revenue recognized for each act should be based on the ratio of the direct cost of the individual act to the total estimated direct costs of the transaction times the total revenues from the complete transaction. A correspondence school, for example, may provide lessons, examinations, and grading as part of total package of educational services. These are different acts that are part of the same service transaction.

Chapter 8/Revenue Recognition  267 Finally, a service transaction may involve an unspecified number of acts over a fixed time period for performance. In this situation, revenue should be recognized over the period during which the acts will be performed by using the straight-line method unless a better method of relating revenue and performance is appropriate. PTS: 1 DIF: Medium OBJ: MSC: AACSB Reflective Thinking 16.

LO 4 TOP: AICPA FN-Measurement

Sand Company, a publicly traded company, delivers twenty truckloads of sand to Gravel Company prior to December 31, 2007, the end of Sand's fiscal year. Sand normally enters into a written sales agreement with customers similar to Gravel Company. The written sales agreement must be signed by both companies in order to be binding. Although the purchasing department of  Gravel has orally agreed to the sale, Gravel management cannot sign the agreement until it is approved by the legal department of Gravel. Personnel of the legal department of Gravel will be on vacation until January 5, 2008. Can Sand recognize on its income statement for the year ending December 31, 2007, the revenue related to the twenty truckloads delivered to Gravel? Explain.

ANS: Sand cannot recognize on its income statement for the year ending December 31, 2007, the revenue related to the twenty truckloads delivered to Gravel. As a public company, Sand is subject to the provisions of Staff Accounting Bulleting 101 that require that persuasive evidence of an arrangement must exist. Since Sand's typical business practice requires a written sales agreement for this class of customer, revenue should not be recognized until the formal sales agreement is approved and signed by Gravel's legal department, which will not occur until sometime on or after January 5, 2008. PTS: 1 DIF: Medium OBJ: MSC: AACSB Reflective Thinking 17.

LO 2 TOP: AICPA FN-Measurement

Bill's Club is a discount retailer subject to SEC regulation. Bill's Club charges its customers an annual membership fee. Although the fee is collected in advance, a customer can cancel and receive a full refund at any time during the year of membership. Should Bill's Club recognize the entire initial membership fee at the beginning of the year or on a straight-line basis over the course of the membership year? Explain. What journal entry should be made to record the initial receipt of the membership fees?

ANS:  No revenue from the membership fee should be recognized until the end of the year. Since the  buyer can legally reclaim the membership fee at any time during the membership year, the final transaction amount would not be known until the end of the year. Nonetheless, Staff Accounting   Bulletin 101 does allow recognition of the membership fee as revenue on a month-to-month basis during the membership year if the seller can make a reliable estimate of the number of refunds that customers will request. The estimates would be considered reliable only if:

268  Chapter 8/Revenue Recognition

1. 2. 3.

The seller has been entering into these transactions long enough (at least two years) to have built up sufficient data on which to base the estimate. The estimate is made based on a large pool of transactions that are essentially the same. Past estimates have not differed materially from actual experience.

Receipt of the initial membership fees should be recorded as follows: Cash

xxx Customers' Refundable Fees Unearned Membership Fees

xxx xxx

The amount credited to the Customers' Refundable Fee account represents the estimate of the amount of the refunds that will be requested by customers during the year. PTS: 1 DIF: Medium OBJ: MSC: AACSB Reflective Thinking 18.

LO 2 TOP: AICPA FN-Measurement

Gary Miller recently purchased on layaway a big screen television from Warren and Willey Home Furnishings. Warren and Willey is a public company. Gary paid $100 as a cash deposit on the television. The television cost Warren and Willey $2,500 and has a total retail price of $3,000. Warren and Willey has set the television aside pending the payment by Miller of the balance owed. Warren and Willey does not require its customers to enter into an installment note or other fixed  payment commitment or agreement when the initial deposit is received. Merchandise on layaway generally is not released to the customer until the customer pays the full purchase price. If the customer fails to pay the remaining purchase price, the customer forfeits his or her cash deposit. In the event the merchandise is lost, damaged, or destroyed, Warren and Willey either must refund the cash deposit to the customer or provide replacement merchandise. When should Warren and Willey recognized the revenue from the sale to Miller? Prepare the appropriate journal entries on Warren and Willey's books to re cord the receipt of the cash and the subsequent delivery of the television when the remaining balance is collected.

ANS: Warren and Willey is a public company subject to the provisions of  Staff Accounting Bulletin 101. Warren and Willey retains custody of the goods as well as legal title to the goods until the entire selling price is paid by the customer and the television is delivered to the customer. SAB 101 states that revenue from sales made under a layaway program should be recognized only upon the 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". Warren and Willey retains the risks of ownership of the merchandise, receives only a cash deposit from the customer, and does not have an enforceable right to the remainder of the  purchase price. Accordingly, revenue should not be recorded upon the receipt of the cash deposit. The journal entries to record the receipt of the cash and the subsequent delivery of the television upon collection of the balance due are as follows: Cash

100 Deposits Received from Customers

100

Chapter 8/Revenue Recognition  269

To record receipt of $100 cash deposit. Cash Deposits Received from Customers Sales

2,900 100 3,000

To record receipt of final cash payment and the delivery of the merchandise to the customer. Cost of Goods Sold Inventory

2,500 2,500

To reduce inventory and recognize cost of merchandise sold.

PTS: 1 DIF: Medium OBJ: MSC: AACSB Reflective Thinking 19.

LO 2 TOP: AICPA FN-Measurement

Revenue is measured in terms of the value of the products or services exchanged in an “armslength” transaction. This value represents either the net cash equivalent or the present discounted value of the money received or to be received in exchange for the products or services that an enterprise transfers to its customer. Required: Explain how this concept of the measurement of revenue might be used to determine the proper  treatment of sales discounts and bad debt losses.

ANS: This concept of the measurement of revenue suggests that sales discounts and any reductions in the fixed prices, such as bad debt losses, are adjustments necessary to compute the true net cash equivalent or the present discounted value of the money to be received and thus should be deducted when computing revenue rather than treated as expenses. E xpenses may be defined as the use or consumption of goods and services in the process of obtaining revenues. Sale discounts do not represent the use of goods and services but rather an adjustment of the sales price in order  to encourage creditors to pay and thus to avoid bad debt losses. The sales discount is an adjustment of the price of the goods or services and should be treated as a reduction of revenues rather than as a cost of borrowing funds. Similarly, bad debt losses do not represent the expiration of goods or services, but rather a reduction in the amount to be received in exchange for the goods or services. PTS: 1 DIF: Medium MSC: AACSB Analytic 20.

OBJ:

LO 1 TOP: AICPA FN-Measurement

Thomas Publishing Company is marketing a new principles of accounting text. The new text is quite revolutionary in its approach. The use of the new approach raises some question as to the marketability of the text, however. On July 31, 2007, Thomas sold 4,000 copies of the new text to college bookstores at a unit price of $55. The textbooks have a unit cost to Thomas of $35. Thomas uses a perpetual inventory system. The company’s accounting period ends on December 31.

270  Chapter 8/Revenue Recognition In view of the uncertainty regarding the marketability of the text, Thomas sold the text with terms of net 30 days, but has allowed the bookstores until January 31, 2008, to return any unsold texts for a cash refund. Thomas has no means of estimating the number of texts that will be returned. On September 12, 2007, Thomas collected $220,000 on the account receivable. On November 15, 2007, 400 texts were returned by the bookstore to Thomas. Required: 1. 2. 3.

Prepare the appropriate journal entries for each of the dates given above. Explain the appropriate treatment on the financial statements of any accounts unique to this sales transaction. Provide authoritative support for the journal entries you made in part 1 above both for   public and private companies.

ANS: 1.

The journal entries would be as follows: July 31, 2007:  Accounts Receivable Sales (4,000  $55)

220,000

Cost of Goods Sold Inventory (4,000  $35)

140,000

Sales

220,000

220,000

140,000

Cost of Goods Sold Deferred Gross Margin

140,000 80,000

September 12, 2007: Cash

220,000  Accounts Receivable

220,000

November 15, 2007: Inventory (400  $35) Deferred Gross Margin Cash

14,000 8,000 22,000

January 31, 2008: Cost of Goods Sold

(3,600  $35) Deferred Gross Margin (3,600  $20) Sales (3,600  $55)

126,000 72,000 198,000

Chapter 8/Revenue Recognition  271 2.

The account unique to this transaction is the Deferred Gross Margin account. This account would appear as a contra account to the Accounts Receivable account on the  balance sheet.

3.

Thomas Publishing recognized no sales revenue in 2007. Sales revenue of $198,000 was recognized in 2008 since the amount of future returns was susceptible to reasonable estimation in 2008. This is one of the six criteria for recognition of revenue where right of return exists from Statement of Financial Accounting Standards No. 48 , “Revenue Recognition When Right of Return Exists.” The SEC has expanded in Staff Accounting Bulletin No. 101 , “Revenue Recognition in Financial Statements,” on the conditions in SFAS No. 48 regarding the inability to estimate the amount of product returns. The additional conditions the SEC identifies as giving rise to an inability to reliably estimate product returns are: a.  b. c.

Significant increases in inventory, either in the hands of the seller or of the seller’s customers. Increase inventories would be direct evidence of channel stuffing. Poor information systems such that it can’t be known whether the inventory in the hands of the seller’s customers has increased. New products, or expected introduction of new replacement or competing products.

If a seller cannot make a reasonable estimate of product returns, based on the conditions identified in both SFAS No. 48 and Staff Accounting Bulletin 101 , no revenue should be recognized until after the return period has expired. PTS: 1 DIF: Medium MSC: AACSB Analytic 21.

OBJ:

LO 2 TOP: AICPA FN-Measurement

Roberts Company sold inventory to Peterson Incorporated and recorded the sale as revenue. Part of the agreement of the sale is that Roberts will repurchase the merchandise at a specified price over a specified period of time. Meanwhile, Peterson uses the inventory purchased from Roberts as collateral for a loan. Peterson uses the proceeds from the loan to pay Roberts for the inventory  purchased. Roberts ultimately repurchases the inventory from Peterson. Peterson then uses the  proceeds of the repayment to pay its loan obligation. Required: 1. 2.

Explain the rationale for the two companies engaging in this series of transactions. Explain how the sale of the inventory would be reported on the records of Roberts Company.

ANS: 1.

Several motivations exist for the two companies to enter into such an agreement. Roberts is able to use its inventory for collateral on a loan without showing the liability on its balance sheet or paying personal property taxes required in certain states on the inventory. Since the timing of the agreement is subject essentially to the whims of the  parties involved, Roberts also could use the “sale” as a means of increasing revenues. Peterson may find the agreement advantageous if the company is facing a LIFO liquidation problem or if the company wishes to execute a similar agreement on its  behalf with Roberts sometime in the future.

272  Chapter 8/Revenue Recognition 2.

The agreement between Roberts and Peterson is a product-financing arrangement. No sale has occurred since Robert retains all the business risk associated with the inventory even though the company does not have legal title to the inventory. Revenue only should  be recognized when the inventory is sold to an outside party with which no related repurchase agreement exists. The FASB has said in Statement of Financial Accounting  Standards No. 49, “Accounting for Product Financing agreements, that the existence of  such a repurchase agreement requires that the company transferring the inventory must record a liability at the time the proceeds are received and cannot record a sale nor  remove the inventory from its records.

PTS: 1 DIF: Challenging MSC: AACSB Analytic 22.

OBJ: LO 1

TOP: AICPA FN-Measurement

The percentage-of-completion method is a generally accepted accounting procedure that allows revenue to be recognized prior to the completion of a project or product. Revenues and gross  profit are recognized each period based upon the progress of the construction. Construction costs  plus gross profit earned to date are accumulated in an inventory account (Construction in Progress) and progress billings are accumulated in a contra-inventory account (Billings on Construction in Progress). Required: Explain the effect on shareholders and managers if an enterprise did not use the percentage-ofcompletion method to account for long-term contracts and projects.

ANS: Deferral of recognition of revenues, costs, and gross profit on a long-term contract until completion would misrepresent the efforts and accomplishments of interim accounting periods  between the beginning and end of the contract. The income statement of an enterprise that has long-term projects but that failed to use the percentage-of-completion method would not be relevant to the decisions either of shareholders or managers. The shareholders of an enterprise that completes contracts at irregular intervals and reports income only when the contracts are completed would have difficulty selling their ownership interest before completion of major  contracts due to a lack of relevant information. Similarly, managers of the enterprise would encounter difficulties in their decision-making activities without some perspective of the status of  the firm for the interim periods during the completion of a contract. PTS: 1 DIF: Challenging MSC: AACSB Analytic 23.

OBJ: LO 3

TOP: AICPA FN-Measurement

The collection of credit sales is usually predictable and reasonably assured as a result of credit approval, collections procedures, and historical evidence. In such cases, revenue is appropriately recognized at the point of sale. If a company makes credit sales to customers of relatively poor  credit risk, however, recognition of revenue at the point of sale may be inappropriate. Although revenue may have been earned and is measurable, ultimate collection of the proceeds on the sale are highly uncertain. The creditor in such circumstances may defer the recognition of revenue until the amount due is collected. The installment sales method thus may be used. Under the installment sales method, both sales and cost of sales are recognized in the period of sale, but the related gross margin is deferred to those periods in which cash is collected. The gross margin rate for the installment sales is computed and multiplied times the cash collection to determine the  portion of deferred gross margin to be recognized.

Chapter 8/Revenue Recognition  273

Required: Evaluate the conceptual soundness of the installment sales method. ANS: Revenue in most instances should be reported if a valid, measurable claim against customers exists and the seller has substantially accomplished what it must do to be entitled to receive the  benefits associated with the sale. The installment sales method is said to apply when collection is doubtful as a result of customers that have over-extended themselves and thus are poor credit risks. The likelihood that problems will be encountered in collecting these accounts suggests that  billing and collection expenses associated with these accounts will be large and difficult to estimate. Critics of the use of the installment sales method suggest that none of these problems is insurmountable. Although the amount of uncollectible accounts may be large, an estimate can be derived based either on past experience or the experience of other firms in the industry. The accounts receivable involved usually are protected by the fact that title to the goods does not pass to the customer until the account is paid in full. Critics of the installment sales method cite two additional problems. The first is that the gross margin is deferred but expenses that help to generate the gross margin are not. Accurate apportionment of these expenses is virtually impossible and, as a result, usually is not attempted. The second issue relates to a basic assumption of the installment method. This method implicitly assumes that the full amount of the sale ultimately will be collected. Every dollar collected is assumed to have a profit component equal to the gross margin rate. This would be true only if it is certain that the total sales price will be collected. PTS: 1 DIF: Challenging MSC: AACSB Analytic 24.

OBJ: LO 5

TOP: AICPA FN-Measurement

Clarity Communications manufactures and sells audio and video conferencing equipment. The company sells its products through a nationwide network of distributors complemented by a direct sales force. The distributors had a written agreement with Clarity requiring the distributors to pay Clarity within 90 days of receiving Clarity products. The agreement also required distributors to take title to Clarity products at the time the products left Clarity’s warehouse. Through early 2001, Clarity experienced robust growth and increased product sales every quarter. In early 2001, it became apparent to Clarity’s CEO, Melind a Waters, that the company would not meet its sales and revenue projections for the quarter ended March 31, 2001. At the end of March 2001, Waters instructed Phillip Potts, Clarity’s Director of Manufacturing, to assemble enough  products to ship to distributors in order to meet Clarity’s sales projections. Waters entered into an agreement with one of Clarity’s distributors, Star Marketing, to accept these products. The management of Star Marketing was assured that the transaction posed no risk to them. Waters also informed Star management that Star would not be required to pay for the merchandise until it was sold. Meanwhile, Clarity recorded an account receivable and revenue for this sale. These same procedures were followed at the end of each quarter for which Clarity anticipated falling short of its sales projections, including the recognition of revenue by Clarity. During this same time period, Clarity, whose stock was publicly traded, was planning a private  placement of additional shares of stock totaling $25.5 million. Accordingly, the stock price needed to remain high in order for the private placement to be attractive to investors.

274  Chapter 8/Revenue Recognition Required: Does the plan effected by Waters conform with Generally Accepted Accounting Principles (GAAP)? ANS: Waters plan is not in conformity with GAAP. Waters’ plan is commonly known as “channel stuffing.” The sales to Star Marketing are merely sham transactions. Waters has recognized fictitious revenues in order to inflate earnings and to meet sales projections and analysts expectations. Waters is managing earnings through fraudulent revenue recognition. Star Marketing’s inventories would soon become bloated given that the same procedures were followed whenever Clarity’s sales projections were not met. The SEC would e xamine the inventories of the customers of Clarity (in this case, Star Marketing) to find evidence of inventory  bloating in an effort to build a case against Clarity. The fact that Clarity is a public company would result in SEC involvement if the channel stuffing was uncovered. Under Section 12 of the Exchange Act, Waters likely would be permanently  barred from serving as an officer or director of any publicly traded company. Since it is unlikely that the chief financial officer of the company would be involved in such a scheme, he/she also would be barred from serving as an officer or director of any publicly traded company. PTS: 1 DIF: Medium MSC: AACSB Analytic 25.

OBJ:

LO 1 TOP: AICPA FN-Measurement

Marvel System Services provides its customers with computer-based services over an extended  period. Customers are required to prepay the entire fee for the extended service. Marvel performs initial setup activities to enter a customer into its system. The initial setup allows the customer to receive automated services from Marvel from that point forward in the service agreement. The management of Marvel plans to recognize the revenue over the life of the service contract,  but plans to recognize a disproportionate amount of revenue at the beginning of the contract as a result of the completion of the setup activities and the cost incurred in connection with the completion of the setup activities. Required: Do you agree with the proposal by the management of Marvel regarding revenue recognition related to the setup activities? How should revenue be recognized for an agreement such as this?

Chapter 8/Revenue Recognition  275 ANS:  EITF No. 00-21, “Revenue Arrangements with Multiple Deliverables,” addresses business arrangements with several components. Under  EITF No. 00-21, revenue is recognized separately for each “unit of accounting,” which is defined as a component of the business arrangement that has value to the customer on a stand-alone basis. The setup activities alone have no value to the customer without the services to provided subsequent to the setup activities. No customer would  pay for the setup activities as a separate product, and revenue cannot be assigned specifically to the completion of the portion of the agreement covering the setup activities. SAB 101 states that extra revenue cannot be recognized at the beginning of the arrangement just because  proportionately more of the cost is expended during the setup activities. Recognition of revenue should be based on the amount of expected service that has been provided and not the amount of  cost that has been incurred. Revenue for the agreement ordinarily should be recognized on a straight-line basis, independent of the amount of cost occurred. No revenue should be recognized  before the term of the agreement begins.

PTS: 1 DIF: Medium MSC: AACSB Analytic 26.

OBJ:

LO 2 TOP: AICPA FN-Measurement

Kosmo Construction, Inc., is constructing a building for another company. Construction on the  building began in 2008 and is expected to be complete in 2010. The fixed contract price was $1,500,000. During 2008, the company made the following entries: 1. Construction in Progress Cash

200,000

2. Accounts Receivable Contract Billings

250,000

3. Cash

200,000

200,000

250,000

 Accounts Receivable 4. Construction in Progress Construction Costs Construction Revenue

200,000 100,000 200,000 300,000

Required: Briefly explain the 2008 entries and why they occurred. Show the calculations and include in your explanations the nature of and the reporting of the Contract Billings account. ANS: Entry No. 1 records the actual costs incurred in constructing the building during 2008 and the  payment of those costs. Entry No. 2 records the progress billings by the contractor to the customer. Contract Billings is a contra account to Construction in Progress. If Construction in Progress exceeds Contract Billings, this difference represents the contractor’s net ownership interest in the construction project (sometimes called the contractor’s draw) and is shown as a current assets. If the Contract Billings exceeds the Construction in Progress, this difference represents the developer’s (buyer’s or  customer’s) interest in the project and is referred to as the developer’s draw and is shown as a current liability.

276  Chapter 8/Revenue Recognition Entry No. 3 records the collection of the billings by the contractor to the customer. Entry No. 4 records the recognition of revenue, expense, and gross profit. The gross profit recognized is debited to the Construction in Progress account. Gross profit recognized is computed as follows: Percent of total contract price recognized: $300,000/$1,500,000 = .20 Costs incurred to total costs: = total estimated costs $200,000/ = .20  = $1,000,000 

Contract price Costs: To date Expected to complete Expected profit

$

$

1,500,000

$

1,000,000 500,000

200,000 800,000

Expected profit times percent completed equals gross profit recognized in current period. $500,000  .20 = $100,000.

PTS: 1 DIF: Challenging MSC: AACSB Analytic 27.

OBJ: LO 3

TOP: AICPA FN-Measurement

The Buford Corporation introduced a new line of product the profitability of which is quite uncertain. This uncertainty has resulted in Buford choosing to use the cost recovery method to account for this product. The following information relating to the new product line is available for the year 2008: 2008

Sales Cost of goods sold Gross profit

$ $

80,000 60,000 20,000

Payments applicable to 2008 sales:

Customer Customer Customer Customer

payments in 2008 payments in 2009 payments in 2010 payments in 2011

10,000 52,000 18,000 -

Chapter 8/Revenue Recognition  277 Required: 1. 2. 3. 4.

Explain the general approach of the cost recovery method and when it should be used. Record the journal entries for the new product for 2008 and 2009 based on the information given above. How and in what amount would the deferred gross margin be presented on the balance sheet of Buford at December 31, 2008? How does the cost recovery method differ from the installment sales method?

ANS: 1.

2.

The cost recovery method (or sunk cost method) requires that all costs incurred for a highly speculative product be recovered before any profit is recognized. The cost recovery method is used only for highly speculative transactions when the ultimate realization of revenue or profit is unpredictable. The following journal entries would be made for 2008 and 2009: For the year ending 12/31/2008:

 Accounts receivable Sales

80,000

Cost of goods sold Inventory

60,000

Sales

80,000

80,000

60,000

Deferred gross margin on sales Cost of goods sold Cash

20,000 60,000 10,000

 Accounts receivable

10,000

For the year ending 12/31/2009:

Cash

52,000  Accounts receivable

Deferred gross margin on sales Realized gross margin on sales 3.

2,000 2,000

The deferred gross margin on sales would be presented on the balance sheet at December 31, 2008, as a contra account to accounts receivable as follows:  Accounts receivable Less: Deferred gross margin on sales Net accounts receivable

4.

52,000

$ $

70,000 20,000 50,000

The cost recovery method applies all cash collected from customers to the recovery of   product costs. The installment method recognizes gross margin when cash is collected

278  Chapter 8/Revenue Recognition and does not require that product costs be fully recovered before gross margin is recognized. PTS: 1 DIF: Medium MSC: AACSB Analytic 28.

OBJ:

LO 5 TOP: AICPA FN-Measurement

You are an accounting major who recently completed your masters degree in accounting and  began working in public accounting as of September 1, 2008. Your younger brother currently is enrolled in a principles of accounting course. Your brother calls you at your  firm’s offices one day to congratulate you on the purchase of your new stereo system for your apartment. In the course of the conversation, your brother tells you that his accounting instructor discussed the installment sales method of recognition in class recently. Since your brother knows that you are  paying for the stereo by making monthly payments, your brother (in an attempt to impress with his new-found knowledge) begins to describe the process for accounting under the installment sales method of revenue recognition. Your brother finds it particularly curious that the store that sold you the stereo system will be deferring revenue on the sale until cash is collected. Required: How would you respond to your younger brother’s comments?

ANS: The installment sales method is used only when collection of the sales price is not reasonably assured and the portion of the sale that will ultimately prove uncollectible cannot be estimated. Many consumer products, however, are sold on an installment or deferred payment plan, but are not necessarily required to be accounted for using the installment sales method. Immediate revenue recognition is acceptable at the point of sale when the company has a reasonable basis for  estimating the amount of receivables that will prove uncollectible. Thus a retail customer  installment sale does not mean that the installment sales method must be used. PTS: 1 DIF: Medium MSC: AACSB Analytic 29.

OBJ:

LO 5 TOP: AICPA FN-Measurement

Assume that a company receives $500 cash from a customer as the initial sign-up fee for a service. In addition to the sign-up fee, the customer also is required to pay $25 per month for the service. The expected economic life of the service agreement is 50 months. The company  providing the service could subcontract with a third party to provide the service for 100 months for $100, which is also the cost to the company of providing the service. Current professional standards regarding revenue recognition would require that the sign-up fee  be recognized over the 50 months the service is provided. Nonetheless, you have heard that the FASB is considering another approach to revenue recognition called the asset-and-liability approach. Required: Explain how this transaction would be accounted for under the F ASB’s asset-and-liability approach and evaluate this new approach.