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Financial Accounting: Intregrated Approach, Sixth Edith Chapter 6 Revenue and Expense Recognition Solution Outline for Problem 6.1 1. • Accrual accounting recognizes economic phenomena prior to and subsequent to cash flows, as well as at the point of cash flows. The accrual entries work to allocate revenues and expenses to the period in which they are earned or incurred, whether or not the associated cash receipts and disbursements occur during that period. • Revenue that is earned but not received before period end is recorded as revenue of the current period. • Revenue earned in prior periods but received in the current period is excluded from revenue of the current period. • Expenses incurred in the current period but not paid for until a subsequent period are included in expense of the current period. • Expenses incurred in a previous period and not paid for until the current period are not included in expense of the current period. Revenue and expenses of a future period are excluded from the current period’s income statement, but where cash is involved (unearned revenue or prepaid expenses), the balance sheet reflects the other side of the transaction. • Costs of resources having economic benefits at the end of a period are recorded as assets, and the benefits of these resources are recorded as expenses in the periods that these resources benefit, regardless of the period in which they are paid for. • Obligations building up over a period (e.g., interest expense) are recognized as expenses of the period whether they are paid or not. 2. Timing is at the centre of accrual accounting because in accrual accounting an attempt is made to recognize revenue earned in the current period and to recognize expenses required to generate that revenue in the same period. Cash flow accounting depends only on the timing of cash receipts and cash payments. Since revenues are not necessarily earned at the time cash is received nor expenses paid for in cash at the time they are matched to revenues, accrual income will be different in most periods from cash flow income. Over the life of a business total accrual income will be equal to total cash income. Solution Outline for Problem 6.2 1. The primary responsibility for the accuracy of the financial records and the preparation of the financial statements rest with management in accordance with generally accepted accounting principles. It is most often CEO and the CFO who are ultimately responsible. 2. It is the responsibility of the independent auditors, usually Chartered Accountants, to carry out an examination of the financial statement s in accordance with Generally Accepted Auditing Standards. Based on the results of their examination the auditors express an opinion on the fairness of the statements in accordance with Generally Accepted Accounting Standards. 3. Information must be timely and have predictive or feedback value to be relevant to any decision. That information which is not relevant is not useful. Information that is not reliable, accurate and unbiased will not be relied on and is therefore also not useful in decision making 162 Instructor’s Solution Manual Some points that might be made: • • • • • • • measuring availability and use of “real resources” involves more than cash flow, because the resources do not necessarily generate cash immediately or smoothly therefore something besides cash is needed to do the measurement job the business person seems to want: “income” is an attempt to do that “income” measures economic performance, which is the generation of returns before, after or even coincidentally with cash flow therefore accrual accounting does not so much diverge from measuring cash flow as enrich or augment it cash flow may be affected by forces beyond the enterprise's earnings performance, such as customers' ability to make payments, debt payment deadlines or unexpected opportunities, so using it as a performance measure contaminates the measure with non-performance events: income avoids this similarly, cash flow tends to be a “lumpy” measure but income is smoother (because it is not mixed with non-performance events) and therefore may better measure the enterprise's basic performance income also reflects the “matching” principle, in which revenue generation and expense incurrence are measured consistently, producing a more meaningful net figure (income): cash flow does not reflect any similar principle Solution outline for Problem 6.3 Income over the life of the business is easily measured as the liquidation proceeds at the end of its life plus any dividends (or withdrawals in the case of a proprietorship) paid out during the life of the entity less all investments made since the inception of the business by the owners. The difficulty arises only when we attempt to divide the life of the entity into artificial fiscal periods. It then becomes necessary to develop criteria for the recognition of revenue and the matching of expenses. Solution Outline for Problem 6.4 This problem is provocative. It may be answered provocatively too, but these comments take a middle ground! 1. The professor's views are cynical! While accrual accounting does permit manipulation, so does cash flow (for example by choosing the timing of receipts and payments to help produce desired results). Management has other opportunities to affect the measurement of performance; it is a little extreme to ascribe the “invention” of accrual accounting to management's wish to manipulate. The historical review at the beginning of this book indicated that accrual accounting, especially as reflected in income measurement, has a variety of origins, including a demand for better performance measures than the cash basis permits. When the measures move away from the simple transaction or cash basis, choices arise about how to do the accounting. Because enterprises and situations differ, managements will make different choices. This does not necessarily mean managements are “manipulating” in a pejorative sense (though of course they might be). 163 Financial Accounting: Intregrated Approach, Sixth Edith 2. Use your imagination on this one! Perhaps the professor expects other academics to be cynical too? It seems likely at least that practitioners, who deal with practical accounting problems every day, would be annoyed at the implied questioning of the ethics and professionalism of people involved in preparing financial statements. They may be unlikely, or unwilling, to see themselves in such an uncomplimentary light. Academics, on the other hand, more removed from the daily press of practical issues, may be able to stand back from them and recognize the signs of manipulation. Of course, the academics instead may not be close enough to recognize manipulation! Many academics consider it important to be sceptical and critical of current practice, in the hope of improving it, while practitioners may be more likely to avoid the controversy, in the hope of getting the daily job done without adding to the stress of already-difficult accrual judgments. 3. If the professor is right, placing the responsibility for financial reporting on management may be unwise. Giving those being measured too much latitude in “tampering with” the measures may reduce their value and reduce public trust in accounting information. In such a case, giving someone else the responsibility (such as auditors, professional information preparers or government agencies) would reduce the manipulation, but it might also reduce the value of the information by making it less tailored to each enterprise's circumstances. Solution Outline for Problem 6.5 1. Revenue is economic value created through a transaction with a customer, whether or not the customer pays the cash at the time. A cash receipt is the payment by the customer. 2. Revenue but not receipt: credit sales. Receipt but not revenue: a deferred revenue, such as down payments or cash advances for work yet to be performed. Both revenue and receipt: cash sales. 3. Expense: cost of assets used or commitments incurred to pay assets (usually cash) in producing revenue. Matched with revenue, not necessarily with outflow of cash. Recognition of expense may precede, accompany, or follow payment of cash (cash disbursement). Expenses are found on the income statement, their cash components are determined in preparing the cash flow statement. 4. Expense but not disbursement: depreciation, accrued interest, COGS (contrast with cash purchases, added to inventories). Disbursement but not expense: purchase asset, reduce a payable, pay dividends. Both expense and disbursement: small bills, utilities, donations. Solution Outline for Problem 6.6 1:e; 2:d; 3:f; 4:g; 5:b; 6:i; 7:h; 8:j; 9:c; 10:a Solution Outline for Problem 6.7 Here are example circumstances, illustrated in journal entry form: 1. a. DR Insurance expense CR Prepaid insurance DR Supplies expense CR Prepaid supplies b. DR Amortization expense CR Accumulated amortization DR Bad debts expense CR Allowance for doubtful accounts 164 Instructor’s Solution Manual c. DR Interest receivable CR Interest revenue DR Accounts receivable CR Revenue d. DR Revenue CR Unearned revenue DR Revenue CR Non-refundable deposits 2. The executive is quite right: some assets and liabilities are easier to explain as “residuals” of income measurement than as items of significant future economic value. Examples of the executive's four categories (and mixtures): o Assets with real economic value: cash, land, investments o Income measurement residuals: prepaid expenses, accumulated amortization o Mixtures of both: receivables, inventories o Liabilities with real economic value: bank loans, bonded debt, accounts payable o Income measurement residuals: future income tax, deferred revenue o Mixtures of both: accrued interest, pension liability Solution Outline for Problem 6.8 NOTE: This problem may be solved either by using the conceptual structure illustrated in the chapter and thinking about what accrual accounting does to income in each balance sheet category, or by reasoning from the cash flow statement format. Either is entirely valid and reaches the same result. Both are shown below. a. Reasoning from conceptual framework: 2006 cash basis net income 2005 current asset difference1 2006 current asset difference2 2006 change in noncurrent assets3 2005 current liability difference4 2006 current liability difference5 2006 noncurrent liability difference6 $ 169,000 (61,000) 78,000 (6,000) 18,000 (41,000) (16,000) 2006 accrual basis net income $141,000 See footnotes for approach a. later, after approach b. is shown. b. Reasoning from cash flow statement format (operations section) Accrual net income for 2006 Add back change in noncurrent assets, presumably amortization (30-36) Add back change in noncurrent liabilities, e.g. pensions or FIT (16-0) Deduct change in non-cash current assets ((174-96)-(144-83)) Add change in non-cash current liabilities ((78-37)-(55-37)) Cash from operations (cash income) 165 $ X 6,000 16,000 (17,000) 23,000 $169,000 Financial Accounting: Intregrated Approach, Sixth Edith So accrual net income would be 147-7-14+28-21=$133,000 You can also think of this approach this way. Accrual accounting would show different income than cash income because of adding revenue recognized but not collected ($17,000 change since 2005), deducting expense recognized but not paid ($23,000 change since 2005), and deducting non-cash expenses ($6,000 and $16,000). Footnotes for approach a. 1. Current assets 2005 cash basis Accrual basis Difference $ 83,000 144,000 $ 61,000 At the start of the year, current assets, on an accrual basis, exceeded the cash basis current amount by $61,000. This means that during the year $61,000 collected in cash was 2005 revenue. In other words, had the accrual basis been used, accounts receivable of $61,000 would have been set up in 2005. When this cash was collected in 2006 the cash basis recorded revenue, but the accrual basis would have a reduction in receivables. Therefore, cash basis net income must be reduced by this $61,000 to arrive at accrual basis net income. 2. Current assets 2006 cash basis Accrual basis Difference $ 96,000 174,000 $78,000 An increase in current assets at year-end results from accruing credit sales as accounts receivable and recognizing any prepaid portion of expenses. This increases net income for the period by $78,000. 3. Noncurrent assets 2005 cash basis Accrual basis Difference $ 36,000 $36,000 Had the accrual accounting method been used during 2005, noncurrent assets worth $36,000 would have been recognized. These would have been fixed assets purchased in the years preceding 2005. For example, because the company used a cash basis it would have expensed the assets completely in the year it purchased them. Noncurrent assets 2006 cash basis Accrual basis Difference $ 30,000 30,000 At the end of the year the noncurrent assets, on an accrual basis, would have been $30,000 or $6,000 less than the $36,000 at the start of the year. What could explain this decrease? It was, most likely, amortization: the company would have had an amortization expense of $6,000 had it used the accrual basis. 166 Instructor’s Solution Manual 4. Current liabilities 2005 cash basis Accrual basis Difference $ 37,000 55,000 18,000 Using an accrual basis the company would have had $18,000 more expenses in 2005. These bills were paid and recorded as expenses in 2006. To change the cash basis to the accrual basis would mean reducing the expenses in 2006 by $18,000, which would increase 2006 net income. 5. Current liabilities 2006 cash basis Accrual basis Difference $37,000 78,000 $41,000 At the end of 2006 the company had $41,000 in current bills outstanding that it did not record because it was using a cash basis. These extra (accrued) expenses would decrease net income in 2006. 6. Noncurrent liabilities 2006 cash basis Accrual basis Difference $ 16,000 $16,000 At the end of the year the company had $16,000 in noncurrent liabilities outstanding. For the same reasons as in #5 above this reduces the 2006 net income prepared on the accrual basis. Such liabilities might include pensions payable later to employees for their efforts in 2006. Solution Outline for Problem 6.9 1. Timing is at the centre of accrual accounting because in accrual accounting an attempt is made to recognize revenue earned in the current period and to recognize expenses required to generate that revenue in the same period. Cash flow accounting depends only on the timing of cash receipts and cash payments. Since revenue is not necessarily earned at the time cash is received, nor expenses paid for in cash at the time they are matched to revenues, accrual income will be different in most periods from flow income. Over the life of a business, total accrual income will be equal to cash income. 2. Revenue is often recognized at a point different from the associated cash receipts. The revenue recognition note will give you an indication of the timing of recognition when this differs from the timing of cash receipts. Examples of some timing differences are: • Revenue recognition at completion of production. Here revenue is recognized prior to sales to customers because the earnings process is complete. • When sales are granted on credit, revenue may be recognized at the point of sale which will be prior to the receipt of cash. • If there are major uncertainties related to collection of cash at point of sale, revenue recognition may be deferred until cash is received • If cash is received before goods are provided or services are performed, revenue is recognized after the cash is received, at the time when goods are provided or services are performed. 3. Over time cash revenue will equal accrual revenue. Customers granted credit may default or fail to make payments. Estimates are made in each period of the amount of possible defaults by customers. Because these are estimates, the amounts may not be 100% correct in any one period. However, over time estimated defaults by customers will equal actual defaults by customers. 167 Financial Accounting: Intregrated Approach, Sixth Edith 4. When expenses are matched to revenues the timing of payment of the expenses often differs from the timing of recognition of expenses. This can affect the balance sheet in a number of ways. Some examples are as follows: • An interest obligation occurs over time, therefore prior to payment we recognize the expense and record a liability. • Assets are paid for at the time of purchase, prior to the use of the asset to provide a benefit. We match the cost of the asset to the benefit generated by the use of the asset over time. Thus an expense is recognized in the appropriate period and the net value of the asset is reduced on the balance sheet. • We often pay for services prior to using those services. An example is rent paid in advance. This is recorded as an asset on the balance sheet until such a time as we obtain the benefit of the rented premises. • We often must make estimates of future obligations such as warranties. To the extent that the cost of the warranty is associated with the generation of current period revenues we recognize the estimated cost of the warranty as an expense of the current period and increase our liabilities by recording a liability for warranties. We will not pay for the costs associated with the warranty until a future period. Solution Outline for Problem 6.10 This problem is intended to prompt discussion. Though the problem takes a strong position, the discussion could lead to a more balanced conclusion, though agreeing with the commentator is quite possible. Here are some points that might be raised in a discussion: • Management’s interests are varied and do not necessarily emphasize narrow self-interest. For example, managers wanting to be supported by investors are likely to see value in fair reporting if it increases investor confidence. • The implication that management is conniving is unfair to many managers who view themselves as professionals who have reputations distinguishable from their companies’ and are concerned with having positive reputations. • Accounting policy choices are not freely made and are not all vague: there is a large network of rules and regulations that constrain companies to make fair choices (e.g., GAAP, stock exchange regulations, corporate incorporation statutes, and tax laws). • Various techniques exist for analyzing and interpreting financial statements and these will flag many potential abuses of accrual accounting, especially significant ones: management is in a bit of a “fish bowl” when financial statements are made public. • If management were inclined to make unfair choices, the “fort” is maintained by more than auditors, including financial analysts and competitors, and of course management can always be sued or charged under various laws if unfair financial statements are produced. • The auditor is not alone: in addition to various legal and contractual rights, the auditor has support from professional organizations and standard-setters and so has considerable power to insist on fair reporting or object if reporting is not fair. • Large corporations have audit committees of their boards of directors, composed of directors who are not part of management. Audit committees are intended to provide a check on management’s financial reporting and provide support to the auditor. Solution Outline for Problem 6.11 This problem invites the student to take any position on the choice of accounting policies and support that position. Some issues that might be raised are: • who has the knowledge to make the most appropriate choice; • who can do it cost-effectively (costs and benefits not necessarily borne by the same party, for example present shareholders may bear the costs and potential shareholders get some of the benefits); 168 Instructor’s Solution Manual • • • • • • • what are the broader social costs and benefits; who is motivated to make a fair choice; who has, or would have, the responsibility to report to shareholders and others on the enterprise's performance; what implications to competent and independent auditing of the results would there be (including the degree to which an audit would even be considered necessary) depending on who is making the accounting policy choice; political or economic considerations from the “interference” with management's job of running the enterprise that would result if someone other than management chooses accounting policies (perhaps governments or independent boards); effects on the attractiveness and remuneration of auditors; effects on the motivation of and incentives for managers, investors, stock market analysts and other important parties. Solution Outline for Problem 6.12 1. People may care for other reasons than effects on share prices, but the business person has a point in that research has not clearly shown policy choice to affect share prices. Policy choice that affects income tax payable or worsens ratios significant to agreements with creditors may well affect stock prices. Accrual accounting income reflects policy choices and there is some indication accrual income correlates better with stock prices than cash flow does, which suggests policy choices may matter to some market traders at least sometimes. 2. A company that follows accepted accounting standards and applies them on a conservative basis is not likely to produce any surprises for financial statement users. As long as the company consistently takes a cautious approach, the financial performance and position should be understandable to users. 3. The notes would not be needed if it was obvious what all the company's policy choices were, or if all supplementary details (such as details of shares, debt, income taxes, pensions, etc.) could be incorporated into the body of the financial statements. As neither of those conditions are likely to be true, the notes are necessary. They may be a nuisance, but they are not irrelevant! Solution Outline for Problem 6.13 Some points you might consider: • The clash between the two objectives is real and yet unavoidable in all measurement systems intended for general use (for example, university grading systems). • Somehow both objectives must be met (at least to some significant degree) or the financial statements will not be useful to anyone outside the company. • One solution proposed (and used) is to rely on the expert judgment of accounting professionals to find solutions applicable to each company that are still sufficiently comparable to other companies. • The conflict is important: it occupies much of the time and effort of accountants, auditors, and managers, and court cases have been fought over it. (It was determined in one important U.S. case that it was possible to follow GAAP and still provide financial statements that are unfair in representing the particular company.) • The large structure of authoritative accounting standards and other development of GAAP began after the 1929 stock market crash and subsequent depression. Has all this helped to prevent repetitions of those problems? 169 Financial Accounting: Intregrated Approach, Sixth Edith • Perhaps a measurement system that does not adjust for individual circumstances (your height measure is not affected by your management objectives) provides a more credible, useful measure than our approach of fitting the measure to the company. Some countries have quite inflexible rules for financial statements—why not Canada? Solution Outline for Problem 6.14 1. The kinds of information included in the Significant Accounting Policies note are descriptions of any important policies in which there is a choice between popular alternatives and/or the choice the company made is not otherwise apparent. Such kinds as: • inventory policy; • amortization policy; • accounting for pensions and other post-retirement benefits for employees; • revenue recognition policy (usually mentioned only if that policy is unusual or the company's circumstances are unusual); • policy for intercorporate accounting for any partly or fully-owned companies; • any other policies such as regarding accounts receivable allowances, intangible assets such as goodwill, or income taxes, knowledge of which is thought necessary to interpreting the financial statements. 2. A company should include factors such as these: • which policies appear important to understand the company's performance and position; • which company circumstances are sufficiently unusual or relevant that readers of the statements should be informed; • GAAP and the practices of similar companies; • any policies changed or more important since the previous year. 3. Consideration of this idea might include points such as: • value to users that is (presumably) the basis of the idea: would it help, how, whom? • perhaps paternalistic in suggesting that users cannot make this determination themselves (but reasonable too in that such a calculation probably uses information not normally available outside the company); • cost of preparing the information; • cost of auditing it if it is part of the formal financial statements; • quite a bit of judgment needed in determining whether the company's policy is “unusual” and deciding what the “more usual practice” is, especially where GAAP provide for several policies (as in inventories and amortization, for example). Solution Outline for Problem 6.15 These are some brief ideas to get you thinking. 1. It is presumed that users want to know whether or not the financial statements have been prepared following methods and policies that would be expected in the circumstances. Such knowledge is necessary to evaluating the information in the statements. The auditor's report therefore provides assurance on this important issue. 170 Instructor’s Solution Manual 2. Standards are written on the assumption that professional judgment will be applied to fit the general standards to each company's particular circumstances. Accrual accounting, by its very nature, lacks hard and fast rules and depends on the exercise of judgment. 3. How “aggressive” is it? In what ways? Does it serve the interests of any group such as investors, management, bankers, etc? If you were management, would you use “rosy” information or would you prefer the pessimistic forecast? Extremely conservative financial statements do not necessarily mean that “reality” (whatever that is) is appropriately depicted. Solution Outline for Problem 6.16 Points for discussion: The problems of companies boosting their earnings through the use of accounting practices are likely to be greater for high-tech firms. The issues of how to account for R&D and how to maintain growth patterns will lead some companies to use the techniques mentioned in the question. These companies are in the business of creating new ideas that will either be widely successful or a major failure. Accounting standards are more suited to traditional “bricks and mortar” types of business. Some have argued that harmonization of accounting practices would help with comparison of international high-tech companies. Problems are likely to continue whatever practices are required. The issue may be more a question of inflated market expectations and growth companies not wanting to admit that expansion cannot be sustained continuously. In the article the companies that argue that they are using “conservative” accounting practices are making these claims in relation to other high-tech companies that are even more aggressive. Relative to other industries the companies mentioned are hardly conservative in their accounting practices. Solution Outline for Problem 6.17 a. Cash, which is the same as point of sale for this fast-food business. b. On delivery, or perhaps even later to ensure the customer is satisfied. Selling such software often involves substantial effort later to help the customer use it. c. When production completed, but not necessarily when a specific customer has been found, might be considered, since selling gold is not a problem. But given the currently variable gold market prices, recognizing revenue on delivery might be most sensible. d. Cash basis—these are installment sales for which the collection is uncertain. e. Percentage of completion—these are long-term construction contracts with customers from which collection is reasonably assured, but may be slow and is unlikely to be earlier than the completion rate for the projects. f. Delivery basis (i.e. upon title transfer)—until this point, no customer or price is assured. Solution Outline for Problem 6.18 Case 1: Revenue should be recognized as the coupons are used not when the booklets are sold. The revenue from unused coupons would be recognized when the expiry date has passed. Case 2: The revenue should not be recognized until verified by a sale transaction. The cost of the building should be reported as an inventory asset on the balance sheet, not as part of buildings used in the business activities of the enterprise. 171 Financial Accounting: Intregrated Approach, Sixth Edith Case 3: The earnings activities of Korean Kar are substantially complete at the time of sale. The warrantee costs can be reasonably estimated and should be accrued in order to match the expense to the revenue recognized in the period. Case 4: No commissions are earned until the sale is completed. Allan should recognize all his commission revenue when the sale closes (the title to the property transfers to the purchaser). Solution Outline for Problem 6.19 a. Alaska Gold Co. • The company may be able to sell its entire inventory of gold at any time at the prevailing market price. This means that the amount of revenue can be measured in dollar terms. Although the gold has not been provided to customers, sales are reasonably likely. • Since mining and refining are the major costs of producing and selling gold, these costs have been incurred or are estimable at the end of the production process. • No collectibility problems. Therefore, gold mining companies used to recognize revenue when the production process was complete. However, in recent years when governments have been selling their gold stocks and there is no longer a guaranteed market, companies are more likely to recognize revenue on delivery to the customer. b. Crazy Freddie Co. • Goods have been provided to customers when they take delivery. • Cost of the goods have been established by purchase by Freddie from the wholesaler. • Amount of revenue is estimable by the selling price of the goods. • Severe collectibility problems because of customer defaults. Therefore, recognize revenue when cash is received. c. Tom and Mark's Construction Co. • Revenue can be reasonably measured because contracts are for a fixed fee. • Not likely to be a collection problem since there hasn’t been a problem in the past. • Costs can be measured with reasonable accuracy. • Although all of the services have not been performed until construction is complete, the customer has already been identified. Usually as construction proceeds, the purchaser obtains an interest in the partially completed asset. Therefore, recognize revenue as construction proceeds using the percentage of completion method for accounting for long-term contracts. d. Cecily Cedric Co. • Costs to generate revenue have been incurred by the time the toys are shipped. • Once the toys are shipped, the goods have been provided to the customers. • Revenue is established by the selling price of the toys. • Collection problems are minimal and can be estimated, thus the amount of cash or receivable can be measured with reasonable accuracy. Therefore, recognize revenue at the time the toys are shipped. 172 Instructor’s Solution Manual Solution Outline for Problem 6.20 a. Your answer should fit the circumstances. Some comments: • Point of delivery is probably too soon, because there are substantial after-sale adjustments. • However, point of delivery could be used as long as the revenue recognition was accompanied by an estimated reduction for later returns and allowances, if such an estimate is reliable. • Or a reasonable time after point of delivery, to allow for time for returns and adjustments, could be selected. • Point of cash collection subsequent to delivery could be considered, because some customers are very slow and there is some risk of noncollection. • Explanation of why the method chosen is appropriate should refer to the four revenue recognition criteria at the end of Section 6.6, and no recommended policy should be inconsistent with any of the criteria. b. (i) An unfilled order is not normally considered to affect the accounting by the transaction rule of Section 1.6. However, in this case, an unfilled order does have some impact. First is the inventory (asset) obtained, special to each order as each is a one-time-only design. Second is the cash received for the deposit on the order, accompanied by the customer deposits liability representing the obligation to the customer. (ii) Probably the best fiscal year-end would be in late fall to mid-winter, between the fall and spring busy seasons. There would be few deliveries then, and accounts receivable and inventories of specially ordered fabrics would likely be relatively small. Solution Outline for Problem 6.21 1. The following chart is a summary of events to assist in aswering this problem : End of 2005 – unused 2006 memberships sold 2006 visits used End of 2006 – unused Visits 85,000 120,000 (140,000) 65,000 Dollars ($4/visit) $340,000 $480,000 (or 1,200 x $400) $(560,000) $260,000 a. Revenue = 140,000 x ($400 / 100) = $560,000 (Revenue can also be calculated as (85,000 +120,000 –65,000) x $4 = $560,000) b. Deferred revenue = (85,000 + 120,000 – 140,000) x $4 = $260,000 2. The following chart is a summary of accounts receivable. This is for information purposes, since the information isn’t required to answer the problem. A/R, end of 2005 2006 memberships sold Collections (plug) Bad debts written off A/R, end of 2006 $22,000 $480,000 $(483,100) $(1,400) $17,500 Allowance for doubtful accounts $1,500 173 Financial Accounting: Intregrated Approach, Sixth Edith a. Accounts receivable No effect. Why: The members mentioned in the proposed policy are paid-up, so there would not be any receivables from them. b. Revenue Up. Why: Some of the deferred revenue would be added to revenue (in effect, the company would earn more revenue per actual visit). Solution Outline for Problem 6.22 1. Franchise revenue recognized by each company (assuming no discounting of future cash flows - see section 10.7, Chapter 10): Clucky Poulet Chicken Chicken 2004: CC $75,000 x 8; PC $150,000 x 8 $6,000,000 $1,200,000 2005: PC $75,000 x 6; PC ($150,000 x 6)+($120,000 x 8) 4,500,000 1,860,000 2006: CC no sales; PC $120,000 x 14 2007: PC no sales; PC $120,000 x 14 Subsequent years – for 2004 & 2005 agreements 2008: PC $120,000 x 14 2009: PC $120,000 x 14 2010: PC $120,000 x 6 0 0 10,500,000 1,680,000 1,680,000 6,420,000 0 0 0 10,500,000 1,680,000 1,680,000 720,000 10,500,000 Each year, the revenue recognized by each company will be different, however, over time it will be the same. 2. Any of the three possibilities could be chosen with a careful analysis based on the four main revenue recognition criteria: a. All or most of products/services provided? b. Most costs incurred, the rest estimable? c. Revenue reasonably measurable? d. Cash received or reasonably assured? However, it is unlikely that such an analysis would support PC's method (all revenue recognized upon signing). It is not generally acceptable in franchising because of the great initial uncertainty that a new franchisee can make a go of it (criterion d) and about how much help the franchisee will need (criterion b). Recognition over the life of the franchise agreement would be the usual method, and recognition as cash is received (CD’s method) would be indicated if there is substantial uncertainty about the viability of the franchises and/or the franchisees' ability to make the promised payments to the franchiser. Solution outline to problem 6.23 Rosemead should recognize revenue only at the time of sale. The uncertainty surrounding the ultimate timing and sales price of the trees is too great to allow revenue recognition at any earlier point. The costs of planting and raising the trees may be accumulated as inventory consistent with the lower of cost and market approach. 174 Instructor’s Solution Manual Solution Outline for Problem 6.24 Redneck Airlines, January 2, 2005 DR Accounts receivable CR Advance ticket sales To record sale of ticket to John. January 5, 2005 DR Cash CR Accounts receivable To record receipt of payment for ticket by John. January 17, 2005 DR Advance ticket sales CR Non-refundable passenger credits To record cancellation of ticket by John. February 7, 2005 DR Non-refundable passenger credits DR Cash CR Advance ticket sales CR Revenue (cancellation fees) To record John’s rebooking of flight and payment of cancellation fee. February 21, 2005 DR Advance ticket sales CR Revenue (flights) To record revenue from departing flight (half of the $400 return fare). February 23, 2005 DR Advance ticket sales CR Revenue (fare cancellations) To record revenue from returning flight missed by John. DR Cash CR Revenue (flights) To record revenue from one-way flight paid by John. 300 300 300 300 300 300 300 120 400 20 200 200 200 200 200 200 Solution Outline for Problem 6.25 a. The “economist's view” suggests a revenue earning pattern something like figure 6.6 in Section 6.6. The shape of the line will vary by product, by company and by other factors. If this view is correct, the accountant's method would lead to an undistorted measure of periodic income only if the accounting method of recognizing revenue and all related expenses exactly matches this line, whatever it is. For example, using completion of any of the activities in the figure as the single “critical event” in recognizing revenue and related expenses provides an abrupt recognition of 100% of the revenue. Drawing a vertical line anywhere along the figure would represent use of a single event. The distortion is clear: to the left of the vertical line, zero revenue is recognized although some has been earned according to the “economist's view”, and to the right of that line, 100% of the revenue has been recognized although not all has been earned yet according to the “economist's view”. 175 Financial Accounting: Intregrated Approach, Sixth Edith Under the “economist's view” revenue is earned at all points in the production process as well as at the time of sale and delivery. If we consider an example such as the manufacture of automobiles, the “economist's view” would be that each time an auto worker did something to the automobile, for example bolting the engine to the frame, revenue is created. Thus for the economist it is not necessary that the earnings process be complete in order to consider that revenue has been earned, nor is it necessary that there be some assurance as to the ultimate collectibility of that revenue. The accountant on the other hand considers that revenue has been earned when the earnings process is complete and collectibility of the revenue is somewhat assured. An event such as an autoworker bolting the engine to the frame of a vehicle would not cause the accountant to consider that revenue had been earned. Thus the only time that the economists view and the accountant’s view of the earning of revenue would coincide would be if all activities associated with the earnings process, including production, delivery and sale commenced in one period and were completed in the same period. Therefore, over the entire life of an entity, the economists and the accountant’s revenue numbers would agree. b. Some obstacles to the practical implementation of the “economist's view” as the basis of accounting income determination: • measuring the value added at each stage of the sequence of activities is quite difficult; • this difficulty would increase the subjectivity and estimation involved in determining income; • the extra paperwork and recordkeeping required by continuous revenue recognition would be costly; • once a company has been established for a while and has developed a “track record”, its performance may be evaluated reasonably well over time as long as it uses a consistent revenue recognition method that is not unreasonable, so perhaps there would be little real benefit to a more complex recognition method, to offset its higher cost; • complications involving income taxes, management bonus calculations and other arrangements may arise; • even if more accurate, a more complex method may be harder to understand, so users of the financial statements may not be grateful for the “better” information. Solution Outline for Problem 6.26 $000’s a. Completed contract basis: Year 1 Year 2 Year 3 Total Revenue Expense Income 0 0 5,200 5,200 0 0 4,300 4,300 0 0 900 900 b. Percentage completion basis: Year 1 Year 2 Year 3 Total 900,000 4,300,000 1,990,000 4,300,000 1,410,000 4,300,000 = 21% 1,092 (21%) 903 (21%) 189 (21%) = 46% 2,392 (46%) 1,978 (46%) 414 (46%) = 33% 1,716 (33%) 1,419 (33%) 297 (33%) 5,200 4,300 900 176 Instructor’s Solution Manual c. Cash received basis: Year 1 Year 2 Year 3 1,000,000 5, 200,000 2,030,000 5,200,000 2,170,000 5, 200,000 = 19% 1,000 (19%) 817 (19%) 183 (19%) = 39% 2,030 (39%) 1,677 (39%) 353 (39%) = 42% 2,170 (42%) 1,806 (42%) 364 (42%) 5,200 4,300 900 Total Solution Outline for Problem 6.27 Rimrock Construction Ltd. has several contracts for buildings: 1. 2. 3. a. Using the completed contracts basis to recognize contract revenues and expenses. #48 (100% complete): 200,000 #50 (100% complete): 150,000 350,000 b. Using the percentage of completion basis to recognize contract revenues and expenses. % complete in 2006 x Expected Income = 2006 Income #48 100% - 60% = 40% 200,000 80,000 #49 80% - 20% = 60% 200,000 120,000 #50 100% 150,000 150,000 #51 90% 480,000 432,000 #52 20% 280,000 56,000 838,000 Completed contracts method (a) is more conservative. Income recognition is postponed (to 100% completion) compared to partial earlier recognition so income accumulated to any date will always be equal to or greater than completed contracts basis. The amount of expenses recognized will not change, but $860,000 of expected revenue has been recognized instead of the revised expectation of only $100,000. Or, looking at another way: Income, completed contract method (1a above) Revised loss: $100,000 - $710,000 Adjustment required DR CR Bad debts expense Allowance or Accounts Receivable 150,000 610,000 760,000 760,000 760,000 177 Financial Accounting: Intregrated Approach, Sixth Edith Solution Outline for Problem 6.28 All parts in 000’s of Dollars a. Completed contract basis: 2004 2005 2006 Total Revenue Expense 0 0 7,500 7,500 0 0 5,850 5,850 b. Percentage of completion basis: 2004: (1,500/6,000)=25% 2005 (2,750/6,000)=46% 2006 remainder Total 1,875 (25%) 3,438 (46%) 2,187 7,500 1,500 (25%) 2,759 (46%) 1,600 5,580 c. Cash received basis: 2004 (2,025/7,500)=27% 2005 (3,150/7,500)=42% 2006 (2,325/7,500)=31% Total 2,025 3,150 2,325 7,500 1,620 2,520 1,7101 5,850 Income 0 0 1,650 1,650 375 (25%) 688 (46%) 587 1,650 405 630 615 1,650 1 Expense in 2004 and 2005 are calculated based on expected cost of 6,000. Expense in 2006 is the remainder of the actual costs since the contract is completed. d. If the contract were not completed 2006 figures become: Revenue (1,600/6,000) * 7,500 = 2,000 Expense 1,600 Income 400 The remainder of expenses and revenues would be recognized in 2007 if the contract is completed that year. Solution Outline for Problem 6.29 2006 contract expense: $11,210 (38% of $29,500); 2006 contract income: $5,130 (38% of ($43,000 – $29,500)). Solution Outline for Problem 6.30 Revenue (174,320 – 11,380 + 520 + 9,440) $172,900 Bad debts expense $ 520 COGS, wages, etc. (145,690 – 12,770 + 15,510 + 21,340 – 24,650) 145,120 Interest (12,000 × 8% × 1/12) 80 Income tax (2,340 + 3,400 + 1,230) 6,970 152,690 Accrual net income $ 20,210 178 Instructor’s Solution Manual Solution Outline for Problem 6.31 1. Contract payments called for: Stretch 1, completed and approved: 5 kilometres x $125,000 x (.35 + .45) Stretch 2, concrete poured: 5 kilometres x $125,000 x .35 Stretch 3, graded: 5 kilometres x $125,000 x 0 $500,000 218,750 0 $718,750 2. Contract income recognition: Two ways to compute the income are: (1) accrue income according to the work done; (2) match income only to contract progress payments. The first method would be sensible if the contract is going well and there is evidence the income has been earned, while the second method is more conservative and would be sensible if there is doubt about having earned more than just what the contract progress payments involve. Method (1) Stretch 1 % to recognize based on expenses incurred to date 100,000/ 100,000 =100% Revenue (above % of $125Kx5) Expense (above % of $100Kx5) Income $625,000 500,000 $125,000 Method (2) Stretch 1 % to recognize based on payments to date (from Part 1) Revenue (above % of $125Kx5) Expense (above % of $100Kx5) Income 80% $500,000 400,000 $100,000 Stretch 2 80,000/ 100,000 =80.0% $500,000 400,000 $100,000 Stretch 3 12,500/ 100,000 =12.5% $78,125 62,500 $15,625 $1,203,125 962,500 $240,625 Stretch 2 Stretch 3 35% 0% $218,750 140,000 $78,750 Total $0 0 $0 Total $718,750 540,000 $178,750 Solution Outline for Problem 6.32 This problem focuses on the idea of matching revenues to expenses, a central concept in accrual accounting. It uses various revenue and expense recognition policies. Here the focus is on the general process of measuring income by matching measures of revenue with measures of expense. Income taxes are ignored. 1. Net incomes: Units 2005: 2006: Produced Shipped Collected* Produced Shipped Collected* a. Production Basis Basis b. Shipment Basis c. Collection 150,000 120,000 60,000 120,000 135,000 95,000 179 Financial Accounting: Intregrated Approach, Sixth Edith Income 2005 ($3 per unit**) 2006 ($3 per unit**) $ 450,000 $ 360,000 $ 360,000 $ 405,000 $ 180,000 $ 285,000 Income statement*** 2005: Revenue($15) COGS($8) Selling($4) Income($3) 2006: Revenue($15) COGS($8) Selling($4) Income($3) $2,250,000 (1,200,000) (600,000) $ 450,000 $1,800,000 (960,000) (480,000) $ 360,000 $ 1,800,000 (960,000) (480,000) $ 360,000 $ 2,025,000 (1,080,000) (540,000) $ 405,000 $ 900,000 (480,000) (240,000) $ 180,000 $ 1,425,000 (760,000) (380,000) $ 285,000 * ** Units “collected” computed as total collections divided by $15 per unit. A proper matching of revenue and expense would include all revenues and expenses involved in the units being recognized as the basis of the income: $15 revenue minus $8 cost of goods sold and $4 selling expenses, net $3 per unit. Income statements were not asked for but are included here in case students calculated income the “long way” (but the equally valid way) of calculating total revenues and expenses instead of doing it the shorter per-unit way. *** 2. This is a challenging problem, because it requires thinking about the flow of numbers through inventory, accounts receivable, prepaid or accrued shipping expenses, and cash. The asset total is affected by the recognition basis, as the calculations below show: Cash Unaffected by accrual accounting. In all cases, cash would be the same: Inflow: Outflow: collections $900,000 + $1,425,000 production cost (150,000 + 120,000) x $8 selling expenses (120,000 + 135,000) x $4 Cash at end of 2006 $ 2,325,000 (2,160,000) (1,020,000) $ (855,000) Accounts receivable In all cases, the deduction from accounts receivable would be the same: total collections of $2,325,000 calculated above under Cash. But the addition to accounts receivable would vary: i. i. ii. Production basis: Revenue = (150,000 + 120,000) x $15 = $4,050,000. So receivables at end of 2006 would be $1,725,000. Shipment basis: Revenue = (120,000 + 135,000) x $15 = $3,825,000. So receivables at end of 2006 would be $1,500,000. Collection basis: Revenue = (60,000 + 95,000) x $15 = $2,325,000. So receivables at end of 2006 would be zero. 180 Instructor’s Solution Manual Inventory In all cases, the addition to inventory would be the same: total production cost of $2,160,000 calculated above under Cash. But the deduction of COGS from inventory would vary: i. Production basis: COGS = (150,000 + 120,000) x $8 = $2,160,000. So inventory at end of 2006 would be zero. ii. Shipment basis: COGS = (120,000 + 135,000) x $8 = $2,040,000. So inventory at end of 2006 would be $120,000. iii. Collection basis: COGS = (60,000 + 95,000) x $8 = $ 1,240,000. So inventory at end of 2006 would be $920,000. Prepaid shipping expenses (or accrued shipping liability) In all cases, the debit would be the same: total shipping expenses of $ 1,020,000 calculated above under Cash. But the credit would vary as different expenses are recognized (debit expense, credit prepaid or accrued): i. Production basis: Expense = (150,000 + 120,000) x $4 = $1,080,000. So accrued liability at end of 2006 would be $60,000. ii. Shipment basis: Expense = (120,000 + 135,000) x $4 = $1,020,000. So accrued liability (or prepaid expense) at end of 2006 would be zero. iii. collection basis: Expense = (60,000 + 95,000) x $4 = $620,000. So prepaid expense at end of 2006 would be $600,000. 3. Net incomes: 2005 Income before tax Tax provision Net income after tax 2006 Income before tax Tax provision a. Production Basis Basis b. Shipment Basis c. Collection 450,000 135,000 315,000 360,000 108,000 252,000 180,000 54,000 126,000 360,000 108,000 252,000 405,000 121,500 283,500 285,000 85,500 199,500 Solution Outline for Problem 6.33 Review of different companies financial statements will result in different discussions of these issues. a. Information can be obtained from other information in the annual report such as the MD&A section, as well as by reviewing the revenue and expense categories on the income statement. b. Information can be obtained from the significant accounting policy note. c. This will depend on the company selected. Reference can be made to the alternative revenue and expense policies in the chapter. d. Cash from operations may be higher or lower than net income. This depends on the non-cash items and changes in working capital accounts. 181 Financial Accounting: Intregrated Approach, Sixth Edith Solution Outline for Problem 6.34 Monthly expenses: a. April 30, 2005 April 30, 2006 b. June 30, 2005 June 30, 2006 c. Sept. 30, 2005 Sept. 30, 2006 d. Dec. 31, 2005 Dec. 31, 2006 Months in 2004: $375 ($4,500 / 12) Months in 2005: $400 ($4,800 / 12) Assume 2006 charge and payment timing are same as for 2005 Months in 2007: $425 ($5,100 / 12) Accrued: 4 months × $400 = $1,600 Expense: 8 × $375 + 4 × $400 = $4,600 Accrued: 4 months × $400 = $1,600 Expense: 8 × $400 + 4 × $400 = $4,800 Accrued: 6 months × $400 = $2,400 Expense: 6 × $375 + 6 × $400 = $4,650 Accrued: 6 months × $400 = $2,400 Expense: 6 × $400 + 6 × $400 = $4,800 Accrued: 9 months × $400 = $3,600 Expense: 3 × $375 + 9 × $400 = $4,725 Prepaid: 3 months × $400 = $1,200 Expense: 3 × $400 + 9 × $400 = $4,800 Accrued or prepaid = 0 Expense: 12 × $400 = $4,800 Accrued or prepaid = 0 Expense: 12 × $400 = $4,800 Solution Outline for Problem 6.35 1. Training costs, beginning of 2005 (prepaid expense) Training costs paid in 2005 Training incurred in 2005 Training costs, end of 2005 (negative, so an accrued liability) 148,560 808,760 (960,370) Expense (3,050) Injuries are irrelevant to the question as stated. 2. Tour costs, beginning of 2005 (accrued liability) Tour costs paid in 2005 Tour costs incurred in 2005 Tour costs, end of 2005 (negative, so accrued liability) (62,380) 814,630 (876,320) Expense 123,070 Solution Outline for Problem 6.36 January 31, 2006 1. DR Sales and marketing expense 11,000 CR Prepaid expenses 8,000 CR Accrued liabilities 3,000 2. DR Accrued liabilities 3,000 DR Prepaid expenses 10,000 CR Cash 13,000 182 Instructor’s Solution Manual February 28, 2006 1. DR Sales and marketing expense 16,000 CR Prepaid expenses 10,000 CR Accrued liabilities 6,000 2. DR Accrued liabilities 5,000 DR Prepaid expenses 4,000 CR Cash Prepaid expenses Accrued liabilities 9,000 10,000 8,000 6,000 4,000 2,000 0 2,000 4,000 6,000 8,000 10,000 Jan 1 Jan 31 Feb 28 Solution Outline for Problem 6.37 a. Aggressive accounting can involve selecting accounting policies that recognize revenue sooner rather than later, thereby increasing current net income. It can also involve selecting accounting policies that support capitalizing rather than expensing items, thereby increasing income and also the balance sheet value of assets, or deferring expense recognition until a subsequent period, thereby increasing current net income. b. Articulation refers to the double-entry reality that recognizing a revenue or expense for the income statement affects a corresponding asset or liability (cash, accounts receivable, inventory, accounts payable, customer deposits, etc.). Therefore, income measurement and balance sheet valuation are directly related. c. A deferred revenue represents revenue not used yet for income measurement because it has not yet been earned, and therefore kept on the balance sheet, usually as a current (vs long-term) liability. The existence of such an account means that revenue and income are lower than they would be otherwise, and that the balance sheet is weaker (higher current liabilities and lower working capital). d. Matching is a process whereby expenses are recognized at the same time as the related revenue. An expense that does not yet match with current revenue is deferred on the balance sheet as a prepaid expense or other asset. Matching thus affects both income and balance sheet values. e. Period expenses are those, like interest, that do not relate much to the revenue of a period but rather to the passage of time. Balance sheet values (like accrued or prepaid interest) thus relate also to the passage of time rather than revenue. So period expenses represent one of the weaker connections between income measurement and balance sheet valuation: they affect both, but do not tie them as the usual matching of revenues and expenses do. 183 Financial Accounting: Intregrated Approach, Sixth Edith f. Conservatism results in the recognition of anticipated losses but not anticipated gains. The effect is not to be overly optimistic in the reflection of net income and net assets. Thus income measurement is somewhat depressed, as are balance sheet values for such assets as accounts receivable and inventories, and balance sheet values for liabilities are raised. Solution Outline for Problem 6.38 a. b. c. d. e. f. g. h. Adjust? Journal Entry Y DR Accounts receivable 3,200 CR Revenue Y DR Cost of goods sold expense 1,900 CR Inventory Y DR Customer deposits liability 3,900 CR Revenue Y DR Store building (asset) 62,320 CR Maintenance expense Y DR Warranty expense 4,300 CR Warranty liability N No adjustment seems required for the pain and suffering claim. Y DR Audit expense 2,350 CR Accounts payable Y DR Automobile (asset) 17,220 CR Accounts payable Y DR Disribution rights amortization expense 500 CR Distribution rights (asset) 3,200 1,900 3,900 62,320 4,300 2,350 17,220 500 Solution Outline for Problem 6.39 a. Recognizing revenue when it has been earned means that accrual accounting records revenue when criteria have been met that provide reasonable assurance that the revenue is real. Thus, overly optimistic recording of revenue early on, such as when the customer makes an order, is unlikely, but so is overly pessimistic recording, waiting for all the cash to be collected. This procedure results in an asset called accounts receivable and means that the revenue on the income statement is different than the cash collected from customers. Reconciling the revenue with the cash collection is a major reason for having the cash flow statement to supplement the income statement. b. Balance sheet assets and liabilities include real physical assets and financial assets and liabilities, such as land, investments, loans, and debts. But the balance sheet also includes accounts that result from the attempt to measure income on a sensible economic basis in accordance with the company’s way of doing business. These include such “residuals” as accounts receivable (revenue recorded in the income statement but not yet collected), accounts payable (expenses deducted from income but not yet paid), accumulated amortization (the sum of amounts deducted from income to represent the economic use of noncurrent assets), and long-term liability provisions such as for warranties, pensions, and income taxes, which all represent expenses deducted from income but not yet due to be paid. c. Matching expense recognition to the period in which it was incurred means that expenses that arise due to the passage of time, or at least arise from other sources than the direct attempt to earn revenue, are deducted from income in the period in which they arose, not necessarily the period in which they were paid or had their greatest effect on income. Examples are interest expense, donations (whose effects on income may be much in the future due to increased reputation in the community), property taxes, and most research and development costs. 184 Instructor’s Solution Manual Solution Outline for Problem 6.40 1. (a) Assuming all 2005 receivables were collected in 2006: $12,460. (b) Assuming all 2006 deposits received are earned in 2007: $1,800. (c) Following through on those assumptions, $3,900 were earned in 2006 but not yet collected. 2. (a) Expenses paid in 2006 to be matched to 2005: $4,250. Expenses paid in 2006 to be matched to 2007: $2,500. (b) Expenses paid in previous years to be matched to 2006: $1,900. (All these assume that prepaids and accruals are for one year only.) 3. 4. Mike Stammer Accrual Basis Income Statement For the Year Ended June 30, 2006 Revenue ($85,000 - $12,460 - $1,800 + $3,900) Expenses ($34,600 - $4,250 - $2,500 + $1,900 + $5,250) Accrual basis income $74,640 35,000 $39,640 Reconciliation: Cash basis income 2005 items producing 2006 cash flows: (-$12,460 + $4,250) 2007 items producing 2006 cash flows: (-$1,800 + $2,500) $50,400 (8,210) 700 2006 items producing 2005 cash flows: (-$1,900) 2006 items producing 2007 cash flows: ($3,900 - $5,250) Accrual basis income $39,640 (1,900) (1,350) This reconciliation illustrates the four “cut-off” adjustments accrual accounting may have to make: 1. Recognizing in past years' incomes cash flows happening this year (-$8,210); 2. Recognizing in future years' incomes cash flows happening this year ($700); 3. Recognizing in this year's income cash flows happening in past years (-$1,900); 4. Recognizing in this year's income cash flows happening in future years (-$1,350). 5. Cash basis shows higher net income (although not so good if income tax has to be paid on it). Mike's earning cycle is short - his investigations likely do not take long to complete. He probably has few, if any, fixed assets. For these reasons, cash accounting should not be too far removed from accrual accounting, and the records are easier to keep. The major concern here is that the cash basis shows inflated income for 2006 due to collections on receivables; the receivables seem to be in line now but if they vary widely, Mike should pay some attention to this aspect of his business. The accrual basis will make it more clear how much economic value Mike actually generates each year in his business. Solution Outline for Problem 6.41 1. Several points B.B.P.L.'s revenue could be recognized: i. When the order is received; ii. When the toy manufacturer is notified (B.B.P.L. having done its job); iii. When the manufacturer ships the toy; iv. Two weeks after the estimated time the customer receives the doll. 185 Financial Accounting: Intregrated Approach, Sixth Edith Recommending one of the above (or others) should be based on the key criteria for recognizing revenue: a. All or most of the products or services have been provided. b. Most of the costs have been incurred, and the remaining costs can be measured. c. Revenue can be reasonably measured in dollar terms. d. Cash has been received or is reasonably assured, or a promise of cash can be relied on. The application of these criteria to this situation is certainly discussable, and different conclusions based on different judgments about the situation are to be expected. In this case, as B.B.P.L. has the cash early on, it may be quite acceptable to recognize revenue at point i. There is not much doubt the order will be filled, but if the manufacturer is falling behind and quality/delivery might suffer, and/or if returns are likely to be significant, a later point (even point iv) may be indicated. In any case, if an earlier point is used, the revenue recognition should be reduced by an allowance for returns and other problems. 2. Several points the manufacturer's revenue could be recognized: i. When the order is received from B.B.P.L.; ii. When the order is shipped; iii. Two weeks after customer's estimated date of receipt of order; iv. When payment is received from B.B.P.L. 3. The two components of the payments to players would be accounted for differently: a. The lump sum would be treated as an asset of G.S.P.I. and then would be amortized over the period of time each particular basketball player's name is expected to be helpful in selling dolls, to match the amortization expense to the revenue recognized. (It might be hard to estimate this period as player popularity can fall quickly, so if the lump payment is not very large it might just be expensed immediately, or over just one basketball season or two.) b. The royalty payments would be charged to expense as paid, or more appropriately (but requiring more accounting effort), accrued as an expense when the revenue from the relevant dolls is recognized. Solution Outline for Problem 6.42 1. a) Accounts for a book rewards liability and corresponding expense should be set up in the general ledger: DR Expense, CR Liability. This should be recorded continuously as customers earn the points (or at least when financial statements are needed), based on 5 cents for every $1 of revenue. b) The liability and the books inventory should both be reduced: DR Liability, CR Inventory. This should be done continuously as customers take their free books (or at least when financial statements are needed). 2. Some of the expected expense and liability would not be incurred. The policy should be modified to remove a portion of the entry in a) above for this. The entry should be recorded at less than the stated rate of redemption, or the liability and expense could be adjusted downward once in a while (when financial statements are being prepared). 3. Conservatism: showing a greater liability and smaller income to recognize the obligation to customers that the reward plan represents. Matching: getting the expense for giving out free books into the same period as the revenue the free books inducement helps to earn. 186 Instructor’s Solution Manual Solution Outline for Problem 6.43 1. Revenue recognition points: a. As cash is received: b. After the outlets have opened, recognize all revenue; c. At the signing of the contract, recognize all revenue; d. Recognize the full revenue after the down payment is received; e. On some other basis. 2. Rank: a. As cash is received; b. After the outlets have opened; c. After the down payment is received; d. After the signing of the contract. Most Conservative to Least Conservative 3. Methods of recognizing expenses: a. All general and franchise-related cost immediately; b. All general expenses, but only 18/28 of the franchise-related costs; c. All general expenses, but only 26/28 of the franchise-related costs; d. In proportion to the cash received; e. Some other formula. 4. Matching: a. “Cash received” revenue with “proportion of cash received” expenses (for example, ($5,000/$20,000) x ($230,000/28): after down payment is received); b. “After the outlets have opened” with general expenses plus (18/28) x $230,000; c. “After the down payment is received” with general expenses plus (26/28) x $230,000: d. “After the signing of the contract” with expensing all general and franchise-related costs immediately. 5. a. After the outlets have opened: Revenue: Expenses: General Franchise Total Expenses Net Income b. As cash is received: Revenue: Expenses: General Franchise Bad Debts Total Expenses Net Income (Loss) $360,000 $ 55,000 147,857 ($20,000 x 18) (18/28 x $230,000) 202,857 $157,143 $130,000 $ 55,000 53,393 24,643 (26 x $5,000) ([$5,000/$20,000]) x [$230,000/28] x 26) 133,036 $ (3,036) 187 Financial Accounting: Intregrated Approach, Sixth Edith Explanation: assuming that the existing $230,000 in franchise-related expenses are evenly distributed to each franchise, the total cost for each franchise to this date is $230,000/28 franchises = $8,214.29. Since we are using the cash received basis for income measurement, revenue is 26 x $5,000 = $130,000: franchise expense is ($8,214.29 x ($5,000/$20,000) x 26). The reason that only 26 franchises are included is that two have not paid any money ($0/$20,000 x $8,214.29 = $0 expenses). Bad debt expenses total (4 x $8,214.29 x $15,000/$20,000) = $24,643, because four franchises appear to be incapable of ever paying the remaining $15,000 outstanding. 6. The second revenue and expense recognition policy in Question 5 seems to be the best, because The Pie Place and its franchises are new and not really established yet. However, the complexity of its assumptions may be confusing. 7. A typical footnote may read: The company recognizes revenue on a cash basis and expenses are deferred and recognized according to the percentage that cash received is of the total franchise price remaining to be received. All general expenses are expensed in the period they are incurred. Remaining deferred expenses for any insolvent or closed franchises are written off. Solution Outline for Problem 6.44 1. Some methods of recognizing revenue from sales of the systems: i. percentage completion (as systems are built); ii. as contract billings are made; iii. as cash is received (including the non-refundable deposits); iv. when each contract is completed. 2. Any of the above methods could be chosen and defended, depending on an assessment of the quality of the systems, the contracts, the customers and other such factors. Assuming that these factors are reasonably under control, it is probably unnecessary to use conservative methods such as iii. or iv. above and appropriate to use a proportional method such as i. or ii. above. 3. Revenues and contract cost expenses (not including amortization of development costs) for the year ended November 30, 2006, based on the four methods in part #1: i. Revenue: Co. A: 40% x $2,000,000 $800,000 Co. B: zero 0 $800,000 Expenses: Co. A: 40% x ($2,000,000 - $250,000 margin) $700,000 Co. B: zero 0 $700,000 ii. Revenue: Co. A: billed $750,000 Co. B: no billings yet 0 $750,000 Expenses: Co. A: ($750,000/$2,000,000) x ($2,000,000 - $250,000) $656,250 Co. B: zero 0 $656,250 188 Instructor’s Solution Manual iii. Revenue: Co. A: cash received Co. B: cash received $600,000 337,500 $937,500 Expenses: Co. A: ($600,000/$2,000,000) x ($2,000,000 - $250,000) Co. B: ($337,500/$2,250,000) x ($2,250,000 - $250,000) iv. Revenue: Neither contract completed Expenses: Neither contract completed $525,000 300,000 $825,000 $ 0 $ 0 4. It appears that $1,000,000 of the costs were for a failed project, so a maximum of $1,500,000 may be capitalized if there is evidence of continuing value (that is, if those costs were really necessary to the existence of the systems as they are now being built and sold). 5. Amortization of any such capitalized development costs is necessary because the reason they were capitalized is that they were necessary to the production of the systems. As systems are built, the value represented by the costs is presumed to be consumed (especially as there is a limited time during which the systems are expected to be marketable) and so the costs should be amortized to recognize the expense from that consumption. 6. Amortization methods can be arbitrary. We have only covered straight line amortization in the text so far. However, there are many different methods of allocating the cost of assets to the income statement. Two methods of amortizing the development cost (more could be imagined): a. Straight-line over 5 years: Capitalized costs (part #4) $1,500,000 Amortization for 2006 (1/5) $ 300,000 b. Per system, based on expected sales: Capitalized costs (part #4) Expected system sales Costs per system $1,500,000 12 $ 125,000 Amortization expense should vary depending on the revenue recognition method (parts (a) and (c)), but to keep this illustration simpler, it will be matched to proportion of expected contract costs spent: Co. A 40% x $125,000 = Co. B zero 7. $50,000 0 $50,000 Combining parts #3 and #6 provide many possible sets of financial statements. Here are four using amortization method i., based on expected sales. They all assume that, in addition to the revenue recognition and amortization, the further $200,000 in contract costs are accrued and the $1,000,000 of failed development costs are written off. 189 Financial Accounting: Intregrated Approach, Sixth Edith Programs Plus Inc. Statements of Income and Retained Earnings for 2006 i. Revenue Expenses: Contract costs Amortization Operating income Cost write-off Loss for 2006 Beginning R.E. Ending deficit Revenue Recognition Method ii. iii. $ 800,000 $ 750,000 $ $ 700,000 50,000 $ 750,000 $ 50,000 (1,000,000) $ (950,000) $ (950,000) $ 656,250 50,000 $ 706,250 $ 43,750 (1,000,000) $ (956,250) $ (956,250) $ 825,000 50,000 $ 875,000 $ 62,500 (1,000,000) $ (937,500) $ (950,000) 937,500 iv. $ - $ 50,000 $ 50,000 $ (50,000) (1,000,000) $(1,050,000) $(1,050,000) Programs Plus Inc. Balance Sheets as at November 30, 2006 i. Assets: Cash Cost inventory* Unamort. costs Liab. + Equity: Deposits** Cost liability* Accounts payable Share loan Share capital Deficit * ** $ 937,500 $ 937,500 1,450,000 $2,387,500 $ 137,500 200,000 1,500,000 1,500,000 (950,000) $2,387,500 ii. $ 937,500 43,750 $ 981,250 1,450,000 $2,431,250 $ 187,500 200,000 1,500,000 1,500,000 (956,250) $2,431,250 iii. $ 937,500 $ 937,500 1,450,000 $2,387,500 $ 125,000 200,000 1,500,000 1,500,000 (937,500) $2,287,500 iv. $ 937,500 700,000 $1,637,500 1,450,000 $3,087,500 $ 937,500 200,000 1,500,000 1,500,000 (1,050,000) $2,387,500 Inventory of not-yet-expensed contract costs (or cost liability) equals the total costs of $700,000 after accruing the $200,000, minus the contract costs expensed in 2006. Deposits liability equals the total cash received ($937,500) minus the revenue recognized in 2006. The statements using other amortization bases would be different only in the amortization expense which would therefore affect net income, deficit and net unamortized costs asset. 190 Instructor’s Solution Manual 8. Cash flow statements for 2006, using the four income statements above: Programs Plus Inc. Cash Flow Statement for 2006 i. Operations: Net loss Non-cash exp.: Amort. Write-off ii. iii. iv. $ (950,000) $ (956,250) $ (937,500) $(1,050,000) 50,000 1,000,000 $ 100,000 50,000 1,000,000 $ 93,750 50,000 1,000,000 $ 112,500 50,000 1,000,000 $ - 137,500 200,000 $ 325,000 (43,750) 187,500 200,000 $ 437,500 125,000 200,000 $ 437,500 (700,000) 937,500 200,000 $437,500 Non-cash W.C.: Inventory Deposits Cost liability Accounts payable Increase in cash Proof: $825,000 cash received minus $500,000 cash paid during 2003 = $325,000. Solution Outline for Case 6A This case is composed of six independent real-company examples, the identities of all of which have been disguised. Any of the six, in any order, may be discussed and may be related to other examples in Chapter 6. Below are ideas to assist in holding a discussion of the examples. 1. Accounting and business issues. Great Chicken is unfortunately typical of many fast food franchise operations. Initially, there is great enthusiasm for the business idea and many investors step forward to purchase individual franchises. The company that initiated the operation (the franchisor) has an important decision to make regarding revenue recognition: when can it say it has earned the revenue from selling the franchises? Great Chicken appears to have taken an aggressive approach to recognizing revenue, which is not justified unless all the franchise operations are successful. At the beginning, Great Chicken looks great. Lots of revenue, little in expenses, good profits. The real problem comes in the near future, when all the revenue has been recognized but the inevitable operating problems and decline of enthusiasm occur, as described in the case. As growth slows down due to operating problems at the franchise level, the franchisor is faced with writedowns in the value of the franchises, higher expenses and lower revenues (because too much revenue was recognized already). The individual franchises also see their profits decline and in many cases they close down. Great Chicken failed completely. A more conservative approach to revenue and receivable recognition may not generate as much initial investor interest, but will in the long run produce a better outcome because the company’s real ability to earn revenue is better reported and so dampens the over-enthusiasm at the beginning. Nothing, however, would compensate for the plain incompetence that Great Chicken and its franchisees displayed! Ethics. A discussion would be useful of the ethics of taking people’s money without having the expertise to help them be successful. Another ethical issue is the use of aggressive accounting to mislead everyone about the company’s performance (probably including the company’s managers, certainly including franchisees and investors). 191 Financial Accounting: Intregrated Approach, Sixth Edith Accounts involved. The main accounts are the ones we saw in Chapter 6 regarding revenue recognition: franchise receivables and the associated franchise revenue. Probably the associated expenses and liabilities were not recorded either, leaving the balance sheet looking much too strong, with overstated current assets, overstated equity (due to high profits) and understated liabilities. Working capital would be overstated. The cash flow statement would probably have revealed these problems, if it had been carefully read: cash from operations would have been much less than net income. 2. Accounting and business issues. Intensive Research Inc. is faced with a familiar problem of start-up companies – low revenues and large expenses that would produce losses instead of earnings and deficits rather than retained earnings. Losses on the income statement and a deficit on the balance sheet may make it difficult to raise capital through the issue of shares or long-term debt; however, this is the obvious consequence of not yet producing much revenue, and it should not be hidden by accounting machinations. The president’s contention that deferring (capitalizing) expenses produces a better matching of the remaining expenses with low or zero current revenue is not appropriate. The R&D expenses cannot be deferred until future periods unless there is a clear indication of financial and operational viability of the specific products. The proposed long-term asset should only be recorded if there is a strong likelihood of future benefit from the asset. Capitalizing enough each year to produce a net income just above zero is obviously a manipulation that should be criticized. Doing something like this is what got WorldCom into trouble in 2002, for example. Ethics. The main ethical issue is the attempt to use accounting to paint a desired picture rather than reflect what is actually happening to Intensive Research Inc. It is slow to get started, and that is the reality. Perhaps the president would raise another ethical issue: do GAAP (not allowing capitalizing R&D – see Chapter 8) result in an improper portrayal of the company and hurt its prospects? Accounts involved. Long-term assets, R&D expenses, retained earnings (deficit). For such a company, a reasonable picture of its real viability might be obtained from its cash flow statement, which would “correct” for expense capitalization and amortization. 3. Accounting and business issues. The Central Community Association included cash deposits for future events as revenue when they should have been recorded as deferred revenue. The Association did not follow the matching principle that would require them to specifically match the revenue against the actual expenses incurred at the time of the event. By recognizing revenue early the association manager had made an incorrect assumption about the cash available for repairs and cleaning, which would produce a loss for the year. Since the by-laws and government rules prevent the association from recording a loss, there is a reluctance to establish a deferred revenue account. The manager’s reasons for not deferring revenue are not appropriate and the association has little choice other than recording a loss for this period. The idea that asking for payments in advance amounts to a permanent gain really follows from a “cash income” concept – the Association is better off in cash by getting it earlier (at least as long as the manager doesn’t spend it!). One avenue tobe explored is whether the manager’s extra spending did create some assets such as prepaid expenses, which if removed from expenses might also remove the loss. This should not be done unless there is clear evidence of asset creation (as in the Intensive Research Inc. example). Ethics. Failure to follow proper accounting to avoid a by-law problem is inappropriate. Accounting should report the economic reality, not be used to disguise it. There is also an ethical issue in the manager’s behavior, or in the board of directors’ failure to supervise the manager properly. Is not understanding the accounting implications of the business decision to require prepayment an ethical issue? It would be if there were professional accountants involved in the board of directors! 192 Instructor’s Solution Manual Accounts involved. Deferred revenue liability and revenue. Perhaps prepaid expenses and operating expenses. The Association’s working capital and equity will be overstated along with its income. 4. Accounting and business issues. Morgan Lumber has created a “plugged” number for inventory in order to produce the necessary number for cost of goods sold and hence income. This is a serious manipulation that appears to be the work of the president alone. Whether the financial statements are audited or not, an actual count of inventory at year-end is always required. The periodic method of recording inventory requires that once a year the inventory be adjusted to the actual amount on hand (see Chapter 7). Income statement results should never be adjusted to meet bank, tax or even budget expectations. The results should reflect the year’s financial performance by properly measuring cost of goods sold and will normally show some variation from year to year. Ethics. Any auditors or professional accountants involved should not associate themselves with the president’s procedure. It is clearly an unethical accounting manipulation, without even the justification that Great Chicken and Intensive Research had. The president is deliberately misleading the bank, and may be accused of criminal tax evasion. Accounts involved. Inventory and cost of goods sold. Resulting income, working capital and equity are incorrect. The cash flow statement would not reveal this sort of manipulation because it is not an accrual adjustment, but rather falsifies the data on which accounting depends. 5. Accounting and business issues. The Western Business Bank was relying on the increased value of property owned by borrowers to act as security for their loans receivable asset. The fact that borrowers were having trouble making interest and principal payments on these loans should have alerted the bank to potential trouble ahead. Banks are required to make appropriate loan loss provisions for non-performing loans (see Chapter 7 re: allowance for doubtful accounts). The Western Business Bank may also have made a bad operating decision to have so many borrowers relying on real estate values, so that when the real estate market collapsed, the bank was dragged down too. Accumulating the loan interest on top of the principal part of the loan was poor judgment and probably against current GAAP. The interest was claimed to have been earned, which is rather doubtful when borrowers were not making the interest payments. Ethics. The Bank’s responsibility to depositors to safeguard their money may have been forgotten in its attempts to maintain a positive set of financial statements. The ethical implications of accounting manipulation are still present even if the Bank’s accounting was not deliberately wrong, just based on faulty reasoning. Accounts involved. Accounts receivable (both principal and accumulated unpaid interest portions), interest revenue, resulting net income. The Bank’s failure also involved its customer bank accounts liability. 6. Accounting and business issues. Brilliant Software suffered from a classic problem of actual sales not meeting growth projections. When sales were slower than managers and investors would like, the company resorted to a series of frauds to inflate sales. Falsifying sales orders would not produce higher income, so the company had to find a way to increase shipments of products. Obviously, shipping to their own warehouse was a deliberate attempt to hide the inventory from the company’s auditor and was an illegal practice. 193 Financial Accounting: Intregrated Approach, Sixth Edith Ethics. The accountants and auditors seem to have been asleep at the switch. The whole revenue base of the company was fraudulent, and head office was active in the fraud, which produced growing accounts receivable that someone should have noticed. There must have been considerable collusion to the fraud within the company, as the invoices, receivables and falsely shipped inventories would have involved several people. Accounts involved. Accounts receivable, revenue, inventories, cost of goods sold, plus the resulting equity. Working capital, net income and debt-equity ratio would all be mis-stated. The cash flow statement should have revealed the fraud, but only if someone was paying attention! Solution Outline for Case 6B This case discussion should be based on ideas and events depicted in the Collingwood article plus any events happening since. Some possible “lessons” that might be discussed are outlined here. • Investors and analysts’ “fixation” on earnings reports has created incentives for managers to manipulate those reports. Such reports require considerable scrutiny, not just faith. • Comparing earnings to earnings targets may exacerbate the problem, because now there is an additional incentive to manipulate the targets and then to manipulate earnings against those targets. If both targets and earnings are under management’s control, the temptations for manipulation of something may be too great. • Maybe companies that seem to perform too well, or too close to expectations, should be given extra scrutiny. • The article indicates that the obsession was not just with earnings, but with growth in earnings. So the points above apply also to growth. A study is reported that indicates no company forecasts anything but growth. • The article suggests that managers are almost compelled to play such accounting games, because presumably of the incentives built into the system. Does that mean managers are not responsible for their accounting manipulations? • The article mentions two economic lessons. One: higher earnings this quarter don’t predict higher earnings next quarter. Two: rapidly growing profits don’t necessarily indicate financial health – they may indicate accounting tricks. The article mentions cash generated from operations as a better indicator than net income, especially when tricks are suspected. This is a message also from Chapter 4, which points out that the cash flow statement can be helpful in detecting tricks, or at least indicating questions to be followed up. • A lesson mentioned by the article is not to rely too much on one indicator but rather to use as much data as can be found about company performance. • The article talks about failures by professionals like auditors and securities analysts to do their job of subjecting accounting reports to scrutiny. One lesson is that the fact that financial statements have been audited doesn’t take away investors’ and other financial statement users’ responsibility to study and understand the information. • The article mentions “divided loyalties” examples of auditors being too much involved in their clients’ business to be properly objective. 194 Instructor’s Solution Manual • A possible lesson is that GAAP are too flexible. (This is contentious: US accounting standards are generally very detailed, more so than in many other countries. This detail did not prevent abuse – instead, there appeared to be more abuse in the rule-based US setting than in the more judgmental GAAP systems in Canada, Britain, etc.) • Related to this chapter’s content, the kinds of manipulations referred to in the article involve improper recognition of revenues and expenses and so improperly calculated income (earnings are the article’s main focus). It’s clear that accrual accounting’s main strength, its ability to go beyond cash flow to “tell a story” that has a broader economic meaning, is also a great vulnerability because that story may be improper. A lesson is that accrual accounting only works well if it is done properly and if the temptations to push the numbers around are resisted by managers, or at least by the auditors and accountants involved. 195