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Financial Accounting: Assets Assignment

Question 1 (15 marks)Evergreen Inc. operates a tree farming business. It plants, maintains, and harvests evergreen trees. It sells the trees for cash, primarily during the Christmas season in parking lots at select locations in major urban areas. It normally takes about 15 years for a tree to grow to a suitable size. The biggest cost of this business is the cost of fertilizing, pruning and maintaining the trees over the 15-year period.

Required1. (10 marks)

Use the criteria for revenue recognition to explain when revenue should be recognized for this tree farming business.

2. (5 marks)

How should the annual cost of fertilizing, pruning and maintaining the trees be accounted for?

Question 2 (27 marks)Multiple choice (1 mark each)a. In general, in what period should costs be expensed?

1) The same period in which they are incurred2) The period in which they are paid for3) The same period in which the related revenue is recognized4) The period after the related revenue is recognized

b. When is revenue recognized under the percentage-of-completion method of recognizing revenue from long-term construction contracts?

1) Revenue is recognized as soon as the contract price is known.2) Revenue is recognized in each period based on an estimate of the amount of

work completed in that period.3) Revenue is recognized when the construction project is completed and all

costs are known with certainty.4) Revenue is recognized as the progress payments are received from the

customer.

c. In selecting an accounting method for a newly contracted long-term construction project, what is the principal factor that should be considered?

1) The terms of payment in the contract2) The methods used by other contractors in the industry3) The reliability of the estimate of the progress toward contract completion4) The method usually used by the contractor to account for other long-term

construction contracts

d. Revenue is recognized earliest using which of the following revenue recognition methods?

1) At date of sale

2) Instalment sales method3) Completion-of-production method4) At delivery

e. In general, revenue is recognized when the earning process is substantially complete and also which of the following?

1) The sales price is measurable and collectible.2) The sales price has been collected.3) Production is completed.4) A purchase order has been received.

f. Why do most retail enterprises recognize revenue at the point of sale?

1) The price is known.2) Collectibilty of any amounts owing is reasonably assured.3) Future costs associated with the sale such as warranty costs and returns can be

reasonably estimated.4) All of the above

g. What is the accounting definition of losses?

1) Decreases in net assets from regular operating activities2) Decreases in net assets from activities outside the enterprise’s normal business

activities3) Expenses4) Increases in net assets from activities outside the enterprise’s normal business

activities

h. The process of recognizing depreciation expense by allocating the cost of an asset to depreciation expense over its useful life is an example of what accounting principle?

1) The revenue recognition principle2) The matching principle3) The reliability principle4) The historic cost principle

i. Which financial statements are affected when revenue is recognized?

1) Balance sheet only2) Income statement only3) Both Balance sheet and Income statement4) Depends on the type of revenue

j. Which of the following is true with respect to depreciation?

1) Depreciation is an allocation of the cost of property, plant, and equipment in a rational and systematic manner to the periods in which such items are used.

2) Depreciation is a process of recognizing the decreasing value of an asset over time.

3) Depreciation is a cash expense.4) Depreciation of €4,000 reflects a €4,000 increase in liquid assets.

k. When inventory items are not ordinarily interchangeable, what inventory costing method should be used to compute ending inventory and cost of goods sold?

1) Moving weighted average2) FIFO3) Specific identification4) Weighted average

l. In a period of declining prices, which inventory costing method will normally produce the lowest ending inventory figure?

1) Weighted average2) Specific identification3) Moving weighted average4) FIFO

m. How should development costs be accounted for according to IAS 38?

1) They must be capitalized when incurred and then depreciated over their useful lives.

2) They must be expensed in the period incurred.3) They must be capitalized when incurred and then expensed over a period not

exceeding five years.4) They must be expensed in the period incurred unless it is reasonably certain

that the expenditures will provide future benefits.

n. How should research costs be accounted for according to IAS 38?

1) They must be capitalized when incurred and then depreciated over their useful lives.

2) They must be expensed in the period incurred.3) They must be capitalized when incurred and then expensed over a period not

exceeding five years.4) They must be expensed in the period incurred unless it is reasonably certain

that the expenditures will provide future benefits.

o. The straight-line method of depreciation is based on what assumption?

1) The calculation of depreciation expense should be as simple as possible.2) Revenue is generated from the asset at a constant rate over time.3) Proportionately more revenue is generated in the early years of the asset’s

useful life than in the later years.4) The asset has an indefinite useful life.

p. Which depreciation method would, in theory, provide for the best matching of cost to the related revenue?

1) Straight-line2) Double declining balance3) Sum-of-the-units4) Compound interest

q. If a company constructs a laboratory building to be used as a research and development facility, how should the cost of the laboratory building be expensed?

1) Research and development expense in the period(s) of construction2) Depreciation deducted as part of research and development costs3) Depreciation or immediate write-off depending on company policy

4) An expense at such time as productive research and development has been obtained from the facility

r. What is the similarity between deferred charges and prepaid expenses?

1) They are both reported as current assets on a classified balance sheet.2) They will both be debited to expense in some subsequent period in accordance

with the matching principle.3) They are both reported as non-current assets on a classified balance sheet.4) They are both expensed in the period immediately following the balance sheet

on which they appear.

s. Mango Inc. went to court this year and successfully defended the brand name of its product, “EnviroPack,” from infringement by a competitor. The cost of this defence should be charged to?

1) Patents and amortized over the legal life of the patent2) Legal fees and amortized over five years or less3) Expenses of the period4) Trademarks and amortized over a given period

(2 marks each)Note: The following information should be used to answer part (t) and part (u)

BC Construction Limited contracted to build an office building for XYZ Holdings Inc. for €2,000,000. Construction began in January 20X6 and was completed in December 20X7. Details of the activities related to this contract are summarized as follows (in €000s):

20X6 20X7

Costs incurred to date 400 1,700Estimated costs to complete 1,200Progress billings to date 300 2,000Collections on progress billings to date 250 2,000

t. How much gross profit can BC recognize for this contract in 20X6 under the percentage-of-completion method of revenue recognition?

1) Zero2) €100,0003) €133,3334) €266,667

u. Assuming BC is unable to estimate costs to complete the project at the end of 20X6, how much gross profit would BC recognize on this contract in 20X7?

1) Zero2) €50,0003) €300,0004) €450,000

v. Vermil Inc. began operations on January 1, 20X6, and uses the FIFO method of inventory costing. Management is contemplating a change to the average costing

method to be consistent with Vermil’s parent company and is interested in determining what effect such a change will have on 20X7 profit. Accordingly, the following information has been developed (in €000s):

20X6 20X7

Ending Inventory: FIFO € 96 € 108Average cost 80 84

Profit (computed under the FIFO method) 580 780

Based on the above information, what will the 20X7 profit be after a change to the average cost method of inventory costing?

1) €7402) €7563) €7724) €780

w. Zenon Ltd. sells products with a two-year warranty period. During the current year Zenon has sales of €600,000. Based on many years of experience, Zenon is able to reliably estimate warranty costs at 6% of the original sales amount. During the current year, Zenon incurs €30,000 of warranty costs related to products sold the prior year and also incurs €14,000 of warranty costs related to products sold this year. Assuming Zenon records revenue at the time of sale, what is warranty expense for the current year?

1) €44,0002) €14,0003) €36,0004) €12,000

Question 3 (26 marks)Caragana Construction Ltd. contracted to build an office building for €6,600,000. Construction began in September 20X5 and is scheduled to be completed in May 20X7. Data related to this contract are summarized as follows (in €000s):

20X5 20X6 20X7

Costs incurred during the year € 1,000 € 3,600 € 2,100Estimated additional costs to complete 5,000 2,200 —Billings during the year 900 2,600 3,100Cash collections during the year 850 2,200 3,550

The balance sheet presentation for this contract for 20X5 and 20X6 was as follows:

20X5 20X6Assets:

Accounts receivable € 50 € 450Construction in process € 1,000 € 4,400

Less: Progress billings (900 ) 100 (3,500 ) 900


Which method of accounting for revenue recognition (percentage-of-completion or completed contract) did Caragana use for the long-term construction contract for 20X5 and 20X6? Explain.

2. (9 marks)

Prepare the income statement presentation for this contract for 20X5 and 20X6 under the other method of accounting for revenue recognition. Show your supporting calculations.

3. (2 marks)

Which method would you recommend for Caragana? Explain.

4. (12 marks)

Prepare journal entries for each of the three years under each of the alternative revenue recognition methods.

Question 4 (14 marks)Air Plain Ltd. is a regional airline. Individual travellers typically reserve their flights at least three weeks prior to departure, and pay for the flights two weeks prior to departure. Corporate travelers typically book their flights through a travel agent and do not pay for their flights until 30 days after the flights have been taken and the invoice rendered.

Occasionally, travellers make reservations but do not take the reserved flight and do not bother cancelling their reservations. These passengers receive a refund of amounts paid less a €75 administration fee. If they did not pay for the reserved flight, they are billed a €75 administration fee for not using the flight. However, more than 50% of these €75 billings are never collected and are eventually written off by the company


Based on the information provided and using the criteria for revenue recognition, state why revenue should or should not be recognized:

a. at the time of reservationb. when cash is collected (prior to taking the flight)c. at the completion of the flight

2. (8 marks)

Now assume that all revenue is recognized at the completion of the flight.

a. How should cash received for flights reserved but not yet taken be accounted for?b. How should the unused but unpaid flights (reservations made, flight not taken, and

reservations not cancelled) be accounted for?

Question 5 (18 marks)Global Aircraft Manufacturers Ltd. is a manufacturer and seller of a wide range of commercial and military aircraft for markets around the world. During the year it has incurred expenditures of €32,000,000 on its RX7 project. The RX7 is a stretch version of its popular RX6 aircraft that has been in service for a number of years. During the year, a prototype was completed and a number of test flights were successfully completed.

Major airlines around the world have been impressed with the plane and have signed firm orders for 50 of the aircraft, expected to be in commercial production in three years. Global expects that it will need to sell 150 of the planes to break even on its investment and is comfortable it will be able to do so.

During the year, Global also incurred expenditures of €2,500,000 on its Personal Jet (PJ) project. The PJ project is dedicated to designing and building a commercially viable personal jet about the size of a car that can fly at speeds up to 900 kilometres per hour. Most of the €2,500,000 in expenditures incurred in the current year was for salaries for a team of aeronautical engineers working on the project. To date, a number of computer models of the PJ have been developed, but no prototypes have been developed. Global thinks there will be a market for these personal jets but, at this time, has no idea what the total development costs will be and what an estimated sales price might be. No orders for the PJ have been taken by Global.


How should Global account for the expenditures incurred during the year on its RX7 project? Carefully support your answer with specific reference to the appropriate criteria.

2. (6 marks)

How should Global account for the expenditures incurred during the year on its PJ project? Carefully support your answer with specific reference to the appropriate criteria.

3. (6 marks)

Using inventory held for resale as an example, explain when costs incurred should be expensed.

Suggested solutions

Question 1 (15 marks)Requirement 1 (10 marks)

Revenue should be recognized when the trees are sold to the customer during each of the Christmas seasons because that is when the benefits and risks of ownership pass from the company to the customer. Until then, the company does not know whether any customers will buy their trees or how much the customer will pay for the trees (measurement of amount). There is so much competition and one never knows how many trees will be sold. Some trees may have to be discarded if they do not sell. Also, at the time of the sale, cash is collected so there is no uncertainty as to collectibility. The company has little or no risk once the tree is sold because it is very unlikely that the tree will be returned.

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Requirement 2 (5 marks)

The annual cost of fertilizing, pruning, and maintaining the trees should be capitalized as a cost of inventory. In effect, the trees are like work-in-process inventory. Then, when the trees are sold, all of these costs will be expensed as cost of goods sold. This is an example of the matching principle and the point of sale recognition method.

Question 2 (27 marks)Multiple choice (1 mark each)a. 3)

Under the matching principle, costs should be expensed in the same period as the related revenues are recognized.

b. 2)

The percentage-of-completion method of revenue recognition is an example of recognizing revenue as effort is expended, or as the work is done. If a reliable estimate of the percentage of the total work completed in a period can be made, then that proportion of total revenue from the project will be recognized.

c. 3)

If the percentage-of-completion can be reliably estimated, then revenue will be recognized based on the amount of work done. If it is not possible to estimate the stage of completion, then revenue will only be recognized to the extent of costs incurred in the period.

d. 3)

The completion-of-production method of revenue recognition recognizes revenue as soon as production is complete. The other three methods recognize revenue only at date of sale to customer, or later.

e. 1)

Generally, the conditions that are required before revenue can be recognized are that the earnings process is substantially complete and the sales price is measurable and collectible.

f. 4)

The revenue recognition criteria of performance, measurability, and collectibility are generally all met at the time of sale.

g. 2)

Losses are defined as decreases in net assets from activities outside the enterprise’s normal operating activities. Expenses are decreases in net assets from an enterprise’s normal business activities.

h. 2)

Under the matching principle, expenses (cost of efforts) are matched to revenues (accomplishments).

i. 3)

Since revenue is defined as an increase in net assets from normal operating activities, both Income statement accounts (Revenue) and Balance sheet accounts (assets or liabilities) must be impacted.

j. 1)

Depreciation is a method of transferring the cost of an asset to expense over the period that the asset produces revenue in accordance with the matching principle. There is no cash involved in the allocation process.

k. 3)

IAS 2 specifies that the specific identification method of inventory costing should be used when inventory items are not ordinarily interchangeable.

l. 4)

Under FIFO, the newest costs (which will be the lowest in a period of declining prices) will be assigned to ending inventory.

m. 4)

Development costs must be expensed as incurred unless the six criteria for capitalization are met.

n. 2)

Since it is difficult to link research efforts with specific future benefits, IAS 38 recommends that they be expensed as incurred.

o. 2)

Since the same amount of depreciation expense will be recognized each year, we must be assuming that the related revenue from the asset is constant from year to year.

p. 3)

Under the sum-of-the-units method, depreciation expense is based on units produced in the period compared to total units expected to be produced over the life of the asset. This is a direct matching of expense with the related revenue.

q. 2)

The normal depreciation on the building would be calculated. Then, it would be apportioned to research activities or development activities and capitalized or expensed as appropriate.

r. 2)

Both prepaid expenses and deferred charges represent costs that have not yet been expensed. Prepaid expenses will become expenses in the next period while deferred charges will become expenses in the next or future periods.

s. 3)

IAS 38 requires that legal fees be expensed when incurred. However, it can be argued that the successful defence of the trademark ensures that it continues to produce future benefits. Therefore, it could be capitalized and amortized over the shorter of the trademark’s useful and legal life. Note that this latter approach is very uncommon.

(2 marks each)t. 2)

(€400,000 €1,600,000) × €400,000 = €100,000At the end of 2004, €400,000 of the estimated total costs to complete of €1,600,000 had been incurred. This indicates that 25% of the work has been done. The estimated total profit is €400,000 (€2,000,000 – €1,600,000) of which 25% (€100,000) will be recognized this year.

u. 3)

€2,000,000 €1,700,000Since reliable estimates of degree of completion cannot be made, revenue would be recognized in 2004 only to the extent of costs incurred (no profit). In 2005, when the final results are known (Contract price of €2,000,000 and total costs incurred of €1,700,000), the full profit of €300,000 is recognized.

v. 3)

€780 + €16 – €24

The change in accounting method must be applied retroactively. Therefore, opening inventory for 2007 would be decreased by €16 (€96 – €80) and closing inventory for 2007 would be decreased by €24 (€108 – €84). The decrease in opening inventory would cause 2007 profit to increase by €16 and the decrease in closing inventory would cause 2007 profit to decrease by €24.

w. 3)

€600,000 × 6%


Caragana is using the completed contract method of revenue recognition because the Construction in process account contains the actual costs and no profit in 2005, and actual costs less the expected loss of €200,000 in 2006 (See Note 1 to Part 2).


Under the percentage-of-completion method of revenue recognition, profit would be recognized as follows:

CARAGANA CONSTRUCTION LTD.Partial Income Statement

for the year ended December 31

(in €000s)

20X5 20X6

Revenue from construction contracts (Note 1) € 1,100 € 3,364.9Costs of construction contract (Note 2) 1,000 3,664 .9 Gross margin on construction contract € 100 € (300 .0 )

Notes:

1.(in €000s)

20X5 20X6

Actual costs to date € 1,000 € 4,600Estimated costs to complete 5,000 2,200 Total expected costs 6,000 6,800Total expected revenue 6,600 6,600 Total expected profit (loss) € 600 € (200 )

Percentage complete 16.67% 67.65Revenue earned to date *1,100 **4,464.9Less revenue recognized in prior years — (1,100 ) Revenue recognized in current year € 1,100 € 3,364 .9

2. Amount required to produce a gross margin of €100 to end of 20X5 and a cumulative loss of €200 to the end of 20X6.

* 16.67% of €6,600** 67.65% of €6,600


Either method could be selected. However, the percentage-of-completion method matches expenses and revenues on a more timely basis when reliable estimates of progress and costs to complete the contract can be made. The completed contract method is driven by the conservatism constraint and should be used only when reliable estimates cannot be made. The rationale for the choice should be evaluated accordingly.


Following are the journal entries for the three years using the percentage-of-completion method of revenue recognition (in €000s):

20X5

Construction in progress.............................................................. 1,000Cash/AP................................................................................. 1,000

To record construction cost incurred

Accounts receivable..................................................................... 900Progress billings..................................................................... 900

To record contract billings during year

Cash.............................................................................................. 850Accounts receivable............................................................... 850

To record cash collections during year

Construction in progress.............................................................. 100Construction expenses................................................................. 1,000

Contract revenue.................................................................... 1,100To record revenue recognized on contract during year

20X6



Accounts receivable..................................................................... 2,600Progress billings..................................................................... 2,600


Cash.............................................................................................. 2,200Accounts receivable............................................................... 2,200


Construction expenses................................................................. 3,664.9Construction in progress........................................................ 300Contract revenue.................................................................... 3,364.9

To record revenue recognized on contract during year

20X7







Construction in progress.............................................................. 100Construction expenses................................................................. 2,035.1

Contract revenue.................................................................... 2,135.1

To record revenue recognized on contract during year. The contract is now complete for a total cost of €6,700. Therefore, there is a total loss on the contract of €100 (€6,600 – €6,700). Since a cumulative loss of €200 (€100 – €300) has been recognized to the end of 2006, a profit of €100 must be recognized in 20X7. Revenue in 20X7 must be €6,600 minus the amount previously recognized. Therefore 2007 revenue equals €2,135.1 (€6,600 – €1,100 – €3,364.9). Construction expense in 20X7 of €2,035.1 is the expense needed to produce the 20X7 gross profit of €100.

Progress billings........................................................................... 6,600Construction in progress........................................................ 6,600

To close the progress billings account against the construction in progress account

Following are the journal entries for the three years using the completed contract method of revenue recognition (in €000s):

20X5



Accounts receivable..................................................................... 900Progress billings..................................................................... 900


Cash.............................................................................................. 850Accounts receivable............................................................... 850


Construction expenses................................................................. 1,000Contract revenue.................................................................... 1,000

To record contract revenue equal to construction costs incurred

20X6







Construction expenses................................................................. 3,600Construction in progress........................................................ 200Contract revenue.................................................................... 3,400

To record loss as soon as it is known. Under the completed contract method, revenue is recognized to the extent of costs incurred. If a loss on the project is predicted, as it is here of €200, it is recorded as soon as the loss is predicted. By recording contract revenue of €3,400 and construction expense of €3,600, the loss of €200 is recorded in year 2.

20X7







Construction expenses................................................................. 2,100Construction in progress.............................................................. 100

Contract revenue.................................................................... 2,200Overall, there is a loss on the contract of €100 (€6,600 – €6,700). To date, a cumulative loss of €200 has been recorded. A profit of €100 must be recorded in 20X7 to get the cumulative loss of €100.

Progress billings........................................................................... 6,600Construction in progress........................................................ 6,600

To close the progress billings account against the construction in progress account


a. At the time of reservation, the price of the flight is known; therefore, the amount of revenue is known (measurability). However, collectibility is unknown at this point because it is not known whether the passenger will ever take the flight. The service of providing the flight (performance) has not yet been provided.

b. When the cash has been collected (prior to taking the flight), collectibility is now reasonably assured and the amount of revenue is measurable. However, the main service of completing the flight has not been provided (performance).

c. At the completion of the flight, revenue has been earned because all criteria for revenue recognition have been fulfilled — service has been rendered (performance), revenue is measurable, and collectibility is reasonably assured, since most individuals will have already paid and the corporate accounts are likely to be collectable or a reasonable estimate of the allowance for doubtful accounts can be estimated.


a. The cash received for flights reserved but not yet taken should be recorded as a debit to cash and a credit to deposits on flights, which is presented as a current liability (the obligation of the airline to provide the flight).

b. Once the flight for which the reservation was made is completed, the €75 fee should be recorded as revenue with a corresponding reduction in deposits on flights for those passengers who paid for the flight or a corresponding debit to accounts receivable for those travellers who have not yet paid for the flight. In turn, an allowance for doubtful accounts should be established for those travellers who are not likely to pay the €75 fee.


The expenditures on the RX7 project would appear to fall under the IAS 38 definition of development. That is, the new jet that is being worked on qualifies as a plan for the production of a new or improved product. The next question is whether or not the development costs qualify for capitalization and subsequent amortization. If it is relatively certain that the expenditures will lead to future economic benefits from the sale of new products, then the costs should be capitalized. IAS 38 requires six criteria be met before development costs be capitalized. The following is an analysis of this project in terms of those six criteria:

a. Technical feasibility: Since a prototype has been completed and successfully flown, technical feasibility would seem to be satisfied.

b. Intention to complete and sell product: The project seems to be successful so far. There is no indication that Global does not intend to complete. It has already received orders for the new plane.

c. Ability to sell the product: The existence of firm orders from customers suggests Global has the ability to sell the product.

d. Will it generate probable future economic benefits: The existence of the firm orders and a successful prototype suggest the plane will be completed and sold, thus generating future economic benefits through sale of the products.

e. Availability of adequate financial and technical resources to complete the project: There is nothing to suggest that Global does not have the necessary resources to complete the project.

f. Ability to measure the expenditures attributable to the RX7 project: The fact that Global estimates it will need to sell 150 planes to break even suggests that Global is able to track the costs of the project.

It appears that the six criteria for capitalization of development costs have been met in the case of Global’s RX7 project. Therefore, these costs should be capitalized and depreciated to expense as the new planes are sold.


The expenditures on the PJ project would initially appear to fall under the IAS 38 definition of development. That is, the personal jet that is being worked on qualifies as a design for the production of a new product. The next question is whether or not the development costs qualify for capitalization and subsequent depreciation. If it is relatively certain that the expenditures will lead to future economic benefits from the sale of new products, then the costs should be capitalized. IAS 38 requires six criteria be met before development costs be capitalized. The following is an analysis of this project in terms of those six criteria:

a. Technical feasibility: Technical feasibility is still not confirmed. No prototype has yet been built.

b. Intention to complete and sell product: They seem to have the intention to complete, but without an actual product it is difficult to confirm.

c. Ability to sell the product: No attempt has been made at gaining orders and it appears Global has no firm evidence of potential market size.

d. Will it generate probable future economic benefits: Without any orders and no clear idea of what the development costs will be it is hard to argue that there will be positive future economic benefits.

e. Availability of adequate financial and technical resources to complete the project: Without knowing the cost of development, the adequacy of financial resources is suspect.

f. Ability to measure the expenditures associated with the PJ project: There is nothing to suggest that costs attributable to the project cannot be tracked.

Since not all six criteria for capitalization appear to have been met, then the development costs incurred this year should be expensed. There is not enough evidence that the expenditures on the PJ project will lead to future economic benefits.


When a cost is incurred, it must be either capitalized as an asset or expensed when incurred. The general rule is that if the cost is expected to provide future economic benefits, then it should be initially capitalized and then transferred to expense as those future economic benefits are realized. If it is not likely that the expenditure will produce any future economic benefits, then the expenditure should be expensed immediately when it is incurred.

For inventory specifically, the acquisition of inventory for resale usually results in capitalization of the cost on the balance sheet. This is because it is expected that the inventory will be sold in some future period, thus providing an economic benefit (the sale). In the subsequent period when the inventory is sold, the original cost is transferred from the balance sheet to the income statement as Cost of goods sold expense. This accomplishes the proper matching of the revenue (sale of inventory) and expense (cost of inventory). If inventory becomes unsaleable (through obsolescence, for example) then the inventory would be written off to expense (Cost of goods sold) as soon as that becomes known. This is recognizing that there is no future economic benefit to come from the inventory.

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sophiasapiens.chez.comsophiasapiens.chez.com/gestion/Financial-Accounting/Ch… · Web viewMajor airlines around the world have been impressed with the plane and have signed firm