Chapter 6: Revenue and Expense Recognition - cs.mun.caboliver/Ch6.pdf · Chapter 6: Revenue and Expense Recognition ... *W The solution to this assignment is on the text website,

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Solutions Manual to accompany Intermediate Accounting, Volume 1, 7th edition 6-1

Chapter 6: Revenue and Expense Recognition

Suggested Time

Case 6-1 Solar Power Inc.

6-2 Princely Entertainment Ltd.

6-3 Time-Lice Books Ltd.

6-4 Thomas Technologies Corp.

Technical Review

TR6-1 Net versus Gross…………………………….. 5

TR6-2 Prepaid Deposits and Revenue Recognition……. 5

TR6-3 Predictable Rights of Return…………………….. 5

TR6-4 Warranty – Cost deferral…………………………… 5

TR6-5 Licensing Fees……………………………….. 5

TR6-6 Output Measure……………………………… 5

TR6-7 Customer Loyalty Program Revenue Recognition 5

TR6-8 Deferred payments…………………………………. 5

TR6-9 Multiple deliverable……………………………… 5

TR6-10 Contract costs…………………………………. 5

Assignment A6-1 Revenue Recognition—Gross or Net ............... 15

A6-2 IFRS—Revenue Recognition (*W) ................. 15

A6-3 IFRS—Revenue Recognition,Four Cases ........ 20

A6-4 IFRS—Revenue Recognition, Performance Completed

10

A6-5 ASPE—Revenue Recognition, Critical Event . 15

A6-6 IFRS—Revenue Recognition ........................... 20

A6-7 ASPE - Entries for Critical Events (*W) ......... 35

A6-8 IFRS- Revenue Recognition (*W) ................... 35

A6-9 IFRS – Return Policy ....................................... 20

A6-10 ASPE – Unconditional Right of Return ........... 20

A6-11 IFRS - Licensing Fees ..................................... 20

A6-12 IFRS—Customer Loyalty Program .................. 15

A6-13 IFRS - Warranty—Two Accounting Methods . 20

A6-14 IFRS - Warranty—Two Accounting Methods . 30

A6-15 IFRS - Multiple Deliverables ........................... 10

A6-16 ASPE - Multiple Deliverables ......................... 10

A6-17 IFRS—Biological Assets and Agricultural Produce 15

A6-18 IFRS—Biological Assets and Agricultural Produce 10

A6-19 IFRS—Construction Contract .......................... 30

A6-20 IFRS—Construction Contract .......................... 25

A6-21 ASPE - Construction Contract ......................... 30

A6-22 IFRS - Asset Exchanges—Five Situations ....... 30

A6-23 ASPE - Asset Exchanges—Four Situations ..... 25

A6-24 SCF Impact (*W) ............................................. 20

A6-25 Revenue and Expense Recognition .................. 35

*W The solution to this assignment is on the text website, Connect.

This solution is marked WEB.

Cases

Case 6-1 Solar Power Inc.

Overview

SPI’s primary financial statement user is the banker who is placing reliance on the

financial statements to determine the amount of bank loans that will be extended.

Management is very motivated to have the funds of this loan be as high as possible which

may influence the selection of accounting policies. Management will want to maximize

EBITDA to ensure that the loan balance does not exceed three times the EBTDA amount.

This translates to a bias towards accounting policies which maximize the recognition of

revenue and delay/minimize expense recognition.

Issues

(1) Sharone contract - This contract is a multiple deliverable: the delivery of the panels

and installation and the 5 year maintenance contract. The $4 million contract will have

to be allocated based on the stand alone fair values of the panels and installation and the 5

year maintenance contract. The revenue related to the panels and installation will be

recognized when delivery and installation is complete. The portion of the contract related

to the 5 year maintenance contract will be deferred and recognized evenly over the 5 year

period or at intervals when the service is actually performed. In either case, the unearned

revenue will be recognized as a liability. The warranty, being an assurance warranty, will

be recognized as a provision at the time of the sale of the panels.

Allocation based on the fair values:

Standalone fair

values

$

Allocation Contract allocation

$



Panels and

installation

3,200,000 68% 2,720,000

Maintenance

contract

$300,000 X 5

1,500,000 32% 1,280,000

$4,700,000 4,000,000

At December 31, 20X9, the amount of revenue that can be recognized is:

Sale of panels and installation $2,720,000

Maintenance Sept - Dec - 4/60 months X $1,280,000* 85,333

Total $2,805,333

*assumes maintenance is performed evenly throughout the 5 year period

This means that $594,667 ($3,400,000 - 2,805,333) of revenue will have to be reversed

and reported as unearned as at December 31, 20X9.

The warranty likely is an assurance warranty, that is, not sold separately and therefore not

another deliverable. Therefore, the warranty will be recognized using the cost deferral

method. A provision of $150,000 and related warranty costs will be recognized at the

time of delivery and installation.

The non-refundable deposit is recognized as unearned revenue until the revenue is

earned. Even though the deposit is non-refundable, this does not mean that it can be

recognized immediately. Once the delivery and installation is complete, the $3 million

(75%) will be invoiced to Sharone. Regardless of how the cash flows to the company, the

revenue is recognized based on performance completion and meeting the recognition

criteria.

Overall, EBITDA will be reduced by $594,667 for the revenue, and $150,000 for the

recognition of the warranty costs.

(2) Bakers contract - This contract appears to be a bill and hold arrangement. In order

for the revenue to be recorded prior to delivery of the panels, Baker must take title

and control of all of goods. Control of the units shifts to Baker when all of the

following conditions are met:

• The reason for the bill-and-hold arrangement is substantive i.e. the customer has

requested the arrangement. This criterion is met since it was at Baker’s request that

the inventory not be shipped.

• The buyer’s inventory is separately identified as belonging to the buyer (that is, held

apart from the seller’s other inventory). We are told that these items are in a separate

part of the warehouse.

• The inventory is ready to be delivered. This criterion is met; and

• The seller does not have the ability to use the product or sell to another customer

and then replace it. It is indicated that the panels are specific to Baker’s requirements and

so we assume that this criterion is also met. Since all of these criteria are met, SPI may

recognize the full amount of $6 million revenue on the sale of these panels in 20X9.

Since the company has only recognized $5.1 million to date, there is another $0.9 million

that can be recognized. This will increase EBITDA by the gross margin, assuming that

the company has also not recognized fully the related cost of goods sold.

(3) Mason contract – This contract has a fixed and variable component. Variable

consideration is any amount of the consideration that is not fixed and can vary based on

certain terms of the contract. In this case, the amount of the variable consideration is

based on the credit that the customer will receive on selling excess power back to the

power grid. SPI will receive 30% of the amount that Mason receives on selling excess

power. In determining the amount of consideration under the contract, the seller must

estimate the amount of the variable consideration using an expected value or more likely

amount. This amount is included in the transaction price only if it is highly probable (i.e.

likely to occur) that a significant amount will not later be reversed once the uncertainty is

resolved. So the test is to determine if the amount of variable consideration is highly

probable to be received or not. If not, then it should not be included in the price until the

amount is known with certainty.

In this case, there is no support for determining how much of the variable consideration

will be highly probable as the company has no past history with this type of contract.

Therefore, revenue from the variable consideration will be recognized as received. Since

Mason has control of the panels on installation, $55,700 (the initial $50,000 plus the

$5,700) can be recognized by December 31, 20X9.

Although SPI has estimated that $120,000 may be received, this is not the contract

amount and is certainly not highly probable. Mason is only responsible for paying the

upfront amount of $50,000 and remitting 30% of the amount that he sells back to the

grid. Therefore, SPI cannot recognize $120,000 as revenue. SPI must instead only

recognize the revenue as it is received from Mason (or receivable once the monthly

amount is known). The $120,000 should be reversed and only $55,700 recognized as

revenue to December 31, 20X9.

The other issue related to this contract is when the cost of goods sold related to this

contract should be reported. One alternative is to use the cost recovery method and report

costs equal to the amount of revenue reported each period. However, the amount of

revenue is not known at all, and so the amount of deferred gross margin is also not

known.

Since the final revenue amount is not known, the cost of goods should likely be expensed

at October, 20X9 and the variable revenue recognized as it is received.

These adjustments will result in EBITDA declining by $64,300 (120,000 - 55,700) net of

any cost of goods sold not yet recognized.

(d) To determine if this is an agency relationship a variety of factors must be assessed.

Solution does not bear any inventory risk and the 15% fee it receives is fixed. Solution

is also not responsible for shipping to the customer. It also appears that Solution

cannot change the price in any way; the price is set by SPI. However, Solution is



responsible for collection and therefore bears credit risk. Based on this analysis, it

appears that Solution is most likely acting as an agent. This makes SPI the principal

and therefore, SPI will report revenue at gross and the related cost of goods sold and

the commission paid to Solution as expenses. The product that was given to Solutions

for demonstration should be expensed as promotional material. The cost of this

product will reduce the EBITDA if it has not already been expensed.

Case 6-2 Princely Entertainment Ltd.

Suggested solution:

1. Basis of reporting; IFRS vs ASPE

PEL has been a very small company, with three on-line games that generate

revenue through upgrades. Shareholders are the primary financial statement users

along with, likely, CRA. There is no debt financing because of the risk of the

industry. There is now a royalty to pay based on one particular revenue stream.

This is new in 20X3. With one game showing major growth, the primary

owner/manager is thinking about the prospect of being a takeover target, or a

future public offering. This is likely premature because PEL is still very small.

IFRS compliance would not likely be cost-effective at this point. ASPE should be

used as a reporting basis, to provide some structure for reporting in general, and

the royalty payment in particular.

2. Financial reporting issues

a. Revenue recognition, consumables versus durables (unearned revenue)

Revenue is recognized when performance is complete, measurement is possible,

and collection is assured. Performance would be regarded as being achieved

when all of the following criteria have been met:

Seller’s performance is complete; Seller has transferred the significant risks and

rewards of ownership to the buyer.

The amount of revenue can be measured reliably.

The benefit of the revenue will actually flow to the seller.

The seller can reliably measure all costs relating to the transaction, past and

future.

The seller retains no continuing managerial involvement or control over the goods

sold.

Collection is not an issue because of the advance payment. Advance payment

establishes the presence of an arrangement. Performance criteria must be met for

revenue to be recognized. These are contracts to provide services. The real

question is when services have been rendered/performance has been achieved and

how apportionment of delayed services rendered can be measured.

For items that are immediately consumed (e.g., rain or extra life), service is

rendered immediately and all revenue is recognized up front, on collection.

For durables (e.g., stronger engines or tires), the service might be argued to be

delivered up front, with PEL having no ongoing obligations to the customer. The

game itself is provided for free and there is no service obligation present.



However, the alternative point of view is that the revenue from durables can only

be recognized when the durable is used over the playing life of the customer. PEL

has an ongoing obligation to keep the game operational for these customers. A

critical estimate is the playing life, which has been estimated at 5-8 months. This

is used to measure the revenue to be recognized. The average used might be

different for different games and must be substantiated. A final alternative is to

defer all revenue until the player ceases playing. This seems excessively

conservative.

If the playing life estimate is reliable, then deferred revenue recognition for

durables seems appropriate. Revenue has been re-calculated as shown in

Appendix 1. Revenue is lower than cash collected, and an unearned revenue

account of $435,000 is reflected on the balance sheet as a liability.

For DOOM, the developer who gets royalties would prefer earlier revenue

recognition (revenue when collected) to maximize his royalties. PEL might prefer

later revenue recognition to preserve cash flow. This is more than just a timing

issue: there would be unearned revenue from durables at the end of the royalty

agreement, not subject to royalties, and this is a permanent reduction in the royalty

the developer would receive.

b. Revenue recognition, virtual currency (also unearned revenue, but with a

separate analysis)

Revenue for the virtual currency could be recognized:

a. When received – (possibility for unused 10-30%)

b. When used / enters another revenue stream.

Performance criteria must be met for revenue to be recognized. Measurability is

straight-forward, and this payment establishes the presence of an arrangement.

Virtual currency is akin to a gift card that does not expire.

PEL has the obligation to keep the game ―alive‖ for a reasonable period to allow

consumers to use their virtual currency. Since PEL has the obligation to provide

services (either consumables or durables) when the virtual currency is used,

revenue should be recognized at that point, based on the revenue stream that the

virtual currency joins. (i.e., immediately on transfer for consumables, over the

average playing life for durables; consistent with the conclusions in a).

If 10-30% of the amount collected for virtual currency will never be used, it could

be recognized as revenue immediately. If the estimate is reliable, then some

revenue recognition up front seems appropriate. That is, the liability unearned

revenue might be measured at 70-90% of the gross amount.

However, the 10-30% figures are on-line industry averages, and PEL presently has

no historical information about its own experience. The virtual currency never

expires, so there is no legal cut off point. Virtual currency is new in 20X3, and a

past history of sufficient length may not be present. Without historical data, there

should be no revenue recognition for virtual currency that may not be used until

after a few years, at which point historical data would become available.

Accordingly, revenue has been re-calculated as in Appendix 1. A liability of

141,000 for unused virtual currency would be shown on the balance sheet.

Revenue is lower by this amount because PEL has not yet earned the revenue.

c. Gross versus net revenue

The question is whether revenue should be reported net, at $7 and $9.65, or gross,

at $10, with a $3 or $0.65 financing fee. The presentation will affect the perceived

size of the revenue streams, which are possibly important in looking at PEL as an

acquisition target or an IPO candidate. Separate recognition will encourage the

financial statement users to understand that financing fees are a significant

expense (Facebook© is more expensive than Paypal©). For the DOOM revenue

stream, the outcome may affect the royalty payment, because higher gross

revenues may result in higher royalties. As with the issue in a, this contract should

be re-examined with the developer for unintended consequences.

PEL appears to be the principal in these transactions as the other parties in the

channel of distribution, Facebook© and Paypal© do not take on the significant

risks and rewards of providing the service. PEL sets the price and provides the

product. Accordingly, PEL should use the gross method to report revenues. It is

not possible to quantify the impact of this recommendation, because the split of

cash flow between Paypal© and Facebook© is not known. Presentation will be

affected, but not bottom line net income except if there are changes to the royalty

payable for DOOM.

d. DOOM investment

The cost of the investment in the tangible asset – DOOM asset, and the related share

equity issued, are currently recorded at $1. This is a non-monetary transaction that

should be recorded at either fair value if there is commercial substance or at carrying

value if there is no commercial value. (Note that this is not a related party transaction

so none of the guidance for related parties is relevant.)

There is commercial substance in this transaction since the cash flows related to

shares given up would be very different from the timing, risk and amount of

cashflows related to the game received.

Under ASPE, if the non-monetary transaction has commercial substance, the

transaction is reported at the fair value of either the asset given up or the asset

received, depending on which value is more reliably measurable.

For PEL’s transaction, an equity element is given up.



In general the Board of Directors is responsible to existing shareholders, under

legislation, for the obligation to issue common share at fair value. This prevents any

disadvantage to existing shareholders from dilution. Accordingly, valuation of issued

shares at fair value is prudent.

The recommendation is that PEL should value the acquisition at fair value.

As a result, the fair value must be established. PEL must have had some idea as to the

value of the game when it was acquired, as the basis for the number of shares being

issued. It is unlikely that the PEL shares could be valued as a reference point because

the shares are closely held by family members. However, the basis of negotiations

between PEL and the developer is the logical starting point to ascertain an estimate of

fair value.

Objective evidence to support the value of the transaction must be gathered and

assessed. The value as of the transaction date must be set, not the value of the

modified game at the end of the year. The transaction value can be informed by the

first year of revenue from the product.

Appendix 1 – Revised revenue

Prince Entertainment Limited, nine months ended September 30, 20X3

(in 000’s)

Princely Princely Princely Total

CRASH RATS DOOM

Revenue - Consumables No change $ 2,245 $ 110 $ 260 $ 2,615

Revenue - Durables 680 95 170 945

Less: adj

Unearned

revenue

315 10 110 (435)

365 85 60 510

Revenue – Virtual

currency

180 5 30 215

Less: adj

Liability for

Virtual

Currency

120 1 20 141

60 4 10 74

$3,199



Case 6-3 Time-Lice Books Ltd.

Overview

The general objective of this case is to give students practice in applying their

professional judgment to recommend an accounting policy for revenue and expense

recognition. Students must identify the reporting objectives for the company, and must

apply qualitative criteria in deciding what the most appropriate policy is. Note that since

this company is publicly traded, IFRS is the accounting standard that must be applied.

Reporting objectives

1. Minimum disclosure and compliance with securities acts: The company is a public

company; its shares are widely traded and are listed on the Toronto Stock Exchange.

Therefore, a clean audit opinion is important. This reporting objective will cause the

adoption of accounting policies that result in accounting numbers that are reliable and

verifiable.

2. Cash flow prediction: The heirs of the founder own 30% of the common shares and

are likely to be concerned about the dividend flow. The heirs are not actively involved

in the company and retain a professional financial advisor, who may be presumed to

be sophisticated. Since 30% is no doubt the largest single block of stock, the heirs

probably have a substantial say in who is on the Board. Thus the needs of the heirs

must be given consideration in developing accounting policies.

3. Performance evaluation: Similarly, the heirs’ analyst will be evaluating the

performance of management in order to advise the heirs on how to vote their shares.

4. Income tax deferral: The company probably will be permitted to deduct expenses

when incurred and include revenues when received for income tax purposes, in view

of the nature of the operations. If tax is affected by the revenue recognition policies,

then the tax deferral objective is relevant, but probably would be a secondary

objective.

Since revenue and expense recognition is principle based and subject to a lot of

judgement under IFRS, it is critical that the primary user and objective be identified at

this point in time. Otherwise it will be difficult to provide a recommendation for the

client.

Revenue/expense recognition alternatives

Some students may try to fit the recognition of revenue into the molds of recognition at

(1) the point of production, (2) point of sale, or (3) point of cash receipt. This case does

not fit into those molds, however, since all three events are occurring simultaneously (at

different rates) through time. Some students may also concentrate exclusively on revenue

recognition and overlook the related issues of expense recognition.

Students should apply the five steps for revenue recognition under the contract based

approach.

To determine when revenue should be recognized, the five steps must be addressed for

each customer contract:

1. Identify the contract with the customer;

2. Identify separate performance obligations, if they exist.

3. Determine the overall contract price;

4. Allocate the contract price to the separate performance obligations; and

5. Determine when the performance obligation is satisfied and revenue can be recognized.

Revenue is recognized when control of the goods is transferred to the customer and the

performance obligation has been completed.

Initial promotional costs: The initial promotional expenses cannot be deferred but must

be expensed immediately. Under IFRS, in order to justify deferral treatment as ―assets‖,

measurable future benefits have to be demonstrated. This is especially true since the

promotional materials are ―internally generated‖ intangibles. For internally generated

intangible assets to be capitalized they would have to represent development costs and

meet the six criteria for capitalization. Since this is not the case, these promotional costs

must be expensed.

Advance sales – Customers paying upfront for all of the books in the series— At what

point in time is control of the books transferred to the customer? Applying the five steps

for revenue recognition, we have:

1. Identify the contract with the customer. The customer has sent back notification of

their subscription to the series, so this would represent the contract with the customer.

2. Identify separate performance obligations, if they exist. Are the goods distinct? Goods

are distinct if the customer can use each book individually and it is also sold separately.

In addition, each book has to be separately identifiable within the contract. Both of

these criteria are met, and therefore, the delivery of each book is treated as a separate

performance obligation. Note also, that the contract can be cancelled at any time by

the customer.

3. Determine the overall contract price. The contract price will be the total that is paid in

advance when customers opt for this payment choice.

4. Allocate the contract price to the separate performance obligations. The fair value of

each book in the series will be used to allocate the contract price. Each book has a

stand-alone value since books can be paid for individually as received (the alternative

payment method). These values can be used to allocate the contract price.




Each performance obligation will be completed as each book in the series is delivered

to the customer.

Since the cancellation rate is very low, the provision for cancellations would be relatively

small but required nonetheless. The provision should be based on historical data.

So under this method, the payments received in advance will be deferred as a contract

liability. As each book is shipped, its proportion of the contract price will be recognized

as revenue, reducing the contract liability. Related costs for the book will also be

expensed at this time. To the extent that costs can be identified with a specific book

series, they should be capitalized as inventory until delivered at which time, the cost of

goods sold is recognized. Any other related costs would be capitalized as contract assets

and amortized over the period of the series.

Costs that cannot be identified with or reasonably allocated to specific series must be

treated as period costs.

Installment subscribers - Customers who pay as each book is delivered — For these types

of sales, we can again review the five steps to determine the amount and timing of the

revenue recognition.

1. Identify the contract with the customer. The customer has sent back notification of

their subscription to the series, so this would represent the contract with the customer.

2. Identify separate performance obligations, if they exist. Are these goods distinct?

Goods are distinct if the customer can use each book individually and it is also sold

separately. In addition, each book has to be separately identifiable within the contract.

Both of these criteria are met, and therefore, the delivery of each book is treated as a

separate performance obligation. Additionally, the contract can be cancelled at any

time.

3. Determine the overall contract price. In this case, the contract is paid for over time. If

the period is longer than one year, then the amount of consideration must be determined

based on the present value of the cash to be received. Any difference between this

amount and the total cash proceeds received, would be recognized as interest income as

time passed. A portion of the contract will be set up as a long-term accrued receivable

until the book is delivered and an invoice issued. Then the long-term accrual is reduced

and accounts receivable is increased.

4. Allocate the contract price to the separate performance obligations. The fair value of

each book in the series will be used to allocate the contract price. Each book has a

stand-alone value since books can be paid for individually as received (the alternative

payment method). These values can be used to allocate the contract price. In this case,

this also represents the cash that will be received since the customer only pays for each

book as it is delivered.


Each performance obligation will be completed as each book in the series is delivered

to the customer.

So here again, revenue recognition would follow delivery of the books and represent

some portion of the contract. An accrued receivable for the full discounted amount

would be reported, with an offsetting contract liability account. As the books are shipped,

an invoice is prepared, reducing the accrued receivable, and increasing accounts

receivable for the portion related to the book delivered. In addition, the contract liability

is reduced and revenue recognized for this portion of the contract related to the specific

book shipped.

Relationship to objectives

The foregoing discussion does consider the quality of the earnings information under the

various alternatives, but it does not relate directly to the financial reporting objectives that

were identified earlier. Contract compliance calls for reliable measurements, and in both

cases for the advance sales and installment sales - revenue should be recognized as

performance is completed. That is, revenue will be deferred and a percentage recognized

as each book in the series is delivered.

For both cash flow prediction and performance evaluation, early revenue recognition for

each individual series would seem to be desirable, especially for the performance

evaluation objective since management makes the important decisions at the start of each

series. However, early recognition depends on the completion of the performance, which

has not been achieved. Therefore, TLBL must recognize revenue and the related earnings

from a particular series over several accounting periods.

Spreading revenue/expense recognition over the life of the series will result in each

period's reported earnings consisting largely of earnings being realized on series (projects)

started in earlier periods. This will be advantageous to the company because spreading the

earnings of multiple on-going series over several years will help to stabilize TLBL’s

earnings and therefore the share prices.

Similarly, the overall cash flow consequences of the book series are more clearly

represented if the cash flow consequences of a series are reported together, in a single

period. However, revenue (and expense) recognition at the time of subscription does not

lead to ―high quality‖ earnings, because much of the revenue will not be received until a

later period.

In summary, it would appear that the earliest that revenue could be realized (and thereby

satisfy the cash flow prediction and the performance evaluation objectives) and still have



sufficient reliability to satisfy the minimum disclosure objective is to recognize the

revenue as each book is shipped. This is the only method that will be in compliance with

IFRS which is a constraint for this company.

CASE 6-4 Thomas Technologies Corporation

Overview

The management of Thomas Technologies seems intent on increasing reported revenue

(and earnings) in 20X4 by devising contracts that support early recognition. The ethics of

management’s deal-making is suspect, because they seem to be engaging in deliberate

efforts to misrepresent the revenue-generating ability of the company in the short run.

Situation 1

TTC has arranged a 3-year, $6.6 million contract for engineering services that has front-

loaded payments. The company has recognized revenue based on the payment scheme,

with $3.0 million recognized in the first year alone.

There is no indication that TTC is performing almost half of the total contracted services

in the first year, 20X4. Indeed, the company doesn’t even track the costs of services

rendered under this contract, which suggests that either (1) the contract is a relatively

unimportant part of TTC’s operations or (2) management is intentionally hiding the cost

of services in order to justify a revenue recognition pattern that does not match the reality

of services being provided to Howard. The latter reason would be quite unethical.

Instead of recognizing revenue on the basis of cash payments, TTC should recognize

revenue evenly over the term of the contract, as it appears that services are likely

provided evenly over time. Should another basis be more appropriate, TTC must support

this basis to the auditors.

Because payments are made over a three-year period, the total value of the contract is the

present value of these payments. Assuming a discount rate of 6% (assumption required),

the total consideration is only:

$3 million + $2 million /1.06 + $1.6 million/1.062 = $3 million +1.9 million + $1.4

million = $6.3 million.

The total contract price of $6.3 million should be recognized at the rate of $2.1 million

per year. The total contract price should be recognized as $6.3 million and initially

recognized as a contract liability. A long term receivable is also recognized for $3.3

million ($1.9 million + $1.4 million) that is still outstanding. Each year, $2.1 million will

be recognized as revenue. In addition, interest income of $0.3 million ($3 + $2 + $1.6 -

$6.3) will be recognized in 20X5 and 20X6 using the effective interest rate method.

The company also should track the costs of service to determine profitability. Any initial

contract costs to fulfill the contract that have been incurred or to obtain the contract, and

that directly relate to the contract, can be capitalized as contract assets and amortized over

the three year term.

Situation 2

For this contract, the five steps of revenue recognition are examined.



1. Identify the contract with the customer. TTC has entered into a signed agreement to

provide a special-purpose piece of equipment and four years of maintenance service.

2. Identify separate performance obligations, if they exist. There appear to be two

deliverables: the delivery of the equipment and the delivery of the maintenance

services over four years.

3. Determine the overall contract price. In this case, the contract price is paid over a

period of time: $2,240,000 (40% x $5,600,000) on delivery, $3,360,000 (60% x

$5,600,000) within the first 90 days, and $1,500,000 paid annually with the first

payment due within 120 days after delivery. Since these payments are received over

more than one year, the later payments need to be discounted to determine the total

contract price. The estimate of the discounted cash flows, assuming a 6% discount rate

is: 2,240,000 + 3,360,000 + 150,000 + 150,000PVIFA( 6%, 3 years)

= 2,240,000 + 3,360,000 + 1,500,000 + 4,009,520 = 11,109,520

The difference between the total payments of $11,600,000 and the present value of

$11,109,520 will represent interest earned over the term of the contract.

4. Allocate the contract price to the separate performance obligations.

TTC has entered into a contract that has two deliverables: (1) special-purpose equipment

and (2) a 4-year service contract. As per the contract, the equipment seems to be

overpriced, and the service contract appears to be underpriced. As in Situation 1, TTC

seems to be engaging in special agreements with this customer in an attempt to accelerate

revenue recognition, an unethical practice. Overpricing of the equipment is apparent not

only from the relatively lower price that might have been obtained from another

manufacturer, but also from the fact that the manufacturing cost of $3.4 million is only

about 60% of the contracted sales price—an unusually high profit margin.

Overall, the contract provides for total revenue of $11.6 million. The contract allocates

$5.6 million to the equipment and $6.0 million (over four years) to the service contract.

However, under IFRS, the contract price of a contract is allocated based on the stand

alone values of the distinct goods and services. Stand-alone values can be determined by

examining the prices set by competitors. The equipment could be obtained elsewhere for

about 20% less. Therefore, the fair value of the equipment seems to be closer to $4.5

million (that is, $5.6 million × 80%) and the fair value of the service contract is $8.0

million (i.e., $6.0 million ÷ 75%). The auditor should require TTC to reallocate the

revenue on the basis of the fair values of the two components:

Component Fair value Proportion Revenue allocation

Equipment $ 4,500,000 36% $3,999,427

Service contract ($1.5m × 4) ÷ .75 8,000,000 64% 7,110,093

Total $12,500,000 100% $11,109,520

Interest income 490,480

Total contract 11,600,000

5. Determine when the performance obligation is satisfied and revenue can be

recognized.

TTC should recognize revenue of only $3,999,427 (approximately) for the equipment at

the time of delivery (point of transfer of control), with the excess $1,600,573 ($5.6

million - $3,999,427) recorded as a contract liability. As the payments of $1.5 million are

received, the contract liability will be increased. At the same time, the service revenue

will be recognized evenly over the four-year contract period. As well, the interest income

earned will also be recognized using the effective interest rate method.

An additional consideration is that TTC is recognizing Parker’s first $1.5 million annual

payment prematurely. The contract is for the next four years, and yet the revenue was

recognized in 20X4, with an accrual for cost of services not yet rendered. Parker has not

paid the first year’s fee yet, and the indication is that they are not required to pay it within

the next year—thus TTC cannot record this amount as a receivable yet since there is no

obligation for the customer to pay.

Summary

TTC seems to be engaging in some very unethical practices in order to hype their

revenue for 20X4. It would be interesting to know if the company is in financial

difficulty, perhaps in near-violation of some restrictive covenants such as the times-

interest-earned ratio.

It is precisely to curb such revenue manipulation that accounting standard setters have

established criteria for multiple-deliverable contracts.



Technical Review

Technical Review 6-1

Phillips Co is the principal and Crane is the agent in this relationship. Phillips will record

the gross sale of $60,000, commission expense of $9,000 and cost of goods sold of

$37,000. Crane, acting as the agent, would report on a net basis - Commission revenue of

$9,000.


The following are the journal entries required:

15 August:

Dr. Cash 150

Cr. Contract liability (Unearned revenue) 150

21 August

Dr. Contract liability (Unearned revenue) 50

Dr. Cash 200

Cr. Sales Revenue 250

2 September

Dr. Contract liability (Unearned revenue) 100

Dr. Cash 400

Cr. Sales Revenue 500


Since the returns can be estimated, Sojourn estimates revenue to be the most likely

consideration it will receive. This amount is $48,000, which represents 960 (1,000 units

× 96%) products expected to be retained by the customer, multiplied by the price of $50

per unit. At the same time, a refund liability for the products expected to be returned

will be reported at $2,000. This is based on 40 units expected to be returned (4% × 1,000

units) at a price of $50 per unit. A right to recovery asset is set up for the units at $1,400

(40 units at $35 each). This will result in a cost of goods sold equal to $33,600, which

represents 960 units at $35 each. Below, are the entries to record the sale on delivery to

the customer:

1 April :

Dr. Accounts receivable (1,000 × $50) 50,000

Cr. Revenue 48,000

Cr. Refund liability 2,000

Dr. Cost of goods sold 33,600

Dr. Right to recovery asset 1,400

Cr. Inventory (1,000 × $35) 35,000




The following are the journal entries required:

26 February:

Dr. Cash 1,250

Cr. Revenue 1,250

26 February

Dr. Warranty expense 150

Cr. Provision for warranty 150


The license fee revenue will be all immediately recognized since there are no further

performance obligations to change the software in any way. In addition, the license is

perpetual with no finite period. The entry for this sale will be:

16 November

Dr. Accounts Receivable 50,000

Cr. Revenue - software licenses 50,000


Revenue for each year is calculated as follows:

20X10 : 15/50 x $40 million = $12 million

20X11: 22/50 x $40 million = $17.6 million

20X12: 13/50 x $40 million = $10.4 million

Alternatively

Revenue for each year is calculated as follows:

20X10 : 15/50 x $40 million = $12 million

20X11: Total revenue earned to date 37/50 x $40 million = $29.6 million

Revenue to recognize in 20X11: Total revenue earned to date less revenue recognized in

previous years: $29.6 million less $12 million = $17.6 million

20X12: Total revenue earned to date 50/50 x $40 million = $40 million

Revenue to recognize in 20X12: Total revenue earned to date less revenue recognized in

previous years: $40 million less $29.6 million = $10.4 million


The journal entry for May is:

Dr. Cash 60,000

Cr. Sales revenue 58,500

Cr. Provision for loyalty program awards 1,500




With the delayed payments, the contract consideration is the present value of the future

cash flows to be received. Using 7% as the discount rate, the contract price is:

500,000 + 300,000/(1.07) + 300,000/(1.07)2

= 500,000 + 280,374 + 262,032 = 1,042,406

The table below shows how the interest is calculated for each period, using the effective

rate method.

Payment Interest at 7% Principal Balance

Aug 1 20X1 542,406

Aug 1, 20X2 300,000 37,968 262,032 280,374

Aug 1, 20X3 300,000 19,626 280,374 0

Aug 1, 20X1

Dr. Long-term Accounts receivable 542,406

Dr. Cash 500,000

Cr. Revenue 1,042,406

Aug 1, 20X2

Dr. Cash 300,000

Cr. Long-term Accounts receivable 262,032

Cr. Interest income 37,968

Aug 1, 20X3

Dr. Cash 300,000

Cr. Long-term Accounts receivable 280,374

Cr. Interest income 19,626


This is a multiple deliverable and therefore the contract price must be allocated based

on stand-alone fair values to the equipment and the service contract.

Stand-along fair

value

Percentage Allocation

Equipment 400,000 89% 364,900

Contract 50,000 11% 45,100

450,000 100% 410,000

June 1, 20X1

Dr. Accounts receivable 410,000

Cr. Revenue – equipment 364,900

Cr. Contract liability 45,100

Every month from June 30 to November 30 (6 months in total)

Dr. Contract liability 7,517

Cr. Revenue (44,000/36 x 6) 7,517




Only directly related costs are capitalized and amortized over the term of the contract.

Travel costs and the legal costs are specific to the contract; whereas marketing and meals

are costs that would have been incurred regardless. The entry is as follows:

Dr. Marketing expenses 2,500

Dr. Meals expenses 7,000

Dr. Contract costs 15,000

Cr. Cash /Accounts payable 24,500

Assignments

Assignment 6-1

a. Gross revenue, if the company actually buys the books from the publisher and bears

the inventory risk.

Net revenue, if the publisher is sending the books on consignment with full return

privileges and the company never acquires title to the inventory. The publisher is then

bearing all of the risk.

b. Net revenue. The interior design company carries no inventory. Orders are transmitted

directly to the manufacturer, who bears all of the inventory risk.

c. Net revenue. Title remains with the producer until they are sold to the builder.

Presumably, CanLight can return the goods to the producer if they are not sold. On the

other hand, CanLight bears risk of physical loss while the goods are in its inventory.

On balance, it appears that CanLight is acting as a consignee, especially since

CanLight owes no money to the producer until cash has been collected from the

buyer. Canlight also earns a fixed fee of 30% of the sale amount.



Assignment 6-2 (WEB)

a) Interest revenue is recognized as time passes using the effective interest rate method.

b) Interest revenue is recognized as time passes using the effective interest rate method.

c) Revenue recognition would be recognized at a single point in time when the

passenger makes the flight and transporting the passenger is completed.

d) Revenue would be recognized as soon as the service is completed; that is the

transporting of the freight is completed (delivery).

e) As the Christmas trees are biological assets, the change in the fair value of the

maturing trees will be recognized as a gain or loss each year until harvest and sale, at

which point the final gain/loss will be recognized.

f) Revenue will be recognized at a single point in time when the title to the house is

transferred to the buyer. Houses under construction are included in inventory at cost

until sold

g) Revenue is recognized over time since the government owns the land and the homes

during the contract period.. Either an output measure or an input measure is used to

measure the revenue to be recognized, without regard to when payment is received.

h) Revenue is recognized at the point when title to the land transfers to the buyer.

Due to the long-term payment contracts, the contract price represents the present

value of the future cash flows; and interest income is earned during the payment

period using the effective interest rate method. The foregoing assumes that

collection is probable given the long payment terms and the contract is valid. If

collection is considered not probable, then the contract is not valid and revenue is not

recognized until a valid contact is in place, which might be once all of the

consideration has been received.

i) Revenue is recognized over time, i.e., straight-line over 24 months. The large initial

payment will initially be accounted for as a contract liability. The 24 monthly payments

to be received over the two-year period will be discounted to determine the total contract

consideration and a long term receivable will be recognized. Interest income will be

earned over the two-year period using the effective interest rate method.

j) Revenue is earned over time since the government owns the space arm as it is being

constructed. Revenue will be measured using either input or output measure. If

costs cannot be assessed, then an output measure might be more appropriate.

k) No revenue is recorded until title of the silver is transferred to a customer. The costs

to produce the silver will be recognized as inventory until a point of sale.


Case A

1. Revenue from the sale of the machine is recognized at a point of time on delivery on

5 January 20X6 when title transfers to the customer. In addition, since there is a

delayed payment, interest income will also be earned over the year to the next

payment date. The effective interest rate method is used to measure the interest

income earned.

2. 31 December 20x5:

Dr. Cash ................................................................................ 30,000

Cr. Contract liability ....................................................... 30,000

3. It is tempting to record the sale on the transaction date of 31 December but delivery

has not yet taken place and control of the equipment has not yet been transferred.

Case B

1. Recognize revenue over time since this represents revenue to be available as needed;

i.e., month by month from 1 May 20X5 to 30 Apr 20X6.

2. 17 April 20X5:

Dr. Cash ................................................................................ 30,000

Cr. Contract liability ....................................................... 30,000

3. Because the ―retainer‖ is not tied to specific services but instead represents a

readiness to serve whenever called upon to do so, revenue is recognized over the

time of the contract i.e. 12 months.

Case C

1. Revenue recognition on delivery when control of the cement transfers to the buyer.

2. 15 November 20x5

Dr. Goods receivable.................................................................... 600

Cr. Sales revenue ................................................................... 600

3. This is a non-monetary exchange of dissimilar goods and therefore is measured at the

fair value of the consideration received. Therefore, the transaction is measured at the

value of the consideration received, which is $600 (three units worth $200 each).

Case D



1. Revenue recognition is over time - month by month - as revenue is earned by

delivery of each month’s magazine.

2. 2 August 20x5—To recognize collection of the subscription price:

Cash........................................................................................ 720

Contract liability / Unearned subscription revenue .......... 720

3. The cash was collected in advance of delivery. Revenue is recognized as earned (by

delivery), not when cash is collected. Only one magazine issue was delivered in

20x5. The entry to record revenue earned in 20X5 (not required) is:

Contract liability / Unearned subscription revenue ................ 20

Subscription revenue ........................................................ 20

$720 × 1/36 = $20

Assignment 6-4

a. This is a bill and hold transaction.

The five steps to revenue recognition:

1. Identify the contract with the customer - As noted an invoice is prepared as the

order of the windows is completed and put into the warehouse until the time of

delivery.

2. Identify separate performance obligations, if they exist - There is one performance

obligation requiring Rory to deliver the windows to its customer.

3. Determine the overall contract price - The contract price is set out in the invoice.

4. Allocate the contract price to the separate performance obligations - There is only

one performance obligation.


recognized. In this case, the customer has requested that the delivery not be made

until they are ready for the installation. This is a bill-and-hold arrangement. As

such, performance is complete when the customer controls the units. Under this

type of arrangement, the customer has control when all of the following

conditions are met:

The reason for the bill-and-hold arrangement is practical. The hold

makes sense since the builder has nowhere likely to store the windows and

to prevent theft and damage delivery is made when the windows can be

immediately installed.

The buyer’s inventory is separately identified as belongings to the buyer -

In this case, the goods are tagged and stored in the warehouse separately

from the rest of Rory’s inventory.

The inventory is ready to be delivered - Yes, the inventory is fully

completed and ready for delivery.

The seller cannot use the product or sell to another customer and then

replace it. It appears that the windows have all been cut to specific sizes

and shapes to fit the homes and likely could not be reused by other

customers.

Since all of the above conditions are met, control has been completed prior to delivery

and revenue can be recognized as the order is completed and put into the warehouse

awaiting delivery. Related costs for the windows will be expensed also at this time, for

example, cost of goods sold.

b. This is a case where the contract is long-term and it must be determined if control of

the machine is transferred over time or at a single point in time.

The five steps to revenue recognition:



1. Identify the contract with the customer - As noted a contract is signed

outlining the standard sections to be used in building the machine and the

consideration to be paid.

2. Identify separate performance obligations, if they exist - There is one

performance obligation requiring the seller to deliver the machine to its

customer.

3. Determine the overall contract price - The contract price is set out in the

contract.

4. Allocate the contract price to the separate performance obligations - There is

only one performance obligation.


recognized. The issue here is when is control transferred to the customer?

For this we examine the following criteria:

............................ Does the customer receive and consume

benefits from the asset throughout the contract period? In this

case, the answer is ―no‖ since the customer does use the

machine until it is delivered.

............................ Does the contract improve or create an asset

controlled by the customer? No, the customer does not

control this asset until it is delivered.

............................ Can a partially completed machine be re-

sold to another customer and does the seller have the right to

payment for work completed to date? It appears that the

partially completed machine could be easily disassembled and

resold to another customer. Also, it appears that the seller

does not have the right to any payment until the machine is

delivered and inspected by the customer.

As a result, it appears that performance is not complete until delivery has

been made. So all costs would be inventoried as incurred, and once the

machine is completed and delivered (and inspected) by the customer, the

performance is complete and revenue is recognized.

c. The five steps to revenue recognition:

1. Identify the contract with the customer - As noted a contract is signed with the

customer outlining the terms and conditions.

2. Identify separate performance obligations, if they exist - There are several

performance obligations. To assess which performance obligations are distinct,

we consider if either of the following criteria are met:

A customer can use the good or service on its own or with other resources

that it can readily obtain. Evidence of this is when the good or service is

sold separately. In this case, only the ongoing service is sold separately.

Software, training and testing are sold as a package. It is likely that no

other company can provide the on-site installation, testing and training for

the software since it is all custom-designed. It is also unlikely that another

company could provide the upgrades and service for the customized

software.

The seller’s promise to deliver the goods or service is separately

identifiable. This holds true if the good or service are not higher

dependent or integrated with each other. In this case, the customer cannot

use the software until it is installed, tested and employees are trained. The

service contract would be a distinct service since the software will operate

without it.

From this analysis, it appears there are two performance obligations: (1) development of

the software along with the installation, testing and training; and (2) the upgrade and

service agreement for two years.

3. Determine the overall contract price - The contract price is set out in the contract.

4. Allocate the contract price to the separate performance obligations - There are two

performance obligations. The allocation of the total consideration is based on the

stand-alone fair values of each good and service making up each obligation. The

relative method would be used based on the stand-alone fair values of each of the

performance obligations.


recognized. For the performance obligation related to the software, installation,

testing and training, this is complete at the point that the training has been completed

which is likely the last step to be performed after the installation and testing. For the

upgrade and service revenue, this is performed over time and will be recognized

evenly over a 24 month period, starting when the training is complete. Costs

incurred for the software development, installation, testing and training would be

deferred as contract assets, until the training is complete and the revenue and related

costs then can be recognized. Payments received would be reported as contract

liability until the time that revenue could be recognized based on the above

discussion.



Assignment 6-5

1. The revenue should be recognized as the batch of windows are delivered to the

building site. The contractor takes title at that point, which is indicated by the fact that

the contractor takes responsibility for window breakage after Luke delivers them, and

the contractor also is responsible for proper installation.

Luke is still vulnerable to some risk after delivery, including (1) potential liability for

design or manufacturing defects and (2) non-payment by the contractor. The risk of

liability for defects is a contingent liability. The risk of non-payment can usually be

estimated in advance of any financial difficulties experienced by the contractor. Even

if the contractor is unable to pay, Luke still has a lien on the property and can demand

payment (through the courts) from the house owner.

2. Although the contract may run for several years, the production process is not a long-

term contract. Percentage of completion accounting is not appropriate! As each batch

is completed and delivered, revenue is recognized along with the related costs.

The ―bid‖ costs should be expensed when incurred. Luke will win some bids and

lose others. Bidding is a routine part of the business—a selling cost.

Production costs should be accumulated in inventory. When the windows are

delivered to the building site, the inventory cost should be moved to COS and revenue

should be recognized.

Any estimated warranty costs should be established when the revenue is

recognized and set up as a provision for warranty costs, and adjusted thereafter.

Assignment 6-6

Requirement 1

The five steps to revenue recognition are outlined below.

1. Identify the contract with the customer. An agreement has been signed but only

outlines that PGIL will acquire the rights and formulas any time before December 31

20X6.

2. Identify separate performance obligations, if they exist. There is only one performance

obligation and that is the transfer of control of the formulas and rights to Scourge.

3. Determine the overall contract price. The consideration is $16 million which was

agreed to in early 20X6. However, since payments are received in five equal

installments from 20X6 to 20X10, the consideration is the present value of these

payments. In addition, depending on when revenue is actually recognized, SDC may

have an interest expense on advance payments and interest income on delayed

payments.

4. Allocate the contract price to the separate performance obligations. As outline earlier,

there is only one performance obligation.


This will occur once control of the formula and rights are transferred to PGIL. Does

this happen when the option is exercised on March 6, 20X6 or on delivery in January

20X7. Until January 20X7 there is no item that is actually functional. The formulas

are delivered in January 20X7 once they are fully completed. Prior to this date, SDC

still has the obligation to finish the formulas that can actually be used. So the

performance obligation is not completed until delivery to PGIL in January 20X7.

Requirement 2

Costs

The research costs of $3.16 million incurred in 20x4 must be charged to expense in 20x4

because there is no reason to believe in 20x4 that a commercially saleable product has

been created. Accounting standards require that research be expensed for this reason.

20x5 expenditures, which are on an established product with an obvious market, can be

capitalized as development costs. Costs will be accumulated to development costs as

follows:20X5 1,540,000 + 1,800,000 = 3,340,000

20X6 540,000

20X7 260,000

In January 20X7 when revenue is recognized, the total capitalized costs of $4,140,000

will be expensed.

Revenue



SDC received $6,400,000 at the time of the sale and delayed payments of $2,400,000 for

the next five years. To determine the contract consideration, interest income must be

determined from the point of sale which is January 20X7 as follows:

Payment date Amount Contract

Consideration

January 2, 20X7 6,400,000 6,400,000

December 31, 20X7 2,400,000 2,400,000 / (1.06)= 2,264,151

December 31, 20X8 2,400,000 2,400,000 / (1.06)2= 2,135,991

December 31, 20X9 2,400,000 2,400,000 / (1.06)3= 2,015,086

December 31, 20X10 2,400,000 2,400,000 / (1.06)4= 1,901,025

Total 16,000,000 14,716,253

The interest income for each year is determined in the table below using the effective

interest rate:

Revenue

recognized

Payments Interest income

(expense)

(Contract

liability)/Receivable

Balance

January 1,

20X7

14,956,253 14,716,253

January 1,

20X7

6,400,000 8,316,253

December 31,

20X7

2,400,000 8,316,253 x 6% =

498,975

6,415,228

December 31,

20X8

2,400,000 6,415,228 x 6% =

384,914

4,400,142

December 31,

20X9

2,400,000 4,400,142 x 6% =

264,009

2,264,151

December 31,

20X10

2,400,000 2,264,151 x 6% =

135849

0

January 20X7

Dr. Cash ........................................................ 6,400,000

Dr. Long-term receivable .............................. 8,316,253

Cr. Revenue .............................................. 14,716,253

December 31, 20X7

Dr. Cash ........................................................ 2,400,000

Cr Interest income ................................... 498,975

Cr. Long-term receivable ....................... 1,901,025

December 31, 20X8

Dr. Cash ........................................................ 2,400,000



December 31, 20X9

Dr. Cash ........................................................ 2,400,000



December 31, 20X10

Dr. Cash ........................................................ 2,400,000






Requirement (b) Revenue Recognition on

Date (a)Revenue Recognition at

Delivery Cash Receipt (c) Bill and Hold

18 July Inventory 456,000 Inventory 456,000 Inventory 456,000

Cash 456,000 Cash 456,000 Cash

456,000

24 August Inventory 60,000 Inventory 60,000 Inventory 60,000

Cash 60,000 Cash 60,000 Cash

Accts Rec

COS

Sales

Inventory

712,000

516,000

60,000

712,000

516,000

10 September Accts Rec 712,000 Accts Rec 712,000

Sales 712,000 Inventory

Deferred

gross

margin

516,000

196,000

COS

Inventory

516,000

516,000

22 November Cash 712,000 Cash 712,000 Cash 712,000



Accts Rec 712,000 Accts Rec

COS

Deferred gross

margin

Sales

516,000

196,000

712,000

712,000

Accts Rec 712,000

©2014 McGraw-Hill Ryerson Ltd. All rights reserved

6-40 Solutions Manual to accompany Intermediate Accounting, Volume 1, 6th edition

Requirement 2

a. Delivery is the normal revenue recognition point, based on the presumption that the

risks and rewards of ownership pass on this date and that the sales amount is realizable

b. Revenue recognition on cash receipt is appropriate when the collection is not assured

at the point of sale. In these circumstances, revenue cannot be recognized prior to

collection. In this case, the gross margin is deferred until collection is assured and then

the sale and related cost of goods sold can be recognized in net income.

c. The third situation appears to be a bill and hold.

The customer has given approval to be invoiced and accepts title to the goods. As long as

all the criteria are met for the bill and hold arrangement, revenue can be recognized prior

to delivery. The criteria for the bill and hold special treatment are:

The buyer has acknowledged the deferred delivery instructions;

Delivery is probable;

The buyer’s inventory is separately identified as belonging to the buyer (that is, held

apart from the seller’s other inventory);

The inventory is ready to be delivered; and

The customary payment terms apply to the invoice.

© 2014 McGraw-Hill Ryerson Ltd. All rights reserved



Requirement 1

The five steps for revenue recognition are:

1. Identify the contract with the customer. Dominion has a signed contract with the

customer to deliver teledine as it is mined.

2. Identify separate performance obligations, if they exist. Performance obligation is to

deliver all of the teledine produced in the year. The teledine is only produced once a

year, so delivery will take place once the material has been produced. But the customer

also has the right to return defective materials within 60 days of delivery.

3. Determine the overall contract price. The contract price if $13,500,000, as agreed.

4. Allocate the contract price to the separate performance obligations. There is only the

one performance obligation to deliver the teledine once produced.


The performance obligation is satisfied on delivery, if an estimate of returns can be

made at the point of delivery. If there is no reasonable estimate of returns that can be

made at the time of delivery, then the revenue cannot be recognized until after the

return period. Since Dominion is able to estimate potential returns at 7%, revenue can

be recognized at the point of delivery with an estimate of the returns also recognized.

Journal entries (in thousands $’s) Date

30 August Inventory 4,300

Cash, etc. 4,300

30 September Inventory 640

Cash 640

Cash

Contract Liability

1,350

1,350

15 October Accts rec

Contract Liability

12,150

1,350

Revenue 12,555

Refund Liability (7% x 13,500) 945

COGS 4,594

Right to recovery asset (7% x 4,940) 346



Inventory 4,940

Cash

Accounts Rec

6,750

6,750

25 October Refund Liability (5% x 13,500) 675

Accts rec 675

Loss on unsalable product (5% x

4,940)

247

Right to recovery asset 247

Refund Liability (2% x 13,500) 270

Revenue 270

COGS (2% x 4,940) 99

Right to recovery asset 99

30 November Cash 4,725

Accts Rec 4,725

Requirement 2

If the customer asked Dominion to hold 30% until they were ready for delivery, this

would qualify as a bill and hold as long as all of the following criteria were met:

As such, performance is complete when the customer controls the units. Under this type

of arrangement, the customer has control when all of the following conditions are met:

The reason for the bill-and-hold arrangement is practical. The customer

has requested the bill and hold and it likely makes since the buyer not

require all of the inventory ( which is only shipped once per year) or have

the storage space available.

The buyer’s inventory is separately identified as belongings to the buyer -

In this case, this is the only inventory that Dominion has since all of its

production is sold to this single buyer.

The inventory is ready to be delivered - Yes, the inventory is fully

completed and ready for delivery.

The seller cannot use the product or sell to another customer and then

replace it. This is true since all of the production goes to this customer

only.

Since all of the above conditions are met, control has been completed prior to delivery

and revenue can be recognized as the order is completed and put into the warehouse

awaiting delivery. As such, the journal entries would be the same as above in

Requirement 1. Revenue is recognized at the time of delivery.



Assignment 6-9 - Revenue Recognition - Return policy

a. The five steps to revenue recognition:

1. Identify the contract with the customer - As noted, a contract is prepared and signed

that outlines the particulars of the sale, the return policy and the payment terms.

Carnegie ―stands ready‖ to take back up to 50% of the items within 6 months from the

date of sale.

2. Identify separate performance obligations, if they exist - There is one performance

obligation requiring Carnegie to deliver the books to its customer.

3. Determine the overall contract price - The contract price is set out in the contract at

$25,000.

4. Allocate the contract price to the separate performance obligations - There is only one

performance obligation.


- The performance obligation is complete once control of the books is transferred to the

customer. However, there is significant uncertainty about the actual number of books

that will actually remain with the customer and how many will actually be returned due

to the generous return policy. Non-profit organizations (NPOs) can over-order and

then return half of the books within 6 months. Although Carnegie may have a good

historical record of average returns, there can be substantial variation, which makes it

difficult to predict the number and type of books that will be returned, given the long

return period.

Conclusion: Record revenue on 50% of the books that cannot be returned and defer 50%

of the revenue until the return period is completed.

b. Based on revenue being recognized at the end of the return period, the following

journal entries are required:

1 June

Dr. Accounts receivable 25,000

Cr. Revenue 12,500

Cr. Refund liability 12,500

Dr. Cost of goods sold (12,500 x 65%) 8,125

Dr. Right to recovery asset (12,500 x 65%) 8,125

Cr. Inventory 16,250



15 August:

Dr. Refund liability 4,000

Cr. Accounts receivable 4,000

Dr. Inventory ($4,000 x 65%) 2,600

Cr. Right to recovery asset 2,600

3 October



Dr. Inventory ($5,500 x 65%) 3,575


December 1 (end of return period)


Cr. Revenue 3,000

Dr. Cost of goods sold ($3,000 x 65%) 1,950


December 20

Dr. Cash 15,500







Requirement 1

Cash....................................................................................................... 532,000

Deferred gross margin ..................................................................... 244,000

Inventory (48,000 × $6) .................................................................. 288,000

Requirement 2

Inventory (4,500 × $6) .......................................................................... 27,000

Deferred gross margin* ......................................................................... 20,000

Cash................................................................................................. 47,000

*(3,500 × $4) + (1,000 × $6)

Requirement 3

A B A-B

Month

of Sale

Units

Sold

Sales

Price

Monthly

Sales

Gross Units

ROR

Expired *

Total Units

Returned

Net Units

ROR Expired †

ROR Expired

Sales Amount §

September 10,000 $10 $100,000 4,000 2,500 1,500 $15,000

October 12,000 10 120,000 3,600 1,000 2,600 26,000

November 15,000 12 180,000 3,000 1,000 2,000 24,000

December 11,000 12 132,000 1,100 0 1,100 13,200

Totals 48,000 $532,000 11,700 4,500 7,200 $78,200

*

© 2014 McGraw-Hill Ryerson Ltd. All rights reserved.

Solutions Manual to accompany Intermediate Accounting, Volume 1, 6th edition

6-47

Gross number of units sold this month, times 10% times number of months since sale.

For example, at 31 December, 20x5, four months have passed since the September

sales, thus 4 × 10%, or 40% of the right of return (ROR) has expired; (40% × 10,000

units = 4,000 units).

† Equal to gross units for which ROR expired, less units returned.

§ Equal to Net units for which ROR has expired times sale price per unit for this month

sales.

Realized gross margin in 20x5 = $78,200 – (7,200 units × $6) = $78,200 – $43,200 =

$35,000

To record realized gross margin on expired and unused right of return units

shipped:

Cost of Goods Sold (7,200 × $6) ....................................................... 43,200

Deferred gross margin ....................................................................... 35,000

Sales .............................................................................................. 78,200

Requirement 4

Month

of Sale

Units Available

for Return or

Sale**

Units

Returned

Units Sold

in 20x6 ††

Unit Sale

Price

Sales

Amount

September 6,000 1,000 5,000 $10 $ 50,000

October 8,400 2,000 6,400 10 64,000

November 12,000 2,500 9,500 12 114,000

December 9,900 4,000 5,900 12 70,800

9,500 26,800 $298,800

× $6 × $6

Cost of returns $57,000

Costs of units sold $160,800

** Equal to total sold for this month, less those returned or recorded as sold in 20x5 (see

Requirement 3). (Example: For September: units sold of 10,000 less gross units

right-of-return expired is 4,000. Therefore, units available for return or sale is

6,000.

†† Equal to Units available (column 2) less units returned.



Entry to record returns in 20x6:

Inventory (9,500 units × $6) ......................................................... 57,000

Deferred gross margin .................................................................. 51,000

Cash .......................................................................................... 108,000*

*Refund amount on returned units:

(1,000 units × $10) + (2,000 units x $10) + ($2,500 units × $12) + (4,000 units ×

$12) = $108,000



Entry to record realized gross margin in 20x6 related to 20x5 sales:

Cost of goods sold ..................................................................... 160,800

Deferred gross margin ............................................................... 138,000

Sales ...................................................................................... 298,800

Reconciliation:

Total units sold in period September–December ....................... 48,000

Total dollar sales amount for period September–December ..... $532,000

Cost of units sold in period September–December ................... 288,000

Total gross margin ..................................................................... $244,000

Units: 20x5 20x6 Total

Returned .................................................. 4,500 9,500 14,000

Not returned (sold) .................................. 7,200 26,800 34,000

Totals ........................................................... 11,700 36,300 48,000

Gross Sales:

Returned .................................................. $ 47,000 $108,000 $155,000

Not returned ............................................ 78,200 298,800 377,000

Totals ........................................................... $125,200 $406,800 $532,000

Cost of sales:

Returned .................................................. $ 27,000 $ 57,000 $ 84,000


Totals ........................................................... $ 70,200 $217,800 $288,000

Gross margin:

Returned (not realized)............................ $ 20,000 $ 51,000 $ 71,000


Totals ........................................................... $ 55,000 $189,000 $244,000



Assignment 6-11

Requirement 1

The initial $1,000 amount is to cover the assessment of the franchisee and is separate

revenue from the franchise fee. This will be recognized at the end of the assessment

period, which is usually four days after receipt of the cash.

For the franchise fee, the franchise arrangement allows the franchisee to use the GRI’s

trademark for a period of three years. At the end of the initial contract period, the

contract can be extended for an additional two years with an additional payment. This is

a licensing arrangement allowing the franchisee to use the trademark. License

agreements can be designed to either transfer a right to use the license or a promise to

provide access to the seller’s intellectual property for a period of time. Based on the

contract terms which limits the franchisees use to three years, this franchise fee revenue is

recognized over the three-year period. It is a right of access the trademark. During these

three years, GRI will undertake activities that will change the trademark value itself,

thereby impacting the value to the franchisee.

Although there are delayed payments, all of the $150,000 is received within the year, and

so no discounting is required.

Requirement 2

Date of signing

contract

Number of

licenses sold

Months

expired to Dec

31 20X4

(1)

Monthly fees

earned

(2)

$

Revenue

earned in

20X4

(1) X (2)

$

April 3 April - Dec - 9 $150,000 X 3 /

36 = 12,500

9 X 12,500 =

112,500

July 7 6 $150,000 X 7 /

36 = 29,167

175,002

October 5 3 $150,000 X 5 /

36 = 20,833

62,499

November 4 2 $150,000 X 4 /

36 = 16,667

33,334

Total 19 $383,335

Because the one contract in July was revoked, only 7 license agreements were completed.

Journal entries

For 20X4

The problem should read that the $1,000 upfront fee is not part of the $150,000 fee.

Cash (20 x $1,000) ................................................................. 20,000



Revenue – Assessment fees ........................................................ 20,000

Accounts receivable (20 X 150,000) ................................. 3,000,000

Contract liability ......................................................................... 3,000,000

To record sales of licenses.

Cash ............................................................................... 2,700,000

Accounts Receivable ................................................................... 2,700,000

To record receipt of cash during the year.

Contract liability .................................................................. 150,000

Cash (100,000 - 7,500) ................................................................ 92,500

Revenue - other (revoked contract) (150,000 x 5%) Note 1 ....... 7,500

Accounts receivable .................................................................... 50,000

To record the revoked contract and the return of cash.

Contract liability .................................................................. 383,335

Revenue - license fees ................................................................. 383,335

To record sales for the year.

Requirement 3

The balances on SFP:

Accounts receivable ........................................................... $250,000

$3,000,000 – 2,700,000 - 50,000 = $250,000

Contract liability (3,000,000 - 150,000 - 383,335) 2,466,665

Note 1 - The $150,000 relates to the July 20X4 license that was revoked.

The amount on the SCI

Revenue - franchise fees ..................................................... 383,335

Revenue - other ........................................................................ 7,500

Revenue – assessment fees .................................................... 20,000




$

% allocation Allocation

$

Goods sold 1,725,000 98.32% 1,696,020

Points sold

(1,725,000 x $0.017)

29,325 1.68% 28,980

Total 1,754,325 100% 1,725,000

Journal entries required for March, 20X4

Dr. Cash 1,725,000

Cr. Sales 1,696,020

Cr. Provision for loyalty program awards 28,980

To record the sales for the month.

Dr. Provision for loyalty program awards 20,400

Cr. Sales 20,400

To record points redeemed for sales during March 20X4.

(1,200,000 x $0.017)




Requirement 1 — Cost Deferral Method

30 April 20X2:

Accounts receivable 600,000

Revenue 600,000

To record the sale

Note: The product cost should also be removed from inventory with a debit to cost of

goods sold and a credit to inventory. This information has not been provided.

Warranty expense 50,000

Provision for warranty 50,000

To set up the estimated warranty provision

1 May through 31 December 20X2:


Cash, A/P, etc. 20,000

To record costs incurred

31 December 20X2:

Provision for warranty 17,000 Warranty expense 17,000

To reduce warranty provision to new estimate.

1 January through 30 April 20X3:

Provision for warranty 11,000 Cash, A/P, etc. 11,000


30 April 20X3:


To close out unused warranty provision



Requirement 2 — Revenue Deferral Method

This contract now has multiple performance obligations and so the contract consideration

has to be allocated between the product and the warranty. The consideration is allocated

based on relative stand-alone values as follows:

Stand-alone values Percentage Allocation

Product 580,000 88.5% 531,000

Warranty 75,000 11.5% 69,000

655,000 $600,000

30 April 20X2:

Accounts receivable 600,000

Sales revenue 531,000

Contract liability - warranty 69,000

To record the sale, with deferral for warranty

Note: The product cost should also be removed from inventory with a debit to cost of

goods sold and a credit to inventory. This information has not been provided.

1 May through 31 December 20X2:






To amortize 8/12 of deferred revenue (May 1 to December 31, 20X2).

1 January through 30 April 20X3:

Warranty expense 11,000 Cash, A/P, etc. 11,000




To amortize 4/12 of deferred revenue (Jan 1 to April 31, 20X3)



Assignment 6-14

Requirement 1 — Cost Deferral Method

30 September 20X1:

Accounts receivable 2,000,000

Revenue 2,000,000

To record the sale

Cost of goods sold 1,400,000

Inventory 1,400,000

To record the cost of goods sold related to the sale.



To set up the estimated warranty provision

1 October through 31 December 20X1:




31 December 20X1:

Warranty expense 30,000 Provision for warranty 30,000

To increase warranty provision to new estimate.

1 January through 31 December 20X2:



31 December 20X2:


To reduce warranty provision to $20,000

1 January through 30 September 20X3:





30 September 20X3:


To close out warranty provision

Requirement 2 — Revenue Deferral Method

This contract now has multiple performance obligations and so the contract consideration

has to be allocated between the product and the warranty. The consideration is allocated

based on relative stand-alone values as follows:

Stand-alone values Percentage Allocation

Machine 1,900,000 92.7% 1,854,000

Warranty 150,000 7.3% 146,000

2,050,000 $2,000,000

30 September 20X1:

Accounts receivable 2,000,000

Revenue - Machine 1,854,000

Unearned revenue - warranty 146,000

To record the sale, with deferral for warranty

Cost of goods sold 1,400,000

Inventory 1,400,000

To record the cost of goods sold related to the sale.

1 October through 31 December 20X1:




31 December 20X1:


Revenue - warranty 18,250

To amortize 3/24 of deferred revenue

1 January through 31 December 20X2:





31 December 20X2:




1 January through 30 September 20X3:



30 September 20X3:







This $180,000 sale has two deliverables:

fork lift truck, sales price $140,000

3-year service contract, value $60,000

Requirement 1 — Relative Stand-alone Value Method:

The revenue must be divided into two components on the basis of stand-alone values of

each component:

Component

stand-

alone

value

Proportion Revenue

allocation

Fork-lift truck $140,000 70% $126,000

Service contract 60,000 30% 54,000

Total $200,000 100% $180,000

Journal entry:

Accounts receivable ................................................................ 180,000

Revenue – equipment sales ............................................... 126,000

Unearned revenue – service contract ................................ 54,000

Requirement 2 — Residual Value Method:

The residual value method can only be used if either one of the following conditions

exist:

a. The entity sells the same good or service to different customers for a wide

range of different selling prices; or

b. A price for the good or service has not yet been stablished and has not

been previously sold on a stand-alone basis.

In this case, the first criterion is met since the BigBoy sells the service contract for a range

of values. So the residual value method can be used.

The revenue is assigned first to the fork-lift truck, which has a known sales price of

$140,000. The residual revenue is assigned to the service contract and deferred:

Journal entry:

Accounts receivable ................................................................ 180,000

Revenue – equipment sales ............................................... 140,000

Deferred revenue – service contract ................................. 40,000



Assignment 6-16

New subscribers are being given a new cell phone at a ―special‖ low price for the monthly

telephone service. In return, however, they will pay a higher monthly fee. In total, new

subscribers pay $3,700 for product and services:

a mobile phone costing $100; and

36 months of service worth $100 per month, a total of $3,600

Regular subscribers pay $3,160 for the same services:

a mobile phone costing $1,000

36 months of service worth $60 per month, a total of $2,160

Revenue recognition will differ depending on which allocation method is used.

Stand-Alone Value Method

The $3,700 would be allocated proportionately to the two components:

cell phone: $3,700 × ($1,000 ÷ $3,160) = $3,700 × 31.65% = $1,171

service contract: $3,700 × ($2,160 ÷ $3,160) = $3,700 × 68.35% = $2,529

$1,171 revenue from the cell phone would be recognized immediately. Since only $100 is

received up-front from a new subscriber, an asset of ―contract asset‖ or ―accrued revenue‖

of $1,071 should be recognized. The $1,071 will then be offset against the monthly $100

service payments over 36 months at $29.75 per month, thereby reducing monthly service

revenue to $70.25 per month, higher than the normal charge to regular subscribers. In

substance, the phone is being sold at a price 17% higher than normal. The higher price

might be due to expected defaults (and non-recovery of the phones).

Residual Value Method

In this method, the normal price of the phone, $1,000, would be recognized at the

inception of the contract, offset by $100 cash received and $900 ―contract asset‖ or

―accrued revenue‖. The remaining $2,700 (i.e. $3,700 - $1,000) would be recognized

monthly over 36 months, at $75 per month (that is, $2,700 ÷ 36).

Discussion

The company’s motivation probably is to attract new subscribers by offering the

―bargain‖ price of $100 for an expensive phone. Nevertheless, since the bargain price is

linked to a 36-month contract, the company will recover all of the value of the phone.

Either allocation method will, in this example, recognize revenue recognition that is more

realistic of the value of what the company is delivering. Nevertheless, since fair values

are available for both components of the deal, the market value method is preferrable.



Journal entries (not required) for initial transaction and first subsequent payment:

Stand-alone value method:

Initial transaction:

Cash 100

Unbilled revenue 1,071

Sales revenue 1,171

First monthly payment:

Cash 100.00

Service contract revenue 70.25

Unbilled revenue (1,071 ÷ 36) 29.75

Residual value method:

Initial transaction:

Cash 100

Unbilled revenue 900

Sales revenue 1,000

First monthly payment:

Cash 100

Service contract revenue 75

Unbilled revenue (900 ÷ 36) 25



Assignment 6-17 Requirement 1

Journal entries for 20X3

Dr. Agricultural produce - logs 600,000 x 95% 570,000

Cr. Biological assets - timber 570,000

To record the timber harvested into logs

Dr. Inventory - lumber (570,000 x 80%) 456,000

Cr. Agricultural produce 456,000

To record the transfer of the logs into the production of lumber.

Dr. Inventory - lumber 175,000

Cr. Cash or Accounts payable 175,000

To record production costs

Dr. Cost of goods sold (456,000 + 175,000) x 60% 378,600

Cr. Inventory - lumber 378,600

To record lumber sold during the year.

Dr. Biological asset - timber 997,500

Cr. Change in value of biological asset 997,500 To adjust the timber to fair value less costs to sell at year end.

9,350,000(.95) - (8,900,000 (.95) - 570,000) = 8,882,500 - 7,885,000

Requirement 2

Balances on SFP

Inventory - lumber (456,000+175,000 - 378,600) 252,400

(net realizable value 310,000 x 93% = 288,300)

Agricultural produce (570,000-456,000) 114,000

(net realizable value 125,000 x 95% = 118,750)

Biological asset - timber (9,350,000 x 95%) 8,882,500

Balances on SCI

Cost of goods sold (378,600)

Change in fair value of biological asset 997,500



Assignment 6-18

Requirement 1— Items qualifying for carrying at fair value less costs to sell

Biological asset Agricultural produce Inventory

Sheep Wool Yarn

Trees Logs Lumber

Chicken Eggs Frozen omelets

Requirement 2 — General discussion

Biological assets are recorded at fair value less selling costs at each reporting period, with

changes being recognized in current income.

Agricultural produce - is recorded at fair value less costs to sell at the time of harvest.

The rules of lower of cost or net realizable value are applied after the point of harvest.

Inventory - is recorded at cost - ( lower of cost and net realizable value).




Requirement 1

Year

Costs

incurred

Costs

incurred to

date

%

Complete

Revenue

to date2

Revenue for

current

year3

Gross

profit4

20X5 $ 2,700,000 $ 2,700,000 30.51%1

$ 3,340,845 $ 3,340,845 $ 640,845

20X6 4,500,000 7,200,000 81.36%1

8,908,920 5,568,075 1,068,075

20X7 1,800,000 9,000,000 100.00% 10,950,000 2,041,080 241,080

$ 9,000,000 $10,950,000 $ 1,950,000

1 Costs incurred to date total estimated cost of $8,850,000

2 Contract revenue of $10,950,000 percentage of completion

3 Total revenue to date – previous year’s revenue to date

4 Revenue for current year – costs incurred during current year

Requirement 2

20X5 20X6 20X7

To record costs of

construction:

Contract costs 2,700,000 4,500,000 1,800,000

Cash, payables,

etc.

2,700,000 4,500,000 1,800,000

To record progress

billings:

Accounts receivable 2,300,000 4,900,000 3,750,000

Contract liability 2,300,000 4,900,000 3,750,000

To record cash

received:

To recognize

revenue for

performance

completed to date :

Contract asset 1,040,845 668,075 1,708,920


Revenue—long-

term contracts

3,340,845 5,568,075 2,041,080

To recognize costs

related to revenue



recognized to date

Construction costs 2,700,000 4,500,000 1,800,000

Contract costs 2,700,000 4,500,000 1,800,000

Requirement 3

If the customer does not take title until the building is constructed, then revenue is not

recognized until the building is completed in 20X7. Costs are accumulated in inventory

until the building is completed and sold.

20X5 20X6 20X7

To record costs of

construction:

Construction-in-

progress inventory

2,700,000 4,500,000 1,800,000

Cash, payables,

etc.

2,700,000 4,500,000 1,800,000

To record progress

billings:

Accounts receivable 2,300,000 4,900,000 3,750,000


To record cash

received:

To recognize

revenue for

performance

completed to date :

Contract liability 10,950,000

Revenue—long-

term contracts

10,950,000

To recognize costs

related to revenue

recognized to date

Construction costs 9,000,000

Construction-in-

progress

inventory

9,000,000



Assignment 6-20 (EXCEL) (WEB)

Requirement 1

20x5 20x6 20x7 1. Costs of construction:

Contract costs ....................................... 180,000 450,000 195,000

Cash, payables, etc. ......................... 180,000 450,000 195,000

2. Progress billings:

Accounts receivable .............................. 153,000 382,500 439,500

Contract liability ............................. 153,000 382,500 439,500

3. Collections on billings:

Cash ..................................................... 140,000 380,000 455,000

Accounts receivable ........................ 140,000 380,000 455,000

4. Recognition of income:

Contract asset ....................................... 63,667 149,918 213,585

Contract liability ................................... 153,000 382,500 439,500

Revenue - Construction ............... 216,667 532,418 225,915

Construction costs ................................ 180,000 450,000 195,000

Contract costs .................................. 180,000 450,000 195,000

Computations: 20x5 20x6 20x7

Contract price ................................................... $975,000 $975,000 $975,000

Actual costs to date .......................................... 180,000 630,000 825,000

Estimated costs to complete ............................. 630,000 190,000

Total estimated costs ........................................ 810,000 820,000 825,000

Estimated total contract income ....................... $165,000 $155,000 $150,000

% complete ....................................................... 22.22 76.83 100

Apportionment:

20x5: ($180,000 $810,000) × $975,000 = $216,667.

20x6: [($630,000 $820,000) × $975,000] – $216,667 = $532,418.

20x7: $975,000 – $216,667 – $532,418 = $225,915.



Requirement 2

20x5 20x6 20x7

Statement of Financial Position:

Current assets:

Accounts receivable ...................................... $ 13,000 $ 15,500 $ 0

Contract asset ................................................ 63,667 213,585 0

Income statement:

Income on construction (net) ........................... $ 36,667 $ 82,418 $30,915

Check: $36,667 + $82,418 + $30,915 = $150,000 which is the profit from the contract

($975,000 - $825,000)

Requirement 3

20x5 20x6 20x7 1. Costs of construction:

Construction-in-progress

inventory ............................................. 180,000 450,000 195,000

Cash, payables, etc. ......................... 180,000 450,000 195,000

2. Progress billings:

Accounts receivable .............................. 153,000 382,500 439,500

Contract liability ............................. 153,000 382,500 439,500

3. Collections on billings:

Cash ..................................................... 140,000 380,000 455,000

Accounts receivable ........................ 140,000 380,000 455,000

4. Recognition of income:

Construction costs ................................ 825,000

Construction-in-progress inventory . 825,000

Contract liability ................................... 975,000

Revenue - Construction ................... 975,000

20x5 20x6 20x7


Current assets:

Accounts receivable ...................................... $ 13,000 $ 15,500 $ 0

Inventory:

Construction-in-progress inventory .............. 180,000 630,000



Liabilities

Contract liability .............................................. 153,000 535,500 0

Income statement:

Income on construction (net) ........................... $ 0 $0 150,000



Assignment 6-21

Requirement 1

Calculations (thousands):

20x3 20x4 20x5

Contract price $ 1,600 $ 1,600 $ 1,600

Actual costs to date 470 1,170 1,365

Estimated costs to complete 830 210 —

Total 1,300 1,380 1,365

Estimated total profit $ 300 $ 220 $ 235

Actual costs to date $ 470 $ 1,170 $ 1,365

Estimated total costs 1,300 1,380 1,365

Percentage complete 36.2% 84.8% 100.0%

Revenue to be recognized:

20x4: $1,600 × 36.2% $ 579

20x5: ($1,600 × 84.8%) – $579 $ 778

20x6: $1,600 – ($579 + $778) $ 243

Gross profit to be recognized:

Revenue for current period less costs

incurred in current period

20x4: $579 – $470 $ 109

20x5: $778 – $700 $ 78

20x6: $243 – $195 $ 48

Journal entries: in thousands $’s

20X3:

Construction-in-progress inventory ................................................. 470

Cash, accounts payable, etc. ...................................................... 470

Accounts receivable ......................................................................... 380

Billings on contract .................................................................... 380

Cash ................................................................................................. 290

Accounts receivable ................................................................... 290

Cost of construction ......................................................................... 470

Construction in progress inventory .................................................. 109

Construction revenue ................................................................. 579

20X4:







Cash ................................................................................................. 870





20X5:





Cash ................................................................................................. 440





Billings on contract ....................................................................... 1,600

Construction-in-progress inventory ........................................... 1,600

Requirement 2

20x3 20x4 20x5


Current assets:

Accounts receivable ...................................... $90,000 $ 210,000 $ 0

Inventory (or Liability)

Construction-in-progress inventory .............. 579,000 1,357,000

Billings on contracts...................................... 380,000 1,370,000 0

Costs in excess of billings ............................. 199,000 (13,000)

(or Billings in Excess of costs)



Income statement:

Income on construction (net) ........................... $ 109,000 $78,000 48,000



Assignment 6-22

Transaction Value of new asset on

the SFP

Amount on the income

statement. Indicate if a gain

or a loss. If no gain or loss

is recorded, enter ―zero‖

a. GYT Company exchanges a

machine that cost $4,000 and has

accumulated depreciation of

$2,560 for a similar machine.

GYT also receives $25 in the

exchange. The fair market value

of the old asset is $750. The fair

market value of the new asset is

$725. There is no commercial

substance to the transaction.

$725

(net book value of old,

$1,440 ($4,000 –

$2,560) less cash

received, $25 = $1,415

However, cap is fair

value of the new

machine, $725.

Loss of $690

$1,415 – $725 = $690

(essentially, an impairment

loss)

b. FST Company exchanges a

machine that cost $4,000 and has

accumulated depreciation of

$3,560 for a similar machine.

FST also receives $25 in the

exchange. The fair market value

of the old asset is $750. The fair


$725. There is no commercial

substance to the transaction.

$415

(net book value of old,

$440 ($4,000 –

$3,560) less cash

received, $25.

Zero

c. LKC Company pays $250 and

exchanges a machine that cost

$3,000 and has accumulated

depreciation of $1,900 for

another machine. The fair

market value of the old asset is

undeterminable. The fair market

value of the new asset is $690.

The transaction has commercial

substance.

$690

With commercial

substance, the asset is

recorded at fair value

of the asset received

since the fair value of

the asset given up is

not determinable.

Loss of $660

Net book value is $1,100

($3,000 – $1,900);

Consideration paid was

$1,100 + 250 = $1,350

Value of new asset $690

Loss = 1,350 - 690 = 660



d. HRT Company pays $250 and





market value of the old asset is

$435. The fair market value of

the new asset is $680. The

transaction has commercial

substance.

$680

With commercial



Loss of $170

Net book value is $600

($2,000 – $1,400); cash

paid is $250. New asset

recorded at $680:

$600 + $250 – $680 = $170

e. AML Company pays $500 and






$1,580. The transaction has

commercial substance.

$1,580

With commercial



Gain of $480

Net book value is $600

($9,000 – $8,400);

Consideration paid was

$600 + 500 = $1,100

Value of new asset $1,580

Gain = 1,580 - 1,100 = 480



Although not asked for in the question, here are the journal entries for 6-22:

a) Loss on trade

690

Machine

725

Accumulated Depreciation

2,560

Cash

25

Machine

4,000

b) Machine

415


3,560

Cash

25

Machine

4,000

c) Loss on trade

660

Machine

690


1,900

Machine

3,000

Cash

250

d) Loss on trade

170

Machine

680


1,400

Machine

2,000

Cash

250

e) Machine

1,580


8,400

Machine

9,000

Cash

500

Gain on trade

480

e)

If no commercial substance:

Machine

1,100


8,400

Machine

9,000

Cash

500




a. There is no evidence of commercial substance. The new equipment is recorded at the

net book value of the old equipment:

Equipment (new) .................................................................... 144,000

Accumulated depreciation (old) ............................................... 288,000

Equipment (old) ................................................................... 432,000

b. There seems to be commercial substance, since new business can be attracted with the

new equipment. The new equipment is recorded at its fair value, and a gain is

recognized on the exchange:

Equipment (new) .................................................................... 285,000


Equipment (old) ................................................................... 432,000

Gain on equipment ............................................................... 141,000

c. There is commercial substance. The new equipment is recorded at the fair value of the

old equipment, adjusted for cash, as the more reliable measure. A gain is recognized on

the exchange:

Equipment (new) .................................................................... 249,000


Equipment (old) ................................................................... 432,000

Cash ..................................................................................... 24,000

Gain on equipment ............................................................... 81,000

d. There is no commercial substance. The new equipment is recorded at the book value of

the old equipment plus the cash consideration given. No gain or loss is recognized:

Equipment (new) .................................................................... 168,000


Equipment (old) ................................................................... 432,000

Cash ..................................................................................... 24,000



e. There is no commercial substance to this transaction, and therefore the new truck is

recorded at the net book value of the old truck plus the cash paid:

Truck (new)………………………………………………. 60,000

Accumulated amortization (old)………………………….. 60,000

Truck (old)……………………………………. 100,000

Cash……………………………………………. 20,000

f. This transaction has commercial substance since it enables a new type of operation for

Rochester Shipping Company and thereby can be expected to significantly affect the

future cash flows of the company. It seems likely that the fair value of the land and

building given up is more readily determinable than the fair value of the boat, since it

remained unsold for two years and also requires substantial work before it can return

to service. Therefore, the boat should be recorded based on the fair value of the land

and building.

Ferry …………………………………………………….. 1,150,000

Accumulated amortization – building……………………. 210,000

Building………………………………………... 700,000

Land……………………………………………. 300,000

Gain on capital asset disposal……………… 360,000

The additional cost for necessary upgrading and maintenance is added to the cost of the

boat when the work is done:

Ferry…………………………………………………….. 350,000

Cash, accounts payable, etc………………….. 350,000

This brings the recorded ferry value to $1,500,000, which may exceed fair value.

Alternatively, the $1,500,000 may be appropriate; it depends on whether the

expenditures improve the ferry, or just get it into serviceable shape.

The value now assigned to the ferry should be reviewed. It should be reduced if it is

more than fair value. If it is reduced, it seems logical that the gain on capital asset

disposal should be reduced rather than a loss recorded.




Requirement 1

All of the impacts will be in the operating activities:

Change in accounts receivable (215,000)

Change in contract costs (44,0000)

Change in contract liabilities 68,000

Change in provision for warranties 11,000



Assignment 6-25

The 20X0 subscription campaign yielded a total of $706,300 (294,100 + 224,700 +

187,500) in new subscriptions. The revenue from these subscriptions should be

recognized over the term of the subscriptions, as the ―product‖ is delivered to the

subscribers. There is a slight risk of non-payment, and therefore an allowance for doubtful

accounts should be established as a valuation account for accounts receivable.

As at December 31, 20X0, the following revenue amounts are calculated:

Length of

subscription

Total

subscription

revenue

$

Months of

revenue earned

Number of

months

Oct - Dec

Revenue

recognized

$

Unearned

Revenue

$

One year 294,100 3/12 73,525 220,575

Three year 224,700 3/36 18,725 205,975

Five year 187,500 3/60 9,375 178,125

706,300 101,625 604,675

Total revenue to be recognized in 20X0 was $101,625.

The costs fall into four categories:

1. $110,000 for the subscription list

2. $89,000 in direct costs for the subscription campaign—telephone and direct salary

expense

3. The costs of actually producing the newsletter.

If the newsletter production costs are not high, the new subscription revenue clearly will

exceed the cost of the subscription campaign; the campaign costs will result in a net

benefit to the company. The accounting issue is:

Which (if any) of these costs can be deferred and amortized, or should they all be

expensed in Year 0?

The subscription list is a purchased intangible asset. It has resulted in increased revenue,

and if a reasonable proportion of subscriptions are renewed, then it will have future

benefits as well. A strong argument can be made for capitalizing the purchased list as an

intangible capital asset. Subscription lists are usually amortized and are subject to

impairment tests. In this case, an impairment test can be based on the actual renewal rate

when it is known in future years.

The direct costs of the subscription campaign must be expensed as incurred since any

future benefits are unclear and they are not clearly tied to getting the contracts. Such

costs are viewed as being costs of maintaining or enhancing the entity’s internal goodwill



and should be expensed when incurred. The company will continually be incurring costs

to develop its subscription base, and this campaign was just one of a potential series of

such initiatives. Therefore, these costs are expensed.

The bulk of the production costs will be incurred when the newsletter is produced, and

should be expensed as the revenue is recognized. Some costs (e.g., editorial salaries;

information-gathering costs) are incurred in advance of the publication date. Many costs

will have been incurred in 20X0 for 20X1 issues, but these are continuing operating costs.

They should be expensed when incurred.

Documents

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