Chapter 5 Income Measurement and Profitability Analysis

QUESTIONS FOR REVIEW OF KEY TOPICS

Question 5-1
The realization principle requires that two criteria be satisfied before revenue can be recognized:
1. The earnings process is judged to be complete or virtually complete.
2. There is reasonable certainty as to the collectibility of the asset to be received (usually cash).

Question 5-2
At the time production is completed, there usually exists significant uncertainty as to the
collectibility of the asset to be received. We don’t know if the product will be sold, nor the selling price,
nor the buyer if eventually the product is sold. Because of these uncertainties, revenue recognition
usually is delayed until the point of product delivery.

Question 5-3
If the installment sale creates a situation where there is significant uncertainty concerning cash
collection and it is not possible to make an accurate assessment of future bad debts, revenue and cost
recognition should be delayed beyond the point of delivery.

Question 5-4
The installment sales method recognizes gross profit by applying the gross profit percentage on the
sale to the amount of cash actually received each period. The cost recovery method defers all gross
profit recognition until cash has been received equal to the cost of the item sold.

Question 5-5
Deferred gross profit is a contra installment receivable account. The balance in this account is
subtracted from gross installment receivables to arrive at installment receivables, net. The net amount
of the receivables represents the portion of remaining payments that represent cost recovery.

Question 5-6
Because the return of merchandise can retroactively negate the benefits of having made a sale, the
seller must meet certain criteria before revenue is recognized in situations when the right of return
exists. The most critical of these criteria is that the seller must be able to make reliable estimates of
future returns. In certain situations, these criteria are not satisfied at the point of delivery of the product.

Answers to Questions (continued)

Question 5-7
Sometimes a company arranges for another company to sell its product under consignment. The
“consignor” physically transfers the goods to the other company (the consignee), but the consignor
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Solutions Manual, Vol.1, Chapter 5 5-1
retains legal title. If the consignee can’t find a buyer within an agreed-upon time, the consignee returns
the goods to the consignor. However, if a buyer is found, the consignee remits the selling price (less
commission and approved expenses) to the consignor.
Because the consignor retains the risks and rewards of ownership of the product and title does not
pass to the consignee, the consignor does not record revenue (and related costs) until the consignee sells
the goods and title passes to the eventual customer.

Question 5-8
For service revenue, if there is one final service that is critical to the earnings process, revenues and
costs are deferred and recognized after this service has been performed. On the other hand, in many
instances, service revenue activities occur over extended periods and recognizing revenue at any single
date within that period would be inappropriate. Instead, it’s more meaningful to recognize revenue over
time in proportion to the performance of the activity.

Question 5-9
The completed contract method of recognizing revenues and costs on long-term construction
contracts is equivalent to recognizing revenue at point of delivery, i.e., when the construction project is
complete. The percentage-of-completion method assigns a fair share of the project’s expected revenues
and costs to each period in which the earnings process takes place, i.e., the construction period. The fair
share means the project's costs incurred each period as a percentage of the project's total estimated costs.
The completed contract method should only be used when the lack of dependable estimates or inherent
hazards cause forecasts of future costs to be doubtful.

Question 5-10
The billings on construction contract account is a contra account to the asset, construction in
progress. At the end of each reporting period, the balances in these two accounts are compared. If the
net amount is a debit, it is reported on the balance sheet as an asset. Conversely, if the net amount is a
credit, it is reported as a liability.

Question 5-11
An estimated loss on a long-term contract must be fully recognized in the first period the loss is
anticipated, regardless of the revenue recognition method used.

Question 5-12
These SOP’s require that if an arrangement includes multiple elements, the revenue from the
arrangement should be allocated to the various elements based on the relative fair values of the
individual elements, “regardless of any separate prices stated within the contract for each element.”

Answers to Questions (continued)

Question 5-13
Specific guidelines for revenue recognition of the initial franchise fee are provided by SFAS 45. A
key to these guidelines is the concept of substantial performance. It requires that substantially all of the
initial services of the franchisor required by the franchise agreement have been performed before the
initial franchise fee can be recognized as revenue. The term substantial requires professional judgment
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Solutions Manual, Vol.1, Chapter 5 5-2
on the part of the accountant. In situations when the initial franchise fee is collectible in installments,
even after substantial performance has occurred, the installment sales or cost recovery method should be
used for profit recognition, if a reasonable estimate of uncollectibility cannot be made.

Question 5-14

Receivables turnover ratio = Net sales

Average accounts receivable (net)

Inventory turnover ratio = Cost of goods sold

Average inventory

Asset turnover ratio = Net sales

Average total assets

Activity ratios are designed to provide information about a company’s effectiveness in managing
assets. Activity or turnover of certain assets measures the frequency with which those assets are
replaced. The greater the number of times an asset turns over, the less cash a company must devote to
that asset, and the more cash it can commit to other purposes.

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Solutions Manual, Vol.1, Chapter 5 5-3
Answers to Questions (concluded)

Question 5-15

Profit margin on sales = Net income

Net sales

Return on assets = Net income

Average total assets

Return on shareholders' = Net income

equity Average shareholders' equity

A fundamental element of an analyst’s task is to develop an understanding of a firm’s profitability.

Profitability ratios provide information about a company’s ability to earn an adequate return relative to
sales or resources devoted to operations. Resources devoted to operations can be defined as total assets
or only those assets provided by owners, depending on the evaluation objective.

Question 5-16
These perspectives are referred to as the discrete and integral part approaches. Current interim
reporting requirements and existing practice generally view interim reports as integral parts of annual
statements. However, the discrete approach is applied to some items. Most revenues and expenses are
recognized in interim periods as incurred. However, if an expenditure clearly benefits more than just the
period in which it is incurred, the expense should be spread among the periods benefited. Examples
include annual repair expenses, property tax expense, and advertising expenses incurred in one quarter
that clearly benefit later quarters. These are assigned to each quarter through the use of accruals and
deferrals. On the other hand, major events such as discontinued operations, extraordinary items, and
unusual or infrequent items should be reported separately in the interim period in which they occur.

Exercise 5-1
Requirement 1
2003 Cost recovery % :
$216,000
= 60% (gross profit % = 40%)
$360,000

2004 Cost recovery %:

$245,000
= 70% (gross profit % = 30%)
$350,000

2003 gross profit:

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Solutions Manual, Vol.1, Chapter 5 5-4
 Cash collection from 2003 sales = $150,000 x 40% = $60,000

2004 gross profit:

Cash collection from 2003 sales = $100,000 x 40% = $ 40,000
+ Cash collection from 2004 sales = $120,000 x 30% = 36,000
Total 2004 gross profit $76,000
Requirement 2
2003 deferred gross profit balance:
2003 initial gross profit ($360,000 - 216,000) $144,000
Less: Gross profit recognized in 2003 (60,000)
Balance in deferred gross profit account $84,000

2004 deferred gross profit balance:

2003 initial gross profit ($360,000 - 216,000) $ 144,000
Less: Gross profit recognized in 2003 (60,000)
Gross profit recognized in 2004 (40,000)

2004 initial gross profit ($350,000 - 245,000) 105,000

Less: Gross profit recognized in 2004 (36,000)
Balance in deferred gross profit account $113,000

Exercise 5-2

2003 To record installment sales

Installment receivables .................................................................. 360,000
Inventory ................................................................................... 216,000
Deferred gross profit ................................................................. 144,000

2003 To record cash collections from installment sales

Cash ............................................................................................... 150,000
Installment receivables ............................................................. 150,000

2003 To recognize gross profit from installment sales

Deferred gross profit...................................................................... 60,000
Realized gross profit ................................................................. 60,000

2004 To record installment sales

Installment receivables .................................................................. 350,000
Inventory ................................................................................... 245,000
Deferred gross profit ................................................................. 105,000

2004 To record cash collections from installment sales

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Solutions Manual, Vol.1, Chapter 5 5-5
 Installment
Cash receivables .............................................................
............................................................................................... 220,000 220,000

2004 To recognize gross profit from installment sales

Deferred gross profit...................................................................... 76,000
Realized gross profit ................................................................. 76,000

Exercise 5-7
Requirement 1
2003 2004
Contract price $2,000,000 $2,000,000
Actual costs to date 300,000 1,875,000
Estimated costs to complete 1,200,000 -0-
Total estimated costs 1,500,000 1,875,000
Gross profit (estimated in 2003) $ 500,000 $ 125,000

Gross profit recognition:

2003: $ 300,000
= 20% x $500,000 = $100,000
$1,500,000

2004: $125,000 - $100,000 = $25,000

Requirement 2
2003 $ -0-
2004 $125,000
Requirement 3

Balance Sheet
At December 31, 2003
Current assets:
Accounts receivable $ 110,000
Costs and profit ($400,000*) in excess
of billings ($360,000) 40,000

* Costs ($300,000) + profit ($100,000)

Exercise 5-7 (concluded)

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Solutions Manual, Vol.1, Chapter 5 5-6
Requirement 4

Balance Sheet
At December 31, 2003
Current assets:
Accounts receivable $ 110,000

Current liabilities:
Billings ($360,000) in excess of costs ($300,000) $ 60,000

Exercise 5-8
Requirement 1
2003 2004 2005
Contract price $8,000,000 $8,000,000 $8,000,000
Actual costs to date 2,000,000 4,500,000 8,300,000
Estimated costs to complete 4,000,000 3,600,000 -0-
Total estimated costs 6,000,000 8,100,000 8,300,000
Estimated gross profit (loss)
(actual in 2005) $2,000,000 $ (100,000) $ (300,000)

Gross profit (loss) recognition:

2003: $2,000,000
= 33.3333% x $2,000,000 = $666,667
$6,000,000

2004: $(100,000) - 666,667 = $(766,667)

2005: $(300,000) - (100,000) = $(200,000)

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Solutions Manual, Vol.1, Chapter 5 5-7
Exercise 5-8 (continued)
Requirement 2

2003 2004
Construction in progress 2,000,000 2,500,000
Various accounts 2,000,000 2,500,000
To record construction costs.

Accounts receivable 2,500,000 2,750,000

Billings on construction contract 2,500,000 2,750,000
To record progress billings.

Cash 2,250,000 2,475,000

Accounts receivable 2,250,000 2,475,000
To record cash collections.

Construction in progress
(gross profit) 666,667
Cost of construction 2,000,000
Revenue from long-term contracts
(33.3333% x $8,000,000) 2,666,667
To record gross profit.

Cost of construction (2) 2,544,000

Revenue from long-term contracts (1) 1,777,333
Construction in progress (loss) 766,667
To record expected loss.

(1) and (2):

Percent complete = $4,500,000 ÷ $8,100,000 = 55.55%
Revenue recognized to date:
55.55% x $8,000,000 = $4,444,000
Less: Revenue recognized in 2003 (above) (2,666,667)
Revenue recognized in 2004 1,777,333 (1)
Plus: Loss recognized in 2004 (above) 766,667
Cost of construction, 2004 $2,544,000 (2)

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Solutions Manual, Vol.1, Chapter 5 5-8
Exercise 5-8 (concluded)
Requirement 3

Balance Sheet 2003 2004

Current assets:
Accounts receivable $250,000 $525,000
Costs and profit ($2,666,667*) in
excess of billings ($2,500,000) 166,667

Current liabilities:
Billings ($5,250,000) in excess
of costs less loss ($4,400,000) $850,000

* Costs ($2,000,000) + profit ($666,667)

Exercise 5-12
Requirement 1
Revenue should be recognized as follows:
Software - date of shipment, July 1, 2003
Technical support - evenly over the 12 months of the agreement
Upgrade - date of shipment, January 1, 2004

The amounts are determined by an allocation of total contract price in proportion to the
individual fair values of the components if sold separately:

Software - $210,000 ÷ $270,000 x $243,000 = $189,000

Technical support - $30,000 ÷ $270,000 x $243,000 = 27,000
Upgrade - $30,000 ÷ $270,000 x $243,000 = 27,000
Total $243,000

Requirement 2

July 1, 2003 To record sale of software

Cash ............................................................................................... 243,000
Revenue..................................................................................... 189,000
Unearned revenue ($27,000 + 27,000) ..................................... 54,000

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Solutions Manual, Vol.1, Chapter 5 5-9
Exercise 5-15

List A List B

h 1. Inventory turnover a. Net income divided by net sales.

d 2. Return on assets b. Defers recognition until cash collected equals
cost.
g 3. Return on shareholders' equity c. Defers recognition until project is complete.
a 4. Profit margin on sales d. Net income divided by assets.
b 5. Cost recovery method e. Risks and rewards of ownership retained
by seller.
i 6. Percentage-of-completion method f. Contra account to construction in progress.
c 7. Completed contract method g. Net income divided by shareholders' equity.
k 8. Asset turnover h. Cost of goods sold divided by inventory.
l 9. Receivables turnover i. Recognition is in proportion to work completed.
m 10. Right of return j. Recognition is in proportion to cash received.
f 11. Billings on construction contract k. Net sales divided by assets.
j 12. Installment sales method l. Net sales divided by accounts receivable.
e 13. Consignment sales m. Could cause the deferral of revenue recognition
beyond delivery point.

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Solutions Manual, Vol.1, Chapter 5 5-10
Exercise 5-17
Turnover ratios for Anderson Medical Supply Company for 2003:

Inventory turnover ratio = $4,800,000

[$900,000 + 700,000] ÷ 2

= 6 times

Receivables turnover ratio = $8,000,000

[$700,000 + 500,000] ÷ 2

= 13.33 times

Average collection period = 365

13.33

= 27.4 days

Asset turnover ratio = $8,000,000

[$4,300,000 + 3,700,000] ÷ 2

= 2 times

The company turns its inventory over 6 times per year compared to the industry average of 5 times
per year. The asset turnover ratio also is slightly better than the industry average (2 times per year
versus 1.8 times). These ratios indicate that Anderson is able to generate more sales per dollar invested
in inventory and in total assets than the industry averages. However, Anderson takes slightly longer to
collect its accounts receivable (27.4 days compared to the industry average of 25 days).

Exercise 5-18
Requirement 1
a. Profit margin on sales $150 ÷ $5,400 = 2.8%
b. Return on assets $150 ÷ [($1,900 + 1,700) ÷ 2] = 8.3%
c. Return on shareholders’ equity $150 ÷ [($550 + 500) ÷ 2] = 28.6%
Requirement 2
Retained earnings beginning of period $100,000
Add: Net income 150,000
250,000
Less: Retained earnings end of period 150,000
Dividends paid $100,000

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Solutions Manual, Vol.1, Chapter 5 5-11
Problem 5-4
Requirement 1
2003 2004 2005
Contract price $10,000,000 $10,000,000 $10,000,000
Actual costs to date 2,400,000 6,000,000 8,200,000
Estimated costs to complete 5,600,000 2,000,000 -0-
Total estimated costs 8,000,000 8,000,000 8,200,000
Estimated gross profit (loss)
(actual in 2005) $ 2,000,000 $ 2,000,000 $ 1,800,000

Gross profit (loss) recognition:

2003: $2,400,000
= 30.0% x $2,000,000 = $600,000
$8,000,000

2004: $6,000,000
= 75.0% x $2,000,000 = $1,500,000 - 600,000 = $900,000
$8,000,000

2005: $1,800,000 - 1,500,000 = $300,000

Requirement 2

2003 2004 2005

Construction in progress 2,400,000 3,600,000 2,200,000

Various accounts 2,400,000 3,600,000 2,200,000
To record construction costs.

Accounts receivable 2,000,000 4,000,000 4,000,000

Billings on construction contract 2,000,000 4,000,000 4,000,000
To record progress billings.

Cash 1,800,000 3,600,000 4,600,000

Accounts receivable 1,800,000 3,600,000 4,600,000
To record cash collections.

Construction in progress (gross 600,000 900,000 300,000

profit)
Cost of construction (cost incurred) 2,400,000 3,600,000 2,200,000
Revenue from long-term contracts 3,000,000 4,500,000 2,500,000
(1)
To record gross profit.

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Solutions Manual, Vol.1, Chapter 5 5-12
Problem 5-4 (continued)

(1) Revenue recognized:

2003: 30% x $10,000,000 = $3,000,000
2004: 75% x $10,000,000 = $7,500,000
Less: Revenue recognized in 2003 (3,000,000)
Revenue recognized in 2004 $4,500,000
2005: 100% x $10,000,000 = $10,000,000
Less: Revenue recognized in 2003 & 2004 (7,500,000)
Revenue recognized in 2005 $2,500,000
Requirement 3

Balance Sheet 2003 2004

Current assets:
Accounts receivable $ 200,000 $600,000
Construction in progress $3,000,000 $7,500,000
Less: Billings (2,000,000) (6,000,000)
Costs and profit in excess
of billings 1,000,000 1,500,000

Requirement 4
2003 2004 2005
Costs incurred during the year $2,400,000 $3,800,000 $3,200,000
Estimated costs to complete
as of year-end 5,600,000 3,100,000 -

2003 2004 2005

Contract price $10,000,000 $10,000,000 $10,000,000
Actual costs to date 2,400,000 6,200,000 9,400,000
Estimated costs to complete 5,600,000 3,100,000 -0-
Total estimated costs 8,000,000 9,300,000 9,400,000
Estimated gross profit
(actual in 2005) $ 2,000,000 $ 700,000 $ 600,000

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Solutions Manual, Vol.1, Chapter 5 5-13
Problem 5-4 (concluded)

Gross profit (loss) recognition:

2003: $2,400,000
= 30.0% x $2,000,000 = $600,000
$8,000,000

2004: $6,200,000
= 66.6667% x $700,000 = $466,667 - 600,000 = $(133,333)
$9,300,000

2005: $600,000 - 466,667 = $133,333

Requirement 5
2003 2004 2005
Costs incurred during the year $2,400,000 $3,800,000 $3,900,000
Estimated costs to complete
as of year-end 5,600,000 4,100,000 -

2003 2004 2005

Contract price $10,000,000 $10,000,000 $10,000,000
Actual costs to date 2,400,000 6,200,000 10,100,000
Estimated costs to complete 5,600,000 4,100,000 -0-
Total estimated costs 8,000,000 10,300,000 10,100,000
Estimated gross profit (loss)
(actual in 2005) $ 2,000,000 $ (300,000) $ (100,000)

Gross profit (loss) recognition:

2003: $2,400,000
= 30.0% x $2,000,000 = $600,000
$8,000,000

2004: $(300,000) - 600,000 = $(900,000)

2005: $(100,000) - (300,000) = $200,000

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Solutions Manual, Vol.1, Chapter 5 5-14
Problem 5-5
Requirement 1

Year Gross profit recognized

2003 -0-
2004 -0-
2005 $1,800,000
Total gross profit $1,800,000
Requirement 2

2003 2004 2005

Construction in progress 2,400,000 3,600,000 2,200,000
Various accounts 2,400,000 3,600,000 2,200,000
To record construction costs.

Accounts receivable 2,000,000 4,000,000 4,000,000

Billings on construction contract 2,000,000 4,000,000 4,000,000
To record progress billings.

Cash 1,800,000 3,600,000 4,600,000

Accounts receivable 1,800,000 3,600,000 4,600,000
To record cash collections.

Construction in progress (gross 1,800,000

profit)
Cost of construction (costs incurred) 8,200,000
Revenue from long-term contracts 10,000,000
(contract price)
To record gross profit.

Requirement 3

Balance Sheet 2003 2004

Current assets:
Accounts receivable $ 200,000 $ 600,000
Construction in progress $2,400,000 $6,000,000
Less: Billings (2,000,000) (6,000,000)
Costs in excess of billings 400,000 -0-

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Solutions Manual, Vol.1, Chapter 5 5-15
Problem 5-5 (concluded)
Requirement 4
2003 2004 2005
Costs incurred during the year $2,400,000 $3,800,000 $3,200,000
Estimated costs to complete
as of year-end 5,600,000 3,100,000 -

Year Gross profit recognized

2003 -0-
2004 -0-
2005 $600,000
Total gross profit $600,000
Requirement 5
2003 2004 2005
Costs incurred during the year $2,400,000 $3,800,000 $3,900,000
Estimated costs to complete
as of year-end 5,600,000 4,100,000 -

Year Gross profit (loss) recognized

2003 -0-
2004 $(300,000)
2005 200,000
Total project loss $(100,000)

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Solutions Manual, Vol.1, Chapter 5 5-16
Problem 5-9
Requirement 1
Receivables turnover = Net sales
Accounts receivable

J&J = $29,139 = 6.53 times

$4,464

Pfizer = $29,574 = 5.39 times

$5,489

Average collection period = 365

Receivables turnover

J&J = 365 = 55.9 days

6.53

Pfizer = 365 = 67.7 days

5.39

On average, J&J collects its receivables in 12 days less than Pfizer.

Inventory turnover = Cost of goods sold

Inventories

J&J = $8,861 = 3.12 times

$2,842

Pfizer = $4,907 = 1.82 times

$2,702

Average days in inventory = 365

Inventory turnover

J&J = 365 = 117 days

3.12

Pfizer = 365 = 201 days

1.82

On average, it takes Pfizer nearly twice as long as J & J to sell its inventory.

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Solutions Manual, Vol.1, Chapter 5 5-17
Problem 5-9 (continued)
Requirement 2

Rate of return on assets = Net income

Total assets

J&J = $4,800 = 15.3%

$31,321

Pfizer = $3,718 = 11.1%

$33,510

The return on assets indicates a company's overall profitability, ignoring specific sources of
financing. In this regard, J&J’s profitability is more than that of Pfizer.
Requirement 3

Profitability can be achieved by a high profit margin, high turnover, or a combination of the two.

Rate of return on assets = Profit margin x Asset

on sales turnover

= Net income x Net sales

Net sales Total assets

J&J = $ 4,800 x $29,139

$29,139 $31,321

= 16.47% x .9303 times = 15.3%

Pfizer = $ 3,718 x $29,574

$29,574 $33,510

= 12.57% x .8825 times = 11.1%

J&J’s profit margin is much higher than that of Pfizer, and its asset turnover is slightly higher than
Pfizer. These differences combine to produce a higher return on assets for J&J.

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Solutions Manual, Vol.1, Chapter 5 5-18
Problem 5-9 (concluded)
Requirement 4

Rate of return on = Net income

shareholders’ equity Shareholders’ equity

J&J = $4,800 = 25.5%

$18,808

Pfizer = $3,718 = 23%

$16,076

J&J provides a greater return to shareholders.

Real World Case 5-1

Requirement 1
A bill and hold strategy accelerates the recognition of revenue. In this case, sales that would
normally have occurred in 1998 were recorded in 1997. Assuming a positive gross profit on these sales,
earnings in 1997 is inflated.
Requirement 2
A customer would probably not be expected to pay for goods purchased using this bill and hold
strategy until the goods were actually received. Receivables would therefore increase.
Requirement 3
Sales that would normally have been recorded in 1998 were recorded in 1997. This bill and hold
strategy shifted sales revenue and therefore earnings from 1998 to 1997.
Requirement 4
Earnings quality refers to the ability of reported earnings (income) to predict a company’s future
earnings. Sunbeam’s earnings management strategy produced a 1997 earnings figure that was not
indicative of the company’s future profit-generating ability.

Judgment Case 5-7

Requirement 1
The three methods that could be used to recognize revenue and costs for this situation are (1) point
of delivery, (2) the installment sales method, and (3) the cost recovery method.
2003 gross profit under the three methods:

(1) point of delivery:

$80,000 - 40,000 = $40,000

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Solutions Manual, Vol.1, Chapter 5 5-19
 (2) installment sales method:

$40,000
= 50% = gross profit %
$80,000

50% x $30,000 (cash collected) = $15,000

(3) cost recovery method:

No gross profit recognized since cost ($40,000) exceeds cash collected ($30,000).
Requirement 2
Customers sometimes are allowed to pay for purchases in installments over long periods of time.
Uncertainty about collection of a receivable normally increases with the length of time allowed for
payment. In most situations, the increased uncertainty concerning the collection of cash from
installment sales can be accommodated satisfactorily by estimating uncollectible amounts. In these
situations, point of delivery revenue recognition should be used.
If, however, the installment sale creates a situation where there is significant uncertainty
concerning cash collection making it impossible to make an accurate assessment of future bad debts,
revenue and cost recognition should be delayed. The installment sales method and the cost recovery
method are available to handle such situations. These methods should be used only in situations
involving exceptional uncertainty. The cost recovery method is the more conservative of the two.

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Solutions Manual, Vol.1, Chapter 5 5-20