Question & Answer

The following note appears in the “Summary of Significant Accounting Policies” section of the Annual Report of Westinghouse Electric Corporation.

Note 1 (in part): Revenue Recognition. Sales are primarily recorded as products are shipped and services are rendered. The percentage-of-completion method of accounting is used for nuclear steam supply system orders with delivery schedules generally in excess of five years and for certain construction projects where this method of accounting is consistent with industry practice.

WFSI revenues are generally recognized on the accrual method. When accounts become delinquent for more than two payment periods, usually 60 days, income is recognized only as payments are received. Such delinquent accounts for which no payments are received in the current month, and other accounts on which income is not being recognized because the receipt of either principal or interest is questionable, are classified as nonearning receivables.

Instructions

(a) Identify the revenue recognition methods used by Westinghouse Electric as discussed in its note on significant accounting policies.

(b) Under what conditions are the revenue recognition methods identified in the first paragraph of

Westinghouse’s note above acceptable?

(c) From the information provided in the second paragraph of Westinghouse’s note, identify the type of operation being described and defend the acceptability of the revenue recognition method.

Instructions

Go to the book’s companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc.

(a) What were Coca-Cola’s and PepsiCo’s net revenues (sales) for the year 2011? Which company increased its revenues more (dollars and percentage) from 2010 to 2011?

(b) Are the revenue recognition policies of Coca-Cola and PepsiCo similar? Explain.

(c) In which foreign countries (geographic areas) did Coca-Cola and PepsiCo experience significant revenues in 2011? Compare the amounts of foreign revenues to U.S. revenues for both Coca-Cola and PepsiCo.

Employees at your company disagree about the accounting for sales returns. The sales manager believes that granting more generous return provisions and allowing customers to order items on a bill and hold basis can give the company a competitive edge and increase sales revenue. The controller cautions that, depending on the terms granted, loose return or bill and hold provisions might lead to non-IFRS revenue recognition. The company CFO would like you to research the issue to provide an authoritative answer.

Instructions

Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.)

(a) What is the authoritative literature addressing revenue recognition when right of return exists?

(b) What is meant by “right of return”? “Bill and hold”?

(c) When there is a right of return, what conditions must the company meet to recognize the revenue at the time of sale?

(d) What factors may impair the ability to make a reasonable estimate of future returns?

(e) When goods are sold on a bill and hold basis, what conditions must be met to recognize revenue upon receipt 

Hamilton Construction Company uses the percentage-of-completion method of accounting. In 2014, Hamilton began work under contract #E2-D2, which provided for a contract price of $2,200,000.

Other details are as follows. 2014 2015

Costs incurred during the year $640,000 $1,425,000

Estimated costs to complete, as of December 31 960,000 –0–

Billings during the year 420,000 1,680,000

Collections during the year 350,000 1,500,000

Instructions

(a) What portion of the total contract price would be recognized as revenue in 2014? In 2015?

(b) Assuming the same facts as those shown above except that Hamilton uses the cost-recovery method of accounting, what portion of the total contract price would be recognized as revenue in 2015?

Use the information from IFRS18-6, but assume Turner uses the cost-recovery method. Prepare the company’s 2014 journal entries.

Turner, Inc. began work on a $7,000,000 contract in 2014 to construct an office building. During 2014, Turner, Inc. incurred costs of $1,700,000, billed its customers for $1,200,000, and collected $960,000. At

December 31, 2014, the estimated future costs to complete the project total $3,300,000. Prepare Turner’s 2014 journal entries using the percentage-of-completion method.

When is revenue recognized under the cost-recovery method?

What are the two basic methods of accounting for long-term construction contracts? Indicate the circumstances that determine when one or the other of these methods should be used.

Livesey Company has signed a long-term contract to build a new basketball arena. The total revenue related to the contract is $120 million. Estimated costs for building the arena are $40 million in the first year and $30 million in both the second and third years. The costs cannot be reliably estimated. How much revenue should Livesey Company report in the first year under IFRS?

IFRS prohibits the use of the completed-contract method in accounting for long-term contracts. If revenues and costs are difficult to estimate, how must companies account for long-term contracts?

What is a major difference between IFRS and GAAP as regards revenue recognition practices?

Employees at your company disagree about the accounting for sales returns. The sales manager believes that granting more generous return provisions can give the company a competitive edge and increase sales revenue. The controller cautions that, depending on the terms granted, loose return provisions might lead to non-GAAP revenue recognition. The company CFO would like you to research the issue to provide an authoritative answer.

Instructions

If your school has a subscription to the FASB Codification, go to http://aaa.hq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses.

(a) What is the authoritative literature addressing revenue recognition when right of return exists?

(b) What is meant by “right of return”?

(c) When there is a right of return, what conditions must the company meet to recognize the revenue at the time of sale?

(d) What factors may impair the ability to make a reasonable estimate of future returns?

The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report, including the notes to the financial statements, can be accessed at the book’s companion website, www.

wiley.com/college/kieso.

Instructions

Refer to P&G’s financial statements and the accompanying notes to answer the following questions.

(a) What were P&G’s net sales for 2011?

(b) What was the percentage of increase or decrease in P&G’s net sales from 2010 to 2011? From 2009 to 2010? From 2009 to 2011?

(c) In its notes to the financial statements, what criteria does P&G use to recognize revenue?

(d) How does P&G account for trade promotions? Does the accounting conform to accrual accounting concepts? Explain.

Amigos Burrito Inc. sells franchises to independent operators throughout the northwestern part of the United States. The contract with the franchisee includes the following provisions.

1. The franchisee is charged an initial fee of $120,000. Of this amount, $20,000 is payable when the agreement is signed, and a $20,000 non-interest-bearing note is payable at the end of each of the 5 subsequent years.

2  All of the initial franchise fee collected by Amigos is to be refunded and the remaining obligation canceled if, for any reason, the franchisee fails to open his or her franchise.

3. In return for the initial franchise fee, Amigos agrees to (a) assist the franchisee in selecting the location for the business, (b) negotiate the lease for the land, (c) obtain financing and assist with building design, (d) supervise construction, (e) establish accounting and tax records, and (f) provide expert advice over a 5-year period relating to such matters as employee and management training, quality control, and promotion.

4. In addition to the initial franchise fee, the franchisee is required to pay to Amigos a monthly fee of

2% of sales for menu planning, receipt innovations, and the privilege of purchasing ingredients from Amigos at or below prevailing market prices.

Management of Amigos Burrito estimates that the value of the services rendered to the franchisee at the time the contract is signed amounts to at least $20,000. All franchisees to date have opened their locations at the scheduled time, and none have defaulted on any of the notes receivable.

The credit ratings of all franchisees would entitle them to borrow at the current interest rate of 10%. The present value of an ordinary annuity of five annual receipts of $20,000 each discounted at 10% is $75,816.

Instructions

(a) Discuss the alternatives that Amigos Burrito Inc. might use to account for the initial franchise fees, evaluate each by applying generally accepted accounting principles, and give illustrative entries for each alternative.

(b) Given the nature of Amigos Burrito’s agreement with its franchisees, when should revenue be recognized? Discuss the question of revenue recognition for both the initial franchise fee and the additional monthly fee of 2% of sales, and give illustrative entries for both types of revenue.

(c) Assume that Amigos Burrito sells some franchises for $100,000, which includes a charge of $20,000 for the rental of equipment for its useful life of 10 years; that $50,000 of the fee is payable immediately and the balance on non-interest-bearing notes at $10,000 per year; that no portion of the $20,000 rental payment is refundable in case the franchisee goes out of business; and that title to the equipment remains with the franchisor. Under those assumptions, what would be the preferable method of accounting for the rental portion of the initial franchise fee? Explain.

Midwest Health Club (MHC) offers one-year memberships.

Membership fees are due in full at the beginning of the individual membership period. As an incentive to new customers, MHC advertised that any customers not satisfied for any reason could receive a refund of the remaining portion of unused membership fees. As a result of this policy, Richard Nies, corporate controller, recognized revenue ratably over the life of the membership.

MHC is in the process of preparing its year-end financial statements. Rachel Avery, MHC’s treasurer, is concerned about the company’s lackluster performance this year. She reviews the financial statements

Nies prepared and tells Nies to recognize membership revenue when the fees are received.

Instructions

Answer the following questions.

(a) What are the ethical issues involved?

(b) What should Nies do?

Widjaja Company is accounting for a longterm construction contract using the percentage-of-completion method. It is a 4-year contract that is currently in its second year. The latest estimates of total contract costs indicate that the contract will be completed at a profit to Widjaja Company.

Instructions

(a) What theoretical justification is there for Widjaja Company’s use of the percentage-of-completion method?

(b) How would progress billings be accounted for? Include in your discussion the classification of progress billings in Widjaja Company financial statements.

(c) How would the income recognized in the second year of the 4-year contract be determined using the cost-to-cost method of determining percentage of completion?

(d) What would be the effect on earnings per share in the second year of the 4-year contract of using the percentage-of-completion method instead of the completed-contract method? Discuss.

Cutting Edge is a monthly magazine that has been on the market for 18 months. It currently has a circulation of 1.4 million copies. Negotiations are underway to obtain a bank loan in order to update the magazine’s facilities. They are producing close to capacity and expect to grow at an average of 20% per year over the next 3 years. After reviewing the financial statements of Cutting Edge, Andy Rich, the bank loan officer, had indicated that a loan could be offered to Cutting Edge only if it could increase its current ratio and decrease its debt to equity ratio to a specified level.

Jonathan Embry, the marketing manager of Cutting Edge, has devised a plan to meet these requirements.

Embry indicates that an advertising campaign can be initiated to immediately increase circulation.

The potential customers would be contacted after the purchase of another magazine’s mailing list. Thecampaign would include:

1. An offer to subscribe to Cutting Edge at 3/4 the normal price.

2. A special offer to all new subscribers to receive the most current world atlas whenever requested at a guaranteed price of $2.

3. An unconditional guarantee that any subscriber will receive a full refund if dissatisfied with the magazine.

Although the offer of a full refund is risky, Embry claims that few people will ask for a refund after receiving half of their subscription issues. Embry notes that other magazine companies have tried this sales promotion technique and experienced great success. Their average cancellation rate was 25%. On average, each company increased its initial circulation threefold and in the long run increased circulation to twice that which existed before the promotion. In addition, 60% of the new subscribers are expected to take advantage of the atlas premium. Embry feels confident that the increased subscriptions from the advertising campaign will increase the current ratio and decrease the debt to equity ratio.

You are the controller of Cutting Edge and must give your opinion of the proposed plan.

Instructions

(a) When should revenue from the new subscriptions be recognized?

(b) How would you classify the estimated sales returns stemming from the unconditional guarantee?

(c) How should the atlas premium be recorded? Is the estimated premium claims a liability? Explain.

(d) Does the proposed plan achieve the goals of increasing the current ratio and decreasing the debt to equity ratio?

Griseta & Dubel Inc. was formed early this year to sell merchandise credits to merchants who distribute the credits free to their customers. For example, customers can earn additional credits based on the dollars they spend with a merchant (e.g., airlines and hotels). Accounts for accumulating the credits and catalogs illustrating the merchandise for which the credits may be exchanged are maintained online. Centers with inventories of merchandise premiums have been established for redemption of the credits. Merchants may not return unused credits to Griseta & Dubel. The following schedule expresses Griseta & Dubel’s expectations as to percentages of a normal month’s activity that will be attained. For this purpose, a “normal month’s activity” is defined as the level of operations expected when expansion of activities ceases or tapers off to a stable rate. The company expects that this level will be attained in the third year and that sales of credits will average $6,000,000 per month throughout the third year.

Actual Merchandise Credit

Credit Sales Premium Purchases Redemptions

Month Percent Percent Percent

6th 30% 40% 10%

12th 60 60 45

18th 80 80 70

24th 90 90 80

30th 100 100 95

Griseta & Dubel plans to adopt an annual closing date at the end of each 12 months of operation.

Instructions

(a) Discuss the factors to be considered in determining when revenue should be recognized in measuring the income of a business enterprise.

(b) Discuss the accounting alternatives that should be considered by Griseta & Dubel Inc. for the recognition of its revenues and related expenses.

(c) For each accounting alternative discussed in (b), give balance sheet accounts that should be used and indicate how each should be classified.

The earning of revenue by a business enterprise is recognized for accounting purposes when the transaction is recorded. In some situations, revenue is recognized approximately as it is earned in the economic sense. In other situations, however, accountants have developed guidelines for recognizing revenue by other criteria, such as at the point of sale.

Instructions

(Ignore income taxes.)

(a) Explain and justify why revenue is often recognized as earned at time of sale.

(b) Explain in what situations it would be appropriate to recognize revenue as the productive activity takes place.

(c) At what times, other than those included in (a) and (b) above, may it be appropriate to recognize revenue? Explain.

Revenue is usually recognized at the point of sale. Under special circumstances, however, bases other than the point of sale are used for the timing of revenue recognition.

Instructions

(a) Why is the point of sale usually used as the basis for the timing of revenue recognition?

(b) Disregarding the special circumstances when bases other than the point of sale are used, discuss the merits of each of the following objections to the sale basis of revenue recognition:

(1) It is too conservative because revenue is earned throughout the entire process of production.

(2) It is not conservative enough because accounts receivable do not represent disposable funds, sales returns and allowances may be made, and collection and bad debt expenses may be incurred in a later period.

(c) Revenue may also be recognized (1) during production and (2) when cash is received. For each of these two bases of timing revenue recognition, give an example of the circumstances in which it is properly used and discuss the accounting merits of its use in lieu of the sale basis.

Peterson Industries has three operating divisions— Farber Mining, Enyart Paperbacks, and Glesen Protection Devices. Each division maintains its own accounting system and method of revenue recognition.

Farber Mining

Farber Mining specializes in the extraction of precious metals such as silver, gold, and platinum. During the fiscal year ended November 30, 2014, Farber entered into contracts worth $2,250,000 and shipped metals worth $2,000,000. A quarter of the shipments were made from inventories on hand at the beginning of the fiscal year, and the remainder were made from metals that were mined during the year. Mining totals for the year, valued at market prices, were silver at $750,000, gold at $1,400,000, and platinum at $490,000.Farber uses the completion-of-production method to recognize revenue because its operations meet the specified criteria, i.e., reasonably assured sales prices, interchangeable units, and insignificant distribution costs.

Enyart Paperbacks

Enyart Paperbacks sells large quantities of novels to a few book distributors that in turn sell to several national chains of bookstores. Enyart allows distributors to return up to 30% of sales, and distributors give the same terms to bookstores. While returns from individual titles fluctuate greatly, the returns from distributors have averaged 20% in each of the past 5 years. A total of $7,000,000 of paperback novel sales were made to distributors during the fiscal year. On November 30, 2014, $2,200,000 of fiscal 2014 sales were still subject to return privileges over the next 6 months. The remaining $4,800,000 of fiscal 2014 sales had actual returns of 21%. Sales from fiscal 2013 totaling $2,500,000 were collected in fiscal 2014, with less than 18% of sales returned. Enyart records revenue according to the method referred to as revenue recognition when the right of return exits, because all applicable criteria for use of this method are met by Enyart’s operations.

Glesen Protection Devices

Glesen Protection Devices works through manufacturers’ agents in various cities. Orders for alarm systems and down payments are forwarded from agents, and Glesen ships the goods f.o.b. shipping point. Customers are billed for the balance due plus actual shipping costs. The firm received orders for $6,000,000 of goods during the fiscal year ended November 30, 2014. Down payments of $600,000 were received, and $5,000,000 of goods were billed and shipped. Actual freight costs of $100,000 were also billed. Commissions of 10% on product price were paid to manufacturers’ agents after the goods were shipped to customers. Such goods are warranted for 90 days after shipment, and warranty returns have been about 1% of sales. Revenue is recognized at the point of sale by Glesen.

Instructions

(a) There are a variety of methods for revenue recognition. Define and describe each of the following methods of revenue recognition, and indicate whether each is in accordance with generally accepted accounting principles.

(1) Completion-of-production method.

(2) Percentage-of-completion method.

(3) Installment-sales method.

(b) Compute the revenue to be recognized in the fiscal year ended November 30, 2014, for

(1) Farber Mining.

(2) Enyart Paperbacks.

(3) Glesen Protection Devices.

You have been engaged by Buhl Construction Company to advise it concerning the proper accounting for a series of long-term contracts. Buhl commenced doing business on January 1, 2014. Construction activities for the first year of operations are shown below. All contract costs are with different customers, and any work remaining at December 31, 2014, is expected to be completed in 2015.

Cash Contract Estimated

Total Billings Collections Costs Incurred Additional

Contract Through Through Through Costs to

Project Price 12/31/14 12/31/14 12/31/14 Complete

A $ 300,000 $200,000 $180,000 $248,000 $ 72,000

B 350,000 110,000 105,000 67,800 271,200

C 280,000 280,000 255,000 186,000 –0–

D 200,000 35,000 25,000 118,000 87,000

E 240,000 205,000 200,000 190,000 10,000

$1,370,000 $830,000 $765,000 $809,800 $440,200

Instructions

(a) Prepare a schedule to compute gross profit (loss) to be reported, unbilled contract costs and recognized profit, and billings in excess of costs and recognized profit using the percentage-of-completion method.

(b) Prepare a partial income statement and balance sheet to indicate how the information would be reported for financial statement purposes.

(c) Repeat the requirements for part (a), assuming Buhl uses the completed-contract method.

(d) Using the responses above for illustrative purposes, prepare a brief report comparing the conceptual merits (both positive and negative) of the two revenue recognition approaches.

Sue’s Construction is in its fourth year of business. Sue performs long-term construction projects and accounts for them using the completed-contract method. Sue built an apartment building at a price of $1,100,000. The costs and billings for this contract for the first three years are as follows.

2014 2015 2016

Costs incurred to date $240,000 $600,000 $ 790,000

Estimated costs yet to be incurred 560,000 200,000 –0–

Customer billings to date 150,000 410,000 1,100,000

Collection of billings to date 120,000 340,000 950,000

Sue has contacted you, a certified public accountant, about the following concern. She would like to attract some investors, but she believes that in order to recognize revenue she must first “deliver” the product. Therefore, on her balance sheet, she did not recognize any gross profits from the above contract until 2016, when she recognized the entire $310,000. That looked good for 2016, but the preceding years looked grim by comparison. She wants to know about an alternative to this completed-contract revenue recognition.

Instructions

Draft a letter to Sue, telling her about the percentage-of-completion method of recognizing revenue. Compare it to the completed-contract method. Explain the idea behind the percentage-of-completion method. In addition, illustrate how much revenue she could have recognized in 2014, 2015, and 2016 if she had used this method.

Monat Construction Company, Inc., entered into a firm fixed-price contract with Hyatt Clinic on July 1, 2014, to construct a four-story office building. At that time, Monat estimated that it would take between 2 and 3 years to complete the project. The total contract price for construction of the building is $4,400,000. Monat appropriately accounts for this contract under the completedcontract method in its financial statements and for income tax reporting. The building was deemed substantially completed on December 31, 2016. Estimated percentage of completion, accumulated contract costs incurred, estimated costs to complete the contract, and accumulated billings to the Hyatt Clinic under the contract are shown below.

At At At

December December December

31, 2014 31, 2015 31, 2016

Percentage of completion 30% 70% 100%

Contract costs incurred $1,140,000 $3,290,000 $4,800,000

Estimated costs to complete the contract $2,660,000 $1,410,000 –0–

Billings to Hyatt Clinic $1,400,000 $2,500,000 $4,300,000

Instructions

(a) Prepare schedules to compute the amount to be shown as “Cost in excess of billings” or “Billings in excess of costs” at December 31, 2014, 2015, and 2016. (Ignore income taxes.) Show supporting computations in good form.

(b) Prepare schedules to compute the profit or loss to be recognized as a result of this contract for the years ended December 31, 2014, 2015, and 2016. (Ignore income taxes.) Show supporting computations in good form.