Afm 291 Fall 2016 In Class Problems Chapter 4 4w5p28

AFM 291 Fall 2016 In-Class Problems Chapter 4 P4-5. Suggested solution: Activity Sale of products

Method of revenue recognition Upon transfer of risks and rewards, amount of revenue is determinable, and payment is likely (probable that economic benefit will flow to BMW), and costs can be measured reliably.

Lease rentals Financial services Post-sale services (multiple-component contracts) Consignment sales of vehicles (sales with repurchase commitments)

Straight-line over rental period. Interest income using effective interest method. Deferred and recognized as revenue over period of contract according to the pattern of expected costs. Deferred until product is sold to consumer (when “such profits have been realized”).

P4-8. Suggested solution:

a.

b.

Circumstance

Revenue recognition criteria not met

An apartment owner receives a deposit of $1,200 equal to one month’s rent – assume damage deposit An insurance company receives annual s for fire insurance on June 25 for coverage beginning July 1.

Service: It is not probable that the economic benefits (the value of the deposit) will flow to the entity. Service: Revenue should be recognized according to the stage of completion; the coverage period has not yet begun. Good: The transit authority has not transferred to the buyer the risks and rewards of ownership. Service: See next item. Service: Revenue should be recognized according to the stage of completion. The period for which the es are valid has not elapsed. Good: The lottery corporation has not transferred to the buyer the risks and rewards of ownership.

c.

A city transit authority issues 200,000 monthly es at $80 each for sale at various retailers. Retailers act as consignees for these es.

d.

A city transit authority sells 50,000 monthly es at $80 each to transit riders at its own retail offices/stores.

e.

A provincial lottery corporation delivers 10 million scratch-and-win cards to retailers. The cards retail for $2 and generate a commission of $0.20 per card for the retailer. The retailer can return unsold cards to the lottery corporation.

P4-13. Suggested solution: a. The sale price should be allocated using the stand-alone selling prices. Therefore, the amount of revenue that should be recorded is computed as follows: Stand-alone selling price

Stand-alone selling price as percentage of total

45,000

90%

$45,900

$41,310

Basic service package

3,000

6%

$45,900

2,754

Increment for service package

2,000

4%

$45,900

1,836

50,000

100%

Car

Total

× Actual sale price

= Allocation

$45,900

The basic service package is for two years, so its value should be allocated over Year 1 and Year 2 ($2,754 / 2 = $1,377). Likewise, the increment for the package should be allocated over Years 3 and 4 ($1,836 / 2 = $918). The revenue for each time period would be as follows. Upon delivery Car

$41,310

Year 1 $

Year 2

--

$

Year 3

--

$

--

Year 4 $

--

Basic service package

--

1,377

1,377

--

--

Increment for service package

--

--

--

918

918

$41,310

$1,377

$1,377

$918

$918

Total

b. In this case, the sale price should be allocated using the relative stand-alone selling prices. The answer here is similar to that in part (a) except that the revenue for Years 1 to 4 will differ because the two service components have been combined.

Car service pkg Total

Stand-alone selling price

Stand-alone selling price as percentage of total

45,000

90%

$45,900

$41,310

5,000

10%

$45,900

4,590

50,000

100%

Upon delivery Car service pkg Total

$41,310

Year 1 $

--

× Actual sale price

= Allocation

$45,900

Year 2 $

--

Year 3 $

--

Year 4 $

--

--

$1,147.50

$1,147.50

$1,147.50

$1,147.50

$41,310

$1,147.50

$1,147.50

$1,147.50

$1,147.50

c. The assumed facts here suggest that the stand-alone selling prices of the service packages are more reliably determined while the stand-alone selling price of the car varies considerably. Therefore, the residual value method seems more appropriate than the relative stand-alone price method.

Total sale price

$45,900

– Basic service package

– 1,500

– Increment for service package

– 1,800

Residual = amount allocated to car

$42,600

P4-14. Suggested solution: a. The phone packages involve multiple performance obligations, so it is important to separate the two streams of revenue: sale of the phone and cellular services. However, the nominal prices for the two components are not necessarily indicative of the value of the components. For example, the phone is provided for “free” under Option A, but costs $400 under option B and $600 under option C. Option C is the only option with a single deliverable, so the $600 can serve as the stand-alone selling price for the Raspberry 300. For this option, $600 can be recognized as revenue upon delivery of the phone. Option A has total revenue of $1,800 over the 36 months of the contract ($50 × 36 = $1,800). Of that amount, $600 can be allocated to the phone, while the remaining $1,200 should be allocated to the service contract, resulting in $33.33 per month ($1,200 / 36). Likewise, Option B has total revenue of $1,000 over 12 months ($50 × 12 + $400 = $1,000). Allocating $600 to the phone, the remaining $400 should be recognized over 12 months of the contract, or $33.33 per month. b. To ensure the validity of the approach just described, it is important to ascertain whether the $600 price for the phone under Option C is indeed its fair value. If a significant number of customers do choose Option C, then those market transactions s $600 as the fair value. If no one, or if very few customer choose Option C, then that brings into doubt that $600 is the fair value of the phone. The more general point is that prices quoted by the reporting entity may not be truly reflective of fair value. Consider the possibility for earnings management if all such quoted prices were accepted as fair values. In the case of the Raspberry 300, if the company artificially set a high price for Option C, say, $1,000, then accepting $1,000 as the value of the phone that would allow the company to record $1,000 immediately in revenue (and less later) if customers chose Options A or B. However, any rational customer will not accept this price because Option B has the same

cost ($400 initially plus $50/month x 12 months = $1,000) but provides both the phone and one year of service. P4-16. Suggested solution: The sale of the tablet with the assurance-type warranty represents a contract with a single performance obligation. As such the entire transaction price will be recognized at time of sale and an assurance warranty obligation established. The sale of the tablet with the sales-type warranty represents a contract with two performance obligations. The transaction price must be allocated to the two obligations based upon their relative stand-alone sales prices. Revenue pertaining to the sale of the tablet (including the assurance-type warranty) will be recognized at time of sale and an assurance warranty obligation established. Revenue pertaining to the sale of the sales type warranty will be deferred until performance is achieved. a.

DR Cash (100 × $500) CR Sales revenue DR Cost of goods sold (100 × $300) CR Inventory DR Warranty expense (100 × $25) CR Provision for assurance warranty costs

50,000 50,000 30,000 30,000 2,500 2,500

DR Cash (150 × $600) 90,000 CR Sales revenue (150 × $480*) 72,000 CR Unearned sales revenue – service warranty 18,000 (150 × 120*) DR Cost of goods sold (150 × $300) 45,000 CR Inventory 45,000 DR Warranty expense (150 × $25) 3,750 CR Provision for assurance warranty costs 3,750 *The transaction price of $600 must be allocated to the two performance obligations based on their relative standalone sales prices of $500 and $125. $500/$625 × $600 = $480; $125/$625 × $600 = $120. b.

c.

DR Provision for assurance warranty expense claims CR Labour expense ($2,000 × 50%) CR Parts inventory ($2,000 × 50%)

2,000 1,000 1,000

DR Service warranty costs 2,100 CR Labour expense ($2,100 × 50%) 1,050 CR Parts inventory ($2,100 × 50%) 1,050 DR Unearned sales revenue – service warranty* 7,200 CR Sales revenue – service warranty 7,200 *Revenue to be recognized is determined based on the cost based input measure. Total expected costs = # of tablets × cost per tablet = 150 × $35 = $5,250. Cumulative performance to date = costs expensed to date / total expected costs = $2,100 / $5,250 = 40%. Revenue to recognize for the year = unearned revenue originally recognized × cumulative percentage earned – unearned revenue previously recognized = $18,000 × 40% – $0 = $7,200. d.

P4-19. Suggested solution: Note that the gross margin is $7,500 / $30,000 = 25%. Jan 2013

May 2013 Sep 2013 Jan 2014

Dr. Installment s receivable Cr. Inventory Cr. Deferred gross profit

30,000 22,500 7,500

Dr. Deferred gross profit ($10,000 × 25%) Dr. Cost of goods sold ($10,000 × 75%) Cr. Sales revenue ($30,000 × 1/3)

2,500 7,500

Dr. Cash Cr. Installment s receivable

10,000

10,000

10,000

P4-28. Suggested solution: a.

To apply the percentage of completion method, we must use the cost-to-cost approach since no other estimate of the stage of completion is available. 2011 A $ 80,000 B = Sum of A 80,000 C 158,000 D = B+C 238,000 E = B/D 33.61% F = E × 300,000 $100,840 G = Prior F 0 H=F–G 100,840 A 80,000 J=H–A 20,840

2012 $120,000 200,000 39,000 239,000 83.68% $251,046 100,840 150,206 120,000 30,206

2013 $ 50,000 250,000 0 250,000 100% $300,000 251,046 48,954 50,000 (1,046)

Receivables beginning balance Billings during year Collections during year Receivables ending balance

0 65,000 (60,000) 5,000

5,000 130,000 (128,000) 7,000

7,000 105,000 (112,000) 0

CIP inventory beginning balance Cost incurred during year Gross profit (loss) recognized Contract completion CIP inventory ending balance

0 80,000 20,840 n/a 100,840

100,840 120,000 30,206 n/a 251,046

251,046 50,000 (1,046) (300,000) 0

Cost incurred during year Cost incurred to date Additional costs to complete Total estimated costs % complete Cumulative revenue Less: revenue previously recorded Revenue – current year Expenses Gross profit (loss)

b. Year 2011 Incur costs

Cash 80,000

Bill client Receive cash

Accts Receivable

65,000 60,000

20,000

2012 Incur costs

5,000

80,000 100,840

100,840

120,000

Bill client

65,000

128,000

130,000 128,000 30,206

Balance

12,000

2013 Incur costs

7,000

120,000 150,206

251,046

50,000

Bill client

195,000

112,000

105,000 112,000

Rev & exp recog

1,046 0

50,000

300,000

Close project Balance

30,206

50,000 105,000

50,000

*20,840

120,000 130,000

Rev & exp recog

Balance

Revenue or expense

20,840

Balance

Receive cash

Billings on CIP

65,000 60,000

Rev & exp recog

Receive cash

CIP Inventory 80,000

300,000 300,000

0

48,954

1,046

300,000 0

Total income over three years

* Revenue and expenses are temporary s, which are closed at the end of each period, so balances do not carry forward.

50,000

P4-31. Suggested solution:

Cost incurred to date Additional costs to complete Total estimated costs % complete Cumulative revenue Less: revenue previously recorded Revenue – current year Expenses Expected loss accrual (reversal) Gross profit (loss)

2011 B 150,000 C 1,350,000 D=B+C 1,500,000 E=B/D 10% 190,000 F = E  1,900,000 G = Prior F 0 H=F–G 190,000 J = B – prior B 150,000 See Note 1 0 See Note 2 40,000

2012 1,200,000 800,000 2,000,000 60% 1,140,000 190,000 950,000 1,050,000 40,000 (140,000)

2013 2,100,000 0 2,100,000 100% 1,900,000 1,140,000 760,000 900,000 (40,000) (100,000)

Note 1: These figures may be computed directly or as plug figures after determining the gross profit. The direct computation for 2012 is: expected loss accrual = percentage uncompleted  total expected loss – previous accruals = 40%  100,000 – 0 = 40,000. For 2012, expected loss accrual = 0%  200,000 – 40,000 = –40,000. Note 2: Because the expected total cost exceeds the contract price in 2012, the gross profit (loss) in the year must reflect all of the loss, and reverse any prior profit recorded. Thus, the gross profit (loss) = 100%  –100,000 – 40,000 = –140,000. Similarly, in 2013 the computation is gross profit = 100%  –200,000 – –100,000 = –100,000. P4-32. Suggested solution: Under the completed contract method, no revenue would be recognized until the contract is completed. However, it is still necessary to recognize any expected losses so that the financial statements are not overstated. Therefore, the amounts for revenue and profit/loss should be: 2011 2012 2013 Revenue – current year 0 0 1,900,000 Expenses 0 0 2,100,000 Gross profit (loss) before 0 (200,000) Less: Expected loss accrual (reversal) 0 100,000 (100,000) 0 (100,000) (100,000) Gross profit (loss)

P4-36. Suggested solution: a. GP = % complete  estimated total GP – GP previously recognized Year 1: GP = (3,500 / 10,000)  (12,000 – 10,000) – 0 = 35%  2,000 = $700k Year 2: GP = 100%  (12,000 – 13,000) – 700 = 1,000  700 = $1,700k Year 3: GP = 100%  (12,000 – 12,000) – –1,000 = $1,000k b. Revenue = % complete  estimated total revenue – revenue previously recognized = (10,000 / 13,000)  12,000  4,200 = $5,031k

c. ( in $ thousands) Costs incurred Dr. WIP Cr. Cash, A/P

6,500 6,500

Billings Dr. A/R Cr. Billings on construction

4,000

Collections Dr. Cash Cr. A/R

4,200

Revenue and expense recognition Dr. COGS Cr. WIP ((10/13  1,000)  700) Cr. Revenue Dr. Expected loss on LT contract Cr. WIP (3/13  1000)

4,000

4,200

6,500 1,469 5,031 231 231

d.

Project completion Dr. Billings on construction Cr. WIP

12,000 12,000

of $50 million would go down by $200 million to result in a $150 million loss. Over the four years, the loss is $150 million regardless of the estimates used in the first three years. P4-44. Suggested solution: a.

Bombardier uses the cost-to-cost approach to estimate the percentage of completion. When the company anticipates a loss on a contract, it recognizes the entire loss in the period when it identifies the loss. Note 2 on page 146 contains this information.

b.

From Note 15, we can see that Bombardier had work-in-process inventories of $1,737 million in “Production Contracts” and $335 million in “Service contracts,” for a total of $2,072 million. These amounts are net of billings and advances received of $4,818 million ($4,773m + $45m). The gross amount before netting out the billings and advances was $6,890 million ($6,510m + $380m).

Case 7: Patricia Leather Company. Suggested Solution: a. Alternative 1: Revenue would be recognized once the consignee sells the goods to customers because risks and rewards have been transferred to customers. At that point, PLC retains no continuing managerial involvement, the amount can be measured reliably and the economic benefits would flow to PLC when the consignees remit payment to PLC. However, PLC would not be able to recognize any sales when merchandises are shipped to the consignee stores. Alternative 2: Revenue would be recognized on sales but recognition of profit is delayed until payment is received. This is because although the product has been transferred to the customer at the point of sale, there are still many risks, namely credit risks, associated with the possibility of customers not being able to pay back. Alternative 3: Revenue would be recognized once the franchisee has signed the franchise documents for the initial franchise fee, however some of the revenue must be deferred until future obligations of the franchisor is fulfilled. Deferred revenue would then be recognized over the period of the contract. Furthermore, ongoing franchise revenue would be recognized annually. b. Alternative 1: The main concern with this alternative would be that net income could be lower as we would lose sales from the retail stores currently purchasing the products. These stores would now act as our agent to try to sell our products for us, charging us a commission. A minor concern would be that whether PLC had a sophisticated inventory tracking system to for the inventory on consignment. Furthermore, we must also consider that if too many stores were selling the products, it would undermine the sales at our retail boutique.

Alternative 2: The main concern here would be the issue of collectability. There might be uncertainty with the collectability of the installment receivables, as credit risks of customers become a bigger concern when they now have longer period to pay. Since we cannot be completely certain whether the clients will be able to pay the full amount, we might also need to be conservative when ing for these sales, delaying the recognition of gross profits until payment is received. Alternative 3: The main concern here would be the costs associated with becoming a franchisor and whether investors would be willing to become franchisees. Considering the business had a mere net income of $80,000 this year, it is hard to imagine PLC could afford to establish franchises in the same city without undermining sales in its own store. As the franchisor, PLC would also need to incur expenses to exercise adequate oversight on its franchisees. c. In this situation, it is more likely PLC would go for alternative 2. Simply put, extending credit to existing or potential customers was probably the easiest alterative that PLC could adopt in this situation to boost sales. Alternative 3 of starting a franchise was probably unrealistic given the size and business life cycle stage of PLC. Alternative 1 was implementable, but it is uncertain how much additional sales PLC could make on consignment given that PLC has already been selling its products to other retailers.