Financial Reporting and Analysis

Chapter 3 Solutions
Additional Topics in Income Determination
Exercises

E3-1. Revenue recognition before delivery

Requirement 1:
Under the completed-contract method, revenue is recognized when the
contract is complete, however expected losses are recognized immediately in
their entirety. Since Project 2 is estimated to have a $20,000 loss ($300,000 -
$280,000 - $40,000 = $20,000 loss), this loss would be recognized in 2001.

Requirement 2:
For Project 1, $240,000 of the total costs of $360,000 has been incurred, or
2/3 of the total costs. The contract price of $420,000 less estimated costs of
$360,000 gives an estimated profit of $60,000. Current profit from Project 1 is
then 2/3 times $60,000, or $40,000. Project 2 estimates a $20,000 loss
($300,000 - $280,000 - $40,000) which is recognized immediately. Then by
adding these amounts the total gross profit would be $20,000 ($40,000 -
$20,000 = $20,000).

E3-2. Determining gross profit using percentage-of-completion

The gross profit for the percentage-of-completion method is as follows:

Contract price $3,000,000

Cost to date $1,800,000
Est. cost to complete 600,000
Total cost 2,400,000
Expected gross profit 600,000
Percentage complete (18/24) 75%
Profit to date 450,000
Profit previously recognized (300,000)
2002 gross profit $ 150,000

E3-3. Determining gross profit using installment sales

Gross profit = Sales - Cost of sales (COS)

2001: [ $80,000 - $40,000] = $40,000
2002: [ $90,000 - $60,000] = $30,000

Gross profit rate (GP rate) = COS / sales

2001: [ $40,000/ $80,000] = 50%
2002: [ $30,000/ $90,000] = 33.3%
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 2001 Deferred gross profit:
Deferred gross profit = GP rate x Accounts Receivable (AR) on 2001 sales @
12/31/2001
50% x $60,000 = $30,000 Deferred gross profit on 2001 balance sheet

2002 Deferred gross profit:

Deferred gross profit = 2001 GP rate x AR on 2001 sales @ 12/31/2002

50% x $30,000 = $15,000

Deferred gross profit = 2002 GP rate x AR on 2002 sales @ 12/31/2002

33.3% x $69,000 = $23,000

Total deferred gross profit to be reported = $38,000 on 12/31/2002

[$15,000 + $23,000].

E3-4. Determining deferred gross profit using the installment sales method

The total deferred gross profit equals the deferred gross profit from 2000 sales
plus the deferred gross profit from 2001sales.

2001 2000
Sales $900,000 $600,000
Collections
2000 sales (300,000)
2001 sales (300,000)
Written off
2000 (200,000)
2001 (50,000)
550,000 100,000
Gross profit % x 40% x 30%
Deferred gross profit $220,000 $ 30,000

Total deferred gross profit = $30,000 + $220,000 = $250,000.

E3-5. Determining realized gross profit using the installment method

Yardley has collected $300,000 on January 2, 2001, and $300,000 from the not
(interest is recorded separately). $600,000 x 1/3 profit rate ($500,000 profit on
$1,500,000 sale) is $200,000.

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E3-6. Determining installment accounts receivable
The installment sales receivable balance is computed below.

2001 2002
Installment sales ($300,000/.3) = $1,000,000 ($440,000/.4) = $1,100,000
Percentage of gross profit 0% ($300,000 - $120,000)/$300,000 = 60%
recognized
Decrease in installment 60% ´ $1,000,000 = $600,000
accounts receivable
Remaining 2001 installment $1,000,000 - $600,000 = $400,000
sales receivable
2002 Ending installment sales $1,000,000 $1,100,000
receivable balance + 400,000
$1,500,000

E3-7. Determining realized gross profit on installment sales

(AICPA adapted)

The cash collections and realized gross profit amounts are computed below.

Installment sales $280,000/.4 = $700,000

Cash collections $700,000 - $400,000 = $300,000
Percentage of installment sales collected $300,000/$700,000 = 42.86%
Amount of gross profit to be recognized 42.86% ´ $280,000 = $120,000

E3-8. Determining deferred franchise fee revenue

Revenue from franchise sales is recognized when all material obligations of the
franchisor have been substantially performed. The $60,000 down payment is
revenue, because it is nonrefundable. The remaining payments are shown as
unearned at their present value of $72,000.

E3-9. Determining revenue recognized with advanced fees

Revenue is recognized evenly over the contract year as it is earned at $45

per month = $540/12 months (when services are performed) and realized
(cash collected) or realizable (accounts receivable).

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E3-10. Determining deferred service contract revenue

When service contracts are sold, the entire proceeds are reported as
deferred revenue. Revenue is recognized, and deferral reduced as the
service is performed. Since repairs are made evenly (July 1 is average date)
only 1/2 of the 40% of repairs will be in 2001.

2001 deferral ($600 x 1,000) $600,000

Earned in 2001 (600,000 x 40% x 1/2) (120,000)
Deferral 12-31-2001 $480,000

E3-11. Determining accounts receivable and deferred gross profit under

installment sales

Under installment accounting, neither revenue nor profit is recognized at the

time a sale is made, but rather when cash is actually collected. The total
gross profit on the installment sales equals $560,000 [40% x $1,400,000]. Of
that amount, $240,000 was realized, leaving $320,000 [$560,000 - $240,000]
as deferred gross profit.

The installment sales collected in 2001 is the realized gross profit divided by
the gross profit percentage:

$240,000/40% = $600,000.

The balance in the installment receivable account must then be $800,000

[$1,400,000 - $600,000].

E3-12. Determining gross profit and deferred gross profit under the
installment Method

Requirement 1:

At December 31, 2000, Baker's deferred gross profit is 40% of the amount
owed after the down payment.

Sales $14,000,000
Down payment (1,400,000)
Installment accounts receivable 12,600,000
Profit rate 40%
Deferred gross profit on installment receivables $ 5,040,000

Requirement 2:
For 2002, Baker's realized gross profit consists of collections from both 2001
and 2002 sales. Since the profit percentage (40%) is the same for both years,
40% times 2002 collections of $2,020,000 equals $808,000 of realized gross
profit.
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 Financial Reporting and Analysis
Chapter 3 Solutions
Additional Topics in Income Determination
Problems

Problems
P3-1. Income measurement under alternative revenue recognition rules

Computation of net income under production basis

2001: 20,000 units
($16.00 - $12.00)1 $80,000

2002: 4,000 units
($13.00 - $16.00) -12,000
Total income $68,000
1
Revision in expected revenue from liquidation sale.

Computation of net income under sales or delivery basis

2001: 16,000 units
($16.00 - $12.00) $64,000

2002: 4,000 units
($13.00 - $12.00) 4,000
Total income $68,000

Computation of net income under cash collection basis

2001: 14,0002 units
($16.00 - $12.00) $56,000

2002: 2,0003 units
($16.00 - $12.00) = $8,000
4,000 units
($13.00 - $12.00) = 4,000 12,000
Total income $68,000
2
16,000 units sold – 14,000 units for which cash collections were received in 2001 = 2000
units for which collection occurred in 2002.
3
20,000 units produced – 16,000 units sold.

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P3-2. Income determination under alternate bases of revenue recognition

Requirement 1: Income on a production basis

Agri Pro
Income Statement
Production Basis
Revenues:
Wheat sold: 10,000 bu. @ $2.40 = $24,000
1
Wheat produced and in inventory: 5,000 bu. @ ($3.00 - $.10) = 14,500
Total revenues $38,500

Cost of goods produced:

Depreciation on equipment $3,000
Other production costs: 15,000 bu. @ $.50 = _7,500 (10,500)
Gross profit 28,000

Selling and delivery expense: 10,000 bu. @ $.10 = $1,000

Miscellaneous administrative expense 4,000
Interest expense _5,000 (10,000)
Net income $18,000
Alternate Solution
Production Basis
Sales revenue: 10,000 bu. @ $2.40 = $24,000

Cost of goods sold: 2

Depreciation: 10,000 bu. @ $.20 = $2,000
Other production costs: 10,000 bu. @ $.50 = _5,000 (7,000)
Gross profit $17,000

Selling and delivery expense: 10,000 bu. @ $.10 = 1,000

Miscellaneous administrative expense 4,000
Interest expense _5,000 (10,000)
Operating income 7,000

Unrealized holding gain on inventory: 5,000 bu. ´ ($3.00 - $.10 - $.70) 3 _11,000
Net income $18,000
1
Revenues should be recorded at net realizable value which is equal to the current selling price of
$3.00 per bushel less selling and delivery costs of $.10 per bushel.
2 $3,000
Depreciation per bushel produced = = $.20/bu
15,000
3
Other production costs = .50/bu
Production costs/bushel $.70/bu
Inventory carrying (book) value: 5,000 bu. @ $3.00 = $15,000
Accounts receivable: 10,000 bu. @ $2.40 ´ 1/4 = $6,000

3-6
Requirement 2: Income on sales basis

Agri Pro
Income Statement
Sales Basis
Revenues: 10,000 bu. @ $2.40 = $24,000
Cost of goods sold:
$3, 000
Depreciation on equipment: = $.20/bu. ´ 10,000 = 2,000
15, 000
Other production costs: 10,000 bu. @ $.50 = _5,000
Gross profit $17,000
Selling and delivery expense: 10,000 bu. @ $.10 = 1,000
Miscellaneous administrative expense 4,000
Interest expense 5,000 (10,000)
Net income $7,000

Inventory carrying (book) value: 5,000 bu. @ $.70 = $3,500

Accounts receivable: 10,000 bu. @ $2.40 ´ 1/4 = $6,000

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Requirement 3: Cash collection basis

Agri Pro
Income Statement
Cash Collections Basis
Revenues:
10,000 bu. @ $2.40 = $24,000
Less:
2,500 bu. sold but not collected on (2,500) @ $2.40 = (6,000)
Revenue from bushels sold and collected $18,000
Cost of goods sold and collected:
$3, 000
Depreciation on equipment: = $.20 ´ 7,500 bu. = (1,500)
15, 000
Other production costs: 7,500 bu. ´ $.50 = (3,750)
Gross profit $12,750

Selling and delivery expense: 10,000 bu. ´ $.10 = $1,000

Miscellaneous administrative expense 4,000
Interest expense 5,000 (10,000)
Net income $ 2,750

Inventory carrying (book) value: 5,000 bu. @ $.70 = $3,500

Accounts receivable: 10,000 bu. @ $2.40 ´ 1/4 = $6,000

Less: Deferred gross profit: 10,000 x 1/4 ´ ($2.40 - $.70) = (4,250)
Accounts receivable net of deferred gross profit $1,750

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P3-3. Determining pre-tax income and accounts receivable using the
installment method

Installment Sales Method

Sales (700 x $960) $672,000

Less: 40% sold, but not collected (268,800)
Revenues from land sold and collected 403,200
Less: Cost of land sold and collected (700 x $350 x 60%) (147,000)
Gross profit 256,200
Property taxes (75,000)
Income before income taxes $181,200
Accounts receivable balance ($672,000 x 40%) $268,800
Less deferred gross profit (700 x 40% x ($960 - $350)) (170,800)
$98,000

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P3-4. Determining pre-tax income, inventory carrying value, and accounts
receivable under sales and production basis.

Requirement 1: Production basis

Production Basis
Barrels available 30,000
Ending inventory (6,000)
Barrels sold 24,000

Revenues:
Barrels sold (24,000 x $28) $672,000
Barrels in inventory (6,000 x $31) 186,000
Total revenues 858,000

Cost of oils produced:

Direct production costs (30,000 x $12) (360,000)
Depreciation expense (180,000)
Gross profit 318,000
Property taxes (75,000)
Income before income taxes $243,000

Alternative Production Basis

Sales (24,000 barrels x $28.00) $672,000

Cost of oils produced:
Direct production costs (24,000 x $12) (288,000)
Depreciation expense ($180/30 x 24,000) (144,000)
Gross profit 240,000
Property taxes (75,000)
165,000
Unrealized holding gains in inventory [6,000 x ($31-$18)] 78,000
Income before income taxes $243,000

Accounts receivable balance ($672,000 x 40%) $268,800

Inventory carrying value (6,000 x $31) $186,000

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Requirement 2: Sales Basis

Sales (completed transaction) Basis

Barrels available 30,000
Ending inventory (6,000)
Barrels sold 24,000

Sales (24,000 x $28) $672,000

Cost of oils produced:
Direct production costs (24,000 x $12) (288,000)
Depreciation expense ($180/30 x 24,000) (144,000)
Gross profit 240,000
Property taxes (75,000)
Income before income taxes $165,000

Accounts receivable ($672,000 x 40%) $268,800

Inventory carrying value: $108,000

((6,000 x $12) + ($180/30 x 6,000))

Requirement 3: Installment Basis

Installment Basis
Barrels available 30,000
Ending inventory (6,000)
Barrels sold 24,000

Sales (24,000 x $28 x.60) $403,200

Cost of oils produced:
Direct production costs (24,000 x $12 x 60%) (172,800)
Depreciation expense ($180/30 x 24,000 x 60%) (86,400)
Gross profit 144,000
Property taxes (75,000)
Income before income taxes $69,000

Accounts receivable (24,000 x $28 x 40%) $268,800

Less deferred gross profit [24,000 x 40% x ($28-$18)] ($96,000)
$172,800

Inventory carrying value: $108,000

[(6,000 x $12) + ($180/30 x 6,000)]

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P3-5. Percentage-of-completion accounting
(AICPA adapted)

Requirement 1:
1) Contract billings in 2001 $47,000
Accounts receivable: construction contracts (15,000)
Cash collected $32,000

Requirement 2:
2) Construction in progress $50,000
Less: Profit included in above (10,000)
Costs incurred to date $40,000

Let X = Total costs on project (in $000)

$40
($800 − X) = $10
X

$32,000 - $40X = $10X

50X = $32,000
X = $640

Requirement 3:
3) Contract price $800,000
Total estimated expenses (640,000)
Estimated total income $160,000

P3-6. Long-term construction contract accounting

(AICPA adapted)

Completed-Contract Method
Year 2001
D R Construction in progress $290,000
CR Cash, payables, materials, etc. $290,000
D R Accounts receivable $260,000
CR Billings on contract $260,000
D R Cash $240,000
CR Accounts receivable $240,000
Since the project is incomplete, no revenue is recognized for the year
2001.

3-12
 Balance Sheet Presentation at the End of 2001
Completed-Contract Method
Current Assets:
Construction in progress $290,000
Less: Billings on contract (260,000)
Unbilled costs of construction $30,000

Accounts receivable $20,000

Year 2002
D R Construction in progress $150,000
CR Cash, payables, materials, etc. $150,000
D R Accounts receivable $265,000
CR Billings on contract $265,000
D R Cash $285,000
CR Accounts receivable $285,000
D R Billings on contract $525,000
CR Construction in progress $440,000
CR Income on long-term
construction contracts 85,000

Alternate entry:
D R Construction expense $440,000
D R Billings on contract 525,000
CR Construction in progress $440,000
CR Construction revenue 525,000

3-13
 Percentage-of-Completion Method
Year 2001
D R Construction in progress $290,000
CR Cash, payables, materials, etc. $290,000
D R Accounts receivable $260,000
CR Billings on contract $260,000
D R Cash $240,000
CR Accounts receivable $240,000
1
D R Construction in progress $60,000
CR Income on long-term
construction contracts $60,000

Alternate entry: 1
D R Construction in progress $ 60,000
D R Construction expense 290,000
CR Construction revenue $350,000

1
Contract price $525,000
- Actual costs to date ($290,000)
- Estimated costs to complete (145,000)
Total estimated costs of project (435,000)
Estimated total gross margin $90,000

Revenue earned during the period: ($290,000/$435,000) ´ $525,000 = $350,000

Gross margin earned during the period: ($290,000/$435,000) ´ $90,000 = $60,000

Balance Sheet Presentation at the End of 2001

Percentage-of-Completion Method
Current Assets:
Construction in progress $350,000
Less: Billings on contract (260,000)
Unbilled costs of construction $90,000

Accounts receivable $20,000

3-14
 Year 2002
D R Construction in progress $150,000
CR Cash, payables, materials, etc. $150,000
D R Accounts receivable $265,000
CR Billings on contract $265,000
D R Cash $285,000
CR Accounts receivable $285,000
D R Construction in progress $25,000
CR Income on long-term
construction contracts $25,000

Alternate Entry:
D R Construction in progress $ 25,000
D R Construction expense 150,000
CR Construction revenue $175,000

Total 2001 2002

Construction revenue $525,000 $350,000 $175,000
Construction expense 440,000 290,000 150,000
Gross margin $ 85,000 $ 60,000 $ 25,000

P3-7. Determining income under installment sales method

(AICPA adapted)

Income before income taxes on installment sale contract:

Sales $556,000
Cost of sales _417,000
Gross profit 139,000
Interest income (from following calculations) __27,360
Income before income taxes $166,360

Calculations to determine interest income on installment sale contract:

Cash selling price $556,000

Less: July 1, 2001, payment _100,000
456,000
Interest rate ____12%
Annual interest $ 54,720
Interest July 1, 2001, to December 31, 2001
($54,720 ´ 1/2) $ 27,360

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P3-8. Revenue recognition for goods on consignment

Requirement 1:

Englewood Marine
Financial Summary
Quarter Ended
Description July 31 October 31
Revenues $ 392,0001 $ 700,0002
Cost of goods sold
Sales x (1-.30) (274,400) (490,000)
Gross profit $ 117,600 $ 210,000

1
17 boats shipped - 3 boats in inventory = 14 boats sold x $28,000 = $392,000
2
41 boats shipped - 14 boats previously sold - 2 boats in inventory = 25 boats
sold x $28,000 = $700,000

Requirement 2:

Since the boats were on consignment to the dealers, Englewood Marine still
owns them and should include the boats in its finished goods – consigned
inventory. The boats would be valued at cost as follows:

Englewood Marine
Boats on Consignment
Description July 31 October 31
Selling price per boat $ 28,000 $ 28,000
Number of boats x 3 x 2
84,000 56,000
Less gross profit @ 30% (25,200) (16,800)
Cost of boats on consignment (Inventory) $ 58,800 $ 39,200

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P3-9. Do existing receivables represent real sales

Requirement 1:

MogulÕs fourth quarter sales to Composite should include only the deliveries
made during that quarter since the material was sold f.o.b. CompositeÕs
receiving dock. Sales for the fourth quarter of 2001 would be $281,000.
Determined as follows:

Mogul Chemical Company

December 2000 - Sales to Composite, Inc.
Price per
Date Delivered Pounds Pound Sales
November 30, 2001 75,000 $1.00 $75,000
December 7, 2001 80,000 $1.00 80,000
December 14, 2001 60,000 $1.10 66,000
December 21, 2001 50,000 $1.20 60,000
December 2001 Sales $281,000

Requirement 2:

It appears that Mogul has met several criteria required to recognize the
Composite transaction as revenue during calendar year 2001, including:

• Having a written fixed commitment and specific written delivery terms from
the buyer;
• The critical event has taken place, the production of the required
materials in accordance with the buyers written instructions, so that the
earning process appears to be complete except for delivery of the goods;
• The amount to be collected is reasonably assured and is measurable
with a reasonable degree of reliability;
• Material destined for Composite is completely segregated and not
subject to being used to fill other orders;
• Material destined for Composite is complete and ready for shipment.

Requirement 3:

Consistent with guidance in SEC SAB No. 101, Mogul should not include the
Composite transaction as a receivable and sale in calendar year 2001 for the
following reasons:

1. Mogul retained risk of ownership.

2. Composite did not request the “bill and hold” arrangement. Mogul did
this unilaterally.

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3. Mogul accepted Composite’s purchase order and delivery terms.
Composite was unable to take delivery of the material early because it
lacked storage facilities for raw material inventories.

If Mogul included this transaction in 2001 business and if the amount were
material, an adjustment would be required to correctly report this as 2002
business.

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P3-10. Revenue recognition on layaways

Requirement 1:

February 28, 2001:

DR Layaway-- merchandise inventory $49,000
CR Retail inventory $49,000

DR Cash $45,000
CR Customer deposits (unearned revenue) $45,000

DR Customer deposits (unearned revenue) $30,000

CR Sales revenue $30,000

DR Cost of goods sold $24,000

CR Layaway-- merchandise inventory $24,000

March 31, 2001:

DR Layaway-- merchandise inventory $50,000
CR Retail inventory $50,000

DR Cash $67,000
CR Customer deposits (unearned revenue) $67,000

DR Customer deposits (unearned revenue) $70,000

CR Sales revenue $70,000

DR Cost of goods sold $56,000

CR Layaway-- merchandise inventory $56,000

April 30, 2001:

DR Layaway-- merchandise inventory $40,000
CR Retail inventory $40,000

DR Cash $51,000
CR Customer deposits (unearned $51,000
revenue)

DR Customer deposits (unearned revenue) $60,000

CR Sales revenue $60,000

DR Cost of goods sold $48,000

CR Layaway-- merchandise inventory $48,000

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Requirement 2:

DW Hooks
Revenues Earned and Reconciliation of Layaways and
Customer Deposits from January 31, 2001 to April 30, 2001
Sales
Layaway Customer Revenue
Inventory Deposits Earned
Balance at January 31, 2001 $ 72,000 $ 55,000

l February layaways 49,000

l February deposits 45,000
l February deliveries (24,000) (30,000) $ 30,000
Balance at February 28, 2001 97,000 70,000 30,000

l March layaways 50,000

l March deposits 67,000
l March deliveries (56,000) (70,000) 70,000
Balance at March 31, 2001 91,000 67,000 100,000

l April layaways 40,000

l April deposits 51,000
l April deliveries (48,000) (60,000) 60,000
Balance at April 30, 2001 $ 83,000 $ 58,000 $ 160,000

Requirement 3:
The amount of cash received as a deposit should be recognized as a liability
and titled such as “Customer deposits – layaway sales” or “Unearned
revenue – layaway sales.” The amount would be reported on Hook's balance
sheet as a liability.

3-20
 Financial Reporting and Analysis
Chapter 3 Solutions
Additional Topics in Income Determination
Cases

C3-1. Smith’s Farm: Alternate bases of income determination

Requirement 1:
Production Sales Collection
Realized revenue $108,000 $108,000 $72,000
Cost of goods sold _(21,000) _(21,000) (14,000)
Gross profit $87,000 $87,000 $58,000
Other expenses (25,000) (25,000) (25,000)
Value added to unsold
production [($3.60 - $.20) - $.50] _29,000 ––
Net income $91,000 $62,000 $33,000

Requirement 2:

Ending inventory
($3.60 - $.20)
10,000 bu. $ 34,000
$.50
10,000 bu. $5,000 $5,000

Accounts receivable $36,000 $36,000 $36,000

Less: Deferred profit on sale
($3.60 - $.70)
10,000 bu. –– –– ($29,000)
$36,000 $36,000 $7,000

Requirement 3:
Production Sales
Realized revenues $ 28,000 $28,000
Less: Carrying value of
inventory at 12/31/01 (34,000) (5,000)
Less: Delivery costs _(2,000) _(2,000)
Net income (loss) ($8,000) $21,000

The $8,000 loss on the production basis is straightforward. It represents the

1
speculative loss of $.80 per bushel (i.e., $3.40 - $2.60) which occurred
during 2002 times the 10,000 bushels that were held in inventory.
1
$3.40 and $2.60 represent the net realizable values at the start of the year and the time of
sale, respectively.

3-21
The $21,000 profit on the sales basis is more difficult to explain. It can’t be
attributable to 2001 farming profit since Smith didn’t farm in 2002. Similarly, it
can’t be considered speculative profit since Smith incurred a 2002 loss of
$8,000 on speculation. The $21,000 figure is really a mixture of $29,000 of
unrecognized 2001 farming profit and the 2002 speculative loss of $8,000.
Thus, the sales basis does not provide a clear delineation of profit by source.

To generalize beyond farm settings, just as Smith was in two “businesses”

(farming and speculation) so too most manufacturing concerns—albeit
reluctantly—are in two businesses (operations and holding assets).
Continuing the analogy, just as the sales basis “mixes” the profit source in a
farm setting, so too the sales basis “mixes” the profit source in manufacturing
settings. Insofar as these two profit sources (operations and holding assets)
entail different risks and patterns of repeatability, then the sales basis
provides a precarious basis for risk evaluation and cash flow forecasting.

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C3-2. Determining gross profit under the percentage-of-completion method

Requirement 1:

London, Inc.
Schedule of Gross Profit (Loss)

Beta Gamma
For the Year Ended September 30, 2002:
Estimated gross profit (loss):
Contract price $600,000 $800,000
Less: estimated total costs 400,000 820,000
Estimated gross profit (loss) $200,000 $(20,000)

Percent Complete:
Costs incurred to date $360,000 $410,000
Total costs 400,000 820,000
Percent complete 90% 50%

Gross profit (loss) recognized $180,000 ($20,000)

For year ended September 30, 2003:

Estimated gross profit (loss):
1
Contract price $560,000 $840,000
Less total costs 450,000 900,000
Estimated gross profit (loss) $110,000 $(60,000)

Percent complete:
Cost incurred to date $450,000 $720,000
Total costs 450,000 900,000
Percent complete 100% 80%

Gross profit (loss) 110,000 (60,000)

Less gross profit (loss) recognized
In prior year (180,000) - (20,000)
Gross profit (loss) recognized ($70,000) ($40,000)

1
[ Original contract price ($600,000) minus late penalty for 4 weeks (4 X $10,000) = $560,000 ]

3-23
Requirement 2:

London Inc.
Schedule of Selected Balance Sheet Accounts
September 30, 2002

Accounts receivable $115,000

($315,000 + $440,000 - $275,000 - $365,000 = $115,000)

Costs and estimated earnings in excess of billings for Beta:

Construction in progress $540,000
Less: Billings 315,000
Costs and estimated earnings in excess of billings $225,000

Billings in excess of costs and estimated earnings for Gamma:

Construction in progress $390,000
Less: Billings 440,000
Billings in excess of cost ($ 50,000)

Requirement 3:

Under the completed-contract method London would recognize a loss of

$20,000 on the Gamma project in 2002. In 2003, London would recognize
$110,000 of profit on Beta ($560,000 - $450,000 = $110,000) and a $40,000
loss on Gamma ($60,000 total loss minus $20,000 recognized in 2002) for a
total profit of $70,000.

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C3-3. Stewart & Stevenson Services Inc. (KR): Understanding accounts used
for long-term construction contract accounting

Requirement 1:

Stewart and Stevenson Services, Inc.

Construction in Progress Inventory

Beginning balance $80,623 $689,362 Projects completed (plug number)
Costs added 685,879
Profit added 126,647
Ending balance $203,787

Billings on Contract (Progress Payments)

$55,258 Beginning balance
Projects completed $689,362
(from above)
798,182 Progress billings (plug number)
$164,078 Ending balance

Accounts Receivable
Beginning balance $121,030 $776,046 Cash collected (plug number)
Progress billings 798,182
(from above)

Ending balance $143,166

Requirement 2:

Gross margin under the completed-contract method:

Beginning accrued profits + Gross margin under the percentage-of-

completion method - Ending accrued profits

= $9,857 + $126,647 - $13,117 = $123,387

Sales revenue = $689,362 (See T-account for construction in progress)

Cost of goods sold = Sales revenue - Gross margin = $565,975

Gross margin rate = 17.9%

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Requirement 3:

Effects on the accounting equation:

Decrease in construction in progress = $13,117

(Accrued profits recorded under percentage of
completion method as per balance sheet)
Decrease in deferred tax liability ($13,117 ´ .40) = $5,247
Decrease in retained earnings ($13,117 - $5,247) = $7,870

The effect on deferred tax liability can be skipped for now.

Requirement 4:

Stewart & Stevenson is one of a few long-term construction contract

companies that explicitly provide information on the magnitude of accrued
profits that is included in the inventory account. Consequently, in (2), we were
able to precisely estimate their gross margin under the completed-contract
approach. This part considers a more realistic scenario when such
information is not available.

Estimation of gross margin under the completed-contract method:

Using the Year 2 gross margin rate: $689,362 (sales) ´ 15.6% =$107,540

Using the Year 1 gross margin rate: $689,362 (sales) ´ 17.0% =$117,192

Requirement 5:

Obviously, the answer to part (2) provides the most accurate estimate of the
profits under the completed contract method. Of the two estimates provided
in (4), the one obtained using the Year 1 gross margin rate is closer to the
gross margin in (2). This is consistent with the intuition that the higher gross
margin contracts that were started in Year 1 are being completed during
Year 2.

Requirement 6:

Estimation of gross margin under the cash collection basis:

Using Year 2 gross margin rate: $776,046 (collections) ´ 5.6% = $121,063

Using Year 1 gross margin rate: $776,046 (collections) ´ 17.0% = $131,928

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C3-4. Revenue recognition-membership fees

Numbers are rounded for presentation

Requirement 1:
Uncle Mike's
Membership Fees Earned
Quarter Ended Year Ended
Description 3/31/01 6/30/01 9/30/01 12/31/01 12/31/01
Memberships sold 5,500 2,400 2,000 2,500 12,400
Fees collected $ 203,334 $ 65,667 $ 31,666 $ 16,667 $ 317,334

Est. Customer refunds

(Fees collected x 30%) (61,000) (19,700) (9,500) (5,000) (95,200)
Net unearned revenue $ 142,334 $ 45,967 $ 22,166 $ 11,667 $ 222,134

Earned revenue from:

1/1/01 to 3/31/01 $ 26,834 $ 38,500 $ 38,500 $ 38,500 $ 142,334
4/1/01 to 6/30/01 12,367 16,800 16,800 45,967
7/1/01 to 9/30/01 8,166 14,000 22,166
10/1/01 to 12/31/01 11,667 11,667
1
Membership fees earned $ 26,834 $ 50,867 $ 63,466 $ 80,967 $ 222,134
1
The total net membership fees earned are based on memberships actually sold minus the
estimated cancellations. Even though actual cancellations turn out to be different from
estimates we do not adjust the net membership revenues for this difference. Over time,
we expect deviations of actual from estimated cancellations to net to zero.

Uncle Mike's
Membership Fees Earned
Quarter Ended March 31, 2001 Quarter 1
Description Jan Feb March Information
Memberships sold 2,000 2,000 1,500 5,500
Price $ 40.00 $ 36.67 $ 33.33
Fees collected (rounded) $ 80,000 $ 73,334 $ 50,000 $ 203,334
Less estimated refunds
at 30% (24,000) (22,000) (15,000) (61,000)
Unearned revenue 56,000 51,334 35,000 $ 142,334
Remaining months 12 11 10
Earned per month $ 4,667 $ 4,667 $ 3,500
Membership fee earned:
Month 1 $ 4,667 $ 0 $ 0 $ 4,667
Month 2 4,667 4,667 0 9,334
Month 3 4,666 4,667 3,500 12,833
Total earned $ 14,000 $ 9,334 $ 3,500 $ 26,834

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Uncle Mike's
Membership Fee Detail
Quarter 1 Quarter 2 Quarter 3 Quarter 4 Year Ended
Month Information April May June Information July August September Information October November December Information 12/31/01
Memberships sold 5,500 1,000 900 500 2,400 500 500 1,000 2,000 800 900 800 2,500 12,400
Price $ 30.00 $26.67 $23.33 $20.00 $16.67 $13.33 $10.00 $6.67 $ 3.33
Total (numbers rounded) $203,334 $30,000 $24,000 $11,667 $65,667 $10,000 $8,333 $13,333 $31,666 $8,000 $6,000 $2,667 $16,667 $317,334

Estimated customer
refunds (Total x 30%) (61,000) 9,000 7,200 3,500 (19,700) 3,000 2,500 4,000 (9,500) 2,400 1,800 800 (5,000) (95,200)

Net unearned revenue $142,334 21,000 16,800 8,167 $45,967 7,000 5,833 9,333 $22,166 5,600 4,200 1,867 $11,667 222,134

Months 9 8 7 6 5 4 3 2 1
Earned per month 2,333 2,100 1,166 1,167 1,167 2,333 1,867 2,101 1,865

Membership fees earned

by period
1/1/01 - 1/31/01 26,834 38,500 38,500 38,500
Quarter 1 $ 26,834 26,834

4/1/01 - 6/30/01 12,367 16,800 16,800

Quarter 2 $50,867 50,867

7/1/01 - 9/30/01 8,166 14,000

Quarter 3 $63,466 63,466
10/1/01 - 12/31/01 11,667

Year ended 12/31/01 $80,967 80,967

$ 222,134

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Requirement 2:
The membership fee should be credited to different balance sheet accounts.
The portion that represents potential customer refunds (30%) should be
recorded in a monetary liability account such as “Estimated customer
refunds payable” while the remaining amount should be recorded in a
nonmonetary liability account such as “unearned revenue.” As the
membership fees are earned, they would be reported as revenue on the
income statement and the “unearned revenue” account would be reduced
appropriately.

Requirement 3:
In essence Uncle Mike’s is unable to demonstrate that the amount to be
collected is measurable because it cannot accurately estimate membership
refunds. Since customers have the unilateral right to cancel their membership
at any time and receive a full refund up to the last day of the year, the
membership fee cannot be fixed or determinable at any point before the end of
the year. Accordingly, the revenue from such transactions should not be
recognized in earnings prior to the refund privileges expiring on December
31. Net revenue earned would be based on actual memberships sold minus
actual refunds provided, as detailed in the following schedule:
Uncle Mike's
Membership Fees Earned
Quarter Ended March 31, 2001 Quarter 1
Description Jan Feb March Information
Memberships sold 2,000 2,000 1,500 5,500
Price $ 40.00 $ 36.67 $ 33.33
Unearned revenues $ 80,000 $ 73,334 $ 50,000 $ 203,334

Quarter 2
Description April May June Information
Memberships sold 1,000 900 500 2,400
Price $ 30.00 $ 26.67 $ 23.33
Unearned revenues $ 30,000 $ 24,000 $ 11,667 $ 65,667

Quarter 3
Description July Aug Sept Information
Memberships sold 500 500 1,000 2,000
Price $ 20.00 $ 16.67 $ 13.33
Unearned revenues $ 10,000 $ 8,333 $ 13,333 $ 31,666
Quarter 4
Description Oct Nov Dec Information
Memberships sold 800 900 800 2,500
Price $ 10.00 $ 6.67 $ 3.33
Unearned revenues $ 8,000 $ 6,000 $ 2,667 $ 16,667

Total unearned revenues $ 317,334

Less: actual refunds (87,085)
Net earned revenue on 12/31/2001 $ 230,249

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