©Cambridge Business Publishers, 2008

Solutions Manual, Module 5 5-1

Module 5

Reporting and AnalyzingOperating Income

QUESTIONSQ5-1. Revenue must be realized or realizable and earned before it can be reported in the

income statement. Realized or realizable means that the company’s net assetshave increased, that is, the company has received an asset (for example, cash oraccounts receivable) or satisfied a liability as a result of the transaction. Earnedmeans that the company has done everything it must do under the terms of thesale.

For retailers, like Abercrombie & Fitch, revenue is generally earned when title tothe merchandise passes to the buyer (e.g., when the buyer takes possession ofthe merchandise), and the right of return period has passed. For companiesoperating under long-term contracts, the earning process is typically measuredusing the percentage of completion method, that is, by the percentage of costsincurred relative to total expected costs.

Q5-2. Financial statement analysis is usually conducted for purposes of forecastingfuture financial performance of the company. Extraordinary items are, bydefinition, not expected to continue to affect the profits and cash flows of thecompany. Accordingly, the financial statements separately report extraordinaryitems from continuing operations to yield an income measure that is more likely topersist into the future.

Q5-3. In order for an item to be classified as extraordinary, it must be both unusual andinfrequent. Examples include the destruction of property by natural disaster orthe expropriation of assets by a foreign government. Gains and losses on earlyretirement of long-term bonds, once the most common type of extraordinary item,are no longer considered extraordinary unless they meet the tests outlined above.Other events not likely to be included as extraordinary items include asset write-downs, gains and losses on the sales of assets, and costs related to an employeestrike.

©Cambridge Business Publishers, 2008

Financial Accounting for MBAs, 3rd Edition5-6

M5-13 (20 minutes)

Company Revenue recognition

GAP When the customer takes the merchandise and the right of returnperiod has expired.

Merck When the customer takes the merchandise and the right of returnperiod, if any, has expired. The company will also establish areserve and recognize expense for uncollectible accountsreceivable at the time the sale is recorded.

JohnDeere

When the customer takes the merchandise and the right of returnperiod, if any, has expired. The company will also establish areserve and recognize expense for uncollectible accountsreceivable and anticipated warranty costs at the time the sale isrecorded.

Bank ofAmerica

Interest is earned by the passage of time. Each period, Bank ofAmerica accrues income on each of its loans and establishes anaccount receivable on its balance sheet.

JohnsonControls

Revenue is recognized for long-term contracts under thepercentage-of-completion method.

M5-14 (15 minutes)

Two potential revenue recognition problems for a company with operationssimilar to BannerAD follow:

1. Sales on consignment: BannerAD earns revenue as an agent for theseller. It does not take title to the inventory and, as a result, cannotcharacterize the gross revenues as sales. Rather, it should disclose theconsignment arrangement and identify its revenues as commissionsrather than sales. Thus, one potential problem could arise if BannerAdrecords these commissions before the sale is actually made to the finalbuyer.

2. Gross vs. Net: Many dotcom’s recorded commission sales at grossamount, rather than the net commission that represented the trueearnings for the agent on the sale of the inventory. Grossing up thesales inflates top line growth, often a key indicator of Internet site value.

©Cambridge Business Publishers, 2008

Solutions Manual, Module 5 5-7

M5-15 (15 minutes)

The GAP can only recognize revenues once they have been earned. That is,not until after the right of return period has elapsed. At the time of sale, thecompany must estimate the proportion of product that is likely to bereturned and deduct that amount from gross sales for the period. In thiscase, it would record $4.9 million in net sales (98% of $5 million) for theperiod. The company would create an allowance for sales returns on thebalance sheet to offset the 2% of cash sales that they expect to have torefund.

M5-16 (10 minutes)

a. $1,821 / $22,338 = 8.2%. To assess Abbott’s R&D expenditure level, wewould gather R&D expenditure data for Abbott’s competitors to gain asense of the appropriateness of Abbott’s R&D expenditures. As well, wecould gather information about R&D spending for all public companiesto assess whether economy-wide factors are at play.

b. Under current U.S. GAAP, all R&D costs must be expensed whenincurred. This policy applies to depreciable assets that would otherwisebe capitalized, unless the assets have alternative future uses. As aresult, the balance sheet does not reflect the costs incurred for long-term R&D assets. In addition, under current GAAP, operating expensesare increased, retained earnings are reduced and thus stockholders’equity is lower.

M5-17 (15 minutes)

a. 2005: Sales decreased by 1% in 2005. This sales decrease is the netresult of a 2% sales decrease from the volume of goods sold and by a1% sales increase attributable to foreign currency fluctuations.

2004: Sales increased by 4% in 2004. This 4% sales increase is entirelyattributable to foreign currency fluctuations.

b. Foreign exchange fluctuations increased sales in both years. This isconsistent with a weakening of the $US. As the $US weakens, foreignsales are translated to larger amounts in $US terms. This means thatrevenues and expenses both increase. If the company’s foreignoperations are profitable, net income in $US also increases. (Notice thatthe weakening of the $US was less pronounced in 2005.)

©Cambridge Business Publishers, 2008

Financial Accounting for MBAs, 3rd Edition5-10

M5-20 (20 minutes)

a. Koonce should record one-sixth of the season ticket receipts (or$70,000) after each production.

b.Balance Sheet Income Statement

Transaction CashAsset

+ NoncashAssets

= Liabil-ities

+ Contrib.Capital

+ EarnedCapital

Rev-enues

– Expen-ses

= NetIncome

Cash 420,000UR 420,000

420,000

420,000

Cash

UR

Receive cashin advance forseasontickets

+420,000Cash =

+420,000UnearnedRevenue

– =

UR 70,000Rev 70,000

70,000

70,000

UR

Rev

Recognizerevenue forfirstproduction

=-70,000

UnearnedRevenue

+70,000RetainedEarnings

+70,000Revenues – = +70,000

M5-21 (20 minutes)

a. When Target receives the cash it increases a liability called deferredrevenue or unearned revenue. The company will classify this as is acurrent liability on the balance sheet if its experience is that all cards areused within a year. But if historically, a portion of the cards soldroutinely expires or is used after a year, then Target would classify thatportion as a non-current liability

b. Target recognizes revenue when the card is used, or when it expires twoyears later, whichever comes first.

©Cambridge Business Publishers, 2008

Solutions Manual, Module 5 5-11

EXERCISES

E5-22 (20 minutes)

Company Revenue recognition

The Limited When the customer takes the merchandise and the right ofreturn period has expired.

BoeingCorporation

Revenue is recognized under long-term contracts under thepercentage-of-completion method.

Supervalu When the customer takes the merchandise and cash isreceived.

MTV When the content is aired by the TV stations

Real estatedeveloper

When title to the houses is transferred to the buyers.

Bank ofAmerica

Interest is earned by the passage of time. Each period, Bank ofAmerica accrues income on each of its loans and establishesan account receivable on its balance sheet.

Harley-Davidson

When title to the motorcycles is transferred to the buyer. Harleywill also set up a reserve for anticipated warranty costs andrecognize the expected warranty cost expense when itrecognizes the sales revenue.

Time-Warner When the magazines are sent to subscribers. Subscriptionsreceived in advance are deferred revenue (a liability) until themagazines are mailed.

©Cambridge Business Publishers, 2008

Solutions Manual, Module 5 5-13

E5-25 (20 minutes)

a.

($ millions) Percentage of Completion Method Completed Contract

YearCosts

incurred

Percentof total

expectedcosts

Revenuerecognized

(percentage ofcosts incurred

total contractamount)

Income(revenue– costs

incurred)Revenue

recognized Income

2005 $15 18%($15/$85)

$ 21.6 $ 6.6 $ 0 $ 0

2006 40 47%($40/$85)

56.4 16.4 0 0

2007 30 35%($30/$85)

42.0 12.0 120 35

$85 $120.0 $35.0 $120 $35

b. The percentage-of-completion method provides a good estimate of therevenue and income earned in each period. This method is alsoacceptable under GAAP for contracts spanning more than oneaccounting period. Note that recognition of revenue and income is notaffected by the cash received.