SOLUTIONS TO PROBLEMS

PROBLEM 18-1

(a)   1.    Point of sale method recognizes revenue when the earnings process is complete and an exchange transaction has taken place. This can be the date goods are delivered, when title passes, when serv­ices are rendered and billable, or as time passes (e.g., rent or royal­ty income). This method most closely follows the accrual accounting method and is in accordance with generally accepted accounting principles (GAAP).

        2.    The completion-of-production method recognizes revenue only when the project is complete and the contract is completed. This is used primarily with short-term contracts, or with long-term contracts when there is considerable difficulty in estimating the costs remaining to complete a project. The advantage of this method is that income is recognized on final results, not estimates. The disadvantage is that when the contract extends over more than one accounting period, current performance on the project is not recognized and earnings are distorted. It is acceptable according to GAAP only in the extraordinary circumstances when forecasting the amount of work completed to date is not possible.

        3.    The percentage-of-completion method of revenue recognition is used on long-term projects, usually construction. To apply it, the following conditions must exist:

                (i)       A firm contract price with a high probability of collection.

                (ii)      A reasonably accurate estimate of costs (and, therefore, of gross profit).

                (iii)     A way to reasonably estimate the extent of progress to com­pletion of the project.

Gross profit is recognized in proportion to the work completed. The progress toward contract completion is the revenue-generating event. Normally, progress is measured as the percentage of actual costs to date to estimated total costs. This percentage is applied to estimated gross profit to indicate the total profit which should be recognized to that

date. That total less the income that was recognized in previous periods is the amount recognized in the current period. In the final period, the actual total profit is known and the difference between this amount and profit previously recognized is shown as profit of the period.

This method is in accordance with generally accepted accounting prin­ciples for long-term projects when estimates are dependable.

4.   The installment sales method may be applicable when the sales price is received over an extended period of time. The installment method recognizes revenue as the cash is collected and is used when the collection of the sales price is not reasonably assured. This method is commonly used for tax purposes, but it is not in accordance with GAAP, except in certain situations, because it violates accrual basis accounting. The installment method can be used in special circumstances when collectibility is very unsure.

(b)                                                                             Gina Construction

A change of cost estimates calls for a revision of revenue and profit to be recognized in the period in which the change was made (in this case, the first period).

                Contract price                                                                       $30,000,000

                Costs

          Actual costs to 11/30/04             $  7,800,000

          Estimated costs to complete      16,200,000

                  Total cost                                                               24,000,000

          Estimated profit                                                           $  6,000,000

% of contract completed ($7,800,000 ÷ $24,000,000)              32.5%

Revenue to be recognized in 2004 ($30,000,000 X 32.5%) $  9,750,000

   

Gogean Publishing Division

Sales—fiscal 2004                                                                  $8,000,000

Less:  Sales returns and allowances (20%)                        1,600,000

Net sales—revenue to be recognized in fiscal 2004       $6,400,000

Although distributors can return up to 30 percent of sales, prior experience indicates that 20 percent of sales is the expected average amount of returns. The collection of 2003 sales has no impact on fiscal 2004 rev­enue. The 21 percent of returns on the initial $5,500,000 of 2004 sales confirms that 20 percent of sales will provide a reasonable estimate.

Chorkina Securities Division

Revenue for fiscal 2004 = $5,200,000.

The revenue is the amount of goods actually billed and shipped when revenue is recognized at point of sale (terms of F.O.B. factory). Orders for goods do not constitute sales. Down payments are not sales. The actual freight costs are expenses made by the seller that the buyer will reimburse at the time s/he pays for the goods.

Commissions and warranty returns are also selling expenses. Both of these expenses will be accrued and will appear in the operating expenses section of the income statement.