Chapter 6

Reporting and Analyzing Revenues and Receivables

Learning Objectives coverage by question
MiniExercises LO1 Describe and apply the criteria for determining when revenue is recognized. LO2 Illustrate revenue and expense recognition when the transaction involves future deliverables. LO3 Illustrate revenue and expense recognition for long-term projects. LO4 Estimate and account for uncollectible accounts receivable. LO5 Calculate return on capital employed, net operating profit after taxes, net operating profit margin, accounts receivable turnover, and average collection period. LO6 Discuss earnings management and explain how it affects analysis and interpretation of financial statements. LO7 Appendix 6A Describe and illustrate the reporting for nonrecurring items. 14, 15, 17 Exercises Problems Cases and Projects 47 - 49 26, 27, 32, 39

17, 24, 25

30, 39, 40

46

47, 48

13, 16

28 - 30

42

18 - 21, 23

33 - 37

45

49

22

31, 34, 38

44

49

27, 32, 34

43, 44

48

41

Cambridge Business Publishers, 2014 Solutions Manual, Chapter 6 6-1

DISCUSSION QUESTIONS
Q6-1. Revenue must be realized or realizable and earned before it can be reported in the income statement. Realized or realizable means that the companys net assets have increased, that is, the company has received an asset (for example, cash or accounts receivable) or satisfied a liability as a result of the transaction. Earned means that the company has done everything it must do under the terms of the sale. For retailers, like Abercrombie & Fitch, revenue is generally earned when title to the merchandise passes to the buyer (e.g., when the buyer takes possession of the merchandise), because returns can be estimated. For companies operating under long-term contracts, the earning process is typically measured using the percentage-of-completion method, that is, by the percentage of costs incurred relative to total expected costs. Q6-2. Financial statement analysis is usually conducted for purposes of forecasting future financial performance of the company. Discontinued operations are, by definition, not expected to continue to affect the profits and cash flows of the company. Accordingly, the financial statements separately report discontinued operations from continuing operations to provide more useful measures of financial performance and financial income. For example, yielding an income measure that is more likely to persist into the future, and a net assets measure absent discontinued items. In order for an event to be classified as an extraordinary item, its occurrence must be both unusual and infrequent. Items that are considered to be both unusual and infrequent might be the destruction of property by natural disaster or the expropriation of assets by a foreign government in which the company operates. Gains and losses on early retirement of long-term bonds, once comprising the majority of extraordinary items, are no longer considered as such 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 employee strike. Restructuring costs typically consist of two general categories: asset writedowns and accruals of liabilities. Asset write-downs reduce assets and are recognized in the income statement as an expense that reduces income and, thus, equity. Liability accruals create a liability, such as for anticipated severance costs and exit costs, and yield a corresponding expense that reduces income and equity. Big bath refers to an event in which a company records a nonrecurring loss in a period of already depressed income. By deliberately reducing current period earnings, the company removes future costs from the balance sheet or creates reserves that can be used to increase future period earnings.

Q6-3.

Q6-4.

Cambridge Business Publishers, 2014 6-2 Financial Accounting, 4th Edition

Q6-5.

Earnings management may be motivated by a desire to reach or exceed previously stated earnings targets, to meet analysts expectations, or to maintain steady growth in earnings from year to year. This desire to achieve income goals may be motivated by the need to avoid violating covenants in loan indentures or to maximize incentive-based compensation. The tactics used to manage income involve transaction timing (recognizing a gain or loss) and estimations that increase (or decrease) income to achieve a target.

Q6-6.

Pro forma income adjusts GAAP income to eliminate (and sometimes add) various items that the company believes do not reflect its core operations. Such pro forma disclosures are only reported in earnings and press releases and are not part of the published 10-Ks or other annual reports provided for shareholders. The SEC requires that GAAP income be reported together with pro forma income. Yet, companies often report their GAAP income at the very end of the earnings or press release, thus obfuscating their comparison and focusing attention on the pro forma income. It is because of this potential to confuse the reader about the true financial performance of the company that the SEC has become concerned. Also, pro forma numbers are not subject to accepted standards (and, thus, we observe differing definitions across companies), are not subject to usual audit tests, and are subject to considerable management latitude in what is and is not included and how items are measured.

Q6-7.

Estimates are necessary in order to accurately measure and report income on a timely basis. For example, in order to record periodic depreciation of longlived assets, one must estimate the useful life of the asset. Estimates allow accountants to match revenues and expenses incurred in different periods. For example, accountants estimate warranty costs so that the warranty expense is matched against the corresponding sales revenue. If the accounting process waited until no estimates were necessary, there would be a significant delay in the reporting of financial results. When analysts publish earnings forecasts, these forecasts become a benchmark against which some investors evaluate the companys performance. A company that fails to meet analysts forecasts may suffer a stock price decline, even though earnings are higher than previous years earnings and overall performance is good. Consequently, management may feel pressure to meet or slightly exceed analysts forecasts of earnings.

Q6-8.

Cambridge Business Publishers, 2014 Solutions Manual, Chapter 6 6-3

Q6-9.

Bad debts expense is recorded in the income statement when the allowance for uncollectible accounts is increased. If a company overestimates the allowance account, net income will be understated on the income statement and accounts receivable (net of the allowance account) will be underestimated on the balance sheet. In future periods, such a company will not need to add as much to its allowance account since it is already overestimated from that prior period (or, it can reverse the existing excess allowance balance). As a result, future net income will be higher. On the other hand, if a company underestimates its allowance account, then current net income will be overstated. In future periods, however, net income will be understated as the company must add to the allowance account and report higher bad debts expense.

Q6-10. There are several possible explanations for a decrease in the allowance account. First, after an aging of accounts receivable, Wallace Company may have determined that a smaller percentage of its receivables are past due. Wallace Company may have changed its credit policy such that it is attracting lower-risk customers than in the past. Second, experience may have indicated that the percentages used to estimate uncollectibles was too high in previous years. By correcting the estimated percentage of defaults, the estimated uncollectibles would end up lower than in past years. Third, Wallace Company may be managing earnings. By lowering estimated uncollectibles, the company can increase current earnings, but may end up reporting a loss in a future year when write-offs exceed the balance in the allowance account. Q6-11. Minimizing uncollectible accounts is not necessarily the best objective for managing accounts receivable. That objective could be accomplished by not offering to sell to customers on credit. The purpose of offering credit to customers is to increase sales and profits. Losses from uncollectible accounts are a cost of doing business. As long as the benefit (greater contribution to profits due to increased sales) exceeds the cost (increased losses due to uncollectibles) then a higher-risk credit policy which increases the amount of uncollectible accounts would be a more profitable policy. Q6-12. The number of defaults tends to rise and fall with the economy. For example, in a recession, customers are more likely to default and companies take longer, on average, to pay their bills than during a healthy economy. This would result in higher estimated uncollectibles if the estimates are based on an aging of accounts receivable. For many companies, sales revenue also tends to decline during a recession. If estimated uncollectibles are estimated as a percentage of sales, then the estimate would tend to fall in a recession. This is contrary to the increase in the number of defaults that occurs during a recession. Therefore, the percentage of sales approach is not as sensitive to changing economic conditions as is accounts receivable aging.

Cambridge Business Publishers, 2014 6-4 Financial Accounting, 4th Edition

MINI EXERCISES
M6-13. (15 minutes) Note: The completed contract method is not required but is presented for the purpose of comparison. Percentage-of-Completion Method Completed Contract Revenue recognized Percent (percentage of of total Income expected (revenue costs incurred costs total contract costs Revenue (rounded) amount) incurred) recognized Income 21%a 53%b 26%c $ 525,000 1,325,000 650,000 $2,500,000 $125,000 325,000 150,000 $600,000 0 0 0 0

Year 2013 2014 2015 Total

a b c

Costs incurred $ 400,000 1,000,000 500,000 $1,900,000

$2,500,000 $600,000 $2,500,000 $600,000

$400,000 / $1,900,000 $1,000,000/ $1,900,000 $500,000 / $1,900,000

M6-14. (20 minutes) Company GAP Merck Revenue recognition When merchandise is given to the customer and returns can be estimated (or the right of return period has expired). When merchandise is given to the customer and returns can be estimated (or the right of return period has expired). The company will also establish a reserve and recognize expense relating to uncollectible accounts receivable at the time the sale is recorded. When merchandise is given to the customer and the right of return period, if any, has expired. The company will also establish a reserve and recognize expense for uncollectible accounts receivable and anticipated warranty costs at the time the sale is recorded. Interest is earned by the passage of time. Each period, Bank of America accrues income on each of its loans and establishes a receivable on its balance sheet. Revenue is recognized under long-term contracts under the percentage-of-completion method.
Cambridge Business Publishers, 2014 Solutions Manual, Chapter 6 6-5

Deere

Bank of America

Johnson Controls

M6-15. (15 minutes) The Unlimited can only recognize revenues once they have been earned and the amount of returns can be estimated with sufficient accuracy. Assuming that happens at the time of sale, it must estimate the proportion of product that is likely to be returned and deduct that amount from gross sales for the period. In this case, it would report $4.9 million in net revenue (98% of $5 million) for the period. If The Unlimited does not have sufficient experience to estimate returns, then it should wait to recognize revenue until the right of return period has elapsed.

M6-16. (20 minutes) a. Percentage-of-completion method: Year Percent completed Revenue Construction costs Gross profit 2013 30% $12,000,000 9,000,000 $3,000,000 2014 50% $20,000,000 15,000,000 $5,000,000 2015 20% $8,000,000 6,000,000 $2,000,000 Total $40,000,000 30,000,000 $10,000,000

b. Completed contract method: Year Revenue Construction costs Gross profit 2013 2014 2015 $40,000,000 30,000,000 $10,000,000 Total $40,000,000 30,000,000 $10,000,000

M6-17. (20 minutes) a. A.J. Smith should recognize the warranty revenue as it is earned. Since the warranties provide coverage for three years beginning in 2014, one-third of the revenue should be recognized in 2014, one-third in 2015, and the remaining third in 2016. b. Year Revenue Warranty expenses Gross profit 2014 $566,666 166,666 $400,000 2015 $566,667 166,667 $400,000 2016 $566,667 166,667 $400,000 Total $1,700,000 500,000 $1,200,000
continued next page

Cambridge Business Publishers, 2014 6-6 Financial Accounting, 4th Edition

M6-17. concluded c. Total revenue from sales of the camera packages is $79,800 ($399 x 200). The revenue is allocated among the three elements of the sale (camera, printer and warranty) as follows: Element Camera Printer Warranty Total Retail Price $300 125 75 $500 Proportion of Total 60% ($300/$500) 25% ($125/$500) 15% ($75/$500) 100%

Using these proportions, the revenue is allocated among the three elements and recognized for each element as it is earned. In this case, the portion of the revenue allocated to the camera and printer are recognized immediately, while the revenue allocated to the warranty is deferred and recognized over the three-year warranty coverage period. Year 2014 2015 2016 2017 Total Revenue $67,830 3,990 3,990 3,990 $79,800

($79,800 x .6 + $79,800 x .25) ($79,800 x .15 / 3)

M6-18. (15 minutes) a. To bring the allowance to the desired balance of $2,100, the company will need to increase the allowance account by $1,600, resulting in bad debt expense of that same amount. b. The net amount of Accounts Receivable is calculated as follows: $98,000 $2,100 = $95,900. c.
- Allowance for Doubtful Accounts (XA) + 500 Balance 1,600 (a) 2,100 Balance (a) Balance + Bad Debt Expense (E) 1,600 1,600

Cambridge Business Publishers, 2014 Solutions Manual, Chapter 6 6-7

M6-19. (15 minutes) a. Credit losses are incurred in the process of generating sales revenue. Specific losses may not be known until many months after the sale. A company sets up an allowance for uncollectible accounts to place the expense of uncollectible accounts in the same accounting period as the sale and to report accounts receivable at its estimated realizable value at the end of the accounting period. b. The balance sheet presentation shows the gross amount of accounts receivable, the allowance amount, and the difference between the two, the estimated net realizable value. The balance sheet, thus, reports the net amount that we expect to collect. That is the amount that is the most relevant to financial statement users. c. The matching concept requires that expenses (credit losses) related to a given revenue be matched with, and deducted from, the revenue in the determination of net income. This dictates the use of the allowance method. Recognition of expense only upon the write-off of the account would delay the reporting of our knowledge that losses are likely and, thereby, reduce the informativeness of the income statement. Accountants believe that providing more timely information justifies the use of estimates that may not be as precise as we would like.

M6-20. (20 minutes) a. ($ millions) Allowance for uncollectible accounts ............................ 2011 143 2010 $6,539 246 $6,785 3.6% ($246/$6,785) Accounts receivable (net) .............................................$6,361 Gross accounts receivable ...........................................$6,504 Percentage of uncollectible accounts to gross 2.2% accounts receivable ................................................... ($143/$6,504)

b. The decrease in the allowance for uncollectible accounts as a percentage of gross accounts receivable may indicate that the quality of the accounts receivable has improved, perhaps because the economy has improved, the company is selling to a more creditworthy class of customers, or the companys management of accounts receivable is more effective. It may also indicate, however, that the receivables were over-reserved (e.g., allowance account was too high in 2010). This would result in higher reported profits in 2011 because past profits were too low. c. $54,365/[($6,361+$6,539)/2] = 8.43 times 365/8.43 = 43.3 days

Cambridge Business Publishers, 2014 6-8 Financial Accounting, 4th Edition

M6-21. (10 minutes) Bad debt expense of $2,400 ($120,000 0.02) would cause the allowance for uncollectibles to increase by the same amount. If the allowance increased by only $2,100 for the period, Sloan Company must have written off accounts totaling $300. Under accounts receivable, sales revenue increased the account by $120,000, and the write offs would decrease it by $300. If there was a net increase of $15,000 for the period, Sloan Company must have collected $104,700 in cash. ($104,700 = $120,000 $300 - $15,000.)

M6-22. (20 minutes) a. Accounts Receivable Turnover rates for 2011 Procter & Gamble $83,680 / [($6,068+$6,275)/2] = 13.6 times 365 / 13.6 = 26.8 days Colgate-Palmolive $16,734 / [($1,675+$1,610)/2] = 10.2 times 365 / 10.2 = 35.8 days b. P&G turns its accounts receivable faster than Colgate-Palmolive. Receivable turns typically evolve to an equilibrium level for each industry that arises from the general business models used by industry competitors. Differences can arise due to variations in the product mix of competitors, the types of customers they sell to, their willingness to offer discounts for early payment, and their relative strength vis--vis the companies or individuals owing them money. Also, the size of the firm may affect the ability of a company to exert bargaining power over major suppliers or customers. For instance, both of these companies sell a significant amount of their product to Wal-Mart. P&G is a sizable company, and may have greater bargaining power over Wal-Mart than does the smaller ColgatePalmolive. One other possibility is that the difference is due to the companies differing fiscal year-ends. If the receivable balance is not constant during the year due to some seasonality, then the receivable turnover ratio will depend on the choice of fiscal year.

Cambridge Business Publishers, 2014 Solutions Manual, Chapter 6 6-9

M6-23. (20 minutes) a. i. Accounts receivable (+A) Sales revenue (+R, +SE) .. Bad debts expense (+E, -SE) Allowance for uncollectible accounts (+XA, -A). Allowance for uncollectible accounts (-XA, +A) . Accounts receivable (-A) .. Accounts receivable (+A) Allowance for uncollectible accounts (+XA, -A) Cash (+A) .. Accounts receivable (-A) 3,200,000 3,200,000 42,000 42,000 39,000 39,000 12,000 12,000 12,000 12,000

ii.

iii.

iv.

The recovered receivable is reinstated, so that its payment may be properly recorded. b. Besides the $12,000 in recovery, the collections from customers can be summarized in the following entry: v. Cash (+A) Accounts receivable (-A) 2,926,000 2,926,000

(This amount includes payment of the recovered receivable for $12,000. The allowance increases by $15,000 over the period, so the fact that net receivables increased by $220,000 means that gross receivables must have increased by $235,000. That fact allows us to back out the cash received.) c.
(iv) (v) Cash (A) 12,000 2,926,000 2,938,000 + Accounts Receivable (A) 3,200,000 12,000 39,000 12,000 2,926,000 235,000 Allowance for Uncollectibles (XA) 42,000 39,000 12,000 15,000 + Sales Revenue (R) + 3,200,000 (i)

+ (ii) (iii) (iv) (v) + (ii) (iv)

(i) (iv)

Bad Debts Expense (E) 42,000

(iii)

continued next page

Cambridge Business Publishers, 2014 6-10 Financial Accounting, 4th Edition

M6-23. concluded d.
Balance Sheet
Transaction i. Sales on account. ii. Bad debt expense. Cash Asset Noncash + Assets +3,200,000 Accounts Receivable Contra Assets Liabil= ities = + Contrib. Capital Earned + Capital +3,200,000 Retained Earnings -42,000 Retained Earnings

Income Statement
Revenues +3,200,000 Sales Revenue - Expenses = Net Income = +3,200,000

+42,000 Allowance for Uncollectible Accounts -39,000 Allowance for Uncollectible Accounts +12,000 Allowance for Uncollectible Accounts

+42,000 Bad Debt Expense

-42,000

iii. Write-off of uncollectible accounts.

-39,000 Accounts Receivable

iv. Reinstate account previously written off.

+12,000 Accounts Receivable

Collect reinstated account.

+12,000 Cash

-12,000 Accounts Receivable -2,926,000 Accounts Receivable

v. Collect cash on sales. +2,926,000 Cash

M6-24. (20 minutes) a. Fiscal Year 2012 2013 2014 20150 b. Fiscal Year Revenue 2012 48,000 2013 55,000 2014 62,000 2015 62,000 Unearned Revenue Liability (end of year) 20,000 24,000 26,000 25,000 Customer Purchases = Revenue + Change in Unearned Revenue Liability 55,000 + 4,000 = 59,000 62,000 + 2,000 = 64,000 62,000 - 1,000 = 61,000 Growth in Customer Purchases Revenue 48,000 55,000 62,000 62,000 Revenue Growth 14.6% 12.7% 0.0%

8.5% -4.7%

continued next page

Cambridge Business Publishers, 2014 Solutions Manual, Chapter 6 6-11

M6-24. concluded c. In both fiscal year 2014 and 2015, the growth in customer purchases is lower than the growth in reported revenues. The practice of deferring revenue recognition implies that reported revenues in a given period are the result of customer purchases over many periods, resulting in a smoothing of revenues. In the case of Finn Publishing, revenues in any given year are the result of newsstand and bookstore purchases during that year, plus part of the subscriptions from that year, plus part of the subscriptions from the previous year. That means that growth in annual revenues is a composite of growth in customer purchases over an even longer period of time. For 2014 and 2015, Finns growth in revenues exceeds the growth in customer purchases because the revenues are still reflecting growth from prior periods. Purchases are a leading indicator of revenues, and thus, calculating customer purchase behavior can be useful in forecasting future revenue and identifying changes in customers attitudes about a companys current offerings.

M6-25. (15 minutes) This question is based on an actual situation, in which the accounting rules were influencing the product decisions. The rules for revenue deferral when there are multiple deliverables deterred the company from providing enhancements and upgrades that were available. If Commtechs customers (the wireless companies) had been willing to pay for the upgrades to its customers phones, that would have been allowed. (Its not clear what the wireless companies incentives would be, because they may want to encourage users to purchase new phones with a new service contract rather than improving their existing phones.) The question can generate a discussion about whether accounting should drive decisions. Whether it should or not, it does, so the question should evolve into what top management should do about this type of situation. Does the situation described in the problem require some managerial action, or not. Is the company foregoing sales because of its accounting? Within Commtech, the finance staff was skeptical of marketings predictions that the upgrades and enhancements would increase th e sales of existing phone models. If the upgrades and enhancements are delivered, Commtech will have to change its accounting for revenue, with a resulting decrease in near-term profitability. How might the company communicate that change in a way that the investing public will understand as a net benefit to the company?

Cambridge Business Publishers, 2014 6-12 Financial Accounting, 4th Edition

EXERCISES
E6-26. (20 minutes) Company The Limited Boeing Corporation SUPERVALU MTV Real estate developer Wells Fargo Revenue Recognition When merchandise is given to the customer and returns can be estimated (or the right of return period has expired). Revenue is recognized under long-term contracts under the percentage-of-completion method. When merchandise is given to the customer and cash is received. When the content is aired by the TV stations. When title to the houses is transferred to the buyers. Interest is earned by the passage of time. Each period, Wells Fargo accrues income on each of its loans and establishes an account receivable on its balance sheet. When title to the motorcycles is transferred to the buyer. Harley will also set up a reserve for anticipated warranty costs and recognize the expected warranty cost expense when it recognizes the sales revenue. When the magazines are sent to subscribers.

Harley-Davidson

Time-Warner

E6-27. (20 minutes) Company Real Money Revenue Recognition Recognize revenue ratably over the period of time that customers can access its Web site, not when the cash is received. The recognition of revenue is dependent upon Real Money providing updates. The fee to purchase the right to use the software can be recorded as revenue when the software is installed, unless that fee includes future deliverables like upgrades and support. (If such post-sale services are included in the fee, some portion must be deferred and recognized over the appropriate period.) Service revenue can only be recognized ratably over the period of time covered by the service contract. Recognize revenue when the software is sent to customers. The company must estimate potential warranty claims and establish a reserve for them when revenue is recorded. Record revenue after the 10-day right of return period has elapsed.

Oracle

Intuit

Computer game developer

Cambridge Business Publishers, 2014 Solutions Manual, Chapter 6 6-13

E6-28. (20 minutes)

($ millions)

a. Percentage-of-Completion Method
Percent of total expected costs 25% 75% Revenue recognized (percentage of costs incurred total contract amount) $125 375 $500 Income (revenue costs incurred) $ 25 75 $100

b. Completed Contract
Revenue recognized $ 0

Year 2013 2014

Costs incurred $100 300 $400

Income $ 0

500 $500

100 $100

c. The percentage-of-completion method normally provides a reasonable estimate of the revenues, expenses, and income earned for each period based on the amount of work completed. A key assumption underlying the use of this method is that the contract price is fixed and it is possible to obtain reliable estimates of expected costs and costs to date. When such estimates are not available, the completed contract method should be used. The percentage-of-completion method is acceptable under GAAP for a variety of contracts spanning more than one accounting period, such as in the consulting and transportation industries.

E6-29. (20 minutes) a.

($ millions) Percentage-of-Completion Method Percent of Revenue recognized total Income (percentage of costs expected (revenue costs costs incurred total (rounded) contract amount) incurred) 18% $ 21.6 $ 6.6 ($15/$85) 47% ($40/$85) 35% ($30/$85) 56.4 42.0 $120.0 16.4 12.0 $35.0 Completed Contract

Year 2014 2015 2016

Costs incurred $15 40 30 $85

Revenue recognized $ 0 0 120 $120

Income $ 0 0 35 $ 35

b. The percentage-of-completion method provides a good estimate of the revenue and income earned in each period. This method is also acceptable under GAAP for contracts spanning more than one accounting period. Recognition of revenue and income is not affected by the cash received, but the percentage-of-completion method more closely approximates cash flows than the completed contract method.

Cambridge Business Publishers, 2014 6-14 Financial Accounting, 4th Edition

E6-30. (15 minutes) a. Multiple element arrangements are sales transactions in which two or more deliverables are bundled together and sold for one price. The revenue should be recognized on each deliverable element when it is earned. This involves first assigning a portion of the sales revenue to each element and then recognizing each portion of the revenue only when that element has been delivered to the customer. b. The total revenue for the bundle is $190. However the Kindle, if sold alone sells for $170 and the wireless and upgrades sell for $30, which brings the total value to $200. Thus, the Kindle device represents 85% of the total value of the bundle ($170/$200). Amazon should recognize $161.50 at the time of the sale (85% of the $190 sale price) and defer the remaining $28.50. c.
Transaction
To record bundled sale transaction

Cash Asset
+190

Balance Sheet Noncash Contrib. + = Liabil-ities + + Assets Capital

+28.50 Unearned revenue

Income Statement Earned Capital

+161.50 Retained Earnings

Revenues - Expenses =
+161.50 Sales revenue

Net Income
+161.50

Cash (+A) Sales revenue (+R, +SE) Unearned revenue (+L)

190.00 161.50 28.50

E6-31. (15 minutes) a. 2010: 4,674 + 497 x (1-.35) = 4,997 2011: 6,029 + 514 x (1-.35) = 6,363 b. 2010: 4,997 / 97,761 = .0511 or 5.11% 2011: 6,363 / 106,540 = .0597 or 5.97% c. 6,363 / [(143,844 - 23,571 + 131,487 - 21,191) / 2] = .0552 or 5.52%

Cambridge Business Publishers, 2014 Solutions Manual, Chapter 6 6-15

E6-32. (15 minutes) In none of these cases should Simpyl Technologies recognize revenue. Each of the four settings touches on one of the four conditions for revenue recognition listed by the SEC. In part a, persuasive evidence of an exchange agreement does not yet exist, because the companys policies have defined a contract with authorized signatures to constitute persuasive evidence. In part b, delivery has not occurred. The product has been shipped, but not to the customer and not with the specified customizations that are required by the customer. In part c, the price is not yet fixed or determinable, because the negotiations over volume discounts have not been concluded. Finally, the distributor in part d does not have the means to pay for the items delivered, so collectibility cannot be reasonably assured (until the distributor sells the product to an end customer). The delivery should be viewed as a consignment arrangement, in which Simpyl recognizes revenue when the distributor sells the items to a third party. This problem is based on the restatements of Symbol Technologies, Inc.s 10 -K filing for fiscal year 2002, in which they detail the errors and irregularities in financial statements dating back to 1998. Symbol had made accounting entries that violated each of the SECs four criteria for revenue recognition. An article by Steve Lohr describing the incoming CEOs experiences at Symbol Technologies can be found in the New York Times, June 21, 2004. The title of the article is Day 2: I Learn the Books are Cooked. (Motorola, Inc., acquired Symbol Technologies in January 2007 for a price of $3.9 billion.)

E6-33. (20 minutes) a. Prior to the aging of accounts, the balance in the Allowance for Uncollectible Accounts would be a credit of $520 (the opening balance of $4,350 less the amounts written off of $3,830). 2013 bad debt expense computation $250,000 0.5% $ 90,000 1% 20,000 2% 11,000 5% 6,000 10% 4,000 25%

= = = = = =

$1,250 900 400 550 600 1,000 4,700 520 $4,180

continued next page

Less: Unused balance before adjustment Bad debt expense for 2013

Cambridge Business Publishers, 2014 6-16 Financial Accounting, 4th Edition

E6-33. concluded b. Accounts receivable, net = $381,000 - $4,700 = $376,300 Reported in the balance sheet as follows: Accounts receivable, net of $4,700 in allowances ................................... c.
+ (a) Bad Debts Expense (E) 4,180 - Allowance for Uncollectible Accounts (XA) + 4,350 Balance Write-offs 3,830 4,180 (a) 4,700 Balance

$376,300

E6-34. (25 minutes) a. Allowance for doubtful accounts (-XA) Accounts receivable (-A) Provision for doubtful accounts (+E,-SE) Allowance for doubtful accounts (+XA) 70 70 9 9

The provision for doubtful accounts (bad debt expense) has a credit entry that has the effect of decreasing Ethan Allens reported income by $9 thousand for the year. The write-off of $70 thousand of uncollectible accounts has no effect on income. b. Accounts receivable, net Allowance for doubtful accounts Gross receivables (net plus allowance) Allowance as a % of gross receivables 2012 14,919 1,250 $16,169 7.7% 2011 15,036 1,171 $16,207 7.2%

c. $729,373 / [($14,919 + $15,036) / 2] = 48.7 times. The very fast ART is probably due to the custom furniture aspect of Ethan Allens business. Many of their products are not produced until a customer places an order and payment occurs upon delivery or very soon thereafter. d. $729,373 + ($65,465 - $62,649) ($14,919 - $15,036) $9 = $723,297.

Cambridge Business Publishers, 2014 Solutions Manual, Chapter 6 6-17

E6-35. (15 minutes) Accounts receivable Less Allowance for uncollectible accounts Computations Accounts
Receivable Beginning balance Sales Collections Write-offs ($3,600 + $2,400 +$900) Provision for uncollectibles ($1,173,000 0.8%) $ 122,000 1,173,000 (1,150,000) (6,900) _________ $ 138,100 Allowance for Uncollectible Accounts $ 7,900

$138,100 10,384

$127,716

(6,900) 9,384 $ 10,384

E6-36. (20 minutes) a. Aging schedule at December 31, 2013 Current $304,000 1% = 060 days past due 44,000 5% = 61180 days past due 18,000 15% = Over 180 days past due 9,000 40% = Amount required Balance of allowance Provision b. Current Assets Accounts receivable Less: Allowance for uncollectible accounts c.
+ (a) Bad Debts Expense (E) 7,340 - Allowance for Uncollectible Accounts (XA) + 4,200 Balance 7,340 (a) 11,540 Balance

$ 3,040 2,200 2,700 3,600 11,540 4,200 $ 7,340 = 2010 bad debt expense

$375,000 11,540

$363,460

Cambridge Business Publishers, 2014 6-18 Financial Accounting, 4th Edition

E6-37. (30 minutes) a. Year 2012 2013 2014 Total Sales $ 751,000 876,000 972,000 $2,599,000 Collections $ 733,000 864,000 938,000 $2,535,000 Accounts Written Off $ 5,300 5,800 6,500 $17,600

Accounts Receivable at the end of 2014 is $46,400, computed as: ($2,599,000 - $2,535,000 - $17,600). Bad Debts Expense is: 2012 2013 2014 2012-2014 computed as 1% $751,000 computed as 1% $876,000 computed as 1% $972,000 computed as 1% $2,599,000

$ 7,510 8,760 9,720 $25,990

Allowance for Uncollectible Accounts is $8,390 computed as: $25,990 total bad debts expense less $17,600 in total write-offs. b.
Beg Bal Sales 2012 Bal Sales 2013 Bal Sales 2014 Bal Accounts Receivable (A) 0 751,000 5,300 Write offs 733,000 Collections 12,700 876,000 5,800 Write offs 864,000 Collections 18,900 972,000 6,500 Write offs 938,000 Collections 46,400 Allowance for Uncollectibles (XA) 0 Beg Bal Write offs 5,300 7,510 Bad debts exp. 2,210 8,760 5,170 9,720 8,390 2012 Bal Bad debts exp. 2013 Bal Bad debts exp. 2014 Bal

Write offs

5,800

Write offs

6,500

There isnt any indication that the 1% rate is incorrect. If the rate is too high, we would expect the allowance to grow at a faster rate than receivables. If the rate is too low, the opposite would occur. In this case, the allowance percentage of receivables is 17%, 27% and 18% at the end of 2012, 2013 and 2014, respectively. So, there is no clear direction that would indicate an inappropriate estimate.

Cambridge Business Publishers, 2014 Solutions Manual, Chapter 6 6-19

E6-38. (20 minutes) a.

Earnings from Operations Personal Systems Group Services Imaging and Printing Group Enterprise Servers, Storage and Network HP Software HP Financial Services $ 2,350 5,149 3,973 3,026 698 348 End. Assets $ 15,781 40,614 11,939 17,539 21,028 13,543 Beg. Assets $ 16,548 41,989 12,514 18,262 9,979 12,123 Avg. Assets $16,164.5 41,301.5 12,226.5 17,900.5 15,503.5 12,833.0 Return on Capital Employed 14.5% 12.5% 32.5% 16.9% 4.5% 2.7%

b. The most profitable group seems to be the Imaging and Printing Group, which represents HPs traditional strength. However, it is not growing very quickly (based on sales percentage increases). The Enterprise Servers, Storage and Networking Group and the Personal Systems Group (commercial and personal PCs, workstations, etc.) also have good return on capital employed. The HP Software Group has a low return on capital employed but that group appears to have had a major investment in assets during the year, which can distort this measure, depending on the timing of the capital expenditures. c. Restructuring charges are reported above the line, as part of income from continuing operations before income taxes. They are listed as a charge against operating income in the income statement, and thus would reduce our calculation of return on capital employed. Restructuring charges are nonrecurring, however, and should be considered separately when evaluating profitability of a business segment.

Cambridge Business Publishers, 2014 6-20 Financial Accounting, 4th Edition

E6-39. (20 minutes) a. Just like for-profit organizations, not-for-profit organizations cannot recognize revenue until it has been earned. In the case of The Lyric Opera, it cannot recognize the ticket revenue until the performances occur. (The Lyric does not issue quarterly reports, so we cannot observe how much of the revenue has been earned by six months through its fiscal year.) b. This entry is simplified by the fact the fiscal year-end is after the end of the current season and by assuming that all of The Lyrics deferred revenue relates to the following season (and none to any years after the following season). To record revenue for the fiscal year 2012 season: Deferred ticket and other revenue (-L) Cash or Accounts receivable (+A) Ticket sales (+R, +NA) 12,711 12,319 25,030

(As a not-for-profit, The Lyric Opera does not have shareholders equity, but rather net assets. Therefore, the recognition of revenue increases net assets (NA) on the balance sheet.) To record advance purchases for the fiscal year 2012 season: Cash or Accounts receivable (+A) 12,638 Deferred ticket and other revenue (+L)

12,638

c. Its likely that the downturn in the economy caused some subscribers not to renew (or to wait until after April 30 to renew) in 2009 and it would appear that three years later, the advanced ticket sales have not recovered from the 2009 decline. Its possible that the decline in advance purchases is a statement about the opera selections. However, the loyal subscriber base (and the desire to keep ones assigned seating) makes the economy a more likely cause. d. The Lyric Opera usually operates at close to seating capacity. And, in a typical year, approximately more than one-half of its seats are sold by the April 30th preceding the season. So, the quantity of unsold seats will affect The Lyrics marketing efforts for subscribers who have not yet renewed, outreach to new potential subscribers and promotions for individual tickets which go on sale shortly before the season. Those efforts can be scaled up or down depending on the experience with advance sales.

Cambridge Business Publishers, 2014 Solutions Manual, Chapter 6 6-21

E6-40. (20 minutes) a. Membership fees are initially recorded as a liability (deferred membership fee revenue) and recognized over a period of one year. Member rewards are similarly deferred, but the offsetting debit is recorded as a reduction to sales revenue. b. Cash (+A) Deferred membership fees (+L) Deferred membership fees (-L) Membership fee revenue (+R, +SE) c. Sales revenue (-R, -SE) Accrued member rewards (+L) Accrued member rewards (-L) Merchandise inventory (-A)* 900 900 841 841 2.203 2,203 2,075 2,075

*The Costco note does not say how the membership rewards are redeemed. The entry above assumes that the rewards are redeemed for merchandise, as is the case in many such situations. If, instead, the rewards are redeemed for cash, the credit entry would be to cash and not merchandise inventory.

Cambridge Business Publishers, 2014 6-22 Financial Accounting, 4th Edition

PROBLEMS
P6-41.A (20 minutes) a. The following items might be considered to be operating: 1. Net Sales, cost of sales, R&D expenses, and SG&A expenses are typically designated as operating. 2. Amortization of intangible assets and restructuring charges would usually be considered to be operating under the assumptions that the acquisition that gave rise to the intangible assets is included as part of operations, and that the restructuring did not involve discontinuation of distinct parts of the business. 3. The asbestos-related credit, restructuring charges and goodwill impairment losses would be considered to be operating since they are related to Dow Chemicals operating activities. (These items are both operating and nonrecurring see b.) 4. Purchased in-process research and development charges and Acquisitionrelated expenses are caused by the companys investing activities, and would be considered nonoperating. 5. Equity in earnings of nonconsolidated affiliates would be considered operating under the assumption that the affiliates are related to Dows core operations, which is typically the case. 6. Sundry income would generally be considered nonoperating in the absence of a footnote clearly indicating its connection to the operating activities of the company. 7. Interest income is considered nonoperating 8. Interest expense and amortization of debt discount is nonoperating.
continued next page

Cambridge Business Publishers, 2014 Solutions Manual, Chapter 6 6-23

P6-41.A concluded b. The following items might be identified as nonrecurring items: 1. Purchased in-process research and development and Acquisition-related expenses these are one-time (e.g., nonrecurring) costs incurred in connection with the acquisition of another company and can properly be expensed under GAAP. 2. Asbestos-related credit this is a reversal of a previous accrual for litigation in connection with asbestos-related lawsuits. GAAP requires such an accrual if the loss is probable and can be reasonably estimated. Since it is a one-time occurrence, it can be considered to be a transitory item. 3. Goodwill impairment losses this loss results from changes in expectations of the performance of past acquisitions. It would be considered operating, but transitory. 4. Restructuring charges these relate to the companys actions due to the economic decline in 2008 and the expectations that future performance will not meet prior expectations. Restructuring costs are considered special items, meaning that individually they are transitory, but as a category, they happen frequently. 5. The charge for discontinued operations would be considered nonrecurring. We would need to examine prior years income statements to discern if the other categories in Dows income statement are to be considered transitory. c. 2010: $2,321 + ($1,473 + $143 - $125 - $37) x (1-.35) = $3,266.1 $3,266.1 / $53,674 = 6.1% 2009: $676 + ($1,571 + $7 + $166 - $891 - $39) x (1-.35) = $1,205.1 $1,205.1 / $44,875 = 2.7%

Cambridge Business Publishers, 2014 6-24 Financial Accounting, 4th Edition

P6-42. (20 minutes) a. 1. Percentage-of-completion based on number of employees trained

Year Number of employees trained Revenues (# trained x $1,200) Expenses (# trained x $437.50)* Gross Profit 2013 125 $150,000.00 54,687.50 $95,312.50 2014 200 $240,000.00 87,500.00 $152,500.00 2015 75 $90,000.00 32,812.50 $57,187.50 Total 400 $480,000.00 175,000.00 $305,000.00

* $437.50 = $175,000 / 400 2. Percentage-of-completion based on costs incurred

Year Costs incurred Percentage completed Revenues (% x $480,000) Expenses Gross Profit 2013 $60,000 34.29% $164,571.43 60,000.00 $104,571.43 2014 $75,000 42.86% $205,714.29 75,000.00 $130,714.29 2015 $40,000 22.86% $109,714.29 40,000.00 $69,714.29 Total $175,000 100.00% $480,000.00 175,000.00 $305,000.00

3. Completed contract method

Year Revenues Expenses Gross Profit 2013 $0 0 $0 2014 $0 0 $0 2015 $480,000 175,000 $305,000 Total $480,000 175,000 $305,000

b. Assuming that (1) Philbrick has a noncancelable contract that specifies the price at $1,200 per employee, (2) the number of employees and the costs of training can be estimated with a reasonable degree of accuracy, and (3) Elliot Company is a reasonable credit risk, the best method would be to recognize revenues using the percentage-of-completion method based on the number of employees trained. The completed contract method should only be used if either of the first two conditions is not met.

Cambridge Business Publishers, 2014 Solutions Manual, Chapter 6 6-25

P6-43. (15 minutes) a. Management would have an incentive to shift $1 million of income from the current period into next. This might be accomplished by delaying revenue recognition or accelerating expenses. This would increase their bonus by $100,000 next year without decreasing the current bonus. b. Management would have an incentive to shift $3 million of income from next year into income reported this year. This would increase the current year bonus by $300,000 without reducing next years bonus. c. Management would have an incentive to shift income from the current year into next year. Even though this would reduce earnings this year, earnings are already so low that management does not expect to receive a bonus. Shifting earnings into a future period increases the bonus in that period. d. These incentives for earnings management would be mitigated if the kinks in the bonus formula were removed. Alternatively, some companies pay bonuses based on a three-year moving average of earnings to minimize the impact of earnings management. This problem can provide an opportunity to discuss the slippery slope of earnings management. For example, managements optimism about next year in part b may not turn out to be warranted. Suppose next years natural earnings turns out to be $20 million instead of $24 million. Managements action in the first year will have reduced next years $20 million to $17 million, and ea rnings management would again be required to meet the target. And, if meeting the target in one year causes the next years target to increase, things can get out of control very quickly.

Cambridge Business Publishers, 2014 6-26 Financial Accounting, 4th Edition

P6-44. (40 minutes)

(all in $ millions)

a. Net receivables as of January 28, 2012 were $2,033. Net receivables as of January 29, 2011 were $2,026. b. Bad debts expense (+E, -SE) Allowance for credit losses (+XA) Allowance for credit losses (-XA) Accounts receivable (-A) Cash (+A) Allowance for credit losses (+XA) 101 101 153 153 22 22

c. Estimated credit losses to gross credit card receivables are: 5.5% ($115/$2,074) in 2011 6.9% ($145/$2,103) in 2010 The decrease in the allowance for credit losses as a percent of credit card receivables is reflected in the aging of Nordstroms receivables. The percentage of receivables that are 30 or more days past due has decreased from 3.0% on January 29, 2011 to 2.6% at January 28, 2012. This could be caused by (1) a general improvement in economic conditions (fewer customers are late or defaulting on their obligations), (2) tighter credit policies (credit is denied to risky customers) and/or (3) more rigorous collection practices. d. The receivables turnover rate is $10,497 / [($2,033 + $2,026)/2] = 5.17 Days sales in accounts receivable is $365/5.17 = 70.6 days

Cambridge Business Publishers, 2014 Solutions Manual, Chapter 6 6-27

P6-45. (25 minutes) For the instructor: This problem covers the accounting for product returns, which is not covered in the chapter. The description of The Gaps practices should allow students to answer parts a and b. Part c is a bit of a stretch, because it requires that the allowance for returns, which is in gross profit terms, be grossed-up to revenue terms. a. Beginning balance + $634 million - $635 million = $21 million, so Beginning balance = $22 million. b. Sale and expected returns: (1) Record revenue. Cash (+A) Revenue (+R,+SE) (2) Record COGS. Cost of goods sold (+E,-SE) Inventory (-A) (3) Recognize Revenue contra, returns (+XR, -SE) expected returns. COGS contra, returns (+XE, +SE) Sales returns allowance (+L)

5,000 5,000 3,000 3,000 500 300 200

The sales returns allowance is equal to Gross sales ($5,000) times the probability of return (10%) times the gross profit margin (40%), or $200. For these ten units, the cost of goods was $300. Returns: (4) Process return transactions.

Inventory (+A) Sales returns allowance (-L) Cash (-A)

300 200 500

At the conclusion of this transaction, the customers have their cash, the inventory costs have been adjusted to include the returned items, and the sales returns allowance liability has a balance of zero because the actual returns coincided with the expected returns.
continued next page

Cambridge Business Publishers, 2014 6-28 Financial Accounting, 4th Edition

P6-45. concluded c. The Gaps reported gross profit is 36.2% of its net sales ($5,274million/$14,549 million). So, if The Gap expects returns of items with gross profit of $634 million, those items must have had sales prices of $1,751 million ($634 million/0.362) and cost of goods sold of $1,117 million ($1,751 million - $634 million). The entry that would have reflected The Gaps accounting for these expected returns is the following: Recognize expected returns. Revenue contra, returns (+XR, -SE) COGS contra, returns (+XE, +SE) Sales returns allowance (+L) 1,751 1,117 634

The Gaps gross sales revenue would have been $16,300 million ($14,549 million + $1,751 million), and its expected returns as a percentage of sales would be 10.7% ($1,751 million/$16,300 million). The size of the allowance for 2011 ($634 million) relative to the end-of-year return liability ($21 million) means that the vast majority of these product returns occurred during the 2011 fiscal year, so it is more a reflection of actual experience than of managements estimates of future events. d. Under these circumstances, The Gap doesnt have to worry about accounting for expected returns, because it has not satisfied the requirements for revenue recognition. If the amount to be received (or in this case, the amount to be kept) is not yet fixed or determinable, the revenue should not be recognized until it is.

P6-46. (25 minutes) a. Fiscal year ending March 31 2005 2006 2007 2008 2009 2010 2011 2012 Net revenue 3,129 2,951 3,091 3,665 4,212 3,654 3,589 4,143 Growth rate -5.7% 4.7% 18.6% 14.9% -13.2% -1.8% 15.4%
continued next page

Cambridge Business Publishers, 2014 Solutions Manual, Chapter 6 6-29

P6-46. concluded b. Fiscal year ending March 31 2005 2006 2007 2008 2009 2010 2011 2012 Net revenue 3,129 2,951 3,091 3,665 4,212 3,654 3,589 4,143 Deferred net revenue (liability) 0 9 32 387 261 766 1,005 1,048 Purchases = Net revenue + Change in Deferred net revenue 3,129 2,960 3,114 4,020 4,086 4,159 3,828 4,186 Growth rate -5.4% 5.2% 29.1% 1.6% 1.8% -8.0% 9.4%

When companies defer revenue, there is a lag between customers purchases and the recognition of revenue on the income statement. When purchases grow significantly (as they did in 2008) revenues grow in subsequent years. When purchases fall off, we would expect revenues to fall off in subsequent years (see 2009 and 2010). 2012 appears to be an anomaly. Purchases declined in 2011 but revenue grew significantly in 2012. c. If customer purchases in 2012 are a leading indicator of revenue in 2013, we would predict a substantial revenue growth for 2013.

Cambridge Business Publishers, 2014 6-30 Financial Accounting, 4th Edition

CASES and PROJECTS

C6-47. (40 minutes) a. Cash (+A) Sales revenue (+R, +SE) Payable to merchant partners (+L) 120,000 60,000 60,000

b. Revenues were previously recorded at the full amount of the Groupon sale ($120,000 in a above) and the amount payable to the merchant partner was recorded as an expense. This was changed in 2011 to record the sale of the Groupon, net of the amount due to the merchant partner as revenue. The effect of this change was that revenues and expenses were reduced by the amount paid to the merchant partner. This did not alter the bottom line as net income does not change. The NOPM ratio would increase due to the decrease in revenue without a corresponding decrease in operating income. c. Sales revenue contra (-R, -SE) Allowance for returns (+L) Allowance for returns (-L) Payable to merchant partners (-L) Cash (-A) d. Cost of revenue (+E, -SE) Allowance for returns (+L) Allowance for returns (-L) Cash (-A) 6,000 6,000 6,000 6,000 6,000 6,000 6,000 6,000 12,000

e. Groupon could wait to recognize revenue until the 60-day period to pay the merchant partner has expired. By doing so, there would be no need to estimate refunds that would involve reducing the payable or recovering a refund from the merchant partner. Groupon would still need to estimate refunds for any cancelation that might occur after the end of the 60-day period when the merchant partner has been paid. This is when Groupons risk is greatest, since it cannot recover any part of the refund from the merchant. However, by waiting 60 days before recognizing the revenue (and estimating the refunds) Groupon would likely have a better idea about the amount of refunds that will likely occur.

Cambridge Business Publishers, 2014 Solutions Manual, Chapter 6 6-31

C6-48. (30 minutes) a. When Dell sells other companies software products, it is often as part of a multiple element sales agreement. For example, the customer may purchase hardware, software, and customer support for one price. This is an example of a bundled sale. Dell must allocate the sales price based on the relative fair market value of each element. Revenue is recognized for each specific element when it is clear that the element has been delivered and the revenue is earned. There are at least two possibilities for earnings management here. First, Dell could misallocate the sales price. By allocating more of the price to hardware and less to software, Dell may be able to manage when earnings are reported. Second, Dell may be aggressive in applying the earned and realizable criteria to each element, thereby prematurely recognizing revenue. From the information provided, it appears that Dell was recognizing revenue on software resales at the time of sale. However, most software is not truly sold. Instead, the customer purchases a license to use the software. As a result, Dell should have deferred part of the revenue and recognized it ratably over the license period. b. Extended warranties are typically sold separately from other products. Therefore, the revenue should be deferred and recognized ratably over the warranty contract period. Dell employees were apparently recording revenue at the time of sale, or were recognizing the revenue over a shorter time period than the contract period. As a result, revenues and income were overstated. c. It is common for managers to have performance targets based on revenues and earnings. This provides an incentive for these employees to take actions to accelerate revenue recognition when it appears that targets may not be met. On the other hand, in periods when revenues and earnings exceed the targets, managers may delay revenue recognition until a future period. In this way, they can store up revenues and earnings to meet future targets. The key to preventing this type of abuse is the periodic audit of divisional revenues and earnings. In addition, businesses spend a large amount of resources trying to design incentive compensation plans that do not encourage this type of abuse.

Cambridge Business Publishers, 2014 6-32 Financial Accounting, 4th Edition

C6-49. (45 minutes) a. 2011: i. Bad debt expense (+E, -SE) Allowance for doubtful accounts (+XA, -A) ii. Allowance for doubtful accounts (-XA, +A) Accounts receivable (-A)

13,989 13,989 1,206 1,206

2012: iii. Bad debt expense (+E, -SE) Allowance for doubtful accounts (+XA, -A) iv. Allowance for doubtful accounts (-XA, +A) Accounts receivable (-A)

2,111 2,111 14,903 14,903

- Allowance for Doubtful Accounts (XA) ($000) + Balance 6,859 2010 Balance Sales 13,989 (i) (ii) 1,206 Balance 19,642 2011 Balance 2,111 (iii) (iv) 14,903 6,850 2012 Balance

b. 2011: $19,642 / ($168,310 + $19,642 + $65,664) = 7.7% 2010: $6,850 / ($171,561 + $6,850 + $48,612) = 3.0% The extra provision for the Borders account significantly increased Wileys allowance account for 2011. c. If sales returns are material in amount and can be estimated with a reasonable degree of accuracy, they should be estimated just as bad debts are estimated. Sales revenue is debited for the estimated returns while an allowance for returns is credited. One important difference is that with sales returns (unlike bad debts) the customer returns the product to the company and it is often returned to inventory. Hence, the amount of allowance for returns is a net amount equal to the estimated gross profit on expected returns.
continued next page

Cambridge Business Publishers, 2014 Solutions Manual, Chapter 6 6-33

C6-49. concluded d. To record estimated returns: Sales revenue (est. sales returns) (-R, -SE) Allowance for returns A/R (+XA) Allowance for returns Inventory (+A) Cost of sales (-E, +SE) Allowance for returns royalties payable (+XL) Royalty expense (-E, +SE) To record actual returns: Allowance for returns A/R (-XA, +A) Accounts receivable (-A) Inventory (+A) Allowance for returns Inventory (-A) Royalties payable (-L) Allowance for returns Royalties payable (-XL) 130,000 130,000 20,000 20,000 13,963 13,963 112,948 112,948 17,761 17,761 12,286 12,286

The net amount reported in the allowance for returns consists of three separate amounts one offsetting accounts receivable (a contra asset) an amount added to inventory (an adjunct asset) and a third amount offsetting royalties payable (a contra liability): Allowance for returns A/R: $65,664 + $112,948 - $130,000 = $48,612 Allowance for returns Inventory: $9,485 + $17,761 - $20,000 = $7,246 Allowance for returns Royalties: $7,270 + $12,286 - $13,963 = $5,593 Note that $130,000 - $20,000 - $13,963 = $96,037, and $112,948 - $17,761 $12,286 = $82,901. When these three accounts are combined, we get the net amount reported in the allowance for returns each year. e. Accounts receivable turnover: $1,782,742 / [($171,561 + $168,310)/2] = 10.5 times. Average collection period: 365 / 10.5 = 34.8 days.

Cambridge Business Publishers, 2014 6-34 Financial Accounting, 4th Edition