Flashcards in FAR 29 - Revenue Recognition 1 - General Recog. & Other Situations Deck (21):
When would a company use the installment sales method of revenue recognition?
A. When collectability of installment accounts receivable is reasonably predictable.
B. When repossessions of merchandise sold on the installment plan may result in a future gain or loss.
C. When installment sales are material, and there is no reasonable basis for estimating collectability.
D. When collection expenses and bad debts on installment accounts receivable are deemed to be immaterial.
C. The installment method of revenue recognition is used when the realizability criterion of revenue recognition is not met. In other words, there is significant uncertainty that the receivable will be collected. Until cash is collected (realizability is therefore assured for the amount collected), no gross profit is recognized. The cost-recovery method, which is even more conservative, may also be used in this situation.
On January 1, 2005, Rex Co. sold a used machine to Lake, Inc. for $525,000. On this date, the machine had a depreciated cost of $367,500
Lake paid $75,000 cash on January 1, 2005 and signed a $450,000 note, bearing interest at 10%.
The note was payable in three annual installments of $150,000 beginning January 1, 2006. Rex appropriately accounted for the sale under the installment method. Lake made a timely payment of the first installment on January 1, 2006 of $195,000, which included interest of $45,000 to date of payment.
At December 31, 2006, Rex has deferred gross profit of
The gross profit percentage on the machine is 30% [($525,000 - $367,500)/$525,000]. Total gross profit is $157,500 ($525,000 - $367,500). This amount is deferred until cash is collected.
Under the installment method, 30% of each cash receipt is recognized gross profit. The $150,000 installments must be principal amounts, because they sum to the face value of the note. Interest is paid in addition to the installment amounts. As of December 31, 2006, only one $150,000 installment was collected.
Total gross profit on sale $157,500
Less gross profit recognized on cash collections:
($75,000 + $150,000).30 = (67,500)
Equals deferred gross profit at 31 December 2006
UVW Broadcast Co. entered into a contract to exchange unsold advertising time for travel and lodging services with Hotel Co. As of June 30, advertising commercials of $10,000 were used. However, travel and lodging services were not provided.
How should UVW account for advertising in its June 30 financial statements?
A. Revenue and expense are recognized when the agreement is completed.
B. An asset and revenue for $10,000 is recognized.
C. Both the revenue and expense of $10,000 are recognized.
D. Not reported.
B. UVW has a receivable and revenue for the $10,000 of advertising services provided to date. Without receipt of any travel and lodging services, the firm reports a receivable for the unpaid advertising services. These services will be "paid" in the form of travel and lodging.
Drew Co. produces expensive equipment for sale on installment contracts. When there is doubt about eventual collectibility, the income-recognition method least likely to overstate income is
A. At the time the equipment is completed.
B. The installment method.
C. The cost-recovery method.
D. At the time of delivery.
C. The cost recovery is the most conservative of the methods listed in the answer alternatives. It recognizes income slower than any other method listed.
This method recognizes no income until the cash collections exceed the cost of the equipment and would tend to overstate income the least. The cost recovery method is more conservative that the installment method, which recognizes profit on each dollar of cash collected.
During 2002, Fleet Co.'s trademark was licensed to Hitch Corp. for royalties of 10% of net sales of the trademarked items. Returns were estimated to be 1% of gross sales. On signing the licensing agreement, Hitch paid Fleet $75,000 as an advance against future royalty earnings. Gross sales of the trademarked items during the year were $600,000. What amount should Fleet report as royalty income for 2002?
Gross sales of $600,000, less 1% estimated returns = net sales of $594,000. Net sales x 10% = $59,400. The advance would have been unearned royalty revenue. This is earned based upon sales. Therefore, there is still a balance of $15,600 in the unearned account, as the $59,400 was earned in 2002.
Entor Co. sold equipment to Pane Co. for $50,000. The equipment had a net book amount of $30,000. The collections were $20,000 in the first year, $15,000 in the next year, and $15,000 in the last year. What is the amount of gross profit for the third year if Entor used the installment-sales accounting method for the transaction?
The total gross profit to be recognized is $20,000 ($50,000-$30,000). This is recognized over the length of the transaction at a rate of $20,000/$50,000 = 40%. The amount collected in year three multiplied by the gross profit rate is $15,000 X 40% = $6,000
On December 31, 2004, Mill Co. sold construction equipment to Drew, Inc. for $1.8mn.
The equipment had a carrying amount of $1.2mn. Drew paid $300,000 cash on December 31, 2004 and signed a $1.5mn note bearing interest at 10%, payable in five annual installments of $300,000. Mill appropriately accounts for the sale under the installment method.
On December 31, 2005, Drew paid $300,000 principal and $150,000 interest.
For the year ended December 31, 2005, what total amount of revenue should Mill recognize from the construction equipment sale and financing?
Under the installment method of revenue recognition, each payment consists of a return of cost, and gross profit (after separating out interest).
The $150,000 payment is all interest. The $300,000 principal payment is part return of cost, and part gross profit. The gross profit percentage on the equipment is one-third:
[($1.8mn - $1.2mn)/$1.8mn].
Therefore, one-third of the $300,000 principal payment (or $100,000) is gross profit. Therefore, the total increase in earnings is $250,000 = $150,000 interest + $100,000 gross profit.
T/F: The selling price is twice the cost of an item. Cash equal to two-thirds of the cost is collected. Therefore, no profit is recognized on the sale under the installment method.
Profit recognized is equal to the amount of cash received x the gross profit percentage.
T/F: The deferred gross margin under the installment method is the amount of cash collected times the gross margin percentage.
The deferred gross margin under the installment method is the balance in gross accounts receivable times the gross margin percentage.
T/F: The selling price is twice the cost of an item. Cash equal to two-thirds of the cost is collected as of the balance sheet date. Therefore, one-third of the total profit on the sale is recognized as of the balance sheet date.
T/F: Net installment accounts receivable is one minus the gross margin percentage, times the balance in installment receivables. Net installment accounts receivable is the cost of installment sales yet to be recovered.
Macklin Co. entered into a franchise agreement with Heath Co. for an initial fee of $50,000. Macklin received $10,000 when the agreement was signed. The balance was to be paid at a rate of $10,000 per year, starting the next year. All services were performed by Macklin and the refund period had expired. Operations started in the current year.
What amount should Macklin recognize as revenue in the current year?
The entire franchise fee is recognized as revenue when the franchisor has no significant responsibilities remaining under the contract. Also, the fee is not refundable. The installment nature of the payment plan has no bearing on the revenue recognition, because there is no uncertainty as to collection.
Baker Co. has a franchise restaurant business. On January 15 of the current year, Baker charged an investor a franchise fee of $65,000 for the right to operate as a franchisee of one of Baker's restaurants. A cash payment of $25,000 toward the fee was required to be paid to Baker during the current year.
Four subsequent annual payments of $10,000, with a present value of $34,000 at the current market interest rate, represent the balance of the fee, which is expected to be collected in full. The initial cash payment is non-refundable and no future services are required by Baker.
What amount should Baker report as franchise revenue during the current year?
The $25,000 down payment, plus the $34,000 present value of remaining fee payments, is the appropriate amount of revenue to record. $59,000 is the cash equivalent amount accepted by the franchisor and therefore constitutes the amount received. Although the fee is listed at $65,000, the stronger evidence of value is the amount accepted. Also, the payments are non-refundable and the franchisor has no future performance. The revenue-recognition criteria are met.
A shoe retailer allows customers to return shoes within 90 days of purchase. The company estimates that 5% of sales will be returned within the 90-day period. During the month, the company has sales of $200,000 and returns of sales made in prior months of $5,000. What amount should the company record as net sales revenue for new sales made during the month?
The effect of estimated returns is recognized in the month of sale. Net sales to be reported for the current month equal $200,000 less the returns expected on those sales (5% or $10,000), or $190,000. The actual returns granted in the current month on previous months' sales were recognized as reductions in net sales in those previous months.
North Co. entered into a franchise agreement with South Co. for an initial fee of $50,000. North received $10,000 at the agreement's signing. The remaining balance was to be paid at a rate of $10,000 per year, beginning the following year. North's services per the agreement were not complete in the current year. Operating activities will commence next year.
What amount should North report as franchise revenue in the current year?
FAS 45 requires that before the franchisor (North) can recognize revenue, its activities pertaining to the franchise must be substantially complete. The earliest point at which substantial completion occurs is the commencement of operations by the franchisee. Operating activities will not begin until next year - therefore, North recognizes no fee revenue in the current year.
The $10,000 received is recorded in a liability account.
T/F: The six criteria for recognizing revenue when a right of return is present are all met at year-end. Therefore, all sales during the year are recognized as revenue in the year of sale.
Reported net sales for the year equals total sales less actual returns on those sales during the year less estimated returns at year-end.
T/F: The six criteria for recognizing revenue when a right of return is present are not all met at year-end. At year-end, $100,000 of sales can be returned. It is unlikely that all will be returned, but none of these sales can be recognized in the year of sale.
T/F: The selling price is twice the cost of an item. Cash equal to two-thirds of the cost is collected. Therefore, no profit is recognized on the sale under the cost recovery method.
T/F: The six criteria for recognizing revenue when a right of return is present are met, and the firm believes that 10% of accounts receivable at year-end represent sales that will be returned. Ending accounts receivable is $20,000. Total sales for the year are $60,000. There were no returns during the year. Recognized sales for the year are $58,000.
T/F: The six criteria for recognizing revenue when a right of return is present are not all met at year-end. Therefore, no sales can be recognized on sales for which the right of return has not expired as of the end of the year.