Chapter 05 - Income Measurement and Profitability Analysis
Chapter 5
Income Measurement and Profitability Analysis
QUESTIONS FOR REVIEW OF KEYQuestion 5-1 TOPICSThe realization
principle requires that two criteria be satisfied before revenue
can be recognized: 1. The earnings process is judged to be complete
or virtually complete. 2. There is reasonable certainty as to the
collectibility of the asset to be received (usually cash).
Question 5-2At the time production is completed, there usually
exists significant uncertainty as to the collectibility of the
asset to be received. We dont know if the product will be sold, nor
the selling price, nor the buyer if eventually the product is sold.
Because of these uncertainties, revenue recognition usually is
delayed until the point of product delivery.
Question 5-3If the installment sale creates a situation where
there is significant uncertainty concerning cash collection and it
is not possible to make an accurate assessment of future bad debts,
revenue and cost recognition should be delayed beyond the point of
delivery.
Question 5-4The installment sales method recognizes gross profit
by applying the gross profit percentage on the sale to the amount
of cash actually received each period. The cost recovery method
defers all gross profit recognition until cash has been received
equal to the cost of the item sold.
Question 5-5Deferred gross profit is a contra installment
receivable account. The balance in this account is subtracted from
gross installment receivables to arrive at installment receivables,
net. The net amount of the receivables represents the portion of
remaining payments that represent cost recovery.
5-1
Chapter 05 - Income Measurement and Profitability Analysis
Question 5-6Because the return of merchandise can retroactively
negate the benefits of having made a sale, the seller must meet
certain criteria before revenue is recognized in situations when
the right of return exists. The most critical of these criteria is
that the seller must be able to make reliable estimates of future
returns. In certain situations, these criteria are not satisfied at
the point of delivery of the product.
Question 5-7Sometimes a company arranges for another company to
sell its product under consignment. The consignor physically
transfers the goods to the other company (the consignee), but the
consignor retains legal title. If the consignee cant find a buyer
within an agreed-upon time, the consignee returns the goods to the
consignor. However, if a buyer is found, the consignee remits the
selling price (less commission and approved expenses) to the
consignor. Because the consignor retains the risks and rewards of
ownership of the product and title does not pass to the consignee,
the consignor does not record revenue (and related costs) until the
consignee sells the goods and title passes to the eventual
customer.
Question 5-8For service revenue, if there is one final service
that is critical to the earnings process, revenues and costs are
deferred and recognized after this service has been performed. On
the other hand, in many instances, service revenue activities occur
over extended periods and recognizing revenue at any single date
within that period would be inappropriate. Instead, its more
meaningful to recognize revenue over time in proportion to the
performance of the activity.
Question 5-9The completed contract method of recognizing
revenues and costs on long-term construction contracts is
equivalent to recognizing revenue at point of delivery, i.e., when
the construction project is complete. The percentage-of-completion
method assigns a fair share of the projects expected revenues and
costs to each period in which the earnings process takes place,
i.e., the construction period. The fair share typically is
estimated as the project's costs incurred each period as a
percentage of the project's total estimated costs. The completed
contract method should only be used when the lack of dependable
estimates or inherent hazards cause forecasts of future costs to be
doubtful.
5-2
Chapter 05 - Income Measurement and Profitability Analysis
Question 5-10The completed contract method recognizes revenue,
cost of construction, and gross profit at the end of the contract,
after the contract has been completed. The cost recovery method
will recognize an amount of revenue equal to the amount of cost
that can be recovered, which typically is an amount that exactly
offsets costs until all costs have been recovered, and then will
recognize the remaining revenue and gross profit. Therefore,
revenue and cost are recognized earlier under the cost recovery
method than under the completed contract method, but gross profit
recognition is delayed until late in the contract for both
approaches. Assuming that the final costs are incurred just prior
to completion of the contract, both approaches should recognize
gross profit at the same time.
Question 5-11The billings on construction contract account is a
contra account to the construction in progress asset. At the end of
each reporting period, the balances in these two accounts are
compared. If the net amount is a debit, it is reported in the
balance sheet as an asset. Conversely, if the net amount is a
credit, it is reported as a liability.
Question 5-12An estimated loss on a long-term contract must be
fully recognized in the first period the loss is anticipated,
regardless of the revenue recognition method used.
Question 5-13This guidance requires that if an arrangement
includes multiple elements, the revenue from the arrangement should
be allocated to the various elements based on the relative fair
values of the individual elements. If part of an arrangement does
not qualify for separate accounting, revenue recognition is delayed
until revenue is recognized for the other parts.
Question 5-14IFRS has less specific guidance for recognizing
revenue for multiple-deliverable arrangements. IAS No. 18 simply
states that: in certain circumstances, it is necessary to apply the
recognition criteria to the separately identifiable components of a
single transaction in order to reflect the substance of the
transaction and gives a couple of examples, whereas U.S. GAAP
provides more restrictive guidance concerning how to allocate
revenue to various components and when revenue from components can
be recognized.
Question 5-15Specific guidelines for revenue recognition of the
initial franchise fee are provided by FASB ASC 952605251. A key to
these guidelines is the concept of substantial performance. It
requires that substantially all of the initial services of the
franchisor required by the franchise agreement be performed before
the initial franchise fee can be recognized as revenue. The term
substantial requires professional judgment on the part of the
accountant. In situations when the initial franchise fee is
collectible in installments, even after substantial performance has
occurred, the installment sales or cost recovery method should be
used for profit recognition, if a reasonable estimate of
uncollectibility cannot be made.
5-3
Chapter 05 - Income Measurement and Profitability Analysis
Question 5-16Receivables turnover ratio Inventory turnover ratio
Asset turnover ratio = = = Net sales Average accounts receivable
(net) Cost of goods sold Average inventory Net sales Average total
assets
Activity ratios are designed to provide information about a
companys effectiveness in managing assets. Activity or turnover of
certain assets measures the frequency with which those assets are
replaced. The greater the number of times an asset turns over, the
less cash a company must devote to that asset, and the more cash it
can commit to other purposes.
Question 5-17Profit margin on sales Return on assets Return on
shareholders' equity = = = Net income Net sales Net income Average
total assets Net income Average shareholders' equity
A fundamental element of an analysts task is to develop an
understanding of a firms profitability. Profitability ratios
provide information about a companys ability to earn an adequate
return relative to sales or resources devoted to operations.
Resources devoted to operations can be defined as total assets or
only those assets provided by owners, depending on the evaluation
objective.
5-4
Chapter 05 - Income Measurement and Profitability Analysis
Question 5-18Return on equity Net income Ave. total equity = =
Profit margin Net income Total sales X X Asset turnover Total sales
Ave. total assets X Equity multiplier X Ave. total assets Ave.
total equity
The DuPont framework shows return on equity as being driven by
profit margin (reflecting a companys ability to earn income from
sales), asset turnover (reflecting a companys effectiveness in
using assets to generate sales), and the equity multiplier
(reflecting the extent to which a company has used debt to finance
its assets).
Question 5-19These perspectives are referred to as the discrete
and integral part approaches. Current interim reporting
requirements and existing practice generally view interim reports
as integral parts of annual statements. However, the discrete
approach is applied to some items. Most revenues and expenses are
recognized in interim periods as incurred. However, if an
expenditure clearly benefits more than just the period in which it
is incurred, the expense should be spread among the periods
benefited. Examples include annual repair expenses, property tax
expense, and advertising expenses incurred in one quarter that
clearly benefit later quarters. These are assigned to each quarter
through the use of accruals and deferrals. On the other hand, major
events such as discontinued operations, extraordinary items, and
unusual or infrequent items should be reported separately in the
interim period in which they occur.
5-5
Chapter 05 - Income Measurement and Profitability Analysis
BRIEF EXERCISESBrief Exercise 5-1 Brief Exercise 5-22011 gross
profit = $3,000,000 1,200,000 = $1,800,000 2012 gross profit =
0
2011 Cost recovery % = Cost Sales: $1,200,000 = 40% (implying a
gross profit % = 60%) $3,000,000
2011 gross profit = 2011 cash collection of $150,000 x 60% =
$90,000 2012 gross profit = 2012 cash collection of $150,000 x 60%
= $90,000
Brief Exercise 5-3
No gross profit will be recognized in either 2011 or 2012. Gross
profit will not be recognized until the entire $1,200,000 cost of
the land is recovered. In this case, it will take 8 payments to
recover the cost of the land ($1,200,000 $150,000 = 8), so gross
profit recognition will equal 100% of the cash collected beginning
with the ninth installment payment.
Brief Exercise 5-4
Initial deferred gross profit ($3,000,000 1,200,000) $1,800,000
Less gross profit recognized in 2011 ($150,000 x 60%) (90,000) Less
gross profit recognized in 2012 ($150,000 x 60%) (90,000) Deferred
gross profit at the end of 2012 $1,620,000 The seller must meet
certain criteria before revenue can Brief Exercise 5-5be recognized
in situations when the right of return exists. The most critical of
these criteria is that the seller must be able to make reliable
estimates of future returns. If Meyers management can make reliable
estimates of the furniture that will be returned, revenue can be
recognized when the product is delivered, assuming the company has
no additional obligations to the buyer. If reliable estimates
cannot be made because of significant uncertainty, revenue and
related cost recognition is delayed until the uncertainty is
resolved.
Brief Exercise 5-6
Total estimated cost to complete = $6 million + $9 million = $15
million % of completion = $6 million $15 million = 40%5-6
Chapter 05 - Income Measurement and Profitability Analysis
Total estimated gross profit ($20 million 15 million) =
multiplied by the % of completion Gross profit recognized the first
year First year revenue = $20,000,000 x 40% = $8,000,000
$5,000,000 40% $2,000,000
Brief Exercise 5-7
Assets: Accounts receivable ($7 million 5 million)$2,000,000
1,000,000 $5,000,000 40% $2,000,000
Cost plus profit ($6 million + $2 million*) in excess of
billings ($7 million) * Total estimated gross profit ($20 million
15 million) = multiplied by the % of completion Gross profit
recognized in the first year
Brief Exercise 5-8Revenue Less: Costs in year 1 Costs in year 2
Actual profit
Year 1 = 0 Year 2 = $4 million $20,000,000 (6,000,000)
(10,000,000) $ 4,000,000 Year 1: Revenue: Cost: Gross profit: $6
million $6 million $0
Brief Exercise 5-9
Year 2: Revenue: $14 million ($20 million total $6 million in
year 1) Cost: $10 million Gross profit: $ 4 million The anticipated
loss of $3 million ($30 million contract price less total estimated
costs of $33 million) must be recognized in the first year applying
either method. Orange has separate sales prices Brief Exercise 5-10
for the two parts of LearnIt-Plus, so that vendor-specific
objective
Brief Exercise 5-115-7
Chapter 05 - Income Measurement and Profitability Analysis
evidence (VSOE) allows them to allocate revenue to those parts
according to their relative selling prices. LearnIt will be
allocated $200 x [$150 ($150 + $100)] = $120, and that revenue will
be recognized upon delivery of the LearnIt software. LearnIt Office
Hours will be allocated $200 x [$100 ($150 + $100)] = $80, and that
revenue will be deferred and recognized over the life of the
one-year period in which the Office Hours are delivered. If LearnIt
were not sold separately, Orange would not have VSOE for all of the
parts of the contract. In that case, revenue would be delayed until
the later part was delivered. In this case, the $200 would be
deferred and recognized over the life of the one-year period in
which the Office Hours are delivered. Orange has separate sales
prices for the two parts of Brief Exercise 5-12LearnIt-Plus, so the
company can base its estimates of the fair value of those parts
according to their relative selling prices. LearnIt will be
allocated $200 x [$150 ($150 + $100)] = $120, and that revenue will
be recognized upon delivery of the LearnIt software. LearnIt Office
Hours will be allocated $200 x [$100 ($150 + $100)] = $80, and that
revenue will be deferred and recognized over the life of the
one-year period in which the Office Hours are delivered. If LearnIt
were not sold separately, the accounting would be the same. Orange
would estimate the fair value of LearnIt Office Hours to be $100
and allocate revenue in the same fashion as it did when that
product was sold separately. (VSOE is not required under IFRS).
Specific conditions for revenue recognition of the initial Brief
Exercise 5-13franchise fee are provided by FASB ASC 952-605251. A
key to these conditions is the concept of substantial performance.
It requires that substantially all of the initial services of the
franchisor required by the franchise agreement be performed before
the initial franchise fee can be recognized as revenue. The term
substantial requires professional judgment on the part of the
accountant. Often, substantial performance is considered to have
occurred when the franchise opens for business. Continuing
franchise fees are recognized over time as the services are
performed. Receivables turnover ratio Inventory turnover ratio
Brief(net) Exercise 5-14 Receivablesturnover ratio Inventory
turnover ratio = = = = *$600,000 200,0005-8
Net sales Cost of goods sold Average accounts receivable Average
inventory $400,000* $600,000 [$100,000 + 60,000] 2 [$80,000
120,000] 2 5.71 5.45 times
Chapter 05 - Income Measurement and Profitability Analysis
Brief Exercise 5-15
Profit margin = =
= Sales $65,000 $420,000 15.5%
Net income
Return on assets
= = =
Net income Average total assets $65,000 $800,000 8.1%
Return on shareholders equity
=
Net income Average shareholders equity $65,000 $522,500*
12.4%
= =
Shareholders equity, beginning of period Add: Net income Deduct:
Dividends Shareholders equity, end of period
$500,000 65,000 (20,000) $545,000
*Average shareholders equity = ($500,000 + 545,000) 2 =
$522,500
5-9
Chapter 05 - Income Measurement and Profitability Analysis
Brief Exercise 5-16 Return on equity = Profit margin X X Asset
turnover X Equity multiplier
Net income = Net income Ave. total equity Total sales Return on
shareholders equity = = = Profit margin = = = assets = =
Total sales X Ave. total assets Ave. total assets Ave. total
equity
Net income Average shareholders equity $65,000 $522,500 12.4%
Net income Sales $65,000 $420,000 15.5% Asset Turnover Sales =
Average total $420,000 $800,000 52.5%
5-10
Chapter 05 - Income Measurement and Profitability Analysis
Brief Exercise 5-16 (concluded) Equity Multiplier = Average
total assets Average shareholders equity $800,000 $522,500 1.53
= =
Check: 12.4% ROE = 15.5% profit margin x 52.5% asset turnover x
1.53 equity multiplier.
Brief Exercise 5-17Inventory turnover ratio = Cost of goods sold
Average inventory 6.0 = x $75,000 Cost of goods sold = $75,000 x
6.0 = $450,000 Sales $600,000 Cost of goods sold = Gross profit
$450,000 = $150,000
5-11
Chapter 05 - Income Measurement and Profitability Analysis
EXERCISES Exercise 5-1
Requirement 1 Alpine West should recognize revenue over the ski
season on an anticipated usage basis, in this case equally
throughout the season. The fact that the $450 price is
nonrefundable is not relevant to the revenue recognition decision.
Revenue should be recognized as it is earned, in this case as the
services are provided during the ski season. Requirement 2 November
6, 2011 To record the cash collection
Cash............................................................................
.......................................................Unearned
revenue
..............................................................................450
450
December 31, 2011 To recognize revenue earned in December (no
revenue earned in November, as season starts on December 1).
Unearned revenue ($450 x 1/5)....................................
90
......................................................................Revenue
................................................................................90
Requirement 3 $90 is included in revenue in the 2011 income
statement. The $360 remaining balance in unearned revenue is
included in the current liability section of the 2011 balance
sheet.
Exercise 5-2
Requirement 1 2011 Cost recovery %: $234,000 = 65% (gross profit
% = 35%) $360,000
2012 Cost recovery %: $245,000 = 70% (gross profit % =
30%)5-12
Chapter 05 - Income Measurement and Profitability Analysis
$350,000 2011 gross profit: Cash collection from 2011 sales of
$150,000 x 35% = 2012 gross profit: Cash collection from 2011 sales
of $100,000 x 35% = + Cash collection from 2012 sales of $120,000 x
30% = Total 2012 gross profit Requirement 2 2011 deferred gross
profit balance: 2011 initial gross profit ($360,000 234,000) Less:
Gross profit recognized in 2011 Balance in deferred gross profit
account 2012 deferred gross profit balance: 2011 initial gross
profit ($360,000 234,000) Less: Gross profit recognized in 2011
Gross profit recognized in 2012 2012 initial gross profit ($350,000
245,000) Less: Gross profit recognized in 2012 Balance in deferred
gross profit account $52,500 $ 35,000 36,000 $71,000
$126,000 (52,500) $73,500 $ 126,000 (52,500) (35,000) 105,000
(36,000) $107,500
Exercise 5-3
2011To record installment sales Installment
receivables................................................ 360,000
.....................................................................Inventory
.......................................................................234,000
...................................................Deferred gross
profit
.......................................................................126,000
2011 To record cash collections from installment sales
Cash............................................................................
150,000 ................................................Installment
receivables
.......................................................................150,000
5-13
Chapter 05 - Income Measurement and Profitability Analysis
2011 To recognize gross profit from installment sales Deferred
gross profit...................................................
52,500 ...................................................Realized
gross profit
.........................................................................52,500
2012 To record installment sales Installment
receivables................................................ 350,000
.....................................................................Inventory
.......................................................................245,000
...................................................Deferred gross
profit
.......................................................................105,000
2012 To record cash collections from installment sales
Cash............................................................................
220,000 ................................................Installment
receivables
.......................................................................220,000
2012 To recognize gross profit from installment sales Deferred
gross profit...................................................
71,000 ...................................................Realized
gross profit
.........................................................................71,000
Exercise 5-42011 2012 2013 2014 Total
Requirement 1 Year Income recognized $180,000 ($300,000 120,000)
-0-0-0$180,000
Requirement 2 Cost recovery %: $120,000 ------------- = 40%
(gross profit % = 60%) $300,000
5-14
Chapter 05 - Income Measurement and Profitability Analysis
Year 2011 2012 2013 2014 Totals
Cash Collected $ 75,000 75,000 75,000 75,000 $300,000
Cost Recovery(40%) $ 30,000 30,000 30,000 30,000 $120,000
Gross Profit(60%) $ 45,000 45,000 45,000 45,000 $180,000
Requirement 3 Year 2011 2012 2013 2014 Totals Cash Collected $
75,000 75,000 75,000 75,000 $300,000 Cost Recovery $ 75,000 45,000
-0-0$120,000 Gross Profit -0$ 30,000 75,000 75,000 $180,000
5-15
Chapter 05 - Income Measurement and Profitability Analysis
Exercise 5-5
Requirement 1 July 1, 2011 To record installment sale
Installment
receivables....................................................
300,000 Sales
revenue...............................................................
300,000 Cost of goods
sold...........................................................
120,000
Inventory.....................................................................
120,000 To record cash collection from installment sale
Cash................................................................................
75,000 Installment
receivables................................................ 75,000
July 1, 2012 To record cash collection from installment sale
Cash................................................................................
75,000 Installment
receivables................................................
75,000
5-16
Chapter 05 - Income Measurement and Profitability Analysis
Exercise 5-5 (continued) Requirement 2 July 1, 2011 To record
installment sale Installment
receivables................................................ 300,000
.....................................................................Inventory
.......................................................................120,000
...................................................Deferred gross
profit
.......................................................................180,000
To record cash collection from installment sale
Cash............................................................................
75,000 ................................................Installment
receivables
.........................................................................75,000
To recognize gross profit from installment sale Deferred gross
profit................................................... 45,000
...................................................Realized gross
profit
.........................................................................45,000
July 1, 2012 To record cash collection from installment sale
Cash............................................................................
75,000 ................................................Installment
receivables
.........................................................................75,000
To recognize gross profit from installment sale Deferred gross
profit................................................... 45,000
...................................................Realized gross
profit
.........................................................................45,000
5-17
Chapter 05 - Income Measurement and Profitability Analysis
Exercise 5-5 (concluded) Requirement 3 July 1, 2011 To record
installment sale Installment
receivables................................................ 300,000
.....................................................................Inventory
.......................................................................120,000
...................................................Deferred gross
profit
.......................................................................180,000
To record cash collection from installment sale
Cash............................................................................
75,000 ................................................Installment
receivables
.........................................................................75,000
July 1, 2012 To record cash collection from installment sale
Cash............................................................................
75,000 ................................................Installment
receivables
.........................................................................75,000
To recognize gross profit from installment sale Deferred gross
profit................................................... 30,000
...................................................Realized gross
profit
.........................................................................30,000
Exercise 5-6
Requirement 1 Cost of goods sold ($1,000,000 600,000) 100,000
$500,000
$400,000 Add: Gross profit if using cost recovery method Cash
collected Requirement 2 $ 600,000 Gross profit percentage =
$1,000,000 = 60%
Cash collected x Gross profit percentage = Gross profit
recognized $500,000 x 60% = $300,000 gross profit5-18
Chapter 05 - Income Measurement and Profitability Analysis
Exercise 5-7
October 1, 2011....... ............To record the installment
sale Installment
receivable.................................................4,000,000
.....................................................................Inventory
....................................................................1,800,000
...................................................Deferred gross
profit
....................................................................2,200,000
To record the cash down payment from installment sale
Cash............................................................................
800,000
.................................................Installment
receivable
.......................................................................800,000
To recognize gross profit from installment sale Deferred gross
profit ($800,000 x 55%*)................... 440,000
...................................................Realized gross
profit
.......................................................................440,000
October 1,
2012......................................................... To
record the default and repossession Repossessed inventory (fair
value) ............................1,300,000 Deferred gross profit
(balance)...................................1,760,000 Loss on
repossession (difference) .............................. 140,000
..................................Installment receivable (balance)
....................................................................3,200,000
*$2,200,000 $4,000,000 = 55% gross profit percentage
Exercise 5-8
Requirement 1
April 1, 2011 To record installment sale Installment
receivables................................................
2,400,000
5-19
Chapter 05 - Income Measurement and Profitability Analysis
............................................................................Land
....................................................................
480,000 ....................................................Gain on
sale of land
....................................................................1,920,000
April 1, 2011 To record cash collection from installment sale
Cash............................................................................
120,000 ................................................Installment
receivables
.......................................................................120,000
April 1, 2012 To record cash collection from installment sale
Cash............................................................................
120,000 ................................................Installment
receivables
.......................................................................120,000
Requirement 2 April 1, 2011 To record installment sale
Installment
receivables................................................
2,400,000
............................................................................Land
.......................................................................480,000
..............................................................Deferred
gain
....................................................................1,920,000
5-20
Chapter 05 - Income Measurement and Profitability Analysis
Exercise 5-8 (concluded) When payments are received, gain on
sale of land is recognized, calculated by applying the gross profit
percentage ($1,920,000 $2,400,000 = 80%) to the cash collected (80%
x $120,000).
April 1, 2011 To record cash collection from installment sale
Cash............................................................................
120,000 ................................................Installment
receivables
.......................................................................120,000
To recognize profit from installment sale Deferred
gain..............................................................
96,000 ...............................................Gain on sale
of land (80% x $120,000)
....................................................................................
96,000 April 1, 2012 To record cash collection from installment
sale
Cash............................................................................
120,000 ................................................Installment
receivables
.......................................................................120,000
To recognize profit from installment sale Deferred
gain..............................................................
96,000 ...............................................Gain on sale
of land (80% x $120,000)
....................................................................................
96,000
Exercise 5-9
Requirement 1 $2,000,000 300,000 1,200,000 1,500,000 $ 500,000
2011 2012 $2,000,000 1,875,000 -01,875,000 $ 125,000
Contract price Actual costs to date Estimated costs to complete
Total estimated costs Gross profit (estimated in 2011)
Gross profit recognition: 2011: $ 300,000 = 20% x $500,000 =
$100,000
5-21
Chapter 05 - Income Measurement and Profitability Analysis
$1,500,000 2012: $125,000 $100,000 = $25,000
Requirement 2 2011 2012 Requirement 3
$ -0$125,000
Balance Sheet At December 31, 2011 Current assets: Accounts
receivable Costs and profit ($400,000*) in excess of billings
($380,000) * Costs ($300,000) + profit ($100,000) $ 130,000
20,000
5-22
Chapter 05 - Income Measurement and Profitability Analysis
Exercise 5-9 (concluded) Requirement 4 Balance Sheet At December
31, 2011 Current assets: Accounts receivable Current liabilities:
Billings ($380,000) in excess of costs ($300,000) Requirement 1($
in millions)
$ 130,000 $ 80,000
2011 $220 120 60 180 $ 40
2012 $220 170 -0170 $ 50
Exercise 5-10
2013 Contract price 40 120 160 $ 60
$220 Actual costs to date Estimated costs to complete Total
estimated costs Estimated gross profit (actual in 2013) Gross
profit (loss) recognition: 2011: $40
= 25% x $60 = $15 $160 2012: $120 = 66.67% x $40 = $26.67 $15 =
$11.67 $180 2013: $220 170 = $50 ($15 + 11.67) = $23.33
Requirement 2 2011: $220 x 25% = $55 2012: $220 x 66.67% =
$146.67 55 = $91.67 2013: $220 146.67 = $73.33
5-23
Chapter 05 - Income Measurement and Profitability Analysis
Requirement 3 Year 2011 2012 2013 Total project income Gross
profit (loss) recognized -0-050 $50
5-24
Chapter 05 - Income Measurement and Profitability Analysis
Exercise 5-10 (concluded) Requirement 4 2011: Revenue: Cost:
Gross profit: 2012: Revenue: Cost: Gross profit: 2013: Revenue:
Cost: Gross profit: Requirement 5 2012: $120 = 60% x $20* = $12 15
= $(3) loss $200 *$220 ($40 + 80 + 80) = $20 Requirement 1 2011
$8,000,000 4,500,000 3,600,000 8,100,000 $ (100,000) 2012 2013
$8,000,000 8,300,000 -08,300,000 $ (300,000) $100 ($220 contract
price $40 $80) $ 50 $ 50 $80 $80 $ 0 $40 $40 $ 0
Exercise 5-11
Contract price $8,000,000 Actual costs to date 2,000,000
Estimated costs to complete 4,000,000 Total estimated costs
6,000,000 Estimated gross profit (loss) (actual in 2013) $2,000,000
Gross profit (loss) recognition: 2011: $2,000,000
= 33.3333% x $2,000,000 = $666,667 $6,000,0005-25
Chapter 05 - Income Measurement and Profitability Analysis
2012: $(100,000) 666,667
= $(766,667)
2013: $(300,000) (100,000) = $(200,000)
5-26
Chapter 05 - Income Measurement and Profitability Analysis
Exercise 5-11 (continued) Requirement 2 Construction in progress
Various accounts To record construction costs. Accounts receivable
Billings on construction contract To record progress billings. Cash
Accounts receivable To record cash collections. Construction in
progress(gross profit)
2011 2012 2,000,000 2,500,000 2,000,000 2,500,000 2,500,000
2,750,000 2,500,000 2,750,000 2,250,000 2,475,000 2,250,000
2,475,000
Cost of construction Revenue from long-term contracts(33.3333% x
$8,000,000)
666,667 2,000,000 2,666,667 2,544,000 1,777,333 766,667
To record gross profit. Cost of construction (2) Revenue from
long-term contracts Construction in progress (loss) To record
expected loss.(1)
(1) and (2): Percent complete = $4,500,000 $8,100,000 = 55.55%
Revenue recognized to date: 55.55% x $8,000,000 = $4,444,000 Less:
Revenue recognized in 2011 (above) (2,666,667) Revenue recognized
in 2012 1,777,333 (1) Plus: Loss recognized in 2012 (above) 766,667
Cost of construction, 2012 $2,544,000 (2)
5-27
Chapter 05 - Income Measurement and Profitability Analysis
Exercise 5-11 (concluded) Requirement 3 Balance Sheet Current
assets: Accounts receivable Costs and profit ($2,666,667*) in
excess of billings ($2,500,000) Current liabilities: Billings
($5,250,000) in excess of costs less loss ($4,400,000**) 2011
2012
$250,000 $525,000 166,667
$850,000
* Costs ($2,000,000) + profit ($666,667) ** Costs ($2,000,000 +
$2,500,000) loss ($100,000 = $766,667 $666,667)
Exercise 5-12
Requirement 1 Year 2011 2012 2013 Total project loss
Gross profit (loss) recognized -0$(100,000) (200,000)
$(300,000)
Requirement 2 2011 2012 2,000,000 2,500,000 2,000,000 2,500,000
2,500,000 2,750,000 2,500,000 2,750,000 2,250,000 2,475,000
2,250,000 2,475,000 100,000
Construction in progress Various accounts To record construction
costs. Accounts receivable Billings on construction contract To
record progress billings. Cash Accounts receivable To record cash
collections. Loss on long-term contract
5-28
Chapter 05 - Income Measurement and Profitability Analysis
Construction in progress To record an expected loss.
100,000
5-29
Chapter 05 - Income Measurement and Profitability Analysis
Exercise 5-12 (concluded) Requirement 3 Balance Sheet Current
assets: Accounts receivable Current liabilities: Billings
($2,500,000) in excess of costs($2,000,000)
2011 $250,000
2012 $525,000
$500,000 $850,000
Billings ($5,250,000) in excess of costs less loss
($4,400,000*)* Costs ($2,000,000 + $2,500,000) loss ($100,000)
Exercise 5-13
Situation 1 - Percentage-of-Completion $5,000,000 1,500,000
3,000,000 4,500,000 $ 500,000 2011 $5,000,000 3,600,000 900,000
4,500,000 $ 500,000 2012 2013 $5,000,000 4,500,000 -04,500,000 $
500,000
Contract price Actual costs to date Estimated costs to complete
Total estimated costs Estimated gross profit (actual in 2013)
Gross profit (loss) recognized: 2011: $1,500,000 = 33.3333% x
$500,000 = $166,667 $4,500,000 2012: $3,600,000 = 80.0% x $500,000
= $400,000 166,667 = $233,333 $4,500,000 2013: $500,000 400,000 =
$100,000
5-30
Chapter 05 - Income Measurement and Profitability Analysis
Situation 1 - Completed Contract Year 2011 2012 2013 Total gross
profit Gross profit recognized -0-0$500,000 $500,000
5-31
Chapter 05 - Income Measurement and Profitability Analysis
Exercise 5-13 (continued) Situation 2 - Percentage-of-Completion
Contract price Actual costs to date Estimated costs to complete
Total estimated costs Estimated gross profit (actual in 2013) 2011
$5,000,000 1,500,000 3,000,000 4,500,000 $ 500,000 2012 $5,000,000
2,400,000 2,400,000 4,800,000 $ 200,000 2013 $5,000,000 4,800,000
-04,800,000 $ 200,000
Gross profit (loss) recognized: 2011: $1,500,000 = 33.3333% x
$500,000 = $166,667 $4,500,000 2012: $2,400,000 = 50.0% x $200,000
= $100,000 166,667 = $(66,667) $4,800,000 2013: $200,000 100,000 =
$100,000
Situation 2 - Completed Contract Year 2011 2012 2013 Total gross
profit Gross profit recognized -0-0$200,000 $200,000
5-32
Chapter 05 - Income Measurement and Profitability Analysis
Exercise 5-13 (continued) Situation 3 - Percentage-of-Completion
Contract price Actual costs to date Estimated costs to complete
Total estimated costs Estimated gross profit (loss) (actual in
2013) 2011 $5,000,000 1,500,000 3,000,000 4,500,000 $ 500,000 2012
$5,000,000 3,600,000 1,500,000 5,100,000 $ (100,000) 2013
$5,000,000 5,200,000 -05,200,000 $ (200,000)
Gross profit (loss) recognized: 2011: $1,500,000 = 33.3333% x
$500,000 = $166,667 $4,500,000 2012: 2013: $(100,000) 166,667 =
$(266,667)
$(200,000) (100,000) = $(100,000)
Situation 3 - Completed Contract Year 2011 2012 2013 Total
project loss Gross profit (loss) recognized -0$(100,000) (100,000)
$(200,000)
5-33
Chapter 05 - Income Measurement and Profitability Analysis
Exercise 5-13 (continued) Situation 4 - Percentage-of-Completion
Contract price Actual costs to date Estimated costs to complete
Total estimated costs Estimated gross profit (actual in 2013) 2011
$5,000,000 500,000 3,500,000 4,000,000 $1,000,000 2012 $5,000,000
3,500,000 875,000 4,375,000 $ 625,000 2013 $5,000,000 4,500,000
-04,500,000 $ 500,000
Gross profit (loss) recognized: 2011: $ 500,000 = 12.5% x
$1,000,000 = $125,000 $4,000,000 2012: $3,500,000 = 80.0% x
$625,000 = $500,000 125,000 = $375,000 $4,375,000 2013: $500,000
500,000 = $ - 0 -
Situation 4 - Completed Contract Year 2011 2012 2013 Total gross
profit Gross profit recognized -0-0$500,000 $500,000
5-34
Chapter 05 - Income Measurement and Profitability Analysis
Exercise 5-13 (continued) Situation 5 - Percentage-of-Completion
Contract price Actual costs to date Estimated costs to complete
Total estimated costs Estimated gross profit (actual in 2013) 2011
$5,000,000 500,000 3,500,000 4,000,000 $1,000,000 2012 $5,000,000
3,500,000 1,500,000 5,000,000 $ -02013 $5,000,000 4,800,000
-04,800,000 $ 200,000
Gross profit (loss) recognized: 2011: $ 500,000 = 12.5% x
$1,000,000 = $125,000 $4,000,000 2012: 2013: $ 0 125,000 =
$(125,000) $200,000 0 = $200,000
Situation 5 - Completed Contract Year 2011 2012 2013 Total gross
profit Gross profit recognized -0-0$200,000 $200,000
5-35
Chapter 05 - Income Measurement and Profitability Analysis
Exercise 5-13 (concluded) Situation 6 - Percentage-of-Completion
Contract price Actual costs to date Estimated costs to complete
Total estimated costs Estimated gross profit (loss) (actual in
2013) 2011 $5,000,000 500,000 4,600,000 5,100,000 $ (100,000) 2012
$5,000,000 3,500,000 1,700,000 5,200,000 $ (200,000) 2013
$5,000,000 5,300,000 -05,300,000 $ (300,000)
Gross profit (loss) recognized: 2011: 2012: 2013: $(100,000)
$(200,000) (100,000) = $(100,000) $(300,000) (200,000) =
$(100,000)
Situation 6 - Completed Contract Year 2011 2012 2013 Total
project loss Gross profit (loss) recognized $(100,000) (100,000)
(100,000) $(300,000)
Exercise 5-14
Requirement 1 Construction in progress = Costs incurred + Profit
recognized = ? + $20,000
$100,000
Actual costs incurred in 2011 = $80,000 Requirement 2 Billings =
Cash collections + Accounts Receivable $94,000 = ? + $30,000
5-36
Chapter 05 - Income Measurement and Profitability Analysis
Cash collections in 2011 = $64,000 Requirement 3 Let A = Actual
cost incurred + Estimated cost to complete Actual cost incurred x
(Contract price A) = Profit recognized A $80,000 ($1,600,000 A) =
$20,000 A $128,000,000,000 80,000A = $20,000A $100,000A =
$128,000,000,000 A = $1,280,000 Estimated cost to complete =
$1,280,000 80,000 = $1,200,000 Requirement 4 $80,000 = 6.25%
$1,280,000
Exercise 5-15
Requirement 1 Revenue should be recognized as follows: Software
date of shipment, July 1, 2011 Technical support evenly over the 12
months of the agreement Upgrade date of shipment, January 1,
2012
The amounts are determined by an allocation of total contract
price in proportion to the individual fair values of the components
if sold separately: Software Technical support Upgrade Total
Requirement 2 $210,000 $270,000 x $243,000 = $189,000 $30,000
$270,000 x $243,000 = 27,000 $30,000 $270,000 x $243,000 = 27,000
$243,000
5-37
Chapter 05 - Income Measurement and Profitability Analysis
July 1, 2011
To record sale of software
Cash............................................................................
243,000
......................................................................Revenue
.......................................................................189,000
Unearned revenue ($27,000 + 27,000) 54,000
Exercise 5-16
Requirement 1 ($20,000 $50,000) x $45,000 = $18,000 ($10,000
$50,000) x $45,000 = 9,000 ($15,000 $50,000) x $45,000 = 13,500
($5,000 $50,000) x $45,000 = 4,500 $45,000
Conveyer Labeler Filler Capper total Requirement 2
All $45,000 of revenue is delayed until installation of the
conveyer, because the usefulness of the other elements of the
multi-part arrangement is contingent on its delivery.
Exercise 5-17
Requirement 1 ($20,000 $50,000) x $45,000 = $18,000 ($10,000
$50,000) x $45,000 = 9,000 ($15,000 $50,000) x $45,000 = 13,500
($5,000 $50,000) x $45,000 = 4,500 $45,000
Conveyer Labeler Filler Capper total Requirement 2
Under IFRS, it is likely that Richardson would recognize revenue
the same as in Requirement 1, because (a) revenue for each part can
be estimated reliably and (b) the receipt of economic benefits is
probable.
Exercise 5-185-38
Chapter 05 - Income Measurement and Profitability Analysis
October 1, 2011 To record franchise agreement and down payment
Cash (10% x
$300,000).................................................. 30,000
Note
receivable...........................................................
270,000 Unearned franchise fee revenue...... 300,000
January 15, 2012 To recognize franchise fee revenue Unearned
franchise fee revenue.................................. 300,000
.................................................Franchise fee
revenue
.......................................................................300,000
Exercise 5-19h d g a b i c k l m f j e 1. Inventory turnover 2.
Return on assets 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13.
List AList B
a. Net income divided by net sales. b. Defers recognition until
cash collected equals cost. Return on shareholders' equity c.
Defers recognition until project is complete. Profit margin on
sales d. Net income divided by assets. Cost recovery method e.
Risks and rewards of ownership retained by seller.
Percentage-of-completion method f. Contra account to construction
in progress. Completed contract method g. Net income divided by
shareholders' equity. Asset turnover h. Cost of goods sold divided
by inventory. Receivables turnover i. Recognition is in proportion
to work completed. Right of return j. Recognition is in proportion
to cash received. Billings on construction contract k. Net sales
divided by assets. Installment sales method l. Net sales divided by
accounts receivable. Consignment sales m. Could cause the deferral
of revenue recognition beyond delivery point.
Exercise 5-20
Requirement 1
5-39
Chapter 05 - Income Measurement and Profitability Analysis
Inventory turnover ratio
= = =
Cost of goods sold Average inventory $1,840,000 [$690,000 +
630,000] 2 2.79 times
Requirement 2 By itself, this one ratio provides very little
information. In general, the higher the inventory turnover, the
lower the investment must be for a given level of sales. It
indicates how well inventory levels are managed and the quality of
inventory, including the existence of obsolete or overpriced
inventory. However, to evaluate the adequacy of this ratio it
should be compared with some norm such as the industry average.
That indicates whether inventory management practices are in line
with the competition. Its just one piece in the puzzle, though.
Other points of reference should be considered. For instance, a
high turnover can be achieved by maintaining too low inventory
levels and restocking only when absolutely necessary. This can be
costly in terms of stockout costs. The ratio also can be useful
when assessing the current ratio. The more liquid inventory is, the
lower the norm should be against which the current ratio should be
compared.
Exercise 5-21
Turnover ratios for Anderson Medical Supply Company for 2011: =
= = = = =
$4,800,000 $8,000,000 [$900,000 + 700,000] 2 365 [$700,000 +
500,000] 2 $8,000,000 613.33 times The [$4,300,000 +times 13.33
3,700,000] company 2 27.4 days turns its inventory = 2 times over 6
times per year compared to the industry average of 5 times per
year. The asset turnover ratio also is slightly better than the
industry average (2 times per year versus 1.8 times). These ratios
indicate that Anderson is able to generate more sales per dollar
invested in inventory and in total assets than the industry
averages. However,5-40
Inventory turnover ratio Receivables turnover ratio Average
collection period Asset turnover ratio
Chapter 05 - Income Measurement and Profitability Analysis
Anderson takes slightly longer to collect its accounts
receivable (27.4 days compared to the industry average of 25
days).
Exercise 5-22
Requirement 1 a. Profit margin on sales $180 $5,200 = 3.5% b.
Return on assets $180 [($1,900 + 1,700) 2] = 10% c. Return on
shareholders equity $180 [($550 + 500) 2] = 34.3% $100,000 180,000
280,000 150,000 $130,000
Requirement 2 Retained earnings beginning of period Add: Net
income Less: Retained earnings end of period Dividends paid
Exercise 5-23Requirement 1a. b. c. d. Profit margin on sales
$180 $5,200 = 3.5% Asset turnover $5,200 [($1,900 + 1,700) 2] =
2.89 Equity multiplier [($1,900 + 1,700) 2] [($550 + 500) 2] = 3.43
Return on shareholders equity $180 [($550 + 500) 2] = 34.3%
Requirement 2 Profit margin x Asset turnover x Equity multiplier
= ROE 3.5% x 2.89 x 3.43 = 34.7% ~ 34.3% (difference due to
rounding) Quarter Second Third $90,000
First Cumulative income before taxes $50,000 $190,000 Estimated
annual effective tax rate 34% 30% 36% 17,000 27,000 68,400 Less:
Income tax reported earlier 0 17,000 27,000 Tax expense to be
reported $17,000 $10,000 $ 41,400 Incentive compensation $300
million 4 = $ 75 million Exercise 5-25 Depreciation expense $60
million 4 = 15 million Gain on sale 23 million
Exercise 5-24
1st
2nd 3rd 4th
Exercise 5-26
5-41
Chapter 05 - Income Measurement and Profitability Analysis
Advertising $200,000 Property tax 87,500 Equipment repairs
65,000 Extraordinary casualty loss 0 Research and development 0
$200,000 87,500 65,000 185,000 32,000
$200,000 87,500 65,000 0 32,000
$200,000 87,500 65,000 0 32,000
Exercise 5-27Requirement 1The specific citation that specifies
the the circumstances and conditions under which it is appropriate
to use the percentage-of-completion method is: Revenue Recognition
ConstructionType and ProductionType
ContractsRecognitionCircumstances Appropriate for Using the
Percentage-of-Completion Method. Requirement 2 FASB ASC 605352557
reads as follows: The percentage-of-completion method is considered
preferable as an accounting policy in circumstances in which
reasonably dependable estimates can by made and in which all the
following conditions exist: a. Contracts executed by the parties
normally include provisions that clearly specify the enforceable
rights regarding goods or services to be provided and received by
the parties, the consideration to be exchanged, and the manner and
terms of settlement. b. The buyer can be expected to satisfy all
obligations under the contract. c. The contractor can be expected
to perform all contractual obligations.
The FASB Accounting Standards Codification represents the single
source of authoritative U.S. generally accepted accounting
principles. The specific citation for each of the following items
is: 1. When a provision for loss is recognized for a
percentage-of-completion contract: FASB ASC 605352546: Revenue
RecognitionConstructionType and ProductionType
ContractsRecognitionProvisions for Losses on Contracts.
Exercise 5-28
5-42
Chapter 05 - Income Measurement and Profitability Analysis
2.
Circumstances indicating when the installment method or cost
recovery method is appropriate for revenue recognition: FASB ASC
60510254: Revenue RecognitionOverallRecognition Installment and
Cost Recovery Methods of Revenue Recognition. (Note: ASC 60510253
also provides some guidance, as it indicates when installment
method is NOT acceptable). Criteria determining when a seller can
recognize revenue at the time of sale from a sales transaction in
which the buyer has the right to return the product: FASB ASC
60515251: Revenue RecognitionProductsRecognition GeneralSales of
Product when Right of Return Exists.
3.
5-43
Chapter 05 - Income Measurement and Profitability Analysis
CPA / CMA REVIEW QUESTIONSCPA Exam Questions1. b. The earnings
process is completed upon delivery of the product. Therefore, in
2011, revenue for 50,000 gallons at $3 each is recognized. The
payment terms do not affect revenue recognition. 2. d. The deferred
gross profit in the balance sheet at December 31, 2012 should be
the balances in the accounts receivable accounts for 2011 and 2012
multiplied times the appropriate gross profit percentage: Accounts
Receivable Total Sales Less: Collections Less: Write Offs Accounts
Receivable Balance x Gross Profit Rate Deferred Gross Profit
12/31/2012 2011 2012 600,000 900,000 (300,000) (300,000) (200,000)
(50,000) 100,000 550,000 x 30% x 40% 30,000 220,000
The Combined Deferred Gross Profit in the Balance Sheet is
$250,000 ($220,000 + $30,000).
5-44
Chapter 05 - Income Measurement and Profitability Analysis
CPA Review Questions (concluded) 3. a. Year of sale 2011 2012 a.
Gross profit realized $240,000 $200,000 b. Percentage 30% 40% c.
Collections on sales (a/b) $800,000 $500,000 Total sales 1,000,000
2,000,000 Balance uncollected $200,000 $1,500,000 The total
uncollected balance is $1,700,000 ($200,000 + $1,500,000). 4. d.
Construction-in-progress represents the costs incurred plus the
cumulative pro-rata share of gross profit under the
percentage-of-completion method of accounting.
Construction-in-progress does not include the cumulative effect of
gross profit recognition under the completed contract method. 5. c.
2011 actual costs Total estimated costs Ratio Contract Price
Revenue 2011 actual costs Gross profit $20,000 60,000 = 1/3 x
100,000 33,333 -20,000 $13,333
6. d. Since the total cost of the contract, $3,100,000 ($930,000
+ $2,170,000) is projected to exceed the contract price of
$3,000,000, the excess cost of $100,000 must be recognized as a
loss in 2011.
5-45
Chapter 05 - Income Measurement and Profitability Analysis
CMA Exam Questions1.
c. Revenue is recognized when (1) realized or realizable and (2)
earned. On May 28, $500,000 of the sales price was realized while
the remaining $500,000 was realizable in the form of a receivable.
The revenue was earned on May 28 since the title of the goods
passed to the purchaser. The cost-recovery method is not used
because the receivable was not deemed uncollectible until June 10.
d. Based on the revenue recognition principle, revenue is normally
recorded at the time of the sale or, occasionally, at the time cash
is collected. However, sometimes neither the sales basis nor the
cash basis is appropriate, such as when a construction contract
extends over several accounting periods. As a result, contractors
ordinarily recognize revenue using the percentage-of-completion
method so that some revenue is recognized each year over the life
of the contract. Hence, this method is an exception to the general
principle of revenue recognition, primarily because it better
matches revenues and expenses. b. Given that one-third of all costs
have already been incurred ($6,000,000), the company should
recognize revenue equal to one-third of the contract price, or
$8,000,000. Revenues of $8,000,000 minus costs of $6,000,000 equals
a gross profit of $2,000,000.
2.
3.
5-46
Chapter 05 - Income Measurement and Profitability Analysis
PROBLEMSProblem 5-1REAGAN CORPORATION Income Statement For the
Year Ended December 31, 2011[1] $3,680,000
Income before income taxes and extraordinary item
....................................... Income tax expense
....................................... Income before extraordinary
item .................. Extraordinary item: Gain from settlement of
lawsuit (net of $400,000 tax expense)
................................. Net Income
.................................................... Income before
extraordinary item .................. Extraordinary gain
......................................... Net income
....................................................[1]
1,472,000 2,208,000 600,000 $2,808,000 2.21 0.60 $ 2.81
Income from continuing operations before income taxes:
Unadjusted $4,200,000 Add: Gain from sale of equipment 50,000
Deduct: Inventory write-off (400,000) Depreciation expense (2011)
(50,000) Overstated profit on installment sale (120,000) * Adjusted
$3,680,000 $160,000 (40,000) $120,000
* Profit recognized ($400,000 240,000) Profit that should have
been recognized (gross profit ratio of 40% x $100,000) Overstated
profit
Problem 5-2
Requirement 1 2011 Cost recovery % : = 60% (gross profit % =
40%)
$180,000 $300,000 2012 Cost recovery %: $280,000 = 70% (gross
profit % = 30%)5-47
Chapter 05 - Income Measurement and Profitability Analysis
$400,000 2011 gross profit: Cash collection from 2011 sales =
$120,000 x 40% = 2012 gross profit: Cash collection from 2011 sales
= $100,000 x 40% = + Cash collection from 2012 sales = $150,000 x
30% = Total 2012 gross profit Requirement 2 2011 To record
installment sales Installment
receivables................................................ 300,000
.....................................................................Inventory
.......................................................................180,000
...................................................Deferred gross
profit
.......................................................................120,000
2011 To record cash collections from installment sales
Cash............................................................................
120,000 ................................................Installment
receivables
.......................................................................120,000
2011 To recognize gross profit from installment sales Deferred
gross profit...................................................
48,000 ...................................................Realized
gross profit
.........................................................................48,000
$ 40,000 45,000 $85,000 $48,000
5-48
Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-2 (continued) 2012 To record installment sales
Installment
receivables................................................ 400,000
.....................................................................Inventory
.......................................................................280,000
...................................................Deferred gross
profit
.......................................................................120,000
2012 To record cash collections from installment sales
Cash............................................................................
250,000 ................................................Installment
receivables
.......................................................................250,000
2012 To recognize gross profit from installment sales Deferred
gross profit...................................................
85,000 ...................................................Realized
gross profit
.........................................................................85,000
Requirement 3 Date 2011 2011 sales 2012 2011 sales 2012 sales
2012 totals Cash Collected $120,000 $100,000 150,000 $250,000 Cost
Recovery $120,000 $ 60,000 150,000 $210,000 Gross Profit -0$40,000
-0$40,000
5-49
Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-2 (concluded) 2011 To record installment sales
Installment
receivables................................................ 300,000
.....................................................................Inventory
.......................................................................180,000
...................................................Deferred gross
profit
.......................................................................120,000
2011 To record cash collection from installment sales
Cash............................................................................
120,000 ................................................Installment
receivables
.......................................................................120,000
2012 To record installment sales Installment
receivables................................................ 400,000
.....................................................................Inventory
.......................................................................280,000
...................................................Deferred gross
profit
.......................................................................120,000
2012 To record cash collection from installment sales
Cash............................................................................
250,000 ................................................Installment
receivables
.......................................................................250,000
2012 To recognize gross profit from installment sales Deferred
gross profit...................................................
40,000 ...................................................Realized
gross profit
.........................................................................40,000
Problem 5-3Total profit = $500,000 300,000 = $200,000Installment
sales method: Gross profit % = $200,000 $500,000 = 40%8/31/11
8/31/12 8/31/13 8/31/14 8/31/15
Requirement 1
5-50
Chapter 05 - Income Measurement and Profitability Analysis
Cash collections a. Point of delivery method b. Installment
sales method(40% x cash collected)
$100,000 $100,000 $100,000 $100,000 $100,000 $200,000
-0-0-0-0$40,000
$ 40,000 $ 40,000 $ 40,000 $ 40,000 -0-0-
c. Cost recovery method
- 0 - $100,000 $100,000
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Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-3 (continued) Requirement 2Point of Delivery 500,000
500,000 300,000 300,000 Installment Sales
Cost Recovery
Installment receivable Sales revenue Cost of goods sold
Inventory To record sale on 8/31/11. Installment receivable
Inventory Deferred gross profit To record sale on 8/31/11. Cash
Installment receivable Entry made each Aug. 31. Deferred gross
profit Realized gross profit To record gross profit.(entry made
each Aug. 31)
500,000 300,000 200,000 100,000 100,000 40,000 40,000 100,000
100,000
500,000 300,000 200,000 100,000 100,000
Deferred gross profit Realized gross profit To record gross
profit.(entry made 8/31/14 & 8/31/15)
100,000 100,000
5-52
Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-3 (concluded) Requirement 3 Point of Delivery December
31, 2011 Assets Installment receivables Less: Deferred gross profit
Installment receivables, net December 31, 2012 Assets Installment
receivables Less: Deferred gross profit Installment receivables,
net 400,000 Installment Sales 400,000 (160,000) 240,000 Cost
Recovery 400,000 (200,000) 200,000
300,000
300,000 (120,000) 180,000
300,000 (200,000) 100,000
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Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-4Requirement 1
All jobs consist of four equal payments: one payment when the
job is completed and three payments over the next three years.
Bluebird: Job completed in 2009, so down payment made in 2009,
another payment in 2010, and two payments remain. $400,000 gross
receivable at 1/1/2011 implies payments of ($400,000 2) = $200,000
in 2011 and 2012. Four payments of $200,000 implies total revenue
of 4 x $200,000 = $800,000 on the job. 25% gross profit ratio
implies cost of 75% x $800,000 = $600,000.
Cost recovery method gross profit: Payments in 2009 and 2010
have already recovered $400,000 of cost, so cost remaining to be
recovered as of 1/1/2011 is $600,000 total $400,000 already
recovered = $200,000. Therefore, the entire 2011 payment of
$200,000 will be applied to cost recovery, and no gross profit is
recognized in 2011. Installment sales method gross profit: $200,000
payment x 25% gross profit ratio = $50,000 of gross profit
recognized in 2011. PitStop: Job completed in 2008, so down payment
made in 2008, another payment in 2009, another in 2010, and one
payment remains. $150,000 gross receivable at 1/1/2011 implies a
single payment of $150,000 in 2011. Four payments of $150,000
implies total revenue of 4 x $150,000 = $600,000 on the job. 35%
gross profit ratio implies cost of 65% x $600,000 = $390,000. Cost
recovery method gross profit: Payments in 2008, 2009 and 2010 of a
total of $450,000 have already recovered the entire $390,000 of
cost and allowed recognition of $60,000 of gross profit. Therefore,
the entire 2011 payment of $150,000 will be applied to gross
profit. Installment sales method gross profit: $150,000 payment x
35% gross profit ratio = $52,500 of gross profit recognized in
2011.
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Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-4 (concluded) Totals: Cost recovery method: $0
(Bluebird) + $150,000 (PitStop) = $150,000. Installment sales
method: $50,000 (Bluebird) + $52,500 (PitStop) = $102,500.
Requirement 2 If Dan is focused on 2011, he would not be happy with
a switch to the installment sales method, because that would
produce gross profit of only $102,500, which is $47,500 less than
he would show under the cost recovery method. It is true that the
installment sales method recognizes gross profit faster than does
the cost recovery method, but the installment sales method also
recognizes gross profit more evenly than does the costrecovery
method. The timing of these jobs is such that 2011 is a year in
which almost all of the gross profit associated with the PitStop
job gets recognized, so 2011 looks more profitable under the cost
recovery method.
Problem 5-5Requirement 1Contract price Actual costs to date
Estimated costs to complete Total estimated costs Estimated gross
profit (loss) (actual in 2013) 2011 $10,000,000 2,400,000 5,600,000
8,000,000 $ 2,000,000 2012 $10,000,000 6,000,000 2,000,000
8,000,000 $ 2,000,000 2013 $10,000,000 8,200,000 -08,200,000 $
1,800,000
Gross profit (loss) recognition: 2011: $2,400,000 = 30.0% x
$2,000,000 = $600,000 $8,000,000 2012: $6,000,000 = 75.0% x
$2,000,000 = $1,500,000 600,000 = $900,000 $8,000,000 2013:
$1,800,000 1,500,000 = $300,000
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Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-5 (continued) Requirement 2 2011 Construction in
progress Various accounts To record construction costs. Accounts
receivable Billings on construction contract To record progress
billings. Cash Accounts receivable To record cash collections.
Construction in progress (gross profit) Cost of construction (cost
incurred) Revenue from long-term contracts (1) To record gross
profit. 2012 2013
2,400,000 3,600,000 2,200,000 2,400,000 3,600,000 2,200,000
2,000,000 4,000,000 4,000,000 2,000,000 4,000,000 4,000,000
1,800,000 3,600,000 4,600,000 1,800,000 3,600,000 4,600,000
600,000 2,400,000 3,000,000 900,000 3,600,000 4,500,000 300,000
2,200,000 2,500,000
(1) Revenue recognized: 2011: 30% x $10,000,000 = 2012: 75% x
$10,000,000 = Less: Revenue recognized in 2011 Revenue recognized
in 2012 2013: 100% x $10,000,000 = Less: Revenue recognized in 2011
& 2012 Revenue recognized in 2013
$3,000,000 $7,500,000 (3,000,000) $4,500,000 $10,000,000
(7,500,000) $2,500,000
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Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-5 (continued) Requirement 3 Balance Sheet Current
assets: Accounts receivable Construction in progress Less: Billings
Costs and profit in excess of billings 2011 $ 200,000 $3,000,000
(2,000,000) 1,000,000 $7,500,000 (6,000,000) 1,500,000 2012
$600,000
Requirement 4 Costs incurred during the year Estimated costs to
complete as of year-end Contract price Actual costs to date
Estimated costs to complete Total estimated costs Estimated gross
profit (actual in 2013) 2011 $2,400,000 5,600,000 2011 $10,000,000
2,400,000 5,600,000 8,000,000 $ 2,000,000 2012 $3,800,000 3,100,000
2012 $10,000,000 6,200,000 3,100,000 9,300,000 $ 700,000 2013
$3,200,000 2013 $10,000,000 9,400,000 -09,400,000 $ 600,000
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Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-5 (concluded) Gross profit (loss) recognition: 2011:
$2,400,000 = 30.0% x $2,000,000 = $600,000 $8,000,000 2012:
$6,200,000 = 66.6667% x $700,000 = $466,667 600,000 = $(133,333)
$9,300,000 2013: $600,000 466,667 = $133,333
Requirement 5 Costs incurred during the year Estimated costs to
complete as of year-end Contract price Actual costs to date
Estimated costs to complete Total estimated costs Estimated gross
profit (loss) (actual in 2013) 2011 $2,400,000 5,600,000 2011
$10,000,000 2,400,000 5,600,000 8,000,000 $ 2,000,000 2012
$3,800,000 4,100,000 2012 $10,000,000 6,200,000 4,100,000
10,300,000 $ (300,000) 2013 $3,900,000 2013 $10,000,000 10,100,000
-010,100,000 $ (100,000)
Gross profit (loss) recognition: 2011: $2,400,000 = 30.0% x
$2,000,000 = $600,000 $8,000,000 2012: 2013: $(300,000) 600,000 =
$(900,000) $(100,000) (300,000) = $200,000 Requirement 1 Year
20115-58
Problem 5-6
Gross profit recognized -0-
Chapter 05 - Income Measurement and Profitability Analysis
2012 2013 Total gross profit Requirement 2
-0$1,800,000 $1,800,000
Construction in progress Various accounts To record construction
costs. Accounts receivable Billings on construction contract To
record progress billings. Cash Accounts receivable To record cash
collections. Construction in progress (gross profit) Cost of
construction (costs incurred) Revenue from long-term contracts
(contract price) To record gross profit.
2011 2012 2013 2,400,000 3,600,000 2,200,000 2,400,000 3,600,000
2,200,000 2,000,000 4,000,000 4,000,000 2,000,000 4,000,000
4,000,000
1,800,000 3,600,000 4,600,000 1,800,000 3,600,000 4,600,000
1,800,000 8,200,000 10,000,000
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Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-6 (concluded) Requirement 3 Balance Sheet Current
assets: Accounts receivable Construction in progress Less: Billings
Costs in excess of billings 2011 $ 200,000 $2,400,000 (2,000,000)
400,000 $6,000,000 (6,000,000) -02012 $ 600,000
Requirement 4 Costs incurred during the year Estimated costs to
complete as of year-end Year 2011 2012 2013 Total gross profit
Requirement 5 Costs incurred during the year Estimated costs to
complete as of year-end Year 2011 2012 2013 Total project loss 2011
$2,400,000 5,600,000 2012 $3,800,000 4,100,000 2013 $3,900,000 2011
$2,400,000 5,600,000 2012 $3,800,000 3,100,000 2013 $3,200,000
-
Gross profit recognized -0-0$600,000 $600,000
Gross profit (loss) recognized -0$(300,000) 200,000
$(100,000)
Problem 5-7
Requirement 1 Year5-60
Gross profit recognized
Chapter 05 - Income Measurement and Profitability Analysis
2011 2012 2013 Total gross profit Requirement 2
-0-0$1,800,000 $1,800,000
Construction in progress Various accounts To record construction
costs. Accounts receivable Billings on construction contract To
record progress billings. Cash Accounts receivable To record cash
collections. Construction in progress (gross profit) Cost of
construction (costs incurred) Revenue from long-term contracts
(contract price) To record gross profit.
2011 2012 2013 2,400,000 3,600,000 2,200,000 2,400,000 3,600,000
2,200,000 2,000,000 4,000,000 4,000,000 2,000,000 4,000,000
4,000,000
1,800,000 3,600,000 4,600,000 1,800,000 3,600,000 4,600,000
1,800,000 2,400,000 2,400,000 3,600,000 3,600,000 2,200,000
4,000,000
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Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-7 (concluded) Requirement 3 Balance Sheet Current
assets: Accounts receivable Construction in progress Less: Billings
Costs in excess of billings 2011 $ 200,000 $2,400,000 (2,000,000)
400,000 $6,000,000 (6,000,000) -02012 $ 600,000
Requirement 4 Costs incurred during the year Estimated costs to
complete as of year-end Year 2011 2012 2013 Total gross profit
Requirement 5 Costs incurred during the year Estimated costs to
complete as of year-end Year 2011 2012 2013 Total project loss 2011
$2,400,000 5,600,000 2012 $3,800,000 4,100,000 2013 $3,900,000 2011
$2,400,000 5,600,000 2012 $3,800,000 3,100,000 2013 $3,200,000
-
Gross profit recognized -0-0$600,000 $600,000
Gross profit (loss) recognized -0$(300,000) 200,000
$(100,000)
Problem 5-8
Requirement 1 2011 2012 2013
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Chapter 05 - Income Measurement and Profitability Analysis
Contract price Actual costs to date Estimated costs to complete
Total estimated costs Estimated gross profit (loss) (actual in
2013) Year 2011 2012 2013 Total project loss Requirement 2Gross
profit (loss) recognition:
$4,000,000 350,000 3,150,000 3,500,000 $ 500,000
$4,000,000 2,500,000 1,700,000 4,200,000 $ (200,000)
$4,000,000 4,250,000 -04,250,000 $ (250,000)
Gross profit (loss) recognized -0$(200,000) (50,000)
$(250,000)
2011: 2012: 2013:
10% x $500,000 = $50,000 $(200,000) 50,000 = $(250,000)
$(250,000) (200,000) = $(50,000)
Requirement 3 Balance Sheet Current assets: Costs less loss
($2,300,000*) in excess of billings ($2,170,000) Current
liabilities: Billings ($720,000) in excess of costs and profit
($400,000) 2011 2012
$ 130,000
$ 320,000
*Cumulative costs ($2,500,000) less cumulative loss recognized
($200,000) = $2,300,000
Requirement 1 The completed contract method of recognizing
revenues and costs on long-term construction contracts is
equivalent to recognizing revenue at the point of delivery, i.e.,
when the construction project is complete. The
percentage-ofcompletion method assigns a share of the projects
expected revenues and costs to each period in which the earnings
process takes place, i.e., the construction period. The share is
estimated based on the project's costs incurred each period as a
percentage of
Problem 5-9
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Chapter 05 - Income Measurement and Profitability Analysis
the project's total estimated costs. The completed contract
method should only be used when a lack of dependable estimates or
inherent hazards make it difficult to forecast future costs and
profits. Requirement 2 Contract price Actual costs to date
Estimated costs to complete Total estimated costs Estimated gross
profit a. 2011 $20,000,000 4,000,000 12,000,000 16,000,000 $
4,000,000 2012 $20,000,000 13,500,000 4,500,000 18,000,000 $
2,000,000
Gross profit recognition: Under the completed contract method
Citation would not report gross profit until the project is
competed. Citation would have to report an overall gross loss on
the contract in whatever period it first revises the estimates to
determine that an overall loss will eventually occur. Citation
never estimates the Altamont contract will earn a gross loss, so
never has to recognize one. Under the completed contract method
Citation would not report any revenue in the 2011 or 2012 income
statements.
b.
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Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-9 (continued) c. Balance Sheet At December 31, 2011
Current assets: Accounts receivable Costs ($4,000,000*) in excess
of billings ($2,000,000) $ 200,000 2,000,000
* Under the completed contract method, this account would only
include costs of $4,000,000 Requirement 3 Contract price Actual
costs to date Estimated costs to complete Total estimated costs
Estimated gross profit a. 2011 $20,000,000 4,000,000 12,000,000
16,000,000 $ 4,000,000 2012 $20,000,000 13,500,000 4,500,000
18,000,000 $ 2,000,000
Gross profit recognition: 2011: $ 4,000,000 = 25% x $4,000,000 =
$1,000,000 $16,000,000 2012: $13,500,000 = 75% x $2,000,000 =
$1,500,000 $18,000,000 Less: 2011 gross profit 1,000,000 2012 gross
profit$ 500,000
b.
2011: $20,000,000 x 25% =
$5,000,000
2012: $20,000,000 x 75% = $15,000,000 Less: 2011 revenue
(5,000,000) $10,000,000
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Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-9 (continued) c. Balance Sheet At December 31, 2011
Current assets: Accounts receivable Costs and profit ($5,000,000*)
in excess of billings ($2,000,000) * Costs ($4,000,000) + profit
($1,000,000) Requirement 4 Contract price Actual costs to date
Estimated costs to complete Total estimated costs Estimated gross
profit a. Gross profit recognition: 2012: Overall loss of
($2,500,000) previously recognized gross profit of $1,000,000 =
$3,500,000. b. 2012: Easiest to solve using a journal entry: Cost
of construction (to balance) Revenue from long-term contracts*
Construction in progress (loss)*
$ 200,000 3,000,000
2011 $20,000,000 4,000,000 12,000,000 16,000,000 $ 4,000,000
2012 $20,000,000 13,500,000 9,000,000 22,500,000 ($
2,500,000)
$10,500,000 $7,000,000 $3,500,000
Total revenue recognized to date = (percentage complete)(total
revenue) = ($13,500,000 $22,500,000) x ($20,000,000) = (60%) x
($20,000,000) = $12,000,000 Revenue recognized this period = total
revenue recognized in prior periods = $12,000,000 $5,000,000 =
$7,000,000
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Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-9 (continued) c. Balance Sheet At December 31, 2012
Current assets: Accounts receivable Current liabilities: Billings
($12,000,000) in excess of costs and profit ($11,000,000*) $
1,600,000
1,000,000
* 2011 costs ($4,000,000) + 2011 profit ($1,000,000) + 2012
costs ($9,500,000) 2012 loss ($3,500,000) Requirement 5 Citation
should recognize revenue at the point of delivery, when the homes
are completed and title is transferred to the buyer. This is
equivalent to the completed contract method for long-term
contracts. The percentage-of-completion method is not appropriate
in this case. There is no contract in place and until the
completion of the home, the transfer of title, and the receipt of
the full sales price, the earnings process is not virtually
complete and there is still significant uncertainty as to cash
collection. Also, the sales price is not fixed. Requirement 6
Income statement: Sales revenue (3 x $600,000) Cost of goods sold
(3 x $450,000) Gross profit
$1,800,000 1,350,000 $ 450,000
Balance sheet: Current assets: Inventory (work in process)
$2,700,000 Current liabilities: Customer deposits (or unearned
revenue) 300,000* *$600,000 x 10% = $60,000 x 5 = $300,000
Problem 5-10
Requirement 1
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Chapter 05 - Income Measurement and Profitability Analysis
a.
January 30, 2011
Cash
...........................................................................
200,000 Note receivable
..........................................................
1,000,000 ..................................Unearned franchise fee
revenue
....................................................................1,200,000
b.
September 1, 2011
Unearned franchise fee revenue..................................
1,200,000 ................................................Franchise
fee revenue
....................................................................1,200,000
c.
September 30, 2011 Accounts receivable ($40,000 x 3%)
............................
..........................................................Service
revenue
...........................................................................1,200
1,200
d.
January 30, 2012 100,000
Cash............................................................................
..........................................................Note
receivable
.......................................................................100,000
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Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-10 (continued) Requirement 2 a. January 30, 2011 Cash
...........................................................................
200,000 Note receivable
..........................................................
1,000,000 ...................................Deferred franchise fee
revenue
....................................................................1,200,000
Note: Could also show as: Cash
...........................................................................
200,000 Note receivable
..........................................................
1,000,000 ...................................Deferred franchise fee
revenue
....................................................................1,000,000
..................................Unearned franchise fee revenue
.......................................................................200,000
b.
September 1, 2011 200,000
Deferred franchise fee revenue
..................................
...........................Franchise fee revenue (cash collected)
.......................................................................200,000
c.
September 30, 2011 Accounts receivable ($40,000 x 3%)
............................
..........................................................Service
revenue
...........................................................................1,200
1,200
d.
January 30, 2012
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Chapter 05 - Income Measurement and Profitability Analysis
Cash............................................................................
..........................................................Note
receivable
.......................................................................100,000
Deferred franchise fee revenue ..................................
................................................Franchise fee
revenue
.......................................................................100,000
100,000
100,000
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Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-10 (concluded) Requirement 3
Balance Sheet At December 31, 2011 Current assets: Installment
notes receivable ($1,000,000) less deferred franchise fee revenue
($1,000,000) Current liabilities: Unearned franchise fee revenue $
-0-
$200,000
Explanation: Revenue recognition on the entire note receivable
is deferred. In addition, $200,000 of unearned revenue must be
shown as a liability.
Problem 5-111. Inventory turnover ratio$6,300 [($800 + 600) 2] =
9.0
2. Average days in inventory365 9.0 = 40.56 days 3. Receivables
turnover ratio $9,000 [($600 + 400) 2] = 18.0 4. Average collection
period 365 18.0 = 20.28 days 5. Asset turnover ratio $9,000
[($4,000 + 3,600) 2] = 2.37 6. Profit margin on sales $300 $9,000 =
3.33% 7. Return on assets $300 [($4,000 + 3,600) 2] = 7.89% or:
3.33% x 2.37 times = 7.89% 8. Return on shareholders equity $300
[($1,500 + 1,350) 2] = 21.1% 9. Equity multiplier [($4,000 + 3,600)
2] [($1,500 + 1,350) 2] = 2.67 10. DuPont framework 3.33% x 2.37 x
2.67 = 21.1%
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Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-12 Receivables turnoverJ&J Pfizer Inventory
turnover
Requirement 1 = = = = Net sales Accounts receivable $41,862
$6,574 = 6.37 times On average, J&J collects its receivables in
14 days less than Pfizer. On average, J&J sells its inventory
twice as fast as Pfizer.
$45,188 goods sold times = 5.15 Cost of $8,775 Inventories 365
$12,176 = 3.39 times Receivables turnover $3,588 365 $9,832 6.37
$5,837 = 57 days = 1.68 times
Average collection period == J&J J&J Pfizer = =
Pfizer = Average days in inventory = J&J Pfizer = =
365 365 = 71 days 5.15 Inventory turnover 365 3.39 365 1.68 =
108 days = 217 days
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Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-12 (continued) Requirement 2 Rate of return on assets
J&J Pfizer = = = Net income Total assets $7,197 $48,263 = 14.9%
The return on assets indicates a company's overall profitability,
ignoring specific sources of financing. In this regard,
J&Js
$1,639 1.4% = $116,775 profitability is significantly higher
than that of Pfizer. Requirement 3
Profitability can be achieved by a high profit margin, high
turnover, or a combination of the two. Rate of return on assets =
J&J = = Pfizer = = = Profit margin on sales x x x x x x Asset
turnover
Net income Net sales $ 7,197 $41,862 17.19% $ 1,639 $45,188
3.63%
Net sales Total assets $41,862 $48,263 .867 times $45,188
$116,775 .387 times = 1.4% = 14.9%
J&Js profit margin is much higher than that of Pfizer, as is
its asset turnover. These differences combine to produce a
significantly higher return on assets for J&J.
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Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-12 (concluded) Requirement 4 Rate of return on =
shareholders equity J&J Pfizer = = Net income Shareholders
equity $7,197 $26,869 = 26.8% J&J provided a much greater
return to shareholders.
$1,639 = 2.5% Requirement 5 $65,377 Total Assets The two Equity
multiplier = companies have shareholders equity Shareholders equity
virtually identical J&J $48,263 equity multipliers, = = 1.80
indicating that they $26,869 are using leverage Pfizer $116,775 = =
1.79 to the same extent $65,377 to earn a return on equity that is
higher than their return on assets. a. Times interest earned ratio
= (Net income + Interest + Taxes) Problem 5-13 Interest = 17 (Net
income + $2 + 12) $2 = 17 Net income + $14 = 17 x $2 Net income =
$20 b. Return on assets = Net income Total assets = 10% Total
assets = $20 10% = $200 c. Profit margin on sales = Net income
Sales = 5% Sales = $20 5% = $400 d. Gross profit margin = Gross
profit Sales = 40% Gross profit = $400 x 40% = $160 Cost of goods
sold = Sales Gross profit = $400 160 = $240 e. Inventory turnover
ratio = Cost of goods sold Inventory = 8 Inventory = $240 8 = $30
f. Receivables turnover ratio = Sales Accounts receivable = 20
Accounts receivable = $400 20 = $20
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Chapter 05 - Income Measurement and Profitability Analysis
g. Current ratio = Current assets Current liabilities = 2.0
Acid-test ratio = Quick assets Current liabilities = 1.0 Current
assets 2 = Current liabilities Quick assets 1 = Current liabilities
Current assets 2 = Quick assets 1 Current assets = 2 x Quick assets
Cash + accts. rec. + Inventory = 2 x (Cash + Accounts receivable)
Cash + $20 + $30 = (2 x Cash) + (2 x $20) Cash + $50 = Cash + Cash
+ $40 Cash = $10 h. Acid-test ratio = (Cash + Accounts receivable)
Current liabilities = 1.0 Current liabilities = ($10 + 20) 1.0 =
$30 i. Noncurrent assets = Total assets Current assets = $200
($10+20+30) = $140 j. Return on shareholders equity = Net income
Shareholders equity = 20% Shareholders equity = $20 20% = $100
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Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-13 (concluded) k. Debt to equity ratio = Total
liabilities Shareholders equity = 1.0 Total liabilities = $100 x
1.0 = $100 Long-term liabilities = Total liabilities Current
liabilities = $100 30 = $70 CADUX CANDY COMPANY Balance Sheet At
December 31, Net income Rate of return on assets Assets = Current
assets: Total assets Cash Metropolitan $ 593.8 Accounts receivable
(net) = $4,021.5 Inventories Total current assets Republic =
Property, plant, and equipment (net) $ 424.6 $4,008.0 Total
assets
2011
Problem 5-14Requirement 1 The
return on assets $ 10 14.8% indicates a = 20 company's 30
overall 60 10.6% profitability, = 140 ignoring specific $200
sources of financing. In this Liabilities and Shareholders Equity
regard, Current liabilities $ 30 Metropolitans Long-term
liabilities 70 Shareholders equity 100 profitability exceeds that
of Total liabilities and shareholders' equity $200 Republic.
Requirement 2 Profitability can be achieved by a high profit
margin, high turnover, or a combination of the two. Rate of return
on assets = Net income Net sales $ 593.8 $5,698.0 10.4% x x =
Profit margin on sales x x Asset turnover
Net sales Total assets
Metropolitan = =
$5,698.0 $4,021.5 1.42 times = 14.8%
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Chapter 05 - Income Measurement and Profitability Analysis
Republic = =
$ 424.6 $7,768.2 5.5%
x x
$7,768.2 $4,008.0 1.94 times = 10.7%
Republics profit margin is much less than that of Metropolitan,
but partially makes up for it with a higher turnover.
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Chapter 05 - Income Measurement and Profitability Analysis
Problem 5-14 (continued) Requirement 3 Rate of return on
shareholders equity Metropolitan Republic = = = Net income
Shareholders equity $593.8 $144.9 + 2,476.9 904.7 $424.6 $335.0 +
1,601.9 964.1 = 34.6% = 43.6%
Republic provides a greater return to common shareholders.
Requirement 4 Equity multiplier Metropolitan Republic = = = Total
assets Shareholders equity $4,021.5 $144.9 + 2,476.9 904.7 $4,008.0
$335.0 + 1,601.9 964.1 = 2.34 = 4.12
When the return on shareholders equity is greater than the
return on assets, management is using debt funds to enhance the
earnings for stockholders. Both firms do this. Republics higher
leverage has been used to provide a higher return to shareholders
than Metropolitan, even though its return on assets is less.
Republic increased its return to shareholders 4.07 times (43.6%
10.7%) the return on assets. Metropolitan increased its return to
shareholders 2.34 times (34.6% 14.8%) the return on assets.
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Chapter 05 - Inc