CHAPTER 7REVENUE RECOGNITION AND RELATED EXPENSES Solutions to Questions, Exercises and Problems, and Teaching Notes to Cases7.1Revenue Recognition. Most firms recognize revenue when (1) the product hasbeen provided to the customer, and (2) either cash, a receivable, or some other asset that can be reasonably measured has been received from the customer. This method is typically referred to as the time of sale method for recognizing revenue. In some circumstances, however, waiting for the product to be completed and delivered to the customer can lead to skewed financial reporting because the production cycle for the product can be extremely long. Long-term contractors, for example, builders of ships or military aircraft, can recognize revenue during the period of construction using the percentage-of-completion method. Circumstances that warrant choice of the percentage-of-completion method include: (1) the time required to build the product spans many accounting periods; (2) a customer is identified and a contract price is agreed upon in advance; (3) the total cost of the product can be estimated with reasonable certainty at the start of the building of the product; and (4) customers make periodic payments of the contract price as the building progresses (thus, minimizing the risk of uncollectibility of payment for the product).7.2Accounting for Customer Sales Incentives. PepsiCo reports sales incentives asa reduction of revenues. Incentives totaled $6.6 billion in Year 4, $6.0 billion in Year3, and $5.5 billion in Year 2, and on average represent about 18 percent of gross revenues (net revenues plus sales incentives). GAAP requires PepsiCo to report sales incentives as a reduction of revenues. PepsiCo’s likely preference would be to report gross revenues on its income statement and include sales incentives as part of selling, general and administrative expenses. Although there is no differential effect on net income between the two reporting options, revenue is an important growth metric for all firms, including PepsiCo, and reporting a higher revenue stream is desirable. On the other hand, reducing gross revenues for sales incentives increases the profit margins for ROA and ROCE.7.3LIFO and FIFO Cost-Flow Assumption for Inventory. The inventory turnoverratio for Year 4 for the two cost-flow assumption methods is:FIFO LIFO5.0 = $4,150.8/.5($788.1 + $861.7)11.5 = $4,417.1/.5($359.1 + $409.3)Inventory measured using the LIFO cost-flow assumption is substantially lower because the costs assigned to the inventory were incurred many years previously.Because the firm grew inventory as a result of meeting increased revenues, older dollars incurred for purchases were attached to inventory, with newer dollars attached to cost of goods sold. With a decade of inventory growth, older dollars continued to be used for measuring inventory that resulted in substantially lower inventory costs using LIFO. The effect of the different cost-flow assumption methods is dramatically demonstrated by noting that the inventory turnover ratio under LIFO is more than double than the ratio under FIFO.7.4Effect of Weighted Average Cost-Flow Assumption on Inventory.Wheninventory turns over rapidly, purchases during the current period receive a heavy weight in the weighted average unit cost. Therefore, the weighted average assumption reflects current prices almost as much as with the FIFO cost-flow assumption method. Note that with the LIFO cost-flow assumption, in periods of growth and/or rising prices, the costs assigned to inventory are usually far removed from current prices.7.5Earnings Management and Depreciation Measurement.D epreciation is aprocess of allocating historical cost of depreciable assets to the periods of their use in a reasonably systematic manner. Three factors must be considered when measuring depreciation expense: (1) acquisition cost, including subsequent expenditures to add to or improve an existing depreciable asset; (2) expected useful life of the depreciable asset; and (3) depreciation method. Many illustrations exist that involve altering one or more of the factors to manage earnings. Transparency demands that firms disclose a change in policy for any of these factors and, as such, analysts can judge whether the change makes sense from a business perspective or whether it appears to be a means for managing earnings. For example, an airline that extends the useful life of aircraft because of implementing more stringent maintenance and inspection schedules might be understandable. On the other hand,a change in aircraft useful lives that positions the firm as an outlier relative to otherairlines would appear to be a means for managing earnings. As another example, a firm may change from on acceptable depreciation method to another acceptable method. Since more firms in the United States use the straight-line method, however, the change would position the firm as an outlier and to questioning about the motivation for the change.7.6Research and Development Costs.Standard setters require R&D costs to beexpensed because of the uncertainty in judging their future revenue-generatingpotential. As an alternative, all R&D costs could be capitalized and then subsequently amortize those that have future revenue-generating potential. R&D costs incurred that subsequently are deemed to have no future revenue-generating potential would no longer be amortized but charged to R&D expense immediately.Although it is debatable which alternative better serves investors, clearly in-depth disclosure of R&D expenditures by firms serves the investor well. This is particularly true for firms with large R&D expenditures, such as biotechnology firms. To date, standard setters have shown no interest in revisiting Statement No.2, the standard that addresses accounting for R&D costs.7.7Capitalization of Software Development Costs.Adobe capitalizes softwaredevelopment costs once a graphics software program reaches the technological feasibility stage of development. However, Adobe indicates that the amount of software cost capitalized is immaterial to the financial statements. The firm states:“Capitalization of software development costs begins upon the establishment of technological feasibility, which is generally the completion of a working prototype that has been certified as having no critical bugs and is a release candidate or when alternative future use exists. To date, software development costs incurred between completion of a working prototype and general availability of the related product have not been material and have not been capitalized.” In essence, Adobe concluded that the time between the prototype and product availability stage is so short that the additional costs incurred at this stage are minor relative to the total costs incurred to develop the software.7.8Testing for Goodwill Impairment.Impairment testing of goodwill entailscomparing the carrying value of goodwill to its fair value. If the fair value is below the carrying value of the goodwill, impairment has occurred. Statement No 142 provides illustrations of how to estimate the fair value. A common approach is to estimate the current fair value of the operating unit that was purchased and that resulted in the goodwill recorded at the time of the acquisition.Impairment testing for a patent is different than that for goodwill. The firm compares the undiscounted cash flows generated by the patent to its carrying value.If the undiscounted cash flows are greater than the carrying value, impairment has occurred. The actual impairment charge recorded is the difference between the amount by which the carrying value exceeds the patent’s fair value. In this case, fair value means market value or present (discounted) value of expected cash flows from the patent.7.9Income Recognition for Various Types of Businesses.a.Savings and loan associations recognize interest revenue each period using theinterest rate or interest pricing procedure specified in the mortgage agreementand the unpaid balance of the loan at the beginning of the period. The principalincome measurement issues relate to the recognition of expenses. Savings andloan associations incur substantial costs initially to set up the loan. Shouldthese firms accelerate the recognition of revenue somewhat to offset these highfront-end expenses and avoid showing a loss in the loan's initial year? Or,should these firms defer the initial costs and recognize them over the life of theloan? Both practices are common. Another income recognition issue relates touncollectible loans. Should the savings and loan association recognize portionsof the estimated losses on such loans each period while the loans are outstandingor wait until a particular loan becomes uncollectible? GAAP requires periodicrecognition of estimated losses on loans.b.Three possible revenue recognition points for the commission revenue of a travelagency are the time of booking a reservation, the time that a customer utilizesthe service booked, and the time that the travel agency receives the commissionin cash from the service provider. The time of booking a reservation is probablytoo early because customers frequently change reservations or cancel entirely.Revenue recognition at the time customers use the service is impractical becausethe cost of obtaining the information is probably prohibitive. Revenuerecognition at the time of cash receipt seems the most plausible in this case.c.Recognizing revenue at the time the baseball team sells season tickets isinappropriate because it must provide substantial future services. As the teamprovides the services (that is, plays the games), it should recognizeproportionate parts of the season ticket revenue. The teams should matchagainst this revenue both the cost of compensation paid to players currently andthe present value of any deferred compensation that the team will pay in thefuture. A liability for the present value of these future services appears on thebalance sheet of the baseball team.d.The issue here is whether the firm should recognize as revenue the increase inthe value of the whiskey as it ages. Uncertainties about the amount of this valueincrease and the amount of cash ultimately received when the aging is completeargue against such early revenue recognition. D elaying revenue recognitionsuggests that the firm also defer all costs of producing and storing the whiskey.The inventory account on the balance sheet includes such costs.e.The amount and timing of revenue appear highly predictable in this case. Otherthan overseeing the growing of the trees, future performance appears negligible.These conditions seem to justify use of the percentage-of-completion method ofincome recognition. Note the contrast between the whiskey producer inQuestion d.and the timber firm in this question with respect to uncertaintyabout the amount of revenue. Although application of the revenue and expensecriteria seems to justify recognition prior to harvesting, most timber-growingfirms would probably delay recognition until harvesting. Customers may cancelorders, fire or disease might destroy the trees, and the costs of harvesting manyyears later create sufficient uncertainties to justify deferral. The timber-growingfirm should defer the costs of maintaining the trees to obtain an appropriatematching of revenues and expenses.f.Airlines recognize revenue each time they provide transportation services. Theymatch the costs of providing the services (salaries, fuel, depreciation) against therevenue as expenses. One might argue that a portion of the revenue from eachflight represents revenue of the free flight that the customer will ultimately take.A proper matching of revenues and expenses requires either that (1) the airlinedefer a portion of current revenues and recognize them at the time of the freeflight, or (2) estimate the costs that the airline will incur in providing the freeflight and recognize it as an expense (and a liability) in the periods whencustomers take fee-paying flights. Airlines have argued that they incur relativelylittle incremental costs when they provide the free flights. They limit thenumber of seats per flight that customers can use for their free flights and thatthe airlines would not otherwise use such seats. Given that the costs of a flightis approximately the same whether the flight is 95 percent full or 100 percentfull, the additional non-fee paying passengers do not add materially to theairline's costs. Thus, the airlines typically do recognize an expense and aliability for the future costs of providing free flights, but include only relativelyminor incremental costs in measuring the expense and the liability.7.10Measuring Income for a Software Manufacturer.a.Financial reporting requires the recognition of revenue under the accrual basis ofaccounting when a firm both (1) has provided all, or a substantial portion, of theservices to be performed, and (2) has received either cash, a receivable, or someother asset whose cash-equivalent amount the firm can measure with reasonableprecision.Mapping these general criteria to PTC’s policy for recognizing software license revenues can be complex. In many cases, the problem relates to the factthat customer contracts often combine products and services, with no cleardistinction as to what portion of the agreed-upon total revenues are applicableto the various promises made by the firm to the customer. Very few softwaremanufacturers, such at PTC, provide only products (in this case, software) oronly IT-related consultancy services. Firm management and its auditors often grapple with this problem on an on-going basis because GAAP is ever evolving for the software and consultancy industries.In the case of PTC, the firm defines “substantially all services performed”(criterion one) by having a contract in place (persuasive evidence of an arrangement), delivery of the software and a fix or determinable fee. PTC defines “has received cash or an equivalent” (criterion two) by the probability that collection is high. PTC uses these same criteria for recognizing software revenue generated through resellers.b.PTC states that all revenue generated from maintenance contracts promising aspecific upgrade are deferred until the future upgrade is delivered. Otherwise, maintenance revenue is recognized over the term of the contract. PTC appropriately defers revenue on contracts that promise a specific upgrade because general revenue recognition criterion one (see Part a. above) has not been met.c.PTC recognizes educational consultancy services as the services are performed.PTC requires its employees to maintain detailed records as to the number of hours that were spent on training and evaluative assessments. These records are used to bill the client and recognize revenue, after taking into consideration the potential of uncollectibility. Similar revenue recognition techniques are used by legal and accounting firms.d.There are many examples of estimates and judgments that PTC must make fordetermining revenues. This is particularly true for PTC because the firm often signs contracts that span providing products and services over an 18-24 month period. As a publicly held company, PTC must report to shareholders on a quarterly basis and break out the revenues generated by these contracts over several quarters and/or fiscal years. In addition, PTC often combines software and service commitments to customers in one contract. The firm must estimate what portion of the agreed-upon payments is for software licensing and what portion is for other services provided the customer. PTC must also estimate how much of the total contract fee structure is related to implementation and training and how much is related to the licensing of the software. In addition, as PTC discusses in its revenue recognition note to the financial statements, the firm must assess the collectibility of the amount due from the customer. The firm states that it places weight on such factors as customer credit-worthiness and historical payment experience.7.11Measuring Income for a Consultancy Firm.a.Sapient generates three types of contracts with customers: (1) fixed-price,fixed-time contracts; (2) support and maintenance contracts; and (3)performance standards contracts. Revenue from fixed-price, fixed-time contractsis recognized based on the ratio of labor hours incurred to estimated total laborhours. The main difficulty in applying this method is ensuring that dependableestimates can be made of the total labor hours necessary to complete the work.In addition, estimates must be made of the revenues and costs applicable to thevarious stages of the contract. Revenue from support and maintenance contractsis recognized ratably over the term of the contract. Often support andmaintenance contracts can be extended by making additional nominal payments;however, the difficulty is assessing the effective life of the contract. Revenuefrom performance standards contracts is recognized based on achieving theperformance standards specified in the contracts. The main difficulty inapplying this method is the fact that Sapient and the customer may disagree onwhether the performance standard is actually met, particularly if the contractdoes not provide precise benchmarks for making this assessment.b.Financial reporting requires the recognition of revenue under the accrual basis ofaccounting when a firm both (1) has provided all, or a substantial portion, of theservices to be performed, and (2) has received either cash, a receivable, or someother asset whose cash-equivalent amount the firm can measure with reasonableprecision. In each of the revenue recognition methods discussed in Part a. above,Sapient meets criterion (1) by waiting to recognize revenue until the bulk of theservices has been provided to the customer. Sapient does not discuss criterion(2) in its revenue recognition note, but one can assume that the firm assesses theprobability of collection in each case before recognizing revenue.c.Customer contracts that contain multiple deliverables add another layer ofcomplexity to revenue recognition because often it is difficult to distinguishwhat amount of the total agreed-upon contract payments relates to whichdeliverables. Recall the Xerox example in the text of the chapter (Example 1).Xerox Corporation typically manufactures and leases copiers to customersunder multi-year leases. Since the length of the leases often approximates theuseful life of the copiers, the arrangement often is equivalent to a sale of thecopier, with Xerox providing financing to the customer signing the lease. Theaccounting is complex, however, because the total lease contract usually entails abundled monthly payment that covers not just use of the copier by thecustomer over the life of the lease, but also maintenance services, photocopyingpaper up to certain minimum usage, and financing costs. The revenuerecognition question is when Xerox should recognize revenue from the fourservices covered in the lease: (1) copier use, (2) maintenance services, (3)photocopying paper, and (4) financing.EITF 00-21, “Revenue Arrangements with Multiple Deliverables,”addresses accounting for these types of arrangements. Sapient distinguishesamong the multiple deliverables of a contract by first assessing whether thedeliverables represent “separate units of accounting.” If so, Sapient thenmeasures and allocates the agreed-upon payments to the separate units based onreliable evidence of the fair value of each deliverable. If Sapient cannot identifyseparate units of accounting for the various components of the contract, the firmprobably defers recognizing revenue until substantially all deliverables promisedin the contract have been delivered to the customer.7.12Measuring Income for A Long-Haul Transport Firm.CN recognizes revenue for its freight transport services using the percentage-of-completion method. Examples of freight customers of CN are the automobile manufacturers in mid-America, the grain producers in Western Canada, and the various European manufacturers that use sea transport to ship their products to the eastern Canadian port where CN picks up the freight and delivers it throughout North America. In most of these cases, the shipments are time sensitive, which means that the length of the time between picking up the freight at the point of origination and delivering it to the point of destination is fairly short.Given this, it is somewhat surprising that CN recognizes revenue using the percentage-of-completion method. In most cases, the length of time for delivery of the freight is not that long, and the complete contract method would appear to be as appropriate. With this alternative, CN would recognize revenue when the freight was successfully delivered to the point of designation. CN probably uses the percentage-of-completion method because (1) it has the ability to recognize revenue faster than under the completed contract method, and (2) the obligation of the shipper to CN is simply a function of distance covered, meaning CN could bill and collect from the shipper for even partially completed transport services. In addition, CN has sophisticated tracking systems (much like the air freight firms) that allow it to easily track revenues over the entire length of a freight shipment.This tracking information is provided to the customer as well, and on occasion, the customer will change the final destination of the products during the course of the shipment.7.13Measuring Income from Long-Term Contracts.a.(amounts in millions)Year 1 and Year 2:no revenues and expenses for the observatory project.Year 3:$120 – $100 = $20.b.(amounts in thousands)Year Revenue Expense Income1.10 x $120,000 =$12,000$10,000 (10%)$2,0002.60 x $120,000 =72,00060,000 (60%)12,0003.30 x $120,000 = 36,000 30,000 (30%)6,000$120,000$100,000$ 20,000c.Year Revenue Expense Income1Sale$30,000 + $22,540 = $52,540.7764a x $52,540 = $40,793$11,747 Interest7,4608,122 (662)$11,085 2Sale$24,793.7764a x $24,793 = $19,249$5,544 Interest5,2077,934 (2,727)$ 2,817 3Sale$27,273.7764a x $27,273 = $21,175$6,098 Interest 2,727 2,727 --$ 6,098$120,000$100,000$20,000 a$81,217 ÷ ($30,000 + $74,606) = .7764.d.Year Completed Contract Method Percentage of Completion Method1$10,000$10,000 + $2,000=$12,0002$10,000 + $60,000 =$70,000$12,000 + $60,000 + $12,000 =$84,0003$70,000 + $30,000 =$100,000$84,000 + $30,000 + $6000=$120,000 7.14Financial Statement Disclosures Regarding Inventories and Fixed Assets(amounts in millions).a.Year 3Year 4Cost of Goods Sold (LIFO).................................$8,469$11,407Excess of FIFO over LIFO:Beginning of Year (310270)End of Year........................................................ (270) (770)Cost of Goods Sold (FIFO).................................$ 8,509$ 10,907b.LIFO Year 3Year 4$8,469 ÷ [.5($1,030 + $1,283)].............................7.32$11,407 ÷ [.5($1,283 + $1,197)]...........................9.20 FIFO$8,509 ÷ [.5($1,030 + $310 + $1,283 + $270)].... 5.88$10,907 ÷ [.5($1,283 + $270 + $1,197 + $770)].. 6.20 c.Year 3Year 4Depreciation Expense (straight line)....................$363$382 Difference between Accelerated and Straight-Line Depreciation:($455 – $365) ÷ .35 (257)($495 – $455) ÷ .35 (114)Depreciation Expense (accelerated)......................$ 620$ 496 d.Straight Line Year 3Year 4$9,328 ÷ [.5($2,978 + $3,414)]............................ 2.92$13,969 ÷ [.5($3,414 + $3,627)].......................... 3.97 Accelerated$9,328 ÷ [.5($1,935 + $2,114)]............................ 4.61$13,969 ÷ [.5($2,114 + $2,213)].......................... 6.46December 31Year 2Year 3Year 4 Property, Plant and Equipment (straight-line).........................................................$2,978$3,414$3,627 Cumulative Additional Depreciation onAccelerated (tax) Method:$365 ÷ .35.............................................(1,043)$455 ÷ .35.............................................(1,300)$495 ÷ .35............................................. (1,414) Property, Plant and Equipment(accelerated)............................................$ 1,935$ 2,114$ 2,213 e.ROAYear 3: [$–479 + .65($130)] ÷ [.5($7,977 + $7,837)] = –4.99%Year 4: [$1,073 + .65($119)] ÷ [.5($7,837 + $10,956)] = 12.24%Profit Margin for ROAYear 3: [$–479 + .65($130)] ÷ $9,328 = –4.23%Year 4: [$1,073 + .65($119]) ÷ $13,969 = 8.24%Assets TurnoverYear 3: $9,328 ÷ [.5($7,977 + $7,837)] = 1.18Year 4: $13,969 ÷ [.5($7,837 + $10,956)] = 1.49f.ROAYear 3: [$–672 + .65($130)] ÷ [.5($7,135 + $6,713)] = –8.49%Year 4: [$1,324 + .65($119)] ÷ [.5($6,713 + $10,043)] = 16.73%Profit Margin for ROAYear 3: [$–672 + .65($130)] ÷ $9,328 = –6.30%Year 4: [$1,324 + .65($119)] ÷ $13,969 = 10.03%Assets TurnoverYear 3: $9,328 ÷ [.5($7,135 + $6,713)] = 1.35Year 4: $13,969 ÷ [.5($6,713 + $10,043)] = 1.67Year 3Year 4 Reported Net Income (Loss)................................$(479)$1,073 Adjustment from LIFO to FIFO:Year 3: .65($270 – $310) (26)Year 4: .65($770 – $270) (325)Adjustment from Straight Line to Accelerated:Year 3: .65($363 – $620) (167)Year 4: .65($382 – $496) (74)Restated Net Income............................................$ (672)$ 1,324Year 2Year 3Year 4 Reported Assets...........................................$7,977$7,837$10,956 Adjustment from LIFO to FIFO:Year 2: .65 x $310 (201)Year 3: .65 x $270 (176)Year 4: .65 x $770 (501)Adjustment from Straight Line to Accelerated:Year 2: $365 ÷ .35..................................(1,043)Year 3: $455 ÷ .35..................................(1,300)Year 4: $495 ÷ .35.................................. (1,414) Restated Assets............................................$ 7,135$ 6,713$ 10,043g.ROCEYear 3: $–479 ÷ [.5($2,027 + $865)] = –33.13%Year 4: $1,073 ÷ [.5($865 + $3,726)] = 46.74%ROA (using NI to Common)Year 3: $–479 ÷ [.5($7,977 + $7,837)] = –6.06%Year 4: $1,073 ÷ [.5($7,837 + $10,956)] = 11.42%Capital Structure LeverageYear 3: [.5($7,977 + $7,837)] ÷ [.5($2,027 + $865)] = 5.47Year 4: [.5($7,837 + $10,956)] ÷ [.5($865 + $3,726)] = 4.09h.ROCEYear 3: $–672 ÷ [.5($1,550 + $196)] = –76.98%Year 4: $1,324 ÷ [.5($196 + $3,308)] = 75.57%ROA (using NI to Common)Year 3: $–672 ÷ [.5($7,135 + $6,713)] = –9.71%Year 4: $1,324 ÷ [.5($6,713 + $10,043)] = 15.80%Capital Structure LeverageYear 3: [.5($7,135 + $6,713)] ÷ [.5($1,550 + $196)] = 7.93Year 4: [.5($6,713 + $10,043)] ÷ [.5($196 + $3,308)] = 4.78Year 2Year 3Year 4 Reported Shareholders' Equity........................$2,027$865$3,726 Adjustment from LIFO to FIFO:Year 2: .65 x $310 (201)Year 3: .65 x $270 (176)Year 4: .65 x $770 (501)Adjustment from Straight Line to Accelerated:Year 2: .65 x $1,043 (678)Year 3: .65 x $1,300 (845)Year 4: .65 x $1,414 (919)Restated Shareholders' Equity.........................$ 1,550$ 196$ 3,308 i.The reported amounts indicate increased profitability between Year 3 and Year4, the result of an increased profit margin (ROA), which was somewhat decreased by lower capital structure leverage ratio (CSL). The increase in the profit margin occurred primarily because of stronger sales in Year 4 and the elimination of restructuring charges present in Year 3 (not reported here). The decreased capital structure leverage ratio occurred in part from increase in。
