6-1
CHAPTER 6
Revenues and Cash Flows
ASSIGNMENT CLASSIFICATION TABLE
Topics
Questions
Brief
Exercises
Exercises
Problems
Cases
*1. Realization and recogni-
tion; sales transactions,
high rates of return.
1, 2, 3, 4,
1 1 1, 2, 3, 4,
5, 7, 8
*2. Long-term contracts. 5, 6, 7, 8,
9
2, 3, 4 1, 2, 3, 4
5, 6
1, 2, 3,
4, 5, 8,
9, 10
1, 6
*3. Installment sales. 10, 11, 12,
14, 15
5, 6 7, 8, 9 1, 6, 7 1
*4. Cost recovery, deposit
methods.
11, 12, 13,
16, 17
7 8, 9, 10
*5. Statement of Cash Flows. 18, 19, 20,
21, 22, 23,
24, 25
8, 9, 10,
11, 12
11, 12, 13,
14, 15, 16,
17
11, 12 9
*6. Entries for long-term con–
tracts.
26 13, 14 18, 20 13 *6
*7. Entries for installment
sales.
15 19, 21, 22 14, 15, 16 *7
*This material is dealt with in the Appendix to the chapter.
6-2
ASSIGNMENT CHARACTERISTICS TABLE
Item
Description
Level of
Difficulty
Time
(minutes)
E6-1 Recognition of profit on long-term contracts. Moderate 20-25
E6-2 Gross profit on uncompleted contract. Moderate 10-12
E6-3 Recognition of profit, percentage-of-completion. Moderate 10-12
E6-4 Recognition of revenue on long-term contract. Moderate 15-20
E6-5 Recognition of profit for long-term contracts. Simple 15-20
E6-6 Long-term contract reporting. Simple 15-25
E6-7 Installment-sales method calculations. Moderate 15-20
E6-8 Installment-sales method and cost-recovery method. Simple 10-15
E6-9 Installment-sales method and cost-recovery method. Simple 15-20
E6-10 Cost-recovery method. Simple 15-20
E6-11 Statement of cash flows—classification. Moderate 15-20
*E6-12 Preparation of a statement of cash flows. Moderate 25-35
*E6-13 Preparation of a statement of cash flows. Moderate 25-35
*E6-14 Preparation of a statement of cash flows. Moderate 25-35
E6-15 Preparation of a statement of cash flows and a balance
sheet.
Moderate 30-35
E6-16 Preparation of a statement of cash flows, analysis. Moderate 25-35
E6-17 Preparation of a statement of cash flows, analysis. Moderate 25-35
*E6-18 Percentage-of-completion and entries. Moderate 30-45
*E6-19 Installment sales entries. Simple 20-25
*E6-20 Analysis of percentage-of-completion financial statements. Moderate 25-35
*E6-21 Gross profit calculations and repossessed merchandise. Moderate 15-20
*E6-22 Interest revenue from installment sales. Moderate 25-30
P6-1 Comprehensive two-part revenue recognition. Moderate 20-25
P6-2 Recognition of profit on long-term contract. Simple 20-25
P6-3 Recognition of profit, percentage-of-completion. Moderate 25-35
P6-4 Recognition of profit, percentage-of-completion. Moderate 20-30
P6-5 Long-term contract with an overall loss. Moderate 20-25
P6-6 Installment sales computations. Moderate 25-30
P6-7 Installment sales income statements. Moderate 30-35
P6-8 Completed-contract method. Moderate 20-30
P6-9 Revenue recognition methods—comparison. Complex 40-50
P6-10 Comprehensive problem—long-term contracts. Complex 50-60
P6-11 Preparation of a statement of cash flows. Complex 35-45
P6-12 Preparation of a statement of cash flows. Complex 40-50
*P6-13 Percentage of Completion, journal entries, and balance
sheet.
Moderate 20-25
*P6-14 Installment-sales—entries. Moderate 20-25
*P6-15 Installment-sales computations and entries. Complex 30-40
*P6-16 Installment-sales entries. Simple 20-25
C6-1 Revenue recognition—alternative methods. Moderate 20-30
C6-2 Recognition of revenue—theory. Moderate 35-45
C6-3 Recognition of revenue—theory. Moderate 25-30
C6-4 Recognition of revenue—bonus dollars. Moderate 30-35
6-3
ASSIGNMENT CHARACTERISTICS TABLE (Continued)
Item
Description
Level of
Difficulty
Time
(minutes)
C6-5 Recognition of revenue from subscriptions. Complex 35-45
C6-6 Long-term contract—percentage-of-completion. Moderate 20-25
C6-7 Revenue recognition—real estate development. Moderate 30-40
C6-8 Membership fees, ethics. Moderate 25-30
C6-9 Cash flow analysis. Complex 40-50
6-4
ANSWERS TO QUESTIONS
1. Revenue is conventionally recognized at the date of sale. For revenue to be recognized at the date
of sale, (1) the amount of the revenue should be reasonably measurable—that is, the collectibility of
the sales price is reasonably assured or the amount uncollectible can be reasonably estimated—
and (2) the earnings process is complete or virtually complete (realized or realizable)—that is, the
seller is not obligated to perform significant activities after the sale to earn the revenue.
2. Revenues are recognized generally as follows:
(a) Revenue from selling products—date of delivery to customers.
(b) Revenue from services rendered—when the services have been performed and are billable.
(c) Revenue from permitting others to use enterprise assets—as time passes or as the assets are
used.
(d) Revenue (gains) from disposing of assets other than products—at the date of sale.
3. Types of sales transactions: (1) Cash sale. (2) Credit sale. (3) C.O.D. sale. (4) Will-call or layaway
sale. (5) Sale in advance of delivery (long-term construction). (6) Branch sale. (7) Intercompany
sale. (8) Installment sale.
The student should identify for each type of sale a form of business which typically engages in that
type of sale. Many of these sales transactions are not mentioned in this chapter, so the student will
probably not identify all these transactions.
4. FASB Statement No. 48 requires that such sales transactions not be recognized as current reve-
nue unless all of the following six conditions are met:
(1) The seller’s price to the buyer is substantially fixed or determinable at the date of sale.
(2) The buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is
not contingent on resale of the product.
(3) The buyer’s obligation to the seller would not be changed in the event of theft or physical
destruction or damage of the product.
(4) The buyer acquiring the product for resale has economic substance apart from that provided
by the seller.
(5) The seller does not have significant obligation for future performance to directly bring about
resale of the product by the buyer.
(6) The amount of future returns can be reasonably estimated.
5. The two basic methods of accounting for long-term construction contracts are: (1) the percentage-
of-completion method and (2) the completed-contract method.
The percentage-of-completion method is preferable when estimates of costs to complete and ex-
tent of progress toward completion of long-term contracts are reasonably dependable. GAAP re-
quires that the percentage-of-completion method be used in circumstances when reasonably de-
pendable estimates can be made and:
(1) The contract clearly specifies the enforceable rights regarding goods or services to be pro-
vided and received by the parties, the consideration to be exchanged, and the manner and
terms of settlement.
(2) The buyer can be expected to satisfy all obligations under the contract.
(3) The contractor can be expected to perform the contractual obligation.
The completed-contract method is preferable when the lack of dependable estimates or inherent
hazards cause forecasts to be doubtful.
6-5
Questions Chapter 6 (Continued)
6. Costs Incurred
Total Estimated Costs X Total Revenue = Revenue Recognized
$ 9 million
$ 50 million X $60,000,000 = $10,800,000
Revenue Recognized — Actual Costs Incurred = Gross Profit Recognized
$10,800,000 — $9,000,000 = $1,800,000
7. Under the percentage-of-completion method, income is reported to reflect more accurately the pro–
duction effort. Income is recognized periodically on the basis of the percentage of the job completed
rather than only when the entire job is completed. The principal disadvantage of the completed-
contract method is that it may lead to distortion of earnings because no attempt is made to reflect
current performance when the period of the contract extends into more than one accounting period.
8. A common technique used to determine the progress toward completion is the cost-to-cost basis.
9. Under both the percentage-of-completion and completed-contract methods, the entire expected
contract loss must be recognized in the current period.
10. Under the installment-sales method of accounting, emphasis is placed on collection rather than
sale. Because of the unique characteristics of installment sales, particularly the longer collection pe–
riod and higher risk of loss through bad debts, gross profit is considered to be realized in proportion
to the collections on the installment accounts. Thus, under the installment sales method, each col-
lection on an installment account is regarded as a partial recovery of cost and a partial realization of
gross profit in the same proportion that these two elements are present in the original selling price.
Under the installment-sales method, accounts receivable, sales, and cost of sales are accounted
for separately for regular and installment sales. Installment receivables are identified by year of sale
so that the gross profit can be recognized in each period in proportion to the original year of sales’
gross profit rate applied to current collections on installment accounts receivable.
11. Under the installment-sales method, income recognition is deferred until the period of cash collec-
tion. At the end of each year, the appropriate gross profit rate is applied to the cash collections from
each year’s sales to determine the realized gross profit. Under the cost-recovery method, no in-
come is recognized until cash payments by the buyer exceed the seller’s cost of the inventory sold.
After all costs have been recovered, all additional cash collections are included in income.
12. The two methods generally employed to account for cash received when cash collection of the sale
price is not reasonably assured are: (1) the cost-recovery method and (2) the installment-sales
method.
The
cost-recovery method is used when the seller has performed on the contract, but cash col-
lection is highly uncertain. Equal amounts of revenue and expense are recognized as collections
are made until all costs have been recovered; thereafter, any cash received is included in income.
The
installment-sales method is used when there is no reasonable basis for estimating the de-
gree of collectibility. Revenue is recognized only as cash is collected. Unlike the cost-recovery
method, a percentage of each cash collection is recorded as realized income.
6-6
Questions Chapter 6 (Continued)
13. The deposit method postpones recognizing a sale by treating the cash received from a buyer as a
deposit. The deposit method is applied when the seller receives cash but has not performed under
the contract and has no claim against the purchaser.
14. An installment sale is a special type of credit arrangement which provides for payment in periodic
installments over a predetermined period of time and results from the sale of real estate, merchan-
dise, or other personal property. In the ordinary credit sale, the collection interval is short (30-90
days) and title passes unconditionally to the buyer concurrently with the completion of the sale
(delivery). In contrast, in an installment sale the cash down payment at the date of sale is followed
by payments over a longer period of time (six months to several years), and in many states the
transfer of title remains conditional until the debt is fully discharged.
15.
Year
Cash
Collected
X
*Gross Profit
Percentage
=
Gross Profit
Recognized
2002
2003
2004
$ 80,000
320,000
100,000
$500,000
38%
38%
38%
$ 30,400
121,600
38,000
$190,000
*[($500,000 – $310,000) ÷ $500,000]
16. Under the cost-recovery method, revenue is recognized (along with the relevant cost of goods sold)
in the period of the sale. However, the gross profit is deferred and is not recognized in the income
statement until cash payments received from the buyer exceed the cost of the merchandise sold.
In those periods in which the cash payments exceed the costs, the excess receipts (representing
gross profits deferred) are reported as a separate item of revenue.
17. Under the deposit method, revenue is not recognized. The deposit method treats cash advances
and other payments received as refundable deposits. The sales transaction is not considered com-
plete and recognizable. Only after sufficient risks and rewards of ownership have been transferred
and the sale is considered complete is one of the other revenue recognition methods discussed in
the chapter applied to the sale transaction.
The major difference is that in the installment-sales and cost-recovery methods, it is assumed that
the seller has performed on the contract but cash collection is highly uncertain. Under the deposit
method, the seller has not performed and no legitimate claim exists.
18. The purpose of a statement of cash flows is to provide relevant information about the cash receipts
and cash payments of an enterprise during a period. It differs from the balance sheet and the in-
come statement in that it reports the sources and uses of cash by operating, investing, and financing
activity classifications. While the income statement and the balance sheet are accrual-basis state-
ments, the statement of cash flows is a cash-basis statement—noncash items are omitted.
19. The difference between these two amounts may be due to increases in current assets, or decreases
in current liabilities, or both. Such items would increase net income under accrual-basis accounting,
as opposed to cash-basis accounting.
6-7
Questions Chapter 6 (Continued)
20. The difference between these two amounts is due to noncash charges that appear in the income
statement. Examples of noncash charges are depreciation, depletion, amortization of intangibles,
discount amortization, and expenses recorded but unpaid.
21. Operating activities involve the cash effects of transactions that enter into the determination of net
income. Investing activities include making and collecting loans and acquiring and disposing of
debt and equity instruments and property, plant, and equipment. Financing activities involve liability
and owners’ equity items and include obtaining capital from owners and providing them with a return
on (dividends) and a return of their investment and borrowing money from creditors and repaying the
amounts borrowed.
22. (a) Net income is adjusted downward by deducting $7,000 from $90,000 and reporting cash pro-
vided by operating activities as $83,000.
(b) The issuance of the preferred stock is a financing activity. The issuance is reported as follows:
Cash flows from financing activities
Issuance of preferred stock $1,150,000
(c) Net income is adjusted as follows:
Cash flows from operating activities
Net income $90,000
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation expense 14,000
Premium amortization (5,000)
Net cash provided by operating activities $99,000
(d) The increase of $20,000 reflects an investing activity. The increase in Land is reported as fol-
lows:
Cash flows from investing activities:
Purchase of Land $(20,000)
23. The company appears to have good liquidity and reasonable financial flexibility. Its current cash debt
coverage ratio is or .90, which indicates that it can almost pay off its current liabilities in a
given year from its operations. In addition, its cash debt coverage ratio is also good at
or .60, which indicates that it can pay off more than 50% of its debt out of current operations.
24. Free cash flow = $860,000 – $75,000 – $20,000 = $765,000.
25. Free cash flow is net cash provided by operating activities less capital expenditures and dividends.
The purpose of free cash flow analysis is to determine the amount of discretionary cash flow a com-
pany has for purchasing additional investments, retiring its debt, purchasing treasury stock, or simply
adding to its liquidity.
$900,000
$1,000,000 $900,000
$1,500,000
6-8
Questions Chapter 6 (Continued)
*26. The difference between the Construction in Process and the Billings on Construction in Process ac-
counts is reported in the balance sheet as a current asset if a debit and as a current liability if a
credit. When the balance in Construction in Process exceeds the billings, this excess is reported as a
current asset, “Costs and Recognized Profit in Excess of Billings.” When the billings exceed the
Construction in Process balance, the excess is reported as a current liability, “Billings in Excess of
Costs and Recognized Profit.”
6-9
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 6-1
(a) Sales Returns and Allowances ………………….. 78,000
Accounts Receivable …………………………. 78,000
(b) Sales Returns and Allowances ………………….. 42,000
Allowance for Estimated Sales
Returns and Allowances …………………. 42,000
[(15% X $800,000) – $78,000]
BRIEF EXERCISE 6-2
Revenue = ($1,715,000 ÷ $4,900,000) X $7,000,000 = $2,450,000
Gross Profit = $2,450,000 – $1,715,000 = $735,000
BRIEF EXERCISE 6-3
Under completed contract, no revenue or gross profit is recognized in
2004. Any profit on the contract will be recognized in the year of comple-
tion.
BRIEF EXERCISE 6-4
(a) Total Revenue $420,000
Total Costs <450,000>*
Loss <$30,000>
*$288,000 + $162,000
(b) $30,000 loss—same as in (a).
BRIEF EXERCISE 6-5
($150,000 – $105,000)
Gross Profit % = $150,000 = 30%
Gross Profit Recognized: $54,000 X 30% = $16,200
6-10
BRIEF EXERCISE 6-6
$20,000
14,000 $6,000
$ 6,000 Gross Profit $20,000 = 30%
Cash
2003 $10,000 X 30% = $3,000
2004 5,000 X 30% = 1,500
2005 5,000 X 30% = 1,500
BRIEF EXERCISE 6-7
2003 $0
2004 $1,000 ($15,000 – $14,000)
2005 $5,000
BRIEF EXERCISE 6-8
Cash Flow Statement
Cash provided by Operations
Net Income $40,000
Increase in Accounts Receivable (10,000)
Increase in Accounts Payable 5,000
Depreciation Expense 4,000
Cash from operations $ 39,000
Investing Activities
Purchase of Equipment (8,000)
Financing Activities
Issue Notes Payable 20,000
Dividends (5,000)
15,000
Net Change in Cash $46,000
Free Cash Flow = $39,000 (Cash provided by operations) – $8,000 (Pur-
chase of equipment) – $5,000 (Dividends) = $26,000.
6-11
BRIEF EXERCISE 6-9
Cash flows from operating activities
Net income $151,000
Adjustments to reconcile net income to
net cash provided by operating activities
Depreciation expense $39,000
Increase in accounts payable 9,500
Increase in accounts receivable (13,000) 35,500
Net cash provided by operating activities $186,500
BRIEF EXERCISE 6-10
Sale of land and building $181,000
Purchase of land (37,000)
Purchase of equipment (53,000)
Net cash provided by investing activities $ 91,000
BRIEF EXERCISE 6-11
Issuance of common stock $147,000
Purchase of treasury stock (40,000)
Payment of cash dividend (85,000)
Retirement of bonds (100,000)
Net cash used by financing activities $ (78,000)
BRIEF EXERCISE 6-12
Free Cash Flow Analysis
Net cash provided by operating activities $400,000
Less: Purchase of equipment (53,000)
Purchase of land* (37,000)
Dividends (85,000)
Free cash flow $225,000
*If the land were purchased as an investment, it would be excluded in the
computation of free cash flow.
*BRIEF EXERCISE 6-13
Construction in Process ………………………………….. 1,715,000
Materials, Cash, Payables, etc. ………………….. 1,715,000
Construction in Process ………………………………….. 735,000*
Construction Expenses……………………………………. 1,715,000
Revenue from Long-term Contract …………….. 2,450,000
*[($1,715,000 ÷ $4,900,000) X $2,100,000 =
[$735,000]
*BRIEF EXERCISE 6-14
Construction in Process ………………………………….. 1,715,000
Materials, Cash, Payables………………………….. 1,715,000
*BRIEF EXERCISE 6-15
