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Chapter 9
Operating Activities
9-21
in whole or in part.
c. Net deferred tax assets will not change in the year when net operating losses
originate. Gross deferred tax assets increase, but the increase in the valuation
d. Assuming that the firm later reduces the deferred tax asset and the valuation
allowance in the same amount and the same year that it claims an income tax
deduction, net deferred tax assets again will not change. The firm will claim an
income tax deduction in that year, which reduces income taxes currently payable.
valuation allowance is not recognized. Income tax expense follows the book
income and expense amounts in the usual case. The deferred tax asset simply
permits interperiod allocation of the benefit.
f. A portion of the equity method income must be subject to income taxes in a later
period (temporarily deferred portion), and a portion must not be subject to tax
(permanently reinvested portion).
Chapter 9
Operating Activities
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in whole or in part.
Integrative Case 9.1: Starbucks
a. 1. Cash customer purchasing coffee at a Starbucks-owned retail store. Starbucks
records revenue at the point of sale equal to the selling price of the coffee
(revenue recognition through asset enhancement).
2. Customer adding cash balance to her Starbucks card. Starbucks records a
exists that the customer will never redeem the card and Starbucks will not have
3. Customer at Starbucks-owned retain store paying for coffee with a Starbucks
through liability satisfaction).
4. Other businesses that purchase Starbucks’ products on credit. Assuming that
Starbucks has a purchase order from the customer or a contract specifying
price to recover the costs. Therefore, Starbucks includes shipping costs in both
revenues and the related cost of goods sold. Given that accounts receivables
5. Licensed stores. Starbucks earns revenue from its licensed stores in several
ways. First, Starbucks sells product to the stores. (See Item 4 above.) Second,
promises made and recognizes revenue in proportion to the fair value of the
promises kept. The remainder of the outstanding promises’ relative fair value is
a royalties receivable.
6. Customer remitting sales taxes to Starbucks when purchasing coffee. Cash
collected by Starbucks for sales taxes on behalf of taxing authorities is a current
Chapter 9
Operating Activities
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b. Presented below are two alternative treatments of the loyalty program. The ultimate
cash consequences of this transaction are cash inflow of $33 (15 sales @ $2.20
each) and cash outflows of $24 (16 cups @ $1.50 each).
Alternative 1:
and
Loyalty Program Expense = $0.10 and Liability under Loyalty Program = $0.10.
The first 15 cups of coffee generate $33 in sales revenue and $22.50 in cost of
goods sold. In addition, the 15 accruals of the cost of delivering the free cup of
coffee results in $1.50 of loyalty program expense and a $1.50 liability under the
Last journal entry upon delivery of free cup of coffee:
Alternative 2:
Because $33 of total revenue needs to be recognized on the delivery of 16 cups of
(a liability).
The first 15 cups of coffee generate $20.9375 in sales revenue, $2.0625 in
After all transactions are completed, revenues equal cash inflows of $33 and
expenses equal cash outflows of $24.
Chapter 9
Operating Activities
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Journal entries for each of first 15 cups of coffee sold:
Last journal entry upon delivery of free cup of coffee:
Discussion of the Two Alternatives:
Both alternatives seem to be reasonable approaches for dealing with establishing a
liability to deliver the 16th cup of coffee. However, the amount of the liability
Remember that a key issue here is reporting any liability to frequent coffee
drinkers. Most of these people have consumed their 16th cup within the year,
sold will be correctly stated because inventory counts will reveal that the inventory
has been consumed, and expenses will be (materially) correct.
Chapter 9
Operating Activities
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in whole or in part.
Case 9.2: Arizona Land Development Company
I. Case Objectives
A. To apply the criteria for revenue and expense recognition to a land develop-
ment business.
B. To discuss a firm’s choice of income recognition methods for financial and
tax reporting.
C. To illustrate the relation between income recognition and asset and liability
valuation.
D. To illustrate the effect of alternative income recognition on methods on cash
flows.
II. Overview of Case
The amounts shown in Exhibits 9.14–9.16 resemble closely those of a land
development company that made its initial public offering of common stock in the
late 1960s. To simplify the numbers in the case, we rounded the sales numbers a bit
and used the average expense and profit margin percentages over the six years to
compute the expense and profit margin amounts for each year. The latter procedure
creates some artificiality to profitability trends over time. However, given that the
case’s principal objective is to illustrate the effects of differences in income recogni-
tion methods on the financial statements, the gain in simplified numbers more than
offsets the loss of a little reality.
III. Responses to Case Questions
a. The instructor may omit this question if desired. We find that, although it
involves much number crunching, it demonstrates students’ understanding of the
four income recognition methods. Alternatively, instructors can assign the
question and distribute the solution at the beginning of class.
Income Recognition at Time of Sale—No Discounting of Cash Flows
Chapter 9
Operating Activities
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Income Recognition at Time of Sale—With Discounting of Cash Flows
Income Recognition Using the Installment Method—With Discounting of
Cash Flows
Gross Profit Percentage, Year 2 Sales: $194,772/$569,543 ... 0.34198
(3) Gross Profit Realized: 0.34198($90,000 + $65,000 +
Income Recognition Using the Percentage-of-Completion Method
Percentage-of-Completion on Year 1 Contracts: ($65,000 +
Chapter 9
Operating Activities
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b. Begin by asking the students how ALDC’s earnings process differs from that of
a typical manufacturing concern. ALDC’s development activity is analogous to
the production phase of a manufacturing concern, and yet it follows the time-of-
sale method for recognizing revenue.
Nine Years
Sale of Transfer of
flows?
3. Interest rates change dramatically so that the interest rates implicit in the
justifiable.
4. Land values change dramatically so that either the customer or ALDC
decides to walk away from the contract.
case.
1. Customers forfeit the land and the cash payments to date if they discontinue
development costs incurred at any point in time. Furthermore, customers
2. Unexpected increases in development costs pose the greatest risk for ALDC.
impediments that increase the cost of development. ALDC’s experience to
