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9-1
in whole or in part.
CHAPTER 9
OPERATING ACTIVITIES
9.1 Delayed Revenue Recognition. The software firm allocates the bundle purchase
price to the multiple elements in the bundle based on their relative fair values. When
the software is delivered to the customer (date of sale), its proportion of fair value is
two-year period, the liability is removed and revenue is recognized.
9.2 Revenue Recognition. Most firms recognize revenue when (1) the product has been
provided to the customer and (2) cash, a receivable, or some other asset that can be
reasonably measured has been received from the customer. This method is typically
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).
9.3 Long-Term Contract Profit Recognition. (a) Both U.S. GAAP and IFRS require
the use of percentage of completion unless the degree of completion or contract
9.4 Working Capital. (a) Accounts Receivable (asset) and Unearned Revenues
(liability); (b) Inventory (asset) and Accounts Payable (liability); (c) Salaries and
in the reconciliation from net income to cash flow from operation.
Chapter 9
Operating Activities
9-2
in whole or in part.
9.5 Expense Recognition. Many examples exist. Three common examples of direct
cause and effect are cost of goods sold (inventory decreases at the time of sale), sales
9.6 Accounts Receivable. I = increases; D = decreases; NE = no effect
Assets
Liabilities
Shareholders’
Equity
Net Income
A credit sale I NE I (through NI) I
Collection of a portion
of accounts receivable
9.7 Inventory Costing and Valuation.
a. In periods of rising prices, reported inventory costs and gross profits, ranked
b. Amounts by which inventory market value exceeds costs are not reflected in the
the loss reported in income of the period.
9.8 LIFO Layer Liquidation. Under the LIFO method, firms assume that a unit sold
was the most recent purchased or produced, thus matching current sales revenues
profitability or sustainable future earnings.
9.9 Effect of Weighted-Average Cost-Flow Assumption on Inventory. When inventory
turns over rapidly, purchases during the current period receive a heavy weight in the
costs assigned to inventory are usually far removed from current prices.
Chapter 9
Operating Activities
9-3
in whole or in part.
9.10 Reconcile PBO/FMV of Plan Assets.
PBO, January 1, 2014 ........................................................................ $ 800,000
Service Cost ....................................................................................... 80,000
Interest on PBO .................................................................................. 70,000
FMV of Plan Assets, January 1, 2014 ............................................... $ 750,000
Actual Return on Plan Assets ............................................................ 100,000
9.11 Financial Statement Effects of Pension Plan Events.
I = increases; D = decreases; NE = no effect
Assets
Liabilities
Shareholders’
Equity
Net Income
Employees performing
current service
NE
I
D (through NI)
D
Plan amendment grants
Retired employees are paid D D NE NE
Contributions made to
plan trustee
D and I
NE
NE
NE
Plan assets increase by
Chapter 9
Operating Activities
9-4
in whole or in part.
9.12 Components of Pension Expense.
a. Service cost cannot reduce pension expense for the year. Service cost increases
each year because employees work an additional year.
c. U.S. GAAP requires firms to reduce pension expense each period by the
expected, not the actual, return on investments. When deciding on its funding
level for employer contributions, firms make an assumption as to the long-term
expected return on pension fund investments. Actual returns over time will vary
investments.
d. Prior service cost results from a firm’s sweetening the benefit formula for
employees. A firm might provide employees higher benefits at retirement or
continue to provide benefits to the employee’s spouse if the employee dies first.
9.13 Postretirement Benefits Other Than Pensions. The firm would report a
postretirement health care benefit obligation of $2.1 billion. The footnotes to the
firm’s financial statements would detail the specific account on the balance sheet
that would include the long-term liability. The $310 million would be reported on
shareholders’ equity section.
9.14 Income Recognition for Various Types of Businesses.
a. Banks recognize interest revenue each period using the interest rate or interest
pricing procedure specified in the mortgage agreement and the unpaid balance of
issue relates to uncollectible loans. Should the bank recognize portions of the
estimated losses on such loans each period while the loans are outstanding or
wait until a particular loan becomes uncollectible? U.S. GAAP requires periodic
recognition of estimated losses on loans.
Chapter 9
Operating Activities
9-5
in whole or in part.
b. Three possible revenue recognition points for the commission revenue of a travel
agency are the time of booking a reservation, the time a customer utilizes the
service booked, and the time the travel agency receives the commission in cash
from the service provider. The time of booking a reservation is probably most
conservative.
c. Recognizing revenue at the time the baseball team sells season tickets is
inappropriate because it must provide substantial future services. A liability for
the present value of these future services appears on the balance sheet of the
d. The issue here is whether the firm should recognize as revenue the increase in
the value of the whiskey as it ages or wait until sale to recognize the revenues
associated with the increasing value of the whiskey. Uncertainties about the
amount of this value increase and the amount of cash ultimately received when
e. The amount and timing of revenue appear highly predictable in this case. Other
than overseeing the growing of the trees, future performance appears negligible.
These conditions seem to justify use of the percentage-of-completion method
of income recognition. Note the contrast between the whiskey producer, in
firm should defer the costs of maintaining the trees to obtain an appropriate
matching of revenues and expenses.
Chapter 9
Operating Activities
9-6
in whole or in part.
f. Airlines recognize revenue each time they provide transportation services. They
match the costs of providing the services (salaries, fuel, and depreciation) against
the revenue as expenses. A portion of the revenue from each flight represents
revenue of the free flight the customer will ultimately take. A proper matching of
for free flights and would not otherwise use such seats. Given that the costs of a
Thus, the airlines typically recognize an expense and a liability for the future
9.15 Measuring Income for a Software Manufacturer.
a. Financial reporting requires the recognition of revenue under the accrual basis of
accounting when a firm has done both of the following: (1) has provided all or a
measure with reasonable precision.
Mapping these general criteria to DT’s policy for recognizing software license
what portion of the agreed-upon total revenues are applicable to the various
software and consultancy industries.
In the case of DT, the firm defines “substantially all services performed”
(Criterion 1) by having a contract in place (persuasive evidence of an arrange-
ment), delivery of the software, and a fix or determinable fee. DT defines “has
received cash or an equivalent” (Criterion 2) by the probability that collection is
through resellers.
b. DT states that all revenue generated from maintenance contracts promising a
specific upgrade are deferred until the future upgrade is delivered. Otherwise,
maintenance revenue is recognized over the term of the contract. DT appro-
Chapter 9
Operating Activities
9-7
in whole or in part.
c. DT recognizes educational consultancy services as the services are performed.
DT requires its employees to maintain detailed records as to the number of hours
spent on training and evaluative assessments. These records are used to bill the
accounting firms.
d. There are many examples of estimates and judgments that DT must make for
determining revenues. This is particularly true for DT because the firm often
signs contracts that span the provision of products and services over an 18–24
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 DT discusses
in its revenue recognition note to the financial statements, the firm must assess
9.16 Measuring Income for a Consultancy Firm.
a. Sanders generates three types of contracts with customers: (1) fixed-price, fixed-
of the contract. Revenue from support and maintenance contracts is recognized
ratably over the term of the contract. Often support and maintenance contracts
can be extended by making additional nominal payments; however, the difficulty
is assessing the effective life of the contract. Revenue from performance stan-
making this assessment.
Chapter 9
Operating Activities
9-8
in whole or in part.
b. Financial reporting requires the recognition of revenue under the accrual basis of
accounting when a firm (1) has provided all or a substantial portion of the ser-
vices to be performed and (2) has received cash, a receivable, or some other asset
whose cash-equivalent amount the firm can measure with reasonable precision.
c. Customer contracts that contain multiple deliverables add another layer of com-
plexity to revenue recognition because often it is difficult to distinguish what
amount of the total agreed-upon contract payments relates to which deliverables.
Recall the example in the chapter that discusses Xerox Corporation. Xerox typi-
the lease, but also maintenance services, photocopying paper up to certain
minimum usage, and financing costs. The revenue recognition question is when
should Xerox recognize revenue from the four services covered in the lease: (1)
copier use, (2) maintenance services, (3) photocopying paper, and (4) financing.
accounting for the various components of the contract, the firm probably defers
recognizing revenue until substantially all deliverables promised in the contract
have been delivered to the customer.
9.17 Measuring Income for a Long-Haul Transport Firm.
length of the time between picking up the freight at the point of origination and deli-
vering it to the point of destination is fairly short.
Chapter 9
Operating Activities
9-9
in whole or in part.
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; so the completed-contract method would appear to be as
appropriate. With this alternative, CN would recognize revenue when the freight was
revenues easily over the entire length of a freight shipment. This tracking informa-
tion 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.
9.18 Measuring Income from Long-Term Contracts.
a. (amounts in millions)
b. (amounts in thousands)
Year Revenue Expense Income
2014 0.10 × $120,000 = $ 12,000 $ 10,000 (10%) $ 2,000
c. Year Revenue Expense Income
2016: Sale $27,273 0.7764a × $27,273 = $21,175 $ 6,098
Chapter 9
Operating Activities
9-10
in whole or in part.
d. Construction in Process account balance:
Year Completed-Contract Method Percentage-of-Completion Method
2014 $10,000 $10,000 + $2,000 = $12,000
Criterion 1 Performance substantially complete—Deere has completed the
manufacturing process and shipped equipment.
Criterion 2 Receipt of measurable asset—Deere has received cash or
and allowances.
Earlier Revenue Recognition—Products are not custom-made, so identity of
the buyer is not known and the price is not fixed. Also, dealers are independent
and are not obligated to accept the product.
b. Accounts and Notes Receivable—No change
Inventories—Increased by income recognized during the production process
delivered to dealers
c. Accounts and Notes Receivable—Decreased by deferred gross profit on the
Inventories—No change
the installment method
