COST RECOVERY METHOD
➢ The cost recovery method defers all gross profit recognition until cash equal to the
cost of the item sold has been recovered.
On November 1, 2016, the Belmont Corporation, a real estate developer,
Illustration 5-A3
Gross Profit Recognition
Date
Cash Collected
Cost Recovery
Gross Profit
Nov. 1, 2016
$200,000
$200,000
$ – 0 –
Nov. 1, 2017
Nov. 1, 2018
$800,000
$240,000
T5–50
COST RECOVERY METHOD
(continued)
Journal Entries
Nov. 1, 2016 To record installment sale
Installment receivables …………………………………. 800,000
To record cash collection from installment sale
To recognize gross profit from installment sale
T5–50 (continued)
SOFTWARE AND OTHER
MULTIPLE-ELEMENT ARRANGEMENTS
T5–51
FRANCHISE SALES
On March 31, 2016, the Red Hot Chicken Wing Corporation entered into a franchise
agreement with Thomas Keller. In exchange for an initial franchise fee of $50,000,
Red Hot will provide initial services to include the selection of a location, construction
Initial Franchise Fee
March 31, 2016 To record franchise agreement and down payment
Cash …………………………………………………………………….. 10,000
Continuing Franchise Fees
To recognize continuing franchise fee revenue
Illustration 5-A4
T5–52
1. Real World Scenario
The following is an excerpt from an article that appeared in the August 25, 2002 edition of The Seattle
Times:
When Cutter & Buck revealed two weeks ago that it padded sales figures in
2000 by recording $5.8 million in shipments that were mostly returned, the
news came as a surprise to many investors. But it wasn’t the first time the
Seattle sportswear retailer’s shipping and accounting practices have been called
into question. Shortly before co-founder Joey Rodolfo left in 1997, he accused
the company of shipping orders months before customers were expecting them,
a method of prematurely booking sales.
Some customers and former employees say early shipments persisted for years
after Rodolfo raised the issue. And late last week, Chief Executive Fran Conley
said an internal investigation has found that early shipments were “more
extensive than I had known” and may force the company to further restate sales
figures.
Shipping and booking orders ahead of schedule to meet short-term sales goals
— a practice sometimes called channel stuffing — is not, by definition, illegal.
But by essentially borrowing from future sales to claim bigger current sales and
profit, it can be used to boost a company’s bottom line and create a misleading
appearance of growth for investors.
Suggestions:
This article provides a good way to introduce the topic of channel stuffing. When a company stuffs
the channel, it ships inventory ahead of schedule filling its distribution channels with more product
than is needed. Since companies often record sales as soon as they ship products, channel stuffing can
make it appear that business is booming. Is this practice legal? Is it an acceptable practice according
to GAAP? Is it an ethical practice?
Points to note:
Channel stuffing is not an uncommon practice. There are many examples you can find for your
students. A text case references the Sunbeam incident that occurred in the late 90s. More recent
examples include Microsoft, Novell, Network Associates, and AOL.
GAAP do not address channel stuffing specifically. The key is whether or not the practice
leads to excessive future sales returns that are not adequately provided for by the seller. There may
be an issue with respect to the legality of the practice if it can be shown that the practice resulted in
misleading information to the investing public. And there are ethical dimensions to the practice as
well.
2. Research Activity
Probably most of your students have purchased merchandise via the Internet. You can buy the
products of many companies on line. Some of these companies, such as Amazon.com, often act
merely as intermediaries between the manufacturer and the consumer. Revenue recognition for this
type of transaction has been controversial. If Amazon sells something to a customer for $100 that
costs $80, the profit on the transaction is clearly $20. But should Amazon recognize $100 in
revenue and $80 in cost of goods sold (the gross method), or should it recognize only the $20 in
gross profit (the net method)?
Suggestions:
Discuss with your class the implications of one reporting method versus the other. Why should it
make a difference? What factors might dictate whether or not Amazon should recognize the
transaction gross versus net? Have them access Amazon’s most recent financial statements using
Edgar (atwww.sec.gov ). Or, you can show them Amazon’s disclosure note and discuss the contents
of the note. The following is a portion of the company’s revenue recognition disclosure note that
appeared in its 2013 financial statements:
We evaluate whether it is appropriate to record the gross amount of product sales and related costs
3. PetSmart Analysis
1. Compute the receivables turnover ratio, the profit margin on sales, the return on assets ratio, and
the return on shareholders’ equity ratio for the most three years. Are there any discernible
trends? How might they be interpreted?
2. Read item I of PetSmart’s 10-K. Has there been any significant shift over the last three years in
the company’s product mix?
3. Use Edgar to locate the most recent annual report information for Walmart, PetSmart’s
competitor. Using the most recent annual report information for both companies, compare the
receivables turnover ratio, the profit margin on sales, the return on assets ratio, and the return on
shareholders’ equity ratio. Are there any differences in the way the companies recognize
revenue?
4. Note: another peer comparison of this nature is Federal Express vs. United Parcel Service.
4. Professional Skills Development Activities
Communication Skills. In addition to Communication Cases 5-7 and 5-13, Judgment Case 5-12
can be adapted to ask students to choose one of the two alternatives and write a memo supporting
Research Skills. In their careers, our graduates will be required to locate and extract relevant
information from available resource material to determine the correct accounting practice,
this skill, as does the Air France-KLM case.
Analysis Skills. The “Broaden Your Perspective” section includes Analysis Cases that direct
students to gather, assemble, organize, process, or interpret data to provide options for making
Judgment Skills. The “Broaden Your Perspective” section includes Judgment Cases that require
students to critically analyze issues to apply concepts learned to business situations in order to
5. Ethical Dilemma
The chapter contains the following ethical dilemma:
ETHICAL DILEMMA
The Precision Parts Corporation manufactures automobile parts. The company has reported a profit
every year since the company’s inception in 1977. Management prides itself on this accomplishment
Tony Smith, the company’s chief financial officer, has determined a way to increase December
sales by an amount sufficient to boost operating income over the goal for the year and earn bonuses
for all top management. A reputable customer ordered $120,000 of parts to be shipped on January
You may wish to discuss this in class. If so, discussion should include these elements.
Step 1—The Facts:
Precision Parts Corporation has reported profits since its inception and given top management
bonuses when the operating income goal is achieved. In 2016, however, the company does not expect
to achieve its profit goal. Tony Smith, the CFO, wants to record a sale in 2016 that will not be shipped
Step 2—The Ethical Issue and the Stakeholders:
The ethical issue or dilemma is whether Tony Smith’s obligation to top management to show a
Step 3—Values:
Step 4—Alternatives:
1. Record the parts sales revenue in 2016.
Step 5—Evaluation of Alternatives in Terms of Values:
1. Alternative 1 illustrates loyalty to the company and other top managers.
Step 6—Consequences:
Alternative 1
Positive consequences: Tony would enable other top managers to receive bonuses and permit the
company to meet their operating income goal.
Negative consequences: Users of the financial statements would be misinformed. Users of
Alternative 2
Positive consequences: Users of financial statements would receive more relevant and reliable
reported revenue. Tony would maintain his integrity. He may receive praise for being honest and
keep his job.
Step 7—Decision:
Assignment Chart
Brief
Exercises
Learning
Objective
Est.
Time
BE5-1
05–02
5
BE5-2
05–03
5
BE5-3
05–03
5
BE5-4
05–04
5
BE5-5
05–05
5
BE5-6
05–05
5
BE5-7
05–05
5
BE5-8
05–05
5
BE5-9
05–05
5
BE5–10
05–05
5
BE5–11
05-05, 05-06
5
BE5–12
05–06
5
BE5–13
05–06
5
BE5–14
05–06
5
BE5–15
05–06
5
BE5–16
05–06
5
BE5–17
05–06
10
BE5–18
05–06
10
BE5–19
05–06
10
BE5–20
05–07
10
BE5–21
05–07
10
BE5–22
05–07
10
BE5–23
05–07
10
BE5–24
05–07
10
BE5–25
05–08
10
BE5–26
05-08, 05-09
5
BE5–27
05–09
5
BE5–28
05–09
5
BE5–29
05–09
5
BE5–30
05–09
5
BE5–31
05–10
10
BE5–32
05–10
10
BE5–33
05–10
15
BE5–34
05–10
5
BE5–35
Appendix 5
10
BE5–36
Appendix 5
10
BE5–37
Appendix 5
10
BE5–38
Appendix 5
10
BE5–39
Appendix 5
5
BE5–40
Appendix 5
5
BE5–41
Appendix 5
5
Exercises
Learning
Objective
Est.
Time
E5-1
05-01, 05-02,
05–03
15
E5-2
05–03
15
E5-3
05–04
15
E5-4
05-04, 05-05
15
E5-5
05-02, 05-04,
05–05
20
E5-6
05-02, 05-04,
05–05
15
E5-7
05-03, 05-04,
05–05
15
E5-8
05-04, 05-05
20
E5-9
05–06
15
E5–10
05-03, 05-06
15
E5–11
05-03, 05-06
20
E5–12
05-02, 05-05,
05–06
10
E5–13
05–06
10
E5–14
05-06, 05-07
15
E5–15
05-06, 05-07
20
E5–16
05–08
15
E5–17
05–09
25
E5–18
05–09
30
E5–19
05–09
30
E5–20
05-08, 05-09
20
E5–21
05–09
50
E5–22
05–09
25
E5–23
05–10
10
E5–24
05–10
10
E5–25
05–10
10
E5–26
05–10
10
E5–27
Appendix 5
20
E5–28
Appendix 5
15
E5–29
Appendix 5
15
E5–30
Appendix 5
25
E5–31
Appendix 5
10
E5–32
Appendix 5
20
E5–33
Appendix 5
15
E5–34
Appendix 5
15
E5–35
Appendix 5
30
E5–36
Appendix 5
10
E5–37
Appendix 5
15
E5–38
Appendix 5
10
E5–39
Appendix 5
15
CPA/CMA
Questions
Learning
Objective
Est.
Time
CPA5-1
05–02
15
CPA5-2
05–04
5
CPA5-3
05–04
5
CPA5-4
05–05
5
CPA5-5
05–07
5
CPA5-6
05–08
5
CPA5-7
05–08
5
CPA5-8
05–08
5
CPA5-9
Appendix
5
CPA5-10
Appendix
5
CPA5-11
Appendix
5
CPA5-12
Appendix
5
CPA5-13
Appendix
5
CMA5-1
05–08
10
CMA5-2
Appendix
10
Problems
Learning
Objective
Est.
Time
P5-1
05-04, 05-05
25
P5-2
05-02, 05-04,
05–05
30
P5-3
05-02, 05-04,
05–05
35
P5-4
30
05-02, 05-04,
P5-5
05-03, 05-06
25
P5-6
05-03, 05-06
25
P5-7
05-03, 05-06
20
P5-8
05-03, 05-06
40
P5-9
05-03, 05-06,
05–07
45
P5–10
05-08, 05-09
55
P5–11
05–09
40
P5–12
05–09
25
P5–13
05–09
45
P5–14
05–10
20
P5–15
05–10
40
P5–16
05–10
50
P5–17
05–10
40
P5–18
Appendix 5
25
P5–19
Appendix 5
30
P5–20
Appendix 5
30
P5–21
Appendix 5
30
P5–22
Appendix 5
40
Instructor’s Resource Manual, Chapter 5 5-97