Chapter 18 The Notes Receivable Are Properly Recorded Their

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C18-5 (continued)

3. Classifying “deferred gross profit” as a deferred credit is the traditional treatment, but its

support is diminishing with the decline in the use of the deferred credit caption and with

the growing view that the credit side of the balance sheet should be reserved exclusively

for equities (stockholders’ and creditors’). The installment sales method is a hybrid

C18-6

1. The Carlson Company has three basic alternatives: It could recognize revenue according

to the hours worked by its personnel, according to the amounts billed, or on the basis of

the cash collected.

In a situation where the company can estimate accurately the number of hours to be

worked by each person and the rate at which those hours can be billed, and there is no

C18-6 (continued)

2. The initial fee should be deferred and recognized as revenue over the lifetime of the

related membership by the straight-line method, giving consideration to the proportion of

the members who abandon their memberships before they expire.

The continuing membership fees should be recognized as earned (i.e., each month as the

member is obligated to pay them).

3. It could be argued that this situation is a consignment. However, it may be more

appropriate to argue that it is a sale with a right of return because the distributor must pay

605-15) (discussed in Chapter 7) appear to have been met, given the limited facts.

If the amount to be returned cannot be reasonably estimated, revenue should be

C18-7 (AICPA adapted solution)

1. Income results from economic activity in which one entity furnishes goods or services to

another. To justify revenue recognition, the earning process must be substantially

C18-7 (continued)

1. (continued)

Events that give rise to revenue recognition are: the completion of a sale; the

performance of a service; the progress of a long-term construction project, as in

shipbuilding; and the production of a standard interchangeable good (such as a precious

2. Bonanza is, in effect, a merchandising company that collects cash (for stamps) far in

advance of furnishing the goods. In addition, since the data indicate that about 5% of

the stamps sold will never be redeemed, it also has revenue from this source. Bonanza’s

revenues from these two sources could be recognized on one of three major bases. First,

all revenue could be recognized when the stamps are sold–the sales basis, or cash-

18-59

C18-7 (continued)

2. (continued)

Reasonable estimation is crucial to income determination. Under the first alternative, it is

necessary to estimate future costs of premium issuances well in advance of the actual

occurrence. In the second case, it is necessary to estimate the proportion of revenue that

3. Under all of the alternatives, Bonanza’s major asset (in terms of data given in the question)

would be its inventory of premiums. Another inventory item, perhaps minor in amount,

would be the cost of printing the stamps on hand awaiting sale to dealers. The major

C18-8

Note to Instructor: Case 3 involves accounting for a lease, discussed in Chapter 21.

Case 1

(a) The revenue recognition issues involved are the advance collection, the collectibility

of the initial franchise fee receivable, the completion of the required services, and the

18-60

C18-8 (continued)

Case 2

(a) The revenue recognition issues involved include the collectibility of the receivables,

the financial ability of the land development company to fulfill its obligations, the

length of any refund period, the accumulation of collections, and the ongoing

Case 3

(a) The revenue recognition issues involved include when, if at all, to record the “sale” of

the leased equipment, how to recognize interest revenue, and whether to recognize

Case 4

(a) Two revenue recognition issues are involved. First is the issue of when the “sale” takes

place; that is, when are the benefits and risks of ownership of the bridge transferred

and at what point has “performance” been provided? The second issue involves how

18-61

C18-9 (AICPA adapted solution)

1. The two alternative accounting methods to account for long-term construction contracts

are the percentage-of-completion method and the completed-contract method. The

2. The Ski Park contract must be accounted for by the percentage-of-completion method.

Eighty percent of the estimated total income on the contract should be recognized as of

3. The receivable on the Ski Park contract should be reported as a current asset. If costs plus

C18-10 (AICPA adapted solution)

1. Two primary criteria must be met before Southern Fried Shrimp recognizes revenue:

(1) realization has taken place and (2) the revenues have been earned. Several issues

arise when applying these principles in accounting for the initial franchise fee including the

time of recognition of the fee as revenue–to which of several possible periods should it be

assigned–and the amount of revenue to be recognized which, in turn, is partially a

question of the valuation of the notes received. Possible alternative methods are

illustrated and evaluated as follows:

or

a. Cash 5,000 5,000

Notes Receivable 20,000 15,163

or

b. Cash 5,000 5,000

Notes Receivable 20,000 15,163

18-62

1. (continued)

or

c. Cash 5,000 5,000

Notes Receivable 20,000 15,163

d. Cash 5,000

Earned Initial Franchise Fee 5,000

This procedure is consistent with the cash basis of accounting and is considered

e. Cash 5,000

Unearned Initial Franchise Fee 5,000

The assumption underlying this procedure is that either the down payment is

refundable, or substantial services must be performed by the franchisor before the fee

2. Because the initial cash collection of $5,000 must be refunded if the franchisee fails to

open, it is not fully earned until the franchisee begins operations so that Southern Fried

Shrimp records the initial franchise fee as follows:

or

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C18-10 (continued)

2. (continued)

If there is no time lag between the collection of the $5,000, the performance of the

related services, and the opening by the franchisee, then the initial cash collection of

$5,000 is earned when it is received so the initial franchise fee is recorded as follows:

or

Cash 5,000 5,000

Notes Receivable 20,000 15,163

At the time that a franchisee opens, only two steps remain before Southern Fried Shrimp

will have fully earned the entire franchise fee. First, it must provide expert advice over the

five-year period. Second, it must wait until the end of each of the next five years so that it

may collect each of the $4,000 notes. Since collection has not been a problem, and

since the advice may consist largely of manuals and periodical service tip fliers, it could

3. If the rental portion of the initial franchise fee, $10,000, represents the present value of

monthly rentals over a ten-year period, it is recorded as Unearned Lease Revenue to be

C18-10 (continued)

3. (continued)

If the transaction could be considered to be a sale of equipment, the entire rental

revenue of $10,000 is recognized immediately upon delivery of the equipment.

Since credit risks are no problem, the conditions that must be met to justify recognizing a

C18-11 (AICPA adapted solution)

1. The earning of revenue may or may not coincide with the rendering of service to the

subscriber. The new director suggests that they do not coincide in the magazine business

and that revenue from subscription sales and advertising should be recognized in the

accounts when the difficult task of selling is accomplished and not when the magazines

are published to fill the subscriptions or to carry the advertising.

18-65

C18-11 (continued)

2. Recognizing in the accounts all the revenue in equal portions with the publication of the

magazine every month is subject to some of the same criticism from the standpoint of

3. Recognizing in the accounts a portion of the revenue at the time a cash subscription is

obtained and a portion each time an issue is published meets the tests of recognition

better than the other two alternatives. A portion of the profit is recognized in the accounts

C18-12 (AICPA adapted solution)

No. The factor apparently relied upon by Stony Associates is that revenue is recognized as

the services giving rise to it are performed. The firm has completed the construction of the

building, obtained financing for the project, and secured tenants for most of the space.

C18-13 (AICPA adapted solution)

1. The preferable treatment of the costs of the sample display houses is expensing them over

more than one period. These sample display houses are assets because they represent

C18-13 (continued)

1. (continued)

The alternative of expensing the costs of sample display houses in the period in which the

expenditure is made is based primarily upon the concept of conservatism. These costs are

2. If all of the shell houses are to be sold at the same price, it may be appropriate to allocate

the costs of the display houses on the basis of the number of shell houses sold. This

allocation would be similar to the units-of-production method of depreciation and would

result in a good matching of costs with revenues. On the other hand, if the shell houses

C18-14 (AICPA adapted solution)

1. In an installment sale, income may be taken up in proportion to cash collections; income

may be recognized at the time of sale; or income recognition may be deferred until all

2010.

18-67

C18-14 (continued)

1. (continued)

If repossessions are frequent and involve losses, collections may be applied first to a

recovery of cost, and second, to income. Under this method no income is recognized in

2010.

2. Repossessed Merchandise 50

Deferred Gross Profit–2011 92

Loss on Repossessions 133

C18-15

2. As required by GAAP, the company expenses the production costs of advertisements on

the first date the advertisements take place (p. 72). Since many of these advertisements

C18-16

Note to Instructor: This case does not have a definitive answer. From a financial reporting

perspective, GAAP is identified and summarized. From an ethical perspective, various

issues are raised for discussion purposes.

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C18-16 (continued)

From an ethical perspective, the issue involves whether it is appropriate to record

revenues and expenses so that net income meets the goals of the company. The primary

stakeholders are the accountant, the CPA firm, the company‘s current and future

ANSWERS TO RESEARCH SIMULATIONS

R18-1

Note to Instructor: Students are expected to cite references to GAAP in their research of

1. To: Whom It May Concern

From: Student

I have researched the issue of accounting for advertising costs. According to AICPA

Statement of Position No. 93-7, par. 26 (FASB Cod. # 720-35-25) advertising costs are

2. The quotes refer to a time period before the issuance of AICPA Statement of Position No.

93-7 (FASB Cod. # 720-35). There were no specific accounting principles at that time and

therefore any policy that the companies followed would have been acceptable,

R18-2

Note to Instructor: Students are expected to cite references to GAAP in their research of

this issue. They might use the FARS electronic database, pronouncements listed on the

To: Whom It May Concern

From: Student

I have researched the issue of which methods of accounting are appropriate for the three

companies. Unfortunately there are no specific principles that apply to each of the

situations so I relied on the FASB Statements of Concepts. In each case there is an

argument to support the policy followed by the company – conceptually, there is an asset

(FASB Statement of Concepts No. 6, par. 25-31). The question in each case is whether the

recognition of an asset can be supported when the concept of reliability is applied.