Chapter 18 The Three Necessary Conditions Are Not Often

18-41

P18-9 (continued)

Deferred Gross Profit, 2009 11,800a

Gross Profit Realized on Installment Sales 11,800

a$16,000 – $700 – $3,500

Cash 87,500c

Installment Accounts Receivable, 2010 87,500

18-42

P18-10 (AICPA adapted solution)

HOBSON, INC.

Application of Cash Receipts from Sale of Idle

Plant Facility to Cost Recovery, Deferred Income, and

Income Recognized Under the Cost Recovery Method of Accounting

For the Period January 1, 2008 to February 1, 2012

Date

Cash

received

Debit

Note

receivable

Dr. (Cr.)

Idle plant

(net)

(Credit)

Deferred

income

Dr. (Cr.)

Income

recognized

(Credit)

January 1, 2008

$100,000

$600,000

$(500,000) $(200,000)

P18-11

1. Company A 2010 2011 2012

Gross profit, Contract X $360,000a $150,000c $ —

Gross profit, Contract Y 160,000b 140,000d 100,000f

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P18-11 (continued)

2. Company B

COMPANY B

Condensed Income Statements

For Years Ended

December 31, 2010 December 31, 2011

Revenues $19,360b $20,640e

Expenses

Initial direct cost $1,694c $1,806f

3. Company C

COMPANY C

Condensed Income Statements

For Years Ended

December 31, 2010 December 31, 2011

Gross profit $45,020a $35,440b

P18-11 (continued)

2. (continued)

P18-12

1. Company X

COMPANY X

Condensed Income Statements

For Years Ended

December 31, 2010 December 31, 2011

Revenues $72,960b $47,040e

Expenses

Initial direct costs $ 5,168c $3,332f

P18-12 (continued)

2. Company Y

COMPANY Y

Condensed Income Statements

For Years Ended

December 31, 2010 December 31, 2011

Gross profit $40,130a $41,770b

3. Company Z

2010 2011 2012

Gross profit, Contract 1 $360,000a $200,000c $ —

Gross profit, Contract 2 140,000b 105,000d 105,000f

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P18-13

2010

Cash ($10,000 x 4) 40,000

2011

Unearned Franchise Fees 45,000

Franchise Revenue 45,000

Cash ($140,000 x 10%) 14,000

Interest Revenue 14,000

18-47

P18-14

Note to Instructor. This problem requires knowledge about accounting for real

requirements 2 and 4 the gain is recognized as a single amount on December

31. A portion of the gain could be recognized on January 1.

1. Given the information in the problem, the transaction is a sale. Some students

may question the fact that the note is only secured by the land, but that does

not, by itself, raise questions about collectibility because it is a common

characteristic of real estate sales.

Jan. 1 Cash 9,000,000

Notes Receivable 41,000,000

2. Jan. 1 Cash 9,000,000

Notes Receivable 41,000,000

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P18-14 (continued)

2. (continued)

Dec. 31 Cash 4,349,249

Interest Revenue 4,100,000

Notes Receivable 249,249

$7,861,862

3. Jan. 1 Cash 9,000,000

Deposit 9,000,000

During Liability for Improvements 1,000,000

the Cash, etc. 1,000,000

year

Dec. 31 Cash 4,349,249

Interest Revenue 4,100,000

18-49

P18-14 (continued)

4. (continued)

P18-15

Note to Instructor: Journal entries are not specifically illustrated in the chapter

discussion.

1. Consignment-out 308,000

Inventory 300,000

Cash 8,000

Cash 162,000

Advertising Expense 15,000

Sales Commissions Expense 18,000a

Sales 195,000

P18-15 (continued)

2. The company would include a current asset, Consignment Inventory, of $123,200

3. Memorandum Entry: Merchandise costing $300,000 was received from the

Hadad Company on consignment.

Consignment-in 15,000

Cash 15,000

4. The company would include a current liability, Consignment Obligation, of

$32,400 on its balance sheet.

ANSWERS TO CASES

C18-1 (AICPA adapted solution)

1. Most merchandising companies deal in finished products and recognize revenue at the

point of sale. This is often identified as the moment when title legally passes from seller to

purchaser. At the point of sale there is an arm’s-length transaction to measure reliably the

amount of revenue recognized. With accounting theory based heavily on reliable

2. For service-type companies, accounting recognition of revenue approximates the earning

process. The recognition of revenue for accounting purposes takes place (is recorded)

during the period the services are rendered. Although it is theoretically possible to accrue

revenue continuously as the services are rendered, for practical reasons revenue is usually

accrued periodically with emphasis on the appropriate period of recognition.

C18-1 (continued)

3. Revenue is sometimes recognized at completion of the production activity, or after the

point of sale. The recognition of revenue at completion of production is justified only if

certain conditions are present. The necessary conditions are that there must be a

relatively stable market for the product, marketing costs must be nominal, and the units

C18-2

The percentage-of-completion method is used for certain long-term construction

contracts to recognize revenue prior to the completion of the contract. In such cases,

recognition of revenue at the time of sale (completed contract) can lead to a distortion

of the economic substance of a company’s operations. Under the percentage-of-

The proportional performance method is used to recognize revenue prior to the

completion of long-term service contracts that require services to be performed in more

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C18-2 (continued)

The installment method of revenue recognition is used in special cases where receivables

from credit sales are collected over an extended period and there is no reasonable basis

C18-3 (AICPA adapted solution)

1. a. The percentage-of-completion method is justified because revenue is earned as work

is performed under the long-term construction contract. As a result, it provides more

relevant information. Revenues represent actual or expected cash inflows (or the

2. The income recognized in each year of this long-term construction contract would be

determined using the cost-to-cost method of determining percentage of completion as

follows:

The contract price is the first part of the determination of the total

3. Progress billings sent and collections on these billings would not affect the income

recognized in each year of this long-term contract.

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C18-4 (AICPA adapted solution)

1. The revenue recognized on a long-term contract under the percentage-of-completion

method is determined by applying a percentage representing the degree of completion

to the total contract price at the end of the accounting period. The percentage is

derived by dividing the costs incurred to date by the total estimated costs of the entire

contract based on the most recent information. The percentage may also be derived by

2. The percentage-of-completion method is preferable when estimates of the bases upon

3. Interim billings on long-term contracts are not generally accepted as a method of

recognizing earnings because such billings often do not bear a meaningful relationship to

4. Under the percentage-of-completion method, a schedule is made of the contracts in

process, showing the total costs incurred as of the end of a given period, the estimated

gross profit recognized based on the degree of completion, and the total billings rendered

on each individual contract. If costs incurred plus recognized profits exceed the related

18-55

C18-5 (AICPA adapted solution)

1. The propriety of choosing one method or the other depends primarily on the degree of

completion of the installment transaction at the time the sale is recorded and the

objectivity of its measurement. No sound theoretical reason apparently exists for the use

of the installment method for financial statement purposes in the case of completed

transactions in which collection is dependent merely upon a lapse of time. The

2. Installment contracts receivable which conform generally to normal trade practices and

terms are classified as current assets under both methods of revenue recognition. Current