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CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING
4-15
Projects and Activities
Module 1
LO 2
Comparing the Cash and Accrual Bases of Accounting
In-class discussion: Income versus cash
In the income statement in Example 4-2, Glengarry Health Club had net income of $7,000. Their statement
of cash flows showed a decrease in cash from operating activities of $4,000. Why is net income more than
the cash provided by operating activities?
Solution
The difference is explained by the fact that the income statement is reported on the accrual basis, and
Module 1
LO 3
The Revenue Recognition Principle
In-class discussion: Recognition of revenue from extended warranties
Have you been offered an extended warranty, at extra cost, on a recent purchase? How does the seller
account for these revenues? Let’s use an actual company to explore this question.
The following are excerpts from Note 1 regarding revenue recognition for Best Buy Co. Inc., (fiscal year
ended January 31, 2015 10K):
Revenue Recognition
“Our revenue arises primarily from sales of merchandise and services. We also record revenue from sales
of service contracts, extended warranties, other commissions and credit card programs. Revenue excludes
sales taxes collected.
INSTRUCTOR’S MANUAL
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service contract or subscription, commissions are recognized in revenue when such commissions have been
earned, primarily driven by commencement of service to the customer. Service and commission revenues
earned from the sale of extended warranties represented 2.1%, 2.2% and 2.5% of revenue in fiscal 2015,
2014 and 2013 (11-month), respectively.
Gift Cards
We sell gift cards to our customers in our retail stores, through our websites and through selected third
parties. We do not charge administrative fees on unused gift cards and our gift cards do not have an
expiration date. We recognize revenue from gift cards when: (i) the gift card is redeemed by the customer,
or (ii) the likelihood of the gift card being redeemed by the customer is remote ("gift card breakage"), and
we determine that we do not have a legal obligation to remit the value of unredeemed gift cards to the
◼ Explain in your own words why sales of products and sales of warranty programs are accounted
for differently.
◼ What does the phrase “both title and risk of loss transfer to the customer” mean in regards to
revenue recognition? What would happen if significant obligations still did remain?
◼ How does Best Buy account for gift cards?
Solution
Product sales are generally recognized when the product is delivered, especially in the case where products
are being delivered to commercial customers with established credit, whose payment is reasonably assured.
In-class discussion: New franchises
An entrepreneur has an idea for a series of party and wedding invitation printing outlets to be located in
high-traffic areas like shopping centers. Customers can simply upload their designs or ideas to the
company’s web site or drop off their flash drives and then pick up the printed invitations within a few
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING
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hours. The stores would offer quick, attractively priced, convenient service. The outlets will be franchised
to operators in the local areas. The entrepreneur has “scouted” potential locations in a general way, and is
now offering franchises. In addition to granting the franchisee the right to operate under the company logo,
the franchise fee commits the parent company to help the franchisee find a specific location, build the
required “booth,” and train the franchisee/operator. The franchisees must purchase all supplies and
equipment from the parent company (franchisor). Franchisees are also required to pay a specified portion of
their profits to the parent company.
◼ How should revenue generated from the initial franchise fees be recognized by the parent
company?
◼ Are the supplies a revenue item for the parent company?
◼ How should revenues from the percentage of profits be recognized by the parent company?
◼ Suppose the contract clause that requires the franchisee to pay the franchisor a percentage of
profits also specifies a minimum amount to be paid in the event of very small profits, or a loss.
How would the franchisor recognize these payments? Are they revenue for the franchisor, even if
the franchisee did not make a profit?
◼ Would you change any of your answers if you knew that the company was still owed all or part of
the franchise fee? In other words, if the contract is signed, and location and training arrangements
are moving ahead, but the franchise fee has not been paid to the franchisor, would you account for
anything else differently?
◼ If the franchise agreement allows the initial fee to be refunded under certain circumstances, does
this affect the recognition of revenue? Explain your answer.
Solution
This question is based roughly on the Fotomat IPO. With the age of digital cameras and iPhones, this seems
INSTRUCTOR’S MANUAL
like any other account receivable. However, any doubt about collection introduces a new wrinkle.
Logic dictates a delay in recognition of this revenue. The stage of development of the particular
franchise will be important to know. Students might well question how far the franchisor should
go ahead with developing the location if the prospective franchisee had not yet paid.
In-class discussion: When is a sale a sale?
In an article concerning troubled MiniScribe Corp. it was stated that
“…the company ‘dramatically’ increased shipments to three warehouses, booking $56.4
million in sales and gross profit of $5.4 million.”
2
Note: the warehouses belonged to MiniScribe.
What is MiniScribe doing wrong? Is the dollar amount the problem? Is the problem the destination of the
shipments (warehouses)? How should the company have recorded these shipments? Even though this
article is from 1989, the lessons are still relevant in today’s environment.
Solution
The volume of the shipments only called attention to the real problem. Be certain that everyone in the class
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING
4-19
Module 1
LO 4
Expense Recognition and the Matching Principle
Outside assignment: Expense versus asset
The following are excerpts from Note 1 for Apple Inc. (February 1, 2013 10-K):
Software Development Costs
Research and development (“R&D”) costs are expensed as incurred. Development costs of computer
In their Consolidated Statement of Income for the fiscal year ended September 27, 2014, Apple lists
“Research and development” of $6,041 million as operating expenses on the income statement and total
operating expenses of $18,034 million.
4
Thus, research and development costs represent 33.5% of total
operating expenses.
◼ Define in your own words an asset and an expense.
◼ Won’t research and development produce future benefits for Apple? Why are they expensing this
in the current year, instead of listing it on the balance sheet as an asset?
◼ If they classify research and development as an asset and amortize it over a number of years, how
will they determine the number of years to use?
◼ What do you think “technological feasibility” is? Do you think companies might manipulate
income when determining technological feasibility?
◼ Do you think Apple’s balance sheet has an asset called “Unexpired research and development
costs?” If it does not, doesn’t recognizing a major expense in one year put Apple at an unfair
disadvantage compared to other companies? Would you expect to find a similar item on the
income statements of other companies? What kinds of companies would they be?
Solution
◼ An expense is an item whose usefulness to the company is complete. An asset will produce
benefits in the future.
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net income when dealing with technological feasibility. If a company wants to decrease net
income, it would say that the product has not reached technological feasibility. If they want to
increase net income, they would say technological feasibility has been met.
In-class discussion: Depreciation expense
◼ Upon what estimates is depreciation expense based?
◼ What prevents a company from manipulating these estimates to achieve a desired increase or
decrease in reported income?
◼ Why is salvage value deducted before periodic expense is calculated? Does this mean that the
salvage value is never accounted for? What will eventually happen to the salvage value?
Solution
◼ Depreciation is based on estimates of the useful life of the asset, and its eventual salvage or resale
value.
Module 2
LO 5
Accrual Accounting and Adjusting Entries
In-class discussion: These adjustments appear to be trivial amounts
Lincoln Electric Holdings, Inc. is one of only a few worldwide broad-line manufacturers of welding and
cutting products. Their balance sheet is reproduced on the next page. (Note: The shareholder’s equity is
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING
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Lincoln Electric Holding, Inc.
Consolidated Balance Sheet
For the year ended December, 31, 2014
5
(dollars in thousands)
ASSETS
Current assets
Cash and cash equivalents 278,379
Accounts receivable (less allowance of $7,734) 321,862
Inventories
Other Assets
Prepaid pensions 1,240
Equity investments in affiliates 27,481
Intangibles, net 132,361
Goodwill 179,517
Long-term investments 31,119
Deferred income taxes 2,940
Other non-current assets 28,671
Total other assets 403,329
TOTAL ASSETS $1,939,215
Customer advances 26,468
Other current liabilities 27,070
Current portion of long-term debt 7,011
Total Current Liabilities 492,419
Long-Term Liabilities
Long-term debt, less current portion 2,488
Accrued pensions 32,803
Deferred income taxes 40,761
INSTRUCTOR’S MANUAL
Solution
Homework examples use small dollar amounts to keep arithmetic to a minimum, so students believe that
these entries hardly seem worth the trouble. The accruals and deferrals for a large company provide a sense
of proportion to put adjustments into better perspective.
The accounts that students will most likely notice are:
◼ Deferred income taxes (asset; the liability is also below) results from timing differences between
reported income for tax and book purposes. Students may not fully understand this, but should
recognize the “deferral” part.
◼ Accrued expenses are probably period-end accruals for other operating expenses.
◼ Accrued taxes, including income taxes is probably period-end accruals of taxes due.
◼ Customer advances would appear to result from customers paying Lincoln before the services
have been renederd.
◼ Dividends payable represent dividends declared in 2014 but not payable to the shareholders until
2015.
Outside assignment: Unearned revenue for airlines
Southwest Airlines showed, for 2014, total passenger revenues of $17,658 and also recorded on the same
year’s balance sheet an “Air traffic liability” of $2,897 (all figures in millions).
6
Southwest’s Footnote 1 to their 2014 Annual Report (Summary of Significant Accounting ) reads:
Revenue recognition
Tickets sold are initially deferred as Air traffic liability. Passenger revenue is recognized when
transportation is provided. Air traffic liability primarily represents tickets sold for future travel dates and
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING
canceling were able to be reused on another flight for up to twelve months. On September 13, 2013,
Southwest implemented a No Show policy that applies to nonrefundable fares that are not canceled or
changed by a Customer at least ten minutes prior to a flight's scheduled departure. Based on the Company's
revenue recognition policy, revenue is now recorded at the flight date for a Customer who does not change
his/her itinerary and loses his/her funds. Amounts collected from passengers for ancillary services such as
baggage and other fees are generally recognized as Other Revenue when the service is provided, which is
typically the flight date.
Frequent flyer program
The Company records a liability for the estimated incremental cost of providing free travel under its
frequent flyer program for all amounts earned from flight activity that are expected to be redeemed for
future travel. The estimated incremental cost includes direct passenger costs such as fuel, food, and other
operational costs, but does not include any contribution to fixed overhead costs or profit.
7
◼ What do you think an “Air traffic liability” is? Is the amount significant? When will this liability
be retired?
◼ When does Southwest record revenue:
Is revenue earned when the passenger boards? When the plane takes off? When the round
trip is complete?
Is refundability a factor?
◼ Do you think all airlines have the same policies?
◼ How does Southwest account for the federal fees it must collect?
INSTRUCTOR’S MANUAL
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Solution
An “Air traffic liability” is an airline’s unearned revenue from ticket sales. This liability is approximately
16.4% of airline revenues, a significant amount. The simple answer to retirement of the liability is “when
the ticket holders take the trips.”
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING
In-class discussion: Time, Inc. unearned revenue
How do you suppose a company as big as Time keeps track of unearned subscription revenues? Deferred
revenue and subscriber-related liabilities at the end of 2014 was $552 million (current liability of $458 and
long-term liability of $94).
8
Somewhere in there is your one-year subscription to Time magazine. How do
they know how many issues they have sent you? Magazines are sold at a variety of rates, depending on
how you subscribe and for how long. This looks like an impossible amount of information for Time Warner
to organize. Can they really keep track accurately? Do they have to?
Solution
Advertising Revenues
Advertising revenues are recognized at the magazine cover date, net of agency commissions.
Advertising revenues from websites are recognized as impressions are delivered or as the services are
performed. Customer payments received in advance of the performance of advertising services are recorded
as Deferred revenue in the Balance Sheets.
Circulation Revenues
Circulation revenues include revenues from subscription sales and revenues generated from single-
copy sales of magazines through retail outlets such as newsstands, supermarkets, convenience stores and
INSTRUCTOR’S MANUAL
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Decision
Models
Ethical Decisions and Adjusting Entries
You are a recently hired staff accountant at a small, private, construction company. You are starting to
prepare the monthly financial statements. The company has not had a very good month and based on sales,
you and other employees will probably not receive a bonus. You notice that the company received a large
deposit towards the end of the month for a construction project which will not be started for several
months. You realize that if you make an adjusting entry to take the deposit out of the Deferred Revenue
account and into the Sales Revenue account, the company will show enough profit so that the bonuses
would be received. You rationalize that since the company has a signed contract for the job, the deposit
could be recognized as revenue.
Use the Ethics Decision Making Model to help you determine your course of action.
Solution
This scenario can be used to show students that accountants are confronted with ethical decisions every
day. Although you may know the right way to record something, when it has a personal impact on you
You can also have a discussion about why tying bonuses to financial numbers can lead accountants to
“cook the books.”
1. Recognize an ethical dilemma: The ethical dilemma is whether the adjusting entry should be
made. Is the deposit considered revenue or deferred revenue (unearned revenue) at this point?
3. Determine what alternative methods are available to report the transaction, situation or
event.
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING
a. To leave the deposit as deferred revenue. When does the deposit come out of deferred
revenue and into revenue? Generally, the deposit will not be considered revenue until it
4. Select the best or most ethical alternative, considering all of the circumstances and
consequences.
