3310-Ch 4-End of Chapter Solutions-ST

Chapter 4
Revenue Recognition
N. Problems
P4-1. Suggested solution:
An enterprise creates value at many different points or periods of time. Conceptually, revenue
and associated costs, or income, should be recorded whenever the enterprise creates or adds
value. The discovery of a process or product, manufacturing, distribution, product display, sales,
delivery, credit provision, warranties are all value-adding activities, so revenue/income could be
recognized at all of these points or periods of time.
* It is true that there is significant evidence supporting the efficiency of security prices,
such that those prices reflect information available to market participants.
* Information about a mineral discovery is indeed relevant to the value of a mining
company, so stock price should respond to such information.
* However, accounting’s role is not to simply reflect the information that is already
contained in security prices. Rather, accounting reports should be a source of information
for various purposes, one of them being the valuation of securities.
* The market price for the company’s securities is the result of buying and selling by many
traders who are interpreting information without bias. Allowing companies to record
revenue when they make a mineral discovery (or for similar types of events) gives a great
deal of latitude for making estimates about the value of the discovery, and such estimates
could be severely biased.
* While the mineral discovery may be verifiable by geological engineers to some extent,
numerous estimates are required to translate that discovery to a dollar figure in terms of
future revenue or income.
* Revenue recognition criteria try to balance the demands for relevant information and the
reliability of the recorded revenue, taking into consideration the uncertainty of events, the
motives of management, and the availability of other sources of information.
* The cash basis of revenue recognition would be more reliable since cash receipts are
readily verifiable.
* However, doing so usually delays the recognition of revenue, reducing its timeliness and
relevance to users.
* Cash basis information is generally less useful for making predictions about the future, as
it can fluctuate due to random events affecting the timing of payment.
* While more reliable, the cash basis does not eliminate judgment and overstatements.
Many transactions involve payments in advance of the delivery of goods or provision of
services.
Copyright © 2017 Pearson Canada Inc.

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Third Canadian Edition
* Restricting revenue recognition to the cash basis can have real consequences on business
activities. For instance, a company would be less willing to sell products on credit; the
supply of credit is essential to the health of the economy.
* Revenue recognition criteria try to balance the reliability of reported revenue with the
demand for relevant information.
a.
* ABC’s investment satisfies the definition of an asset, but it fails the recognition criteria
because the future economic benefits of the R&D are highly uncertain. Therefore, the
investment should be expensed.
* XYZ can recognize the $500 million equity investments as assets because the value of the
shares can be readily determined from quoted prices on stock exchanges.
b.
* Success: While the discovery of the vaccine will likely lead to significant future cash
flows in the form of sales of vaccines, those revenues cannot be recognized until the sales
occur.
* Failure: There are no revenues or income to recognize in this instance. In addition, since
the R&D costs had been expensed, there are no assets to write off when the R&D is
unsuccessful.
c.
* Success: XYZ would record income for the increase in the value of its investment and
correspondingly write up the value of the asset.
* Failure: XYZ would record a loss for the decrease in value of its investment and write off
the asset.
* This approach relies on the efficiency of security markets providing reliable evidence of
the value of the vaccine.
d.
ABC XYZ
Vaccine success Revenue = 0 Gain = $1,950 million
Vaccine failure Revenue = 0 Loss = $50 million
e.
* The differences in accounting between ABC and XYZ are due to the recognition criteria,
particularly in regard to whether there is reasonable certainty in the amounts to be
recognized.
* ABC must defer the recognition of revenue until the actual sale of the malaria vaccine (if
any) while XYZ could indirectly recognize its share of future revenues (net of costs) that
the biotechnology company is expected to earn from the vaccine via the increase in its
stock price.

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Chapter 4: Revenue Recognition
Activity Method of revenue recognition

Sale of products Upon transfer of risks and rewards, amount of revenue
is determinable, and payment is likely (probable that
economic benefit will flow to BMW), and costs can be
measured reliably.
Lease rentals Straight-line over rental period.

Financial services Interest income using effective interest method.
Post-sale services Deferred and recognized as revenue over period of
(multiple-component contracts) contract according to the pattern of expected costs.
Consignment sales of vehicles Deferred until product is sold to consumer (when “such
(sales with repurchase commitments) profits have been realized”).
The five steps in the revenue recognition process and the purpose of each are listed below:
1. Identify the contract. The purpose of this step is to identify the contract that will be
accounted for. The contract can be written or oral providing that it meets the commercial
substance test and it is probable that the consideration will be collectible. The contract must
also meet the requirements with respect to identification of the respective parties’ rights and
obligations and payment terms.
2. Identify the performance obligation. The purpose of this step is to determine whether there is
more than one performance obligation and the nature of each obligation.
3. Determine the transaction price. The purpose of this step is to determine the amount that
ultimately needs to be accounted for. This is normally a fairly straight-forward exercise,
however, complications can arise if: the consideration received is a non-cash asset; there is a
significant financing component; there is consideration payable to the customer; and/or the
amount of consideration to be received is not fixed at the outset.
4. Allocate the transaction price to the performance obligations. The purpose of this step is to
determine how much revenue should be recognized for the completion of each part of a
contract that includes multiple performance obligations.
5. Recognize income in accordance with performance. The purpose of this step is to ensure that
revenue is recognized when the enterprise transfers control of the good or service to the
customer. For contracts that include multiple performance obligations, an appropriate amount
of revenue is recognized upon the completion of each obligation.

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Method of
Situation recognition Brief explanation
a. A vendor sells tomatoes at a At point of Sale of goods: risk and rewards
farmers’ market. sale transferred.
b. A department store sells and delivers At point of Sale of goods: significant risk and
a washing machine with a three-year sale rewards transferred; assurance-type
warranty against manufacturing warranty is not a separate
defects. performance obligation.
c. An electronics store sells a At point of Sale of goods: significant risk and
television set with a 14-day “lowest sale rewards transferred; remaining
price” guarantee. (That is, if the indemnity risk is small and
customer finds a lower price on the estimable.
same product offered by the
company or a competitor, the
company will refund the difference
to the customer.)
d. A bus manufacturer signs a contract According Provision of services on long-term
to supply 280 buses over five years to degree of contract involving the transfer of a
for the Toronto transit system. completion series of similar products.
e. A university receives students’ According Provision of services. Revenue
course registrations. to degree of earned as courses progress.
completion
f. An insurance company issues a one- Over time Provision of services. Revenue
year insurance policy on a car. earned as time elapses.
g. A company deposits funds into a Over time Provision of services: a deposit
two-year term deposit that earns 4% provides funds to the bank to use for
per year. lending.
h. A company takes a five-year loan Over time Matching with the benefits received
bearing interest at 8% per year. from using funds.
i. A company purchases computers for Over time Matching with the benefits received
its accounting department. over time.
j. A company purchases According Matching with the benefits of
manufacturing equipment that is to units of production and subsequent sales.
expected to produce 50,000 widgets. production
k. A company incurs delivery costs on At point of Matching delivery costs with the
January 3 for a shipment of products sale (before related sales.
sold five days earlier (before the year-end)
year-end).

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Circumstance Revenue recognition criteria not met

a. An apartment owner receives a deposit of Service: It is not probable that the
$1,200 equal to one month’s rent. economic benefits (the value of the
deposit) will flow to the entity.
b. An insurance company receives annual Service: Revenue should be recognized
premiums for fire insurance on June 25 for according to the stage of completion;
coverage beginning July 1. the coverage period has not yet begun.
c. A city transit authority issues 200,000 monthly Good: The transit authority has not
passes at $80 each for sale at various retailers. transferred to the buyer the risks and
Retailers act as consignees for these passes. rewards of ownership.
Service: See next item.
d. A city transit authority sells 50,000 monthly Service: Revenue should be recognized
passes at $80 each to transit riders at its own according to the stage of completion.
retail offices/stores. The period for which the passes are
valid has not elapsed.
e. A provincial lottery corporation delivers 10 Good: The lottery corporation has not
million scratch-and-win cards to retailers. The transferred to the buyer the risks and
cards retail for $2 and generate a commission of rewards of ownership.
$0.20 per card for the retailer. The retailer can
return unsold cards to the lottery corporation.

a. DR Accounts receivables (10,000 × $350) 3,500,000
CR Sales revenue ($3,500,000 - $300,000) 3,200,000
CR Consideration payable to customers (10,000 × 60% 300,000
× $50)
DR Cost of goods sold (10,000 × $180) 1,800,000
CR Inventory 1,800,000
b. DR Consideration payable to customers (from above) 300,000

CR Sales revenue ($300,000 - $25,000) 25,000
CR Cash (10,000 × 55% × $50) 275,000

Component fair
value as
Component percentage of × Actual sale
Nova fair value total price = Allocation
Car: immediate
14,000 90.32% $15,000 $13,548
recognition
Warranty: defer
1,500 9.68% $15,000 1,452
and amortize
Total 15,500 100.00% $15,000

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Component fair
value as
Component percentage of × Actual sale
Pinto fair value total price = Allocation
Car: immediate
15,000 88.24% $18,000 $15,882
recognition
Warranty: defer
2,000 11.76% $18,000 2,118
and amortize
Total 17,000 100.00% $18,000
a.
– Fair value of more
reliably measured = Residual value
Sale price component (car) (warranty)
Nova $15,000 $14,000 $1,000
Pinto 18,000 15,000 3,000
b.
– Fair value of more
reliably measured
Sale price component (warranty) = Residual value (car)
Nova $15,000 $1,500 $13,500
Pinto 18,000 2,000 16,000

a. The loyalty program creates two performance obligations whereby each sale is a
combination of the delivery of one cup of coffee immediately, and 1/9th of the tenth cup of coffee
for a loyalty customer. Using the stand-alone selling price method and assuming that each
customer consumes the same product each time, then the proceeds from 9 sales need to allocated
over 10 transactions, since the 10th one is “free.”
Dr. Cash (100,000 × $1.50 / sm cup) 150,000

Dr. Cash (250,000 × $1.80 / md cup) 450,000
Dr. Cash (320,000 × $2.00 / lg cup) 640,000
Cr. Revenue 1,116,000
($150,000 + $450,000 + 640,000) × 9/10
Cr. Deferred revenue ($1,240,000 – $1,116,000) 124,000

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b. Using the residual value method and assuming all customers redeem for a large size, the
journal entries would be as follows:
Dr. Cash (100,000 × $1.50 / sm cup) 150,000

Dr. Cash (250,000 × $1.80 / md cup) 450,000
Dr. Cash (320,000 × $2.00 / lg cup) 640,000
Cr. Deferred revenue 134,000
(670,000 cups × 1/10 × $2.00 / lg cup)
Cr. Revenue ($1,240,000 – $134,000) 1,106,000
c. In this scenario, the residual value method would be more appropriate because it uses
only one fair value for a large cup of coffee. In contrast, if the relative stand-alone selling price
method were to be used, the amount of deferred revenue would differ depending on whether the
sale involved a small, medium, or large cup of coffee, even though the three different deferred
revenue amounts relates to the same product to be delivered in the future. While there is nothing
specific in the standards to prohibit this outcome, it is certainly unsatisfying. To see the different
amounts of deferred revenue, compute the revenue amounts using the relative stand-alone price
method (using the nominal prices as their fair values since other customers not on the loyalty
program do pay these prices):
Component
fair value as Amount
Component percentage × Actual = per free
Small cup sales fair value of total sale price Allocation large cup
100,000 sm cups @ $1.50 150,000 88.24% $150,000 $132,353
10,000 lg cups @ $2.00 20,000 11.76% $150,000 17,647 $1.76
Total 170,000 100.00% $150,000
Component
fair value as Amount per
Component percentage × Actual = free large
Medium cup sales fair value of total sale price Allocation cup
250,000 md cups @ $1.80 450,000 90% $450,000 $405,000
25,000 lg cups @ $2.00 50,000 10% $450,000 45,000 $1.80
Total 500,000 100% $450,000

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Component
fair value as Amount per
Component percentage × Actual = free large
Large cup sales fair value of total sale price Allocation cup
320,000 lg cups @ $2.00 640,000 90.91% $640,000 $581,818
32,000 lg cups @ $2.00 64,000 9.09% $640,000 58,182 $1.82
Total 704,000 100.00% $640,000
a. The sale price should be allocated using the stand-alone selling prices. Therefore, the
amount of revenue that should be recorded is computed as follows:
Stand-alone
selling price
Stand-alone as percentage × Actual sale
selling price of total price = Allocation
Car 45,000 90% $45,900 $41,310
Basic service package 3,000 6% $45,900 2,754
Increment for premium
2,000 4% $45,900 1,836
service package
Total 50,000 100% $45,900
The basic service package is for two years, so its value should be allocated over Year 1 and Year
2 ($2,754 / 2 = $1,377). Likewise, the increment for the premium package should be allocated
over Years 3 and 4 ($1,836 / 2 = $918). The revenue for each time period would be as follows.
Upon
delivery Year 1 Year 2 Year 3 Year 4
Car $41,310 $ -- $ -- $ -- $ --
Basic service package -- 1,377 1,377 -- --
Increment for premium
-- -- -- 918 918
service package
Total $41,310 $1,377 $1,377 $918 $918

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b. In this case, the sale price should be allocated using the relative stand-alone selling
prices. The answer here is similar to that in part (a) except that the revenue for Years 1 to 4 will
differ because the two service components have been combined.
Stand-alone
selling price
Stand-alone as percentage × Actual sale
selling price of total price = Allocation
Car 45,000 90% $45,900 $41,310
Premium service pkg 5,000 10% $45,900 4,590
Total 50,000 100% $45,900
Upon
delivery Year 1 Year 2 Year 3 Year 4
Car $41,310 $ -- $ -- $ -- $ --
Premium service pkg -- $1,147.50 $1,147.50 $1,147.50 $1,147.50
Total $41,310 $1,147.50 $1,147.50 $1,147.50 $1,147.50
c. The assumed facts here suggest that the stand-alone selling prices of the service packages
are more reliably determined while the stand-alone selling price of the car varies considerably.
Therefore, the residual value method seems more appropriate than the relative stand-alone price
method.
Total sale price $45,900

– Basic service package – 1,500
– Increment for premium service package – 1,800
Residual = amount allocated to car $42,600
a. The phone packages involve multiple performance obligations, so it is important to

separate the two streams of revenue: sale of the phone and cellular services. However, the
nominal prices for the two components are not necessarily indicative of the value of the
components. For example, the phone is provided for “free” under Option A, but costs $400 under
option B and $600 under option C.
Option C is the only option with a single deliverable, so the $600 can serve as the stand-alone
selling price for the Raspberry 300. For this option, $600 can be recognized as revenue upon
delivery of the phone.

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Option A has total revenue of $1,800 over the 36 months of the contract ($50 × 36 = $1,800). Of
that amount, $600 can be allocated to the phone, while the remaining $1,200 should be allocated
to the service contract, resulting in $33.33 per month ($1,200 / 36).
Likewise, Option B has total revenue of $1,000 over 12 months ($50 × 12 + $400 = $1,000).
Allocating $600 to the phone, the remaining $400 should be recognized over 12 months of the
contract, or $33.33 per month.
b. To ensure the validity of the approach just described, it is important to ascertain whether
the $600 price for the phone under Option C is indeed its fair value. If a significant number of
customers do choose Option C, then those market transactions supports $600 as the fair value. If
no one, or if very few customer choose Option C, then that brings into doubt that $600 is the fair
value of the phone.
The more general point is that prices quoted by the reporting entity may not be truly reflective of
fair value. Consider the possibility for earnings management if all such quoted prices were
accepted as fair values. In the case of the Raspberry 300, if the company artificially set a high
price for Option C, say, $1,000, then accepting $1,000 as the value of the phone that would allow
the company to record $1,000 immediately in revenue (and less later) if customers chose Options
A or B. However, any rational customer will not accept this price because Option B has the same
cost ($400 initially plus $50/month x 12 months = $1,000) but provides both the phone and one
year of service.
The different sources of revenue for REYC warrant different treatment due to their differing
characteristics. The following discusses each in turn.
Initiation fee of $50,000

This fee is charged only once upon a member joining and is non-refundable. Therefore, an
argument can be made that the full amount can be recognized in revenue when received. That is,
the criteria for the recognition of service revenue under IAS 18 paragraph 20 have been satisfied:
a. The amount of revenue can be measured reliably at $50,000.
b. The economic benefits ($50,000) will flow to REYC.
c. The transaction is complete when REYC receives the amount because the amount is not
refundable.
d. The costs incurred for the transaction, which are negligible, can be measured reliably.
On the other hand, recognizing the full $50,000 in revenue can be premature. When members
join, they expect and have rights to certain services as long as they remain members in good
standing. Therefore, it can be argued that REYC has obligations to provide services in the future.
From this perspective, criteria (c) noted above has not been satisfied because the transactions is
only partially complete, if at all, at the time of membership initiation. Furthermore, the club is
operated on a break-even basis, implying that the proceeds from the initiation fees would be used
to cover capital and operating costs (e.g., for the clubhouse, outstations); otherwise, the club
would generate large surpluses from the initiation fees. This argument suggests that REYC

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should record the initiation fee as deferred revenue. Under this approach, the revenue would be
recognized over the expected life of memberships, which is around 25 years.
On balance, it appears that the deferral approach for initiation fees is more appropriate to reflect
the services that the club is expected to provide to new members over many future years.
Annual membership fee of $10,000

On the surface, the treatment of the annual membership fee would seem to be straightforward
because the fees are paid annually for services received in the same period. Therefore, the full
$10,000 should be recognized in revenue in each year. However, the membership fee entails
multiple deliverables. One deliverable is the $2,400 credit toward restaurant meals, and the
second are the use of the facilities (clubhouse, outstation). The fair value of the latter (access to
facilities) is difficult to estimate. Therefore, it would be appropriate to use a residual value
approach where the fair value of the meals would be deducted from the membership fee to obtain
the residual for the value of the facilities access. The $2,400 amount of the restaurant credit
could be a reasonable indication of the value of the meals that will be delivered, leaving $7,600
for the value of the facilities access.
On the other hand, there is evidence that the club restaurant charges prices that are 25% below
market. Therefore, an argument can be made to attribute a stand-alone selling price of $3,200 (=
$2,400 / (1 – 0.25)) to the restaurant credit, leaving $6,800 as the residual value for facilities
access.
While the latter approach is conceptually better, it is not recommended because it would create a
complex billing system in the club restaurant where meals consumed as part of the $2,400 credit
would be grossed up by 1/3 (e.g., a $24 meal would be recorded as $32) while other meals paid
out-of-pocket would be recorded at face value. The combination of the two types of revenue
would hinder the management of the restaurant as some meals will have much higher margins
than other meals. Ultimately, all $10,000 of the annual membership fee including the $2,400 of
restaurant credit will be recognized in income in the year since the credits cannot be carried over
from year to year. Thus, there is little to be gained by allocating any amount other than $2,400 to
the restaurant meals—financial statement readers (the membership) are better served by seeing
the performance of the club restaurant based on actual prices paid for meals rather than imputed
prices.
Other revenue sources

REYC should record revenue from moorage in the period in which the moorage services are
consumed. Likewise, the club should record revenue from courses when the courses are
delivered to participants. As mentioned above, restaurant revenue should be recorded at the
actual prices charged rather than at market rates.
The sale of the tablet with the assurance-type warranty represents a contract with a single
performance obligation. As such the entire transaction price will be recognized at time of sale
and an assurance warranty obligation established.

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The sale of the tablet with the sales-type warranty represents a contract with two performance
obligations. The transaction price must be allocated to the two obligations based upon their
relative stand-alone sales prices. Revenue pertaining to the sale of the tablet (including the
assurance-type warranty) will be recognized at time of sale and an assurance warranty obligation
established. Revenue pertaining to the sale of the sales type warranty will be deferred until
performance is achieved.
a. DR Cash (100 × $500) 50,000

CR Sales revenue 50,000
DR Cost of goods sold (100 × $300) 30,000
CR Inventory 30,000
DR Warranty expense (100 × $25) 2,500
CR Provision for assurance warranty costs 2,500
b. DR Cash (150 × $600) 90,000

CR Sales revenue (150 × $480*) 72,000
CR Unearned sales revenue – service warranty 18,000
(150 × 120*)
DR Cost of goods sold (150 × $300) 45,000
CR Inventory 45,000
DR Warranty expense (150 × $25) 3,750
CR Provision for assurance warranty costs 3,750
*The transaction price of $600 must be allocated to the two performance obligations based on
their relative stand-alone sales prices of $500 and $125. $500/$625 × $600 = $480; $125/$625 ×
$600 = $120.
c. DR Provision for assurance warranty expense claims 2,000

CR Labour expense ($2,000 × 50%) 1,000
CR Parts inventory ($2,000 × 50%) 1,000
d. DR Service warranty costs 2,100

CR Labour expense ($2,100 × 50%) 1,050
CR Parts inventory ($2,100 × 50%) 1,050
DR Unearned sales revenue – service warranty* 7,200
CR Sales revenue – service warranty 7,200
*Revenue to be recognized is determined based on the cost based input measure.
Total expected costs = # of tablets × cost per tablet = 150 × $35 = $5,250.
Cumulative performance to date = costs expensed to date / total expected costs = $2,100 / $5,250
= 40%.
Revenue to recognize for the year = unearned revenue originally recognized × cumulative
percentage earned – unearned revenue previously recognized = $18,000 × 40% – $0 = $7,200.

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Months elapsed Subscription-

Subscriptions by end of months earned in
C received December the year
January 4,600 11 50,600
February 4,000 10 40,000
March 4,500 9 40,500
April 5,200 8 41,600
May 6,000 7 42,000
June 5,300 6 31,800
July 4,700 5 23,500
August 4,400 4 17,600
September 7,200 3 21,600
October 4,000 2 8,000
November 4,200 1 4,200
December 9,500 0 -
Total 63,600 321,400
Number of months per year 12
Subscription years 26,783.33
Price per subscription per year $ 99
Revenue earned in the year $ 2,651,550
These magazines are consignment sales and need to be accounted for as such.
Copies distributed during 2013 1,950,000
Less: Copies distributed during 2013 and returned in 2013 (830,000 – 35,000) (795,000)
Less: Copies distributed during 2013 and returned in 2014 (32,000)
Copies distributed and sold during 2013 1,123,000
Price per copy (Retail price of $4 less 50%)  $2
$2,246,000

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Note that the gross margin is $7,500 / $30,000 = 25%.
Jan 2013 Dr. Installment accounts receivable 30,000

Cr. Inventory 22,500
Cr. Deferred gross profit 7,500
May 2013 Dr. Deferred gross profit ($10,000 × 25%) 2,500

Sep 2013 Dr. Cost of goods sold ($10,000 × 75%) 7,500
Jan 2014 Cr. Sales revenue ($30,000 × 1/3) 10,000
Dr. Cash 10,000

Cr. Installment accounts receivable 10,000
May Dr. Installment accounts receivable 90,000

Cr. Inventory ($90,000 x 60%) 54,000
Cr. Deferred gross profit ($90,000 × 40%) 36,000
Aug, Sep Dr. Deferred gross profit ($36,000 × 1/4) 9,000

Oct, Nov Dr. Cost of goods sold ($54,000 × 1/4) 13,500
Cr. Sales revenue ($90,000 × 1/4) 22,500
Dr. Cash 22,500
Cr. Installment accounts receivable 22.500

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a. First, note that all installment sales made from January to June would have been fully
collected by December 31. Therefore, the amount that remains outstanding can be
computed to be $530,000, as follows:
No. of
Installment payment o/s Total number Amount o/s
Month sales at year-end of payments at year-end
January $ 80,000 0
February 70,000 0
March 90,000 0
April 100,000 0
May 90,000 0
June 100,000 0
July 120,000 x 1 / 4 = $ 30,000
August 110,000 x 2 / 4 = 55,000
September 100,000 x 3 / 4 = 75,000
October 90,000 x 4 / 4 = 90,000
November 130,000 x 4 / 4 = 130,000
December 150,000 x 4 / 4 = 150,000
Installment
accounts
$ 1,230,000 receivable $ 530,000
Gross margin 40%
$ 212,000
b. The amount of deferred gross profit is $212,000, as shown in the table for part (a). This
amount is 40% of the installment accounts receivable.
c. The amount of sales recognized in the year equals the amount of installment sales made
in the year less the amount remaining in receivables at year-end. Thus, the amount is
$1,230,000 – $530,000 = $700,000.

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Path Pavers must use the percentage of completion method, with the amount of trail resurfaced
as an indicator of the percentage complete.
(Dollar amounts in millions) 2011 2012 2013 2014 2015 Total

Distance completed in the year 8 km 12 km 12 km 12 km 6 km 50 km
Cumulative kilometres completed 8 km 20 km 32 km 44 km 50 km
Cumulative % completed 16% 40% 64% 88% 100%

Contract price $25 $25 $25 $25 $25
Cumulative revenue $ 4 $10 $16 $22 $25
Less: revenue previously recognized 0 4 10 16 22
Revenue for the year $ 4 $ 6 $ 6 $ 6 $ 3 $25
Alternative solution:
(Dollar amounts in millions) 2011 2012 2013 2014 2015 Total
Distance completed in the year 8 km 12 km 12 km 12 km 6 km 50 km
Percentage completed (50 km total) 16% 24% 24% 24% 12% 100%
Contract price $25 $25 $25 $25 $25 $25
Revenue for the year $ 4 $ 6 $ 6 $ 6 $ 3 $25
It is important to note that this alternative is quicker but that it will only work in situations where
the original estimates are completely accurate and not later revised (i.e., there is certainty). Thus,
it is not recommended for general application.

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Gross profit recognized in 2011:
Cost incurred to date Estimated Gross profit

Gross profit   
Estimated total cost gross profit previously recognized
2,000,000
(  2,000,000)  0
8,000,000
 25%  2,000,000
 500,000
Gross profit recognized in 2012:

Gross profit   
5,500,000
(  1,200,000)  500,000
8,800,000
 (62.5%  1,200,000)  500,000
 250,000
Since the company is unable to estimate total cost, the company should use the cost recovery
method. In this method, revenue each year prior to completion equals costs incurred. In the final
year, revenue equals the amount that remains to be recognized.
2011 2012 2013 Total

Revenue (= cost of sales) 2m 3.5 m 4.5 m 10 m
Cost of sales 2m 3.5 m 3.5 m 9m
Gross profit 0 0.0 1.0 m 1m
* For cost-plus contracts, SNCL records revenue as costs are incurred.

* For fixed-price contracts, the company uses the percentage of completion method.
* The percentage completed is determined using the cost-to-cost approach.
* For operations and maintenance activities, “fixed-fee” is recognized evenly through the
service period.
* Changes in estimates of costs and revenues are treated prospectively.

4-87
* EADS uses the percentage of completion method.

* The percentage completed can be determined by referring to several indicators:
contractually agreed technical milestones, units delivered (e.g., 5 out of 20 planes
ordered), or as work progresses.
* The company uses the cost recovery method when it cannot reliably estimate the outcome
of the contract.
* The company follows the conservatism principle by recording losses when they become
probable.
a.
* Total cost = 800
* % complete = 320 / 800 = 40%
* Revenue = 40% × 960m – 144m = $240m
b.
2013
* Total cost = 108 + 792 = 900
* % complete = 108 / 900 = 12%
* Revenue to date = 12% × 960m = $115.2m
2014
* Revenue = 40% × 960m – 115.2m = $268.8m

4-88
a. To apply the percentage of completion method, we must use the cost-to-cost approach
since no other estimate of the stage of completion is available.
2011 2012 2013

Cost incurred during year A $ 80,000 $120,000 $ 50,000
Cost incurred to date B = Sum of A 80,000 200,000 250,000
Additional costs to complete C 158,000 39,000 0
Total estimated costs D = B+C 238,000 239,000 250,000
% complete E = B/D 33.61% 83.68% 100%
Cumulative revenue F = E × 300,000 $100,840 $251,046 $300,000
Less: revenue previously recorded G = Prior F 0 100,840 251,046
Revenue – current year H=F–G 100,840 150,206 48,954
Expenses A 80,000 120,000 50,000
Gross profit (loss) J=H–A 20,840 30,206 (1,046)
Receivables beginning balance 0 5,000 7,000

Billings during year 65,000 130,000 105,000
Collections during year (60,000) (128,000) (112,000)
Receivables ending balance 5,000 7,000 0
CIP inventory beginning balance 0 100,840 251,046

Cost incurred during year 80,000 120,000 50,000
Gross profit (loss) recognized 20,840 30,206 (1,046)
Contract completion n/a n/a (300,000)
CIP inventory ending balance 100,840 251,046 0

4-89
b.
Billings Revenue or
Year Cash Accts Receivable CIP Inventory on CIP expense
2011 Incur costs 80,000 80,000
Bill client 65,000 65,000
Receive cash 60,000 60,000
Rev & exp recog 20,840 80,000 100,840
Balance 20,000 5,000 100,840 65,000 *20,840
2012 Incur costs 120,000 120,000

Bill client 130,000 130,000
Receive cash 128,000 128,000
Rev & exp recog 30,206 120,000 150,206
Balance 12,000 7,000 251,046 195,000 30,206
2013 Incur costs 50,000 50,000

Bill client 105,000 105,000
Receive cash 112,000 112,000
Rev & exp recog 1,046 50,000 48,954
Balance 50,000 0 300,000 300,000 1,046
Close project 300,000 300,000
Balance 0 0
Total income over three years 50,000
* Revenue and expenses are temporary accounts, which are closed at the end of each period, so
balances do not carry forward.
Year 1 Year 2 Year 3 Total

Revenue 10,000 20,000 20,000 50,000
 COGS 12,000 18,000 25,000 55,000
 Expected loss (recovery) 8,000 (8,000) 0 0
= Gross profit (loss) (10,000) 10,000 (5,000) (5,000)

4-90
2012 2013 2014 2015 Total

Original contract price 65,000 65,000 65,000 65,000
Price adjustment [50% × (est. cost – 1,000 6,000 500 1,500
60m)]
Adjusted contract price 66,000 71,000 65,500 66,500
Costs incurred to date 15,000 30,000 50,000 63,000

Estimated cost to complete 47,000 42,000 11,000 0
Estimated total cost 62,000 72,000 61,000 63,000
Estimated gross profit (loss) 4,000 (1,000) 4,500 3,500
% complete 24.19% 41.67% 81.97% 100%
Cumulative profit (loss) 968 (1,000) 3,689 3,500

Less: profit (loss) previously recognized 0 968 (1,000) 3,689
Current year gross profit (loss) 968 (1,968) 4,689 (189) 3,500
2011 2012 2013

Cost incurred to date B 150,000 1,200,000 2,100,000
Additional costs to complete C 1,350,000 800,000 0
Total estimated costs D=B+C 1,500,000 2,000,000 2,100,000
% complete E=B/D 10% 60% 100%
Cumulative revenue F = E  1,900,000 190,000 1,140,000 1,900,000
Less: revenue previously recorded G = Prior F 0 190,000 1,140,000
Revenue – current year H=F–G 190,000 950,000 760,000
Expenses J = B – prior B 150,000 1,050,000 900,000
Expected loss accrual (reversal) See Note 1 0 40,000 (40,000)
Gross profit (loss) See Note 2 40,000 (140,000) (100,000)
Note 1: These figures may be computed directly or as plug figures after determining the gross
profit. The direct computation for 2012 is: expected loss accrual = percentage uncompleted 
total expected loss – previous accruals = 40%  100,000 – 0 = 40,000. For 2012, expected loss
accrual = 0%  200,000 – 40,000 = –40,000.
Note 2: Because the expected total cost exceeds the contract price in 2012, the gross profit (loss)
in the year must reflect all of the loss, and reverse any prior profit recorded. Thus, the gross
profit (loss) = 100%  –100,000 – 40,000 = –140,000. Similarly, in 2013 the computation is
gross profit = 100%  –200,000 – –100,000 = –100,000.

4-91
Under the completed contract method, no revenue would be recognized until the contract is
completed. However, it is still necessary to recognize any expected losses so that the financial
statements are not overstated. Therefore, the amounts for revenue and profit/loss should be:
2011 2012 2013
Revenue – current year 0 0 1,900,000
Expenses 0 0 2,100,000
Gross profit (loss) before 0 (200,000)
Less: Expected loss accrual (reversal) 0 100,000 (100,000)
Gross profit (loss) 0 (100,000) (100,000)
The question only asks for the gross profit or loss, so we can simply apply these formulas.
Normal circumstance (year 2011, 2013, 2014):
Note: the following equation is the bottom part of Exhibit 4-17.

Gross profit (loss)   
When there is an expected loss on the contract (year 2012):
Note: the following equation is Exhibit 4-24.

Estimated Gross profit (loss)
Gross profit (loss )  100%  
gross profit previously recognized
2011 gross profit (loss) = 1,000,000/3,500,000  2,000,000 – 0 = 571,429.
2012 gross profit (loss) = 100%  -500,000 – 571,429 = –1,071,429

Cumulative profit (loss) recognized = 571,429 + –1,071,429 = –500,000
2013 gross profit (loss) = 3,000,000/5,000,000  500,000 – –500,000 = 800,000

Cumulative profit (loss) recognized = –500,000 + 800,000 = 300,000
2014 gross profit (loss) = 100%  1,500,000 – 300,000 = 1,200,000

Cumulative profit recognized = 300,000 + 1,200,000 = 1,500,000

4-92
For the completed contract method, no profit is recognized until the end of the contract.
However, any expected losses are recognized in their entirety in the year anticipated. The gross
profits (losses) for the four years are shown in the following table. It is important to note that the
loss is not reversed in 2013 when the project becomes profitable again—all profits are deferred
to the date of contract completion.
Year 2011 2012 2013 2014 Total

Gross profit (loss) 0 (500,000) 0 2,000,000 1,500,000
a. GP = % complete  estimated total GP – GP previously recognized

2012: GP = (42 / 75)  (80 – 75) – 0 = 56%  5 = $2.8m
2013: GP = 100%  (80 – 84) – 2.8 = 4  2.8 = $6.8m
2014: GP = 100%  (80 – 81) – -4 = -1 – -4 = $3.0m
–$1.0m
b. Revenue = % complete  estimated total revenue – revenue previously recognized

2012 Rev = (42 / 75)  80 = 56%  80 = $44.8m
2013 Rev = (63 / 84)  80  44.8 = 75%  80 – 44.8 = $15.2m
c.
Costs Dr. CIP 21
incurred Cr. Cash, A/P 21
Billings Dr. A/R 20

Cr. Billings on construction 20
Collections Dr. Cash 19

Cr. A/R 19
Revenue Dr. COGS 21

and Cr. CIP (63/84  -4m) – 2.8 5.8
expense Cr. Revenue (see part b) 15.2
recognition Dr. Expected loss on construction contract 1
Cr. CIP (21/84  -4m) 1

4-93
a. GP = % complete  estimated total GP – GP previously recognized

Year 1: GP = (3,500 / 10,000)  (12,000 – 10,000) – 0 = 35%  2,000 = $700k
Year 2: GP = 100%  (12,000 – 13,000) – 700 = 1,000  700 = $1,700k
Year 3: GP = 100%  (12,000 – 12,000) – –1,000 = $1,000k
b. Revenue = % complete  estimated total revenue – revenue previously recognized

= (10,000 / 13,000)  12,000  4,200 = $5,031k
c. ( in $ thousands)
Costs incurred
Dr. WIP 6,500
Cr. Cash, A/P 6,500
Billings
Dr. A/R 4,000
Cr. Billings on construction 4,000
Collections
Dr. Cash 4,200
Cr. A/R 4,200
Revenue and expense recognition

Dr. COGS 6,500
Cr. WIP ((10/13  1,000)  700) 1,469
Cr. Revenue 5,031
Dr. Expected loss on LT contract 231
Cr. WIP (3/13  1000) 231
d.
Project completion
Dr. Billings on construction 12,000
Cr. WIP 12,000

4-94
a. Revenue = %complete  total revenue – revenue previously recognized

2012 Rev = (4 / 32)  40 = 12.5%  40 = $ 5m
2013 Rev = (24 / 48)  40  5 = 50.0%  40 – 5 = $15m
2014 Rev = (34 / 40)  40  20 = 85.0%  40 – 20 = $14m
b. 2012: GP = (4 / 32)  (40 – 32) = 12.5%  8 = $1.0m

2013: GP = 100%  (40 – 48) – 1 = 8  1 = $9.0m (given)
2014: GP = (34 / 40)  (40 – 40) – -8 = 0 – -8 = $8.0m
$0.0m
c.
Costs Dr. CIP 10
incurred Cr. Cash, A/P 10
Billings Dr. A/R ($31 – $20) 11
Cr. Billings on construction 11
Collections Dr. Cash ($29 – $17) 12
Cr. A/R 12
Revenue Dr. COGS 10
and Dr. CIP 8
expense Cr. Revenue (see part a) 14
recognition Cr. Expected loss recovery on construction contract 4
a. ( in $ thousands)
Notes 1 2 3 Total
Cost incurred to date A 13,000 40,000 54,000
Estimated cost to complete B 37,000 18,000 0
Estimated total cost C=A+B 50,000 58,000 54,000
Contract price D 60,000 60,000 60,000
Estimated gross profit D–C 10,000 2,000 6,000
% complete E=A/C 26% 68.97% 100%
Gross profit to date F=DE 2,600 1,380 6,000
Gross profit previously recognized G 0 2,600 1,380
Current gross profit F–G 2,600 –1,220 4,620 $ 6,000

4-95
b.
( in $ thousands)
Costs incurred
Dr. WIP 27,000
Cr. Cash, A/P 27,000
Billings
Dr. A/R 25,000
Cr. Billings on construction in progress 25,000
Collections
Dr. Cash 20,000
Cr. A/R 20,000
Revenue (income) recognition

Dr. COGS 27,000
Cr. Revenue [40/58  60,000 – 26%60,000] 25,780
Cr. WIP 1,220
c.
Dr. Billings on construction in progress 60,000
Cr. WIP 60,000
d.
* If the cost to complete is $22 million, estimated total cost would be $62 million, resulting
in a projected loss.
* The entire projected loss must be recognized immediately, and any prior profits reversed.
* Profit (loss) to be recorded = 100%  –2,000,000 – 2,600,000 = –$4,600,000.
a.
i.
* Estimated total gross profit = 20%  $1.9 billion = $380m
* Estimated total cost = (1 – 20%)  $1.9 billion = $1,520m
* 2003 Gross profit = % complete  estimated GP – GP previously recognized
* 2003 Gross profit = 228m / 1,520m  380m – 0
* 2003 Gross profit = 57m
ii.
Dr. COGS 228m
Dr. WIP 57m
Cr. Revenue (15%  1,900m) 285m

4-96
b.
i.
Est. total costs: 2003–2005 $ 684m
2006 380m
Beyond 2006 912m
Total $1,976m > $1,900m contract price
Since a loss is projected, record 100% of loss.
2006 gross profit (loss) = 100%  estimated GP – GP previously recognized
= 100%  –76m  76m
= –$152m
(GP previously recognized = $760m – $684m = $76m)
ii.
% complete = (684m + 380m) / 1,976m = 1,064m / 1,976m = 53.85% (rounded)
Dr. COGS 380.000m
Dr. Expected loss 35.074m
Cr. WIP (46.15%  -76m) 35.074m
Cr. WIP (53.85%  -76m  76m) 116.926m
Cr. Revenue (53.85%  1900m  760m) 263.074m
(The combined reduction in WIP equals 35.074m + 116.926m = 152m)
a. ( in $ millions)
1 2 3 4 Total
Costs incurred to date 480 1,250 2,660 3,750
Estimated cost to complete 2,520 1,875 1,140 0
% complete 16% 40% 70% 100%
Contract price 3,600 3,600 3,600 3,600
Cumulative revenue 576 1,440 2,520 3,600
Less: revenue previously recognized 0 576 1,440 2,520
Current-year revenue 576 864 1,080 1,080 3,600
Cumulative expense 480 1,250 2,660 3,750

Expense previously recognized 0 480 1,250 2,720
Current-year expense without loss 480 770 1,410 1,030 3,690
Additional expense for expected loss* 0 0 60 0 60
Total expense for the year 480 770 1,470 1,030 3,750
Current-year gross profit (loss) 96 94 (390) 50 ( 150)

*
Additional expense for expected loss = % uncompleted × projected total loss = 30% × $200 =
$60.

4-97
b. (in $ millions)
Costs incurred
Dr. CIP 480
Cr. Cash, A/P 480
Billings
Dr. A/R 500
Cr. Billings on construction in progress 500
Collections
Dr. Cash 450
Cr. A/R 450
Revenue and expense recognition

Dr. COGS 480
Dr. CIP 96
Cr. Revenue 576
c.
Dr. Billings on construction in progress 3,600
Cr. CIP 3,600
d.
1 2 3 4 Total
Costs incurred to date 480 1,250 2,660 3,750
Estimated cost to complete 2,520 1,875 940 0
% complete 16% 40% 73.9% 100%
Contract price 3,600 3,600 3,600 3,600
Cumulative revenue 576 1,440 2,660 3,600
Less: revenue previously recognized 0 576 1,440 2,660
Current-year revenue 576 864 1,220 940 3,600
Cumulative expense 480 1,250 2,660 3,750

Expense previously recognized 0 480 1,250 2,660
Current-year expense without loss 480 770 1,410 1,090 3,750
Additional expense for expected loss 0 0 0 0 0
Total expense for the year 480 770 1,410 1,090 3,750
Current-year gross profit (loss) 96 94 (190) (150) ( 150)

Gross profit (loss) from part (a) 96 94 (390) 50 ( 150)
Underestimating the cost to complete by $200 million would reduce the Year 3 loss by $200
million, while the Year 4 gross profit of $50 million would go down by $200 million to result in
a $150 million loss. Over the four years, the loss is $150 million regardless of the estimates used
in the first three years.

4-98
The errors include the following:

* The percentage complete is solely based on hours to date/budget hours. The denominator
needs to be updated to reflect the best estimate, as at December 31, 2011, of the total
hours required to complete the contract.
* After including the updated estimates of total hours, the company needs to determine if
any of the contracts are expected to have a loss.
– The table shows Contract Epsilon as more than 100% complete, meaning that
actual hours exceed budget hours. However, the amount of time elapsed is 6 months out
of 12 months for the contract, so it is likely that the actual progress is closer to 50%,
meaning that this contract is likely to produce a loss.
– Given the 30% margin (average cost is $70 while contract rate is $100 per hour),
it is also likely that projects Alpha and Chi will produce losses.
* The completion dates for projects Phi and Eta have already passed (2011/10/06 and
2011/11/25). Presence in this table suggests these projects are supposedly still in
progress. The actual hours are also substantially below budget (21.3% and 42.9% of
budget). The company has also not sent any invoices to the client. Together, these facts
suggest that the company was not able to fulfill the terms of the contract. If this is true,
then these contracts need to be written off (i.e., revenue reversed and inventory written
off).
* The accrued revenue in the table represents the amount of revenue in excess of amount
billed to the client. Since it is shown together with accounts receivable on the balance
sheet, receivables are overstated. For long-term contracts, the only amount that should be
shown in accounts receivable should be the amount of billings (less any collections).
Revenue indirectly affects the balance sheet through the adjustment of work-in-progress
for the gross profit on the contract. For example,
Dr. Cost of sales 70,000
Dr. Work-in-progress 30,000
Cr. Revenue 100,000
a. In addition to general revenue recognition policies, the company describes five other
revenue recognition policies:
(i) revenue from subscriptions;
(ii) multiple deliverables (i.e., multiple performance obligations);
(iii) whether services for installation and implementation are grouped together with the
related product;
(iv) whether to report the gross revenue or net margin on sales of other company’s
products; and
(v) the basis for recognizing revenue on long-term contracts.
b. For multiple deliverables, the company generally uses the relative fair value method for
allocating revenue to the different components. The portion of Note 1 relating to revenue
recognition indicates, “The amount recognized as revenue for each component is the fair
value of the element in relation to the fair value of the arrangement as a whole.”

4-99
c. For multiple deliverable, the company identifies five critical judgments:

(i) whether there are separately identifiable components;
(ii) how to allocate the price to the components.
To resolve the first issue, the company considers whether a potential component could be
bought or sold separately. For the second issue, the company applies the relative fair value
method using evidence of fair value from components when they are sold separately (i.e.,
stand-alone selling prices). This disclosure is contained in the section of Note 2 on
“Critical judgments in applying accounting policies.”
d. For long-term contracts, the company estimates the percentage of completion use the
number of hours worked divided by the total hours expected on the project (see Note 1 of
the financial statements).
a. Canadian Tire’s accounting policies relating to revenue are: as follows:

(i) Sale of goods – recognize revenue when goods are delivered without right of return.
(ii) Customer loyalty program – defer a portion of revenue until customer redeems
loyalty award.
(iii) Interest income on loans receivable – recognize income using the effective interest
rate method.
(iv) Services rendered – recognize according to terms in contract (usually when service is
provided).
(v) Royalties and license fees – recognized as revenue when “earned in accordance with
the substance of the relevant agreement.”
(vi) Rental income – recognized as revenue evenly over the lease term.
b. Note 30 of the financial statements tabulates the revenue recognized on five of the six
categories noted in part (a).
Note 20 identifies the amount of deferred revenue on services. This amount relates to
premiums received on insurance and Roadside Assistance Club memberships that remain
unearned at year-end (i.e., the portion of insurance or membership that had not expired).

4-100
Note 21 identifies the amount of deferred revenue on customer loyalty programs.
These disclosures allow a better understanding of the source of growth for Canadian Tire.
Whereas as total revenue from all sources grew by 3.1% (from $11,427m to $11,785m),
most of the growth came from the sale of goods (from $10,005m to $10,306m), an increase
of 3.0%, and from interest income (from $707m to $754m), and increase of 6.6%.
a. Bombardier uses the cost-to-cost approach to estimate the percentage of completion. When
the company anticipates a loss on a contract, it recognizes the entire loss in the period
when it identifies the loss. Note 2 on page 146 contains this information.
b. From Note 15, we can see that Bombardier had work-in-process inventories of $1,737
million in “Production Contracts” and $335 million in “Service contracts,” for a total of
$2,072 million. These amounts are net of billings and advances received of $4,818 million
($4,773m + $45m). The gross amount before netting out the billings and advances was
$6,890 million ($6,510m + $380m).

4-101
O. Mini-Cases
Case 1: Revenue Recognition at Telecom Firms. Suggested solution:
* Global Crossing was under pressure to maintain the confidence of lenders who have
advanced them $7 billion and equity investors who have valued the company at $40
billion.
* Also not stated in the facts, there were probably also explicit debt covenants.
Provision of fibre capacity:

* Does the “sale” of fibre-optic capacity satisfy the criteria for revenue recognition?
* Global Crossing’s treatment is consistent with the sale of a good. Assuming that payment
was reasonably assured, the risks and rewards of ownership of the fibre capacity (not the
cable itself) had been transferred to the buyer.
* An alternative treatment is to consider these transactions as long-term contracts for the
provision of services. While there may have been advance payments, the period of
service had not elapsed. If considered a service, revenue should have been recognized
over the term of the contract. (In fact, there were no payments—see note at end of this
solution.)
* Treatment as the provision of services would be more consistent with the company’s
revenue recognition policy for other sources of revenue. Global Crossing charges other
companies as they send data through the company’s cables on a pay-as-you-go basis and
records revenue at that time.
* It is also not clear what costs, if any, have been matched to the revenue recorded.

4-102
Purchases of fibre capacity:

* Global Crossing’s treatment relies on the future benefits to be provided by the purchased
fibre capacity.
* It is questionable whether Global Crossing has use of the additional capacity given that it
is also selling capacity at the same time. Possibly, the capacity could be needed where
there are bottlenecks.
Conclusion:
* Taken in isolation, there are possibly reasonable arguments for Global Crossing’s
accounting treatments.
* However, the nature of the transactions and the way they were recorded—asymmetrically
for sales and purchases of fibre capacity—indicate that this is not a simple matter of
applying judgment to instances where there are a range of alternatives. Rather, it suggested
a deliberate decision to inflate profits. The practice is not appropriate and highly unethical.
* The fact that other companies also engaged in similar practices suggests a concerted
effort to collude and mislead financial statement users. This fact illustrates the perils of
following industry practice.
* This case highlights the necessity to look at a company’s operations holistically rather
than in a piecemeal fashion.
Note: A fact deliberately left out of the case is that much of the transfer of fibre-optic capacity
was conducted in reciprocal swaps (e.g., Global Crossing transferred capacity to Qwest at the
same time that Qwest transferred similar capacity back to Global Crossing). Omission of this fact
is to make the case more open-ended, allowing for more thorough discussion of issues.
Case 2: Modern Electronics’ Product Service Plans. Suggested solution:

To: CFO
From: Controller
Subject: Impact of Product Service Plan on accounting for products sold
The accounting issues relating to the Product Service Plan (PSP, or the Plan) principally concern
the transfer of risk and rewards of ownership, which is a key determinant of whether revenue
recognition criteria have been satisfied. In International Financial Reporting Standards (IFRS),
paragraph 14 of IAS 18 contains the following guidance:
14 Revenue from the sale of goods shall be recognized when all the following conditions
have been satisfied:
(a) the entity has transferred to the buyer the significant risks and rewards of ownership
of the goods;
(b) the entity retains neither continuing managerial involvement to the degree usually
associated with ownership nor effective control over the goods sold;
(c) the amount of revenue can be measured reliably;
(d) it is probable that the economic benefits associated with the transaction will flow to
the entity; and
(e) the costs incurred or to be incurred in respect of the transaction can be measured
reliably.

4-103
While our sale of products clearly satisfies criteria (b), (c), and (d), the provision of the PSP
possibly results in our company bearing a sufficient level of indemnity risk relating to the
product during the Plan’s coverage period such that criterion (a) is not satisfied. In addition, we
will need to satisfy criterion (e) by collecting data on the costs of providing the PSP so that we
can properly match the expense to the period when we record the revenue.
Adding to the complication is the proposal to offer the PSP, or some portion of it, for free as part
of the product purchase. These transactions, if the proposal goes ahead, would more closely tie
the indemnity risk to the product and make it more difficult to separate the sale of the product
from the service provided by the PSP (see below).
Deferring revenue recognition until the expiration of the Plan would be the prudent/conservative
accounting policy. Another similar alternative is to defer and recognize revenue over the period
covered by the PSP.
However, following either of these two alternatives would create two separate revenue
recognition policies: revenue deferral for products sold with PSPs, and revenue recognition at
point of sale for products sold without PSPs (which is the policy that the vast majority of
companies follow for the sale of goods and which complies with the revenue recognition criteria
of IFRS).
Furthermore, having these two revenue recognition policies can lead to dysfunctional managerial
actions. Assuming that the PSPs are profitable, we do not want to discourage sales of these
Plans. However, requiring deferral of revenue for products sold with PSPs means that store
managers would have incentives to sell products without PSPs, as the revenue for those products
would be recognized in full immediately.
A more reasonable approach would be to treat the PSP as a service separate from the product that
the Plan covers. Doing so allows a single, consistent revenue recognition policy for products sold
with and without PSPs.
This approach is justified by the fact that the Plan is a service in substance the same as an
insurance policy, and it is separable from the product just as auto insurance is separable from the
purchase of a car. Indeed, our PSPs are reinsured with American Bankers Insurance Company of
Florida.
As a service, we should follow the revenue recognition criteria of paragraph 20 of IAS 18:
¶20 When the outcome of a transaction involving the rendering of services can be estimated
reliably, revenue associated with the transaction shall be recognized by reference to the
stage of completion of the transaction at the end of the reporting period. The outcome of
a transaction can be estimated reliably when all of the following conditions are satisfied:
(a) the amount of revenue can be measured reliably;
(b) it is probable that the economic benefits associated with the transaction will flow
to the entity;

4-104
(c) the stage of completion of the transaction at the end of the reporting period can be
measured reliably; and
(d) the costs incurred for the transaction and the costs to complete the transaction can
be measured reliably.
Given that the Plan covers multiple years, we should recognize revenue over the period of
coverage. For simplicity, a straight-line method may be adequate. However, the nature of
product breakdowns is that they tend to occur more frequently later rather than sooner. In
addition, we have recourse to the manufacturer in instances where the product becomes defective
during the manufacturer’s warranty period. Thus, we should recognize revenue on the PSPs in a
fashion that is lower initially and higher later on to reflect the stage of completion of the service
provided. We should conduct more analysis of service records to determine the appropriate
percentage of revenue we can recognize.
In conclusion, I believe that it is most reasonable to separate the service revenue for the Product
Service Plan from the sale of goods revenue. Doing so complies with IFRS, provides consistent
accounting treatment for different types of sales, and does not create perverse operational
incentives.
Case 3: Penguins in Paradise. Suggested solution:
To: File
From: David
Subject: Financial Accounting Issues for Penguins in Paradise (PIP)
Overview—users, needs, and objectives

Many users will be relying on the financial statements. Most significantly, equity investors will
be relying on the financial statements to calculate their participation payment. They will want
accounting policies that maximize net income. In addition, they will want to ensure that PIP’s
operations, particularly its costs, are being efficiently controlled.
The bank will also be relying on the financial statements to ensure that the operations are under
control. They will likely want to see statements that maximize revenue since part of the interest
payment on the loan varies with gross revenue.
The client and promoter, Darth Garbinsky, will be relying on the financial statements to calculate
his participation payment. Like all the other investors, he will want net income to be high in
order to maximize his own income.
In the assessment of acceptable accounting policies, we should bear in mind that, in this instance,
accounting policies have a direct impact on PIP’s cash flows. That is, high reported income
results in higher cash outflows. However, in the first stages of the life of the play, expenses will
likely exceed revenues. Early recognition of expenses will not impact payments in the early
(loss) years but will increase future net income and the participation payments, which are based
on operating profits.

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Due to the uncertainty regarding the future success of Penguins in Paradise, we should err on the
side of caution and recommend conservative/prudent accounting policies that have the least risk
of overstating assets and income.
Royalty rights
Accounting for the royalty rights payments to PIP is very important because of the impact this
amount will have on the participation payments to investors.
We must first determine whether the amount paid to PIP for the royalty rights is an income item
or a capital item. A royalty payment is very similar to a dividend. The investors will receive a
royalty (or participation) payment that is based on their initial contribution. The payment that
they receive could also be considered a return of their investment. Both of these facts imply that
the payments to PIP by the investors are on account of capital.
On the other hand, in order for the investors to earn a royalty, the critical event that must take
place is the production of the play. The cost of producing the play is the cost of earning the
income. In addition, the original contributions will not be refunded to the investors.
If the amount paid to PIP by the investors is considered to be on account of income, we must
determine the period in which the amount should be recognized. The critical event here is the
signing of the contract. Also, no future services have to be provided. These facts suggest that the
amount should be recognized as income immediately.
However, if net income is earned and a royalty payment is made by PIP, it will be based on
future net income. Expenses will be incurred in the future, and therefore the amount paid to PIP
by investors should be matched to the period in which the expense is incurred. In addition, by
recognizing the investors’ payments to PIP as income in future periods we would obtain a better
matching of expenses since the production is in a future period.
I recommend that the investor payments to PIP be treated as income and recognized in future
years.
“True operating expenses”

To help avoid interpretation problems in the future, the term “true operating expenses” must be
defined. The definition will help clarify what types of costs should be expenses in a particular
period.
Sale of reservation rights

The timing of recognition of the fees earned from selling reservation rights must be determined.
The amount relates to the future performance of the play, that being next year, in 2012.
Therefore, there is a case for future recognition. On the other hand, arguments favouring
recognition in 2011 include the fact that the reservation rights have been sold, and that the
amount is non-refundable. In addition, the amount paid cannot be applied against future ticket
prices and no future services are to be rendered.

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To be conservative, I recommend recognizing this revenue source in 2012, when the

performances are given.
Sale of movie rights

The payment received for the sale of the movie rights can be taken into income in the current
year (2011) because there is no direct connection to future services or events. Alternatively, the
amount that was paid is based on the success of the play, and should be taken into income in
future periods. From this perspective, at a minimum, the payment should be disclosed as an
unusual item because it will not occur again.
Government grant
We must determine whether the government grant is attributable to income or capital. The
treatment of this amount will affect the royalty program. If the amount is taken into income
immediately, the participation payments will increase.
If the amount is offset against an asset that will be depreciated, then the participation payments
derived from the grant will be paid over time. If the grant is tied to hiring Canadians to perform
in the play, then the amount should be credited against related labour expenses. If the grant has
to be spent on costumes and sets made in Canada, then the amount should be netted against the
related assets.
In order to decide how this amount should be recognized, we must determine what the 50%
content rule pertains to—against what purchases should it be offset? We must also determine the
length of time that the rules apply in case the amount has to be repaid at a later date.
Bank loan
The 5% fixed interest should be expensed. However, there is some uncertainty regarding how to
record the payment to the bank that is based on the play’s success. For the current year (2011),
we could accrue for an amount based on expected future profits. Alternatively, we could record
the expense in a future period when PIP recognizes the revenue that generates the royalty. Given
the difficulty in estimating future revenue, I recommend not recognizing interest expense for the
1% royalty in 2011.
Start-up costs
We need to determine whether start-up costs fit the definition of “true operating expense.” If not,
then the royalty payment to investors will not be based on net income for financial statement
reporting purposes.
As these expenses have been incurred in the start-up phase of operations, the amounts can be
recognized in either the current year or deferred to future years. Arguments can be made for
either treatment. There is no certainty that the play will succeed, so to be conservative the
amount should be expensed in the current period. On the other hand, the amounts do relate to
production in future years, and in order to match expenses with revenues, the amounts should be
expensed in future periods.

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Case 4: Plex-Fame Corporation. Suggested solution:
Overview
As a public corporation, the company’s financial statements will be used by stakeholders for a
variety of purposes, including the evaluation of the company and its management. As a result,
the managers have incentives to increase or smooth earnings to influence the share price or to
present a favourable impression of themselves. In addition, the company is expanding rapidly
and therefore may need to raise capital. By using accounting choices to increase earnings or
otherwise improve the appearance of the financial statements, management may be attempting to
reduce the cost of financing by lowering the cost of debt or increasing the selling price of shares.
While the company may have a competing objective of minimizing taxes, to the extent that the
financial accounting policies apply to tax filings it is likely that management would choose
accounting policies that increase income.
Since PFC is publicly traded, the company must comply with IFRS.
Penalty payment
PFC received a $2 million payment from a contractor who built a theatre complex for PFC in
Montreal. The payment was for completing the project late. If my assumption about PFC’s bias
toward choosing income-increasing accounting policies is correct, management will want to
record the penalty as revenue.
Arguments could be made for treating the penalty payment either as income or as a reduction in
the capital cost of the complex on the balance sheet. If PFC incurred additional costs because of
the delay in opening the new complex, then the penalty should be used to offset the costs, which
may have been expensed or deferred. If the related costs had been expensed when incurred, then
the penalty payment should be recognized in income to offset those expenses. In contrast, if the
related costs were considered pre-opening costs and had been capitalized, then the penalty
payment should be used to reduce those capitalized assets.
Thus, if the penalty payment is compensation for lost revenue or profit, then an argument could
be made for treating the penalty as income, in which case we need to consider whether separate
disclosure is warranted given that the payment is non-recurring. Financial statement users would
find separate disclosure informative because the portion of revenue and income that is non-
recurring has different valuation implications.
“Rue St. Jacques”

Ticket proceeds: The most appropriate treatment for recognizing revenue for “Rue St. Jacques” is
when the show is performed. The show is service provided by PFC, and the company should
recognize revenue according to the provision of services (i.e., staging the performances). At
present, there is no assurance that the production will be completed, or that any shows for which
tickets have been sold will take place. For example, the show could be closed down before it
begins its run or even after it begins to run. In that case, it will be necessary to refund the
purchase price of tickets to buyers.

4-108
PFC would likely prefer to recognize revenue earlier, upon the sale of the tickets, in order to
increase income and lower the cost of financing. If revenue were to be recognized at this early
stage, it would be necessary to match costs against the revenue. However, there would be
considerable uncertainty about those costs. Pre-production costs are not fully known, and the
actual cost of putting on the performances, including wages, advertising, overhead, and so on,
cannot be known with reasonable certainty.
Interest on ticket proceeds: PFC earns a significant amount of interest by holding the money paid
in advance by ticket purchasers. The interest revenue could be treated as income or deferred
revenue. Again, management’s preference will be to recognize the interest revenue immediately.
This position can be justified on the basis that any ticket refunds involve only the ticket price, not
any accrued interest. On the other hand, interest may have been factored into the advance
subscription price that is discounted relative to ticket prices in the future. If this is the case, then
treating the interest as deferred revenue makes more sense.
Pre-production costs: PFC has incurred significant costs in advance of the opening of “Rue St.
Jacques.” We must determine whether these costs should be capitalized and amortized, or
expensed as incurred. In principle, capitalization as an asset and amortization over the life of the
show is reasonable as long as the show is expected to generate adequate revenue to cover costs.
However, it is difficult to determine whether a theatre production will be successful. The long
run of the show in Paris and advance ticket sales suggest that the show will be a success.
However, the situation could easily take a turn for the worse if the actual show receives poor
reviews from critics.
If PFC chooses to capitalize the pre-production costs, they must be amortized over a reasonable
period of time. One method is to use a cost-recovery method, where costs would be matched
against revenue dollar for dollar until the pre-production costs are covered. A second alternative
is to amortize the costs over the estimated life of the show.
Under the capitalization alternative, we must also ensure that only costs pertaining to “Rue St.
Jacques” are capitalized. Management might try to include costs related to other activities (e.g., a
less successful show) among the costs for “Rue St. Jacques.”
Ongoing production costs after the show opens should be expensed as incurred, which matches
the recognition of ticket revenues.
Sale of theatres
PFC began selling theatres recently where economic conditions justified the sale of a particular
theatre. This year, a significant part of net income was generated through the sale of theatres.
PFC has included the proceeds from these sales as revenue on the income statement (as opposed
to treating them as gains or losses on disposition) because it considers such as an ongoing part of
its operations. However, the sales could also be considered incidental to ongoing operations, in
which case the gains and losses would not be included in revenues. Including the proceeds from
the sale of theatres is consistent with management’s objective of making the financial statements
more attractive for going to the capital markets, to the extent that revenues could be increased
(although net income would be unaffected).

4-109
If the sales can be considered a part of ongoing operations, we should consider whether there
should be separate disclosure of revenue from theatre sales. Burying this revenue with revenues
from other sources makes it more difficult for users to predict future revenues.
We should also consider whether the sale of theatres constitutes discontinued operations, which
would require separate disclosure. With the available information, it does not seem appropriate
to consider these theatre sales as discontinued operations, as PFC is not ceasing to operate movie
theatres completely.
If theatre sales are considered part of ongoing operations, then theatres that are available for sale
should be classified as inventory rather than property, plant, and equipment.
Case 5: Happy Valley Homes. Suggested solution:
a.
Memo to: Partner

From: CA
Subject: Happy Valley Homes Ltd. (HVHL)
As requested, I have prepared a draft report to Tom Mullins on the issues raised during your
meeting with him.
Draft Report on Happy Valley Homes Ltd.
In order to recommend accounting policies for your new business, we must first identify the
likely users of HVHL’s financial statements and their information needs and objectives. This will
provide a basis for choosing among accounting policy alternatives.
You, Tom, have explicitly requested that the accounting policies be simple and not too costly.
You will be concerned about presenting a good financial position to attract investors. The other
users of HVHL’s financial statements are as follows:
* The bank will be concerned about liquidity and the ability of HVHL to repay its debt.
The bank would prefer information that focuses on cash flow and the valuation of its
security.
* Investors will require some form of current value information to evaluate HVHL’s
performance.
* The Canada Revenue Agency requires historical cost information to assess income taxes.

4-110
Need for current-value information
The bank and the investors are concerned with liquidity and performance evaluation. For this
purpose, some form of current-value information would be most useful.
Current-value information, sometimes called “fair value,” is more relevant to HVHL’s users
since the objective of the business is to realize gains from holding houses over a long period of
time. The houses should be valued at some form of market value, so that users could determine
unrealized holding gains and losses and thereby evaluate management’s decision-making ability.
This information would be costly, and the values determined would be very subjective since
there will be much uncertainty about the date on which HVHL will eventually gain title to the
property and the market prices at that time.
Although current-value information is costly, the users’ need for this type of information
outweighs the costs, and HVHL must provide this information to attract and retain investors.
There are several different methods of calculating current-value information. HVHL could obtain
independent appraisals of each of the houses as at the financial statement dates. This process
would be costly but would provide the most accurate information since the appraisals would
consider such aspects as the state of repair of the property, and so on. The cost could be reduced
by having appraisals performed on a rotational basis only. That is, HVHL could have a few
homes appraised each year so that all homes are appraised at least once over, say, a five-year
period.
An alternative method is to value the properties based on the present value of future cash flows.
This method would not be practical for HVHL, as no hard estimate of the timing and amount of
future cash flows would be available.
I recommend that market appraisals be performed on a rotational basis to determine the current
value of the homes to reduce the cost of revaluation.
Accounting policies
Asset valuation
We must first determine the nature of the asset before deciding upon the appropriate accounting
and reporting treatment for the properties. The homes could be considered as any of the
following assets:
* inventory, since they are held specifically for resale;
* capital assets, since they will be held for a long period of time and they produce income
through capital appreciation;
* prepaid expenses, since Tom does not have legal title to the property until the death of the
senior citizens; or
* an equity instrument, since they represent an “interest” in real property.
The classification of the homes as short-term or long-term assets must also be considered,
because the date of eventual sale of the homes is uncertain.

4-111
I recommend that the homes be recorded as long-term assets, "Interest in Homes," since
management intends to keep the homes for several years. Detailed note disclosure will be
required to explain the unique nature of the "reverse mortgages."
Revenue recognition
HVHL's operations of purchasing "reverse mortgages" in houses will result in two types of
revenue being recognized over the life of each property venture.
Discount
HVHL pays less than the market value of the home since it receives a "reverse mortgage" only,
and not legal title to the home. The difference between the market value of the home at the time
of purchase and the purchase price of the home is the discount. This discount can be compared to
rent or interest earned over the holding period of the home.
Alternatives are available for recognizing the discount as income:

a. The discount could be recognized as income at the time that the "reverse mortgage"
agreement is signed. This would be very aggressive treatment since it would result in the
home being valued at its fair market value, even though HVHL holds only an interest in
the home.
b. The discount could be taken into income over the expected remaining life of the senior
citizen (i.e., the holding period of the house). The expected life of the senior citizen
would be calculated using actuarial methods and assumptions about life spans.
c. The discount could be recognized as revenue at the time of death of the last inhabitant of
the home. This would be conservative since no revenue would be recognized until legal
title to the home had passed to HVHL.
I recommend that the discount be taken into income over the expected remaining life of the
senior citizen because revenue is earned over this period. Thus, its revenue-generating activity is
being performed as the home is held over time. The revenue can be measured (difference
between market value and purchase price), and collectability is assured since HVHL gains title to
the home at the death of the last inhabitant. This method of recognizing the discount revenue
meets your objective of providing financial statements that are relevant to HVHL's unique
business and that will attract investors.
Capital appreciation or depreciation

Capital appreciation or depreciation arises from the increase or decrease in market value of the
home from the date that the "reverse mortgage" is purchased to the date that the home is sold.
This type of revenue could be recognized at the following times:
1. Capital appreciation could be estimated at the date that the "reverse mortgage" is
purchased and taken into income over the expected remaining life of the senior citizen.
However, this would involve much uncertainty and estimation of future market value and
life spans. Another similar alternative is to recognize actual capital appreciation or
depreciation annually. This would entail an annual appraisal for each home. The change
in the market value of the home between financial statement dates would be recorded as
revenue for the period. This method could result in significant fluctuations in income and

4-112
asset values between years, depending on the volatility of the real estate market. It would
also be costly to obtain annual appraisals. However, relevant information about HVHL's
operations would be provided.
2. Capital appreciation could be recognized when the last inhabitant dies. This method
would be more conservative than the first alternative since revenue would not be
recognized until a market value at the time that HVHL obtains legal title could be
determined.
3. Capital appreciation could be recognized when HVHL finally sells the home. This would
be the most conservative option. No uncertainty exists regarding life spans or market
values between the date of death and the date that the home is resold. This method would
be appropriate only if the actual selling of the home is a significant act in the revenue-
earning process.
I recommend that the capital appreciation be recognized when the last survivor of the home dies.
This is the point at which HVHL obtains legal title to the home, and the decision to hold the
home is a separate management decision that should be reported separately in the financial
statements. Thus, the capital appreciation between the time that the "reverse mortgage" is
purchased and the death of the last survivor will be recorded at the time of death. Any
depreciation in the market value of the homes should be recorded in the period that it occurs so
that assets are not overstated.
The subsequent appreciation or depreciation arising between the time of death and the eventual
resale of the home would be reported when the home is sold, as a gain or loss on holding the
home subsequent to obtaining legal title. This revenue recognition policy meets your objective of
being simple and inexpensive, and it provides relevant information to the users.
Accounting for expenses

The major expenses that HVHL will incur are bank interest and legal fees. These expenses could
be capitalized as part of the cost of the homes, as they could be considered necessary to get the
home in a saleable condition. Capitalization also provides a better matching of costs with the
capital appreciation revenue that is not recorded until legal title is obtained. Alternatively, the
interest costs could be expensed as incurred since the cost of the home should not depend on the
method of financing selected (i.e., debt versus equity).
I recommend that the legal fees be capitalized since they must be incurred to obtain the "reverse
mortgage" in the home. However, the bank interest should be expensed for the reason stated
above.
The costs incurred in producing and distributing the proposed offering document will be
substantial. These costs should be excluded from the determination of income and should be
reported as a reduction in shareholders' equity.

4-113
b. Both adverse selection and moral hazard have important implications for the proposed
business. Adverse selection will result in a pool of seniors that are potentially much less
profitable than would be expected from a random sample from the population. Moral hazard will
result in homes that may be less valuable than anticipated.
To understand why these two information asymmetries are so important for this business, it is
essential to understand the nature of the “reverse mortgages.” A bank that offers a conventional
mortgage to homeowners is a creditor: in exchange for loaning the homeowner a fixed sum of
money, the bank has a fixed claim on the home and other assets of the borrowers. In contrast,
HVHL’s reverse mortgage is an equity claim: in exchange for paying the seniors a fixed sum,
HVHL obtains the uncertain value of the home at some uncertain future date.
If the real estate markets in which HVHL intends to operate are reasonably active, there will be
little information asymmetry between the seniors and HVHL. However, the seniors will always
have an information advantage regarding their own life expectancy given that they have private
knowledge about their own health, the healthiness of their current and past lifestyles, past
illnesses, and their families’ history of diseases. Given this information advantage, rational
seniors will choose between a conventional or reverse mortgage based on their personal
circumstances. Specifically, seniors who are in relatively good health and expect long life
expectancies will choose the reverse mortgage because they receive the cash up front and have
no need to repay any amount until their death, which they expect to be far into the future. Other
seniors who are in relatively poor health and have short life expectancies will choose a
conventional mortgage because they expect fewer payments on the mortgage over the remainder
of their lives. Thus, the adverse selection will result in HVHL attracting seniors who will tend to
live the longest, not those who will die relatively soon and who are most profitable from
HVHL’s perspective. (In a way, this is a macabre business.) HVHL must anticipate the adverse
selection and pay a correspondingly lower amount for the reverse mortgage, which of course will
reduce the attractiveness of the product to seniors.
The realization that conventional and reverse mortgages are debt and equity contracts,
respectively, suggests that moral hazard will be a concern, just as it is for firms that issue debt or
equity. When homeowners obtain a mortgage, they retain the equity in the home and therefore
they are self-interested in maintaining the value of their home. When they obtain a reverse
mortgage, they have sold the entire equity interest in the home, since all proceeds upon the
senior’s death go to HVHL. Consequently, seniors who have reverse mortgages do not have an
interest in maintaining the value of the home.
c. The discussion in part (b) highlights what should be expected to happen if senior citizens
act rationally and choose the financial product that is in their best interest. However, HVHL’s
business plan involves a segment of the population that is particularly vulnerable. While many
seniors are physically and mentally fit, there are many who are more frail and not fully capable
of making financial decisions rationally. Would it be ethical for HVHL to sell reverse mortgages
to such seniors when it is unclear whether it is in the interest of the seniors? HVHL’s business
becomes more successful if it is able to attract seniors who will die relatively soon, so is it a good
business practice to target the seniors who are the most frail? What regulations might be
appropriate to prevent abuses by companies such as HVHL?

4-114
Case 6: Revenue Recognition in Governments. Suggested solution:
* The public needs financial reports to evaluate the government’s performance. To meet
the needs of the public, government accounting should provide an unbiased or
conservative representation of government performance.
* The government needs financial reports for planning purposes. To meet the government’s
needs, accounting should facilitate long-term planning and provide appropriate incentives
to manage public funds.
* B.C.’s policy could be used to manage public expectations about the government’s ability
to spend on social services over the long term.
* B.C.’s policy to recognize revenue over several years is consistent with accrual
accounting. That is, record revenue as the earnings process is completed.
* Doing so avoids “windfall” surpluses that trigger overspending by the government.
* Doing so also allows for better long-term management of public funds.
* Such a policy would provide more relevant information as it gives a fairer depiction of
the government’s financial performance to the public because future revenues are more
predictable.
* Alberta and Saskatchewan’s policy of recognizing revenue all at once is closer to cash
accounting.
* Cash accounting tends to produce reliable numbers.
* However, the amounts tend to be “lumpy,” making it difficult to predict the future.
* Such a policy is not conducive to long-term planning.
* Ebner does not appear to understand the basic principles of accrual accounting.
* If he did understand accrual accounting, then he has presented a biased view against the
B.C. government by alleging secrecy or a cover-up.
* Following accrual accounting is not being secretive; rather, it is being prudent.
* The title of the article is inappropriately sensational.
Epilogue
On February 20, 2009, less than three months after the publication of the article, Alberta
projected a $1 billion deficit for the year ending March 2009, when only six months ago the
province had forecast an $8.5 billion surplus. Alberta’s April 2009 budget for the fiscal year
ending March 2010 projected a deficit of $4.7 billion. The dramatic reversal in fortunes resulted
from plunging commodity prices as the world sank into a deep recession. Meanwhile, B.C.
continued to project a surplus for the year ending March 2009 and a deficit of only $495 million
for the next fiscal year.

4-115
Case 7: Patricia Leather Company. Suggested Solution:

a. Alternative 1: Revenue would be recognized once the consignee sells the goods to
customers because risks and rewards have been transferred to customers. At that point,
PLC retains no continuing managerial involvement, the amount can be measured reliably
and the economic benefits would flow to PLC when the consignees remit payment to
PLC. However, PLC would not be able to recognize any sales when merchandises are
shipped to the consignee stores.
Alternative 2: Revenue would be recognized on sales but recognition of profit is delayed

until payment is received. This is because although the product has been transferred to
the customer at the point of sale, there are still many risks, namely credit risks, associated
with the possibility of customers not being able to pay back.
Alternative 3: Revenue would be recognized once the franchisee has signed the franchise
documents for the initial franchise fee, however some of the revenue must be deferred
until future obligations of the franchisor is fulfilled. Deferred revenue would then be
recognized over the period of the contract. Furthermore, ongoing franchise revenue
would be recognized annually.
b. Alternative 1: The main concern with this alternative would be that net income could be
lower as we would lose sales from the retail stores currently purchasing the products.
These stores would now act as our agent to try to sell our products for us, charging us a
commission. A minor concern would be that whether PLC had a sophisticated inventory
tracking system to account for the inventory on consignment. Furthermore, we must also
consider that if too many stores were selling the products, it would undermine the sales at
our retail boutique.
Alternative 2: The main concern here would be the issue of collectability. There might be
uncertainty with the collectability of the installment account receivables, as credit risks of
customers become a bigger concern when they now have longer period to pay. Since we
cannot be completely certain whether the clients will be able to pay the full amount, we
might also need to be conservative when accounting for these sales, delaying the
recognition of gross profits until payment is received.
Alternative 3: The main concern here would be the costs associated with becoming a
franchisor and whether investors would be willing to become franchisees. Considering
the business had a mere net income of $80,000 this year, it is hard to imagine PLC could
afford to establish franchises in the same city without undermining sales in its own store.
As the franchisor, PLC would also need to incur expenses to exercise adequate oversight
on its franchisees.
c. In this situation, it is more likely PLC would go for alternative 2. Simply put, extending
credit to existing or potential customers was probably the easiest alterative that PLC
could adopt in this situation to boost sales. Alternative 3 of starting a franchise was
probably unrealistic given the size and business life cycle stage of PLC. Alternative 1
was implementable, but it is uncertain how much additional sales PLC could make on
consignment given that PLC has already been selling its products to other retailers.

4-116

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Chapter 4

P4-1. Suggested solution:

P4-2. Suggested solution:

P4-3. Suggested solution:

Copyright © 2017 Pearson Canada Inc.

P4-4. Suggested solution:

Copyright © 2017 Pearson Canada Inc.

P4-5. Suggested solution:

Activity Method of revenue recognition

Lease rentals Straight-line over rental period.

P4-6. Suggested solution:

Copyright © 2017 Pearson Canada Inc.

P4-7. Suggested solution:

Copyright © 2017 Pearson Canada Inc.

P4-8. Suggested solution:

Circumstance Revenue recognition criteria not met

P4-9. Suggested solution:

b. DR Consideration payable to customers (from above) 300,000

P4-10. Suggested solution:

Copyright © 2017 Pearson Canada Inc.

P4-11. Suggested solution:

P4-12. Suggested solution:

Dr. Cash (100,000 × $1.50 / sm cup) 150,000

Copyright © 2017 Pearson Canada Inc.

Dr. Cash (100,000 × $1.50 / sm cup) 150,000

Copyright © 2017 Pearson Canada Inc.

P4-13. Suggested solution:

Copyright © 2017 Pearson Canada Inc.

Total sale price $45,900

P4-14. Suggested solution:

a. The phone packages involve multiple performance obligations, so it is important to

Copyright © 2017 Pearson Canada Inc.

P4-15. Suggested solution:

Initiation fee of $50,000

Copyright © 2017 Pearson Canada Inc.

Annual membership fee of $10,000

Other revenue sources

P4-16. Suggested solution:

Copyright © 2017 Pearson Canada Inc.

a. DR Cash (100 × $500) 50,000

b. DR Cash (150 × $600) 90,000

c. DR Provision for assurance warranty expense claims 2,000

d. DR Service warranty costs 2,100

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P4-17. Suggested solution:

Months elapsed Subscription-

P4-18. Suggested solution:

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P4-19. Suggested solution:

Note that the gross margin is $7,500 / $30,000 = 25%.

Jan 2013 Dr. Installment accounts receivable 30,000

May 2013 Dr. Deferred gross profit ($10,000 × 25%) 2,500

Dr. Cash 10,000

P4-20. Suggested solution:

May Dr. Installment accounts receivable 90,000

Aug, Sep Dr. Deferred gross profit ($36,000 × 1/4) 9,000

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P4-21. Suggested solution:

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P4-22. Suggested solution:

(Dollar amounts in millions) 2011 2012 2013 2014 2015 Total

Cumulative % completed 16% 40% 64% 88% 100%

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