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Chapter5: Income Measurement and Profitability Analysis

Problems

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An alternate exercise and problem set is available on the text website: www.mhhe.com/spiceland6e

P 5-1 Income statement presentation; installment sales method (Chapters 4 and 5)  
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Reagan Corporation computed income from continuing operations before income taxes of $4,200,000 for 2011.

The following material items have not yet been considered in the computation of income:

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1.

  

The company sold equipment and recognized a gain of $50,000. The equipment had been used in the manufacturing process and was replaced by new equipment.

2.

  

In December, the company received a settlement of $1,000,000 for a lawsuit it had filed based on antitrust violations of a competitor. The settlement was considered to be an unusual and infrequent event.

3.

  

Inventory costing $400,000 was written off as obsolete. Material losses of this type were incurred twice in the last eight years.

4.

  

It was discovered that depreciation expense on the office building of $50,000 per year was not recorded in either 2010 or 2011.

     In addition, you learn that included in revenues is $400,000 from installment sales made during the year. The cost of these sales is $240,000. At year-end, $100,000 in cash had been collected on the related installment receivables. Because of considerable uncertainty regarding the collectibility of receivables from these sales, the company's accountant should have used the installment sales method to recognize revenue and gross profit on these sales.

     Also, the company's income tax rate is 40% and there were 1 million shares of common stock outstanding throughout the year.

Required:

Prepare an income statement for 2011 beginning with income from continuing operations before income taxes. Include appropriate EPS disclosures.

P 5-2 Installment sales and cost recovery methods 
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Ajax Company appropriately accounts for certain sales using the installment sales method. The perpetual inventory system is used. Information related to installment sales for 2011 and 2012 is as follows:

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Required:

1.

  

Calculate the amount of gross profit that would be recognized each year from installment sales.

2.

  

Prepare all necessary journal entries for each year.

3.

  

Repeat requirements 1 and 2 assuming that Ajax uses the cost recovery method to account for its installment sales.

P 5-3 Installment sales; alternative recognition methods 
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p. 285

On August 31, 2011, the Silva Company sold merchandise to the Bendix Corporation for $500,000. Terms of the sale called for a down payment of $100,000 and four annual installments of $100,000 due on each August 31, beginning August 31, 2012. Each installment also will include interest on the unpaid balance applying an appropriate interest rate. The book value of the merchandise on Silva's books on the date of sale was $300,000. The perpetual inventory system is used. The company's fiscal year-end is December 31.

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Required:

1.

  

Prepare a table showing the amount of gross profit to be recognized in each of the five years of the installment sale applying each of the following methods:

a.

  

Point of delivery revenue recognition.

b.

  

Installment sales method.

c.

  

Cost recovery method.

2.

  

Prepare journal entries for each of the five years applying the three revenue recognition methods listed in requirement 1. Ignore interest charges.

3.

  

Prepare a partial balance sheet as of the end of 2011 and 2012 listing the items related to the installment sale applying each of the three methods listed in requirement 1.

P 5-4 Installment sales and cost recovery methods  
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Mulcahey Builders (MB) remodels office buildings in low-income urban areas that are undergoing economic revitalization. MB typically accepts a 25% down payment when they complete a job and a note which requires that the remainder be paid in three equal installments over the next three years, plus interest. Because of the inherent uncertainty associated with receiving these payments, MB has historically used the cost recovery method to recognize revenue.

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     As of January 1, 2011, MB's outstanding gross installment accounts receivable (not net of deferred gross profit) consist of the following:

1.

  

$400,000 due from the Bluebird Motel. MB completed the Bluebird job in 2009, and estimated gross profit on that job is 25%.

2.

  

$150,000 due from the PitStop Gas and MiniMart. MB completed the PitStop job in 2008, and estimated gross profit on that job is 35%.

     Dan Mulcahey has been considering switching from the cost recovery method to the installment sales method, because he wants to show the highest possible gross profit in 2011 and he understands that the installment sales method recognizes gross profit sooner than does the cost recovery method.

Required:

1.

  

Calculate how much gross profit is expected to be earned on these jobs in 2011 under the cost recovery method, and how much would be earned if MB instead used the installment sales method. Ignore interest.

2.

  

If Dan is primarily concerned about 2011, do you think he would be happy with a switch to the installment sales method? Explain.

P 5-5 Percentage-of-completion method  
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In 2011, the Westgate Construction Company entered into a contract to construct a road for Santa Clara County for $10,000,000. The road was completed in 2013. Information related to the contract is as follows:

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   Westgate uses the percentage-of-completion method of accounting for long-term construction contracts.

Required:

1.

  

Calculate the amount of gross profit to be recognized in each of the three years.

2.

  

Prepare all necessary journal entries for each of the years (credit various accounts for construction costs incurred).

3.

  

Prepare a partial balance sheet for 2011 and 2012 showing any items related to the contract.

4.

  

Calculate the amount of gross profit to be recognized in each of the three years assuming the following costs incurred and costs to complete information:

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p. 286

5.

  

Calculate the amount of gross profit to be recognized in each of the three years assuming the following costs incurred and costs to complete information:

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P 5-6 Completed contract method  
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[This is a variation of Problem 5-5 modified to focus on the completed contract method.]

Required:

Complete the requirements of Problem 5-5 assuming that Westgate Construction uses the completed contract method.

P 5-7 Construction accounting under IFRS 
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[This is a variation of the Problem 5-5 modified to focus on IFRS.]

Required:

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Complete the requirements of Problem 5-5 assuming that Westgate Construction reports under IFRS and concludes that the percentage-of-completion method is not appropriate.

P 5-8 Construction accounting; loss projected on entire project  
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Curtiss Construction Company, Inc., entered into a fixed-price contract with Axelrod Associates on July 1, 2011, to construct a four-story office building. At that time, Curtiss estimated that it would take between two and three years to complete the project. The total contract price for construction of the building is $4,000,000. Curtiss appropriately accounts for this contract under the completed contract method in its financial statements. The building was completed on December 31, 2013. Estimated percentage of completion, accumulated contract costs incurred, estimated costs to complete the contract, and accumulated billings to Axelrod under the contract were as follows:

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Required:

1.

  

Prepare schedules to compute gross profit or loss to be recognized as a result of this contract for each of the three years.

2.

  

Assuming Curtiss uses the percentage-of-completion method of accounting for long-term construction contracts, compute gross profit or loss to be recognized in each of the three years.

3.

  

Assuming the percentage-of-completion method, compute the amount to be shown in the balance sheet at the end of 2011 and 2012 as either cost in excess of billings or billings in excess of costs.

   (AICPA adapted)

P 5-9 Long-term contract; percentage-of-completion and completed contract methods  
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Citation Builders, Inc., builds office buildings and single-family homes. The office buildings are constructed under contract with reputable buyers. The homes are constructed in developments ranging from 10–20 homes and are typically sold during construction or soon after. To secure the home upon completion, buyers must pay a deposit of 10% of the price of the home with the remaining balance due upon completion of the house and transfer of title. Failure to pay the full amount results in forfeiture of the down payment. Occasionally, homes remain unsold for as long as three months after construction. In these situations, sales price reductions are used to promote the sale.

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   During 2011, Citation began construction of an office building for Altamont Corporation. The total contract price is $20 million. Costs incurred, estimated costs to complete at year-end, billings, and cash collections for the life of the contract are as follows:

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   Also during 2011, Citation began a development consisting of 12 identical homes. Citation estimated that each home will sell for $600,000, but individual sales prices are negotiated with buyers. Deposits were received for eight of the homes, three of which were completed during 2011 and paid for in full for $600,000 each by the buyers. The completed homes cost $450,000 each to construct. The construction costs incurred during 2011 for the nine uncompleted homes totaled $2,700,000.

p. 287

Required:

1.

  

Briefly explain the difference between the percentage-of-completion and the completed contract methods of accounting for long-term construction contracts.

2.

  

Answer the following questions assuming that Citation uses the completed contract method for its office building contracts:

a.

  

What is the amount of gross profit or loss to be recognized for the Altamont contract during 2011 and 2012?

b.

  

How much revenue related to this contract will Citation report in its 2011 and 2012 income statements?

c.

  

What will Citation report in its December 31, 2011, balance sheet related to this contract (ignore cash)?

3.

  

Answer requirements 2a–2c assuming that Citation uses the percentage-of-completion method for its office building contracts.

4.

  

Assume that as of year end 2012 the estimated cost to complete the office building is $9,000,000 and that Citation uses the percentage-of-completion method.

a.

  

What is the amount of gross profit or loss to be recognized for the Altamont contract during 2012?

b.

  

How much revenue related to this contract will Citation report in the 2012 income statement?

c.

  

What will Citation report in its 2012 balance sheet related to this contract (ignore cash)?

5.

  

When should Citation recognize revenue for the sale of its single-family homes?

6.

  

What will Citation report in its 2011 income statement and 2011 balance sheet related to the single-family home business (ignore cash in the balance sheet)?

P 5-10 Franchise sales; installment sales method  
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Olive Branch Restaurant Corporation sells franchises throughout the western states. On January 30, 2011, the company entered into the following franchise agreement with Jim and Tammy Masters:

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1.

  

The initial franchise fee is $1.2 million. $200,000 is payable immediately and the remainder is due in 10, $100,000 installments plus 10% interest on the unpaid balance each January 30, beginning January 30, 2012. The 10% interest rate is an appropriate market rate.

2.

  

In addition to allowing the franchisee to use the franchise name for the 10-year term of the agreement, in exchange for the initial fee Olive Branch agrees to assist the franchisee in selecting a location, obtaining financing, designing and constructing the restaurant building, and training employees.

3.

  

All of the initial down payment of $200,000 is to be refunded by Olive Branch and the remaining obligation canceled if, for any reason, the franchisee fails to open the franchise.

4.

  

In addition to the initial franchise fee, the franchisee is required to pay a monthly fee of 3% of franchise sales for advertising, promotion, menu planning, and other continuing services to be provided by Olive Branch over the life of the agreement. This fee is payable on the 10th of the following month.

     Substantial performance of the initial services provided by Olive Branch, which are significant, is deemed to have occurred when the franchise opened on September 1, 2011. Franchise sales for the month of September 2011 were $40,000.

Required:

1.

  

Assuming that collectibility of the installment receivable is reasonably certain, prepare the necessary journal entries for Olive Branch on the following dates (ignore interest charges on the installment receivable and the costs of providing franchise services):

a.

  

January 30, 2011

b.

  

September 1, 2011

c.

  

September 30, 2011

d.

  

January 30, 2012

2.

  

Assume that significant uncertainty exists as to the collection of the installment receivable and that Olive Branch elects to recognize initial franchise fee revenue using the installment sales method. Prepare the necessary journal entries for the dates listed in requirement 1 (ignore interest charges on the installment receivable and the costs of providing franchise services).

3.

  

Examine your answer to requirement 2a of this problem (the January 30, 2011, journal entry under the installment sales method). What is the effect of that journal entry on Olive Branch's balance sheet? (Ignore cash.) Briefly explain your answer.

P 5-11 Calculating activity and profitability ratios  
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p. 288

Financial statements for Askew Industries for 2011 are shown below:

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Required:

Calculate the following ratios for 2011.

1.

  

Inventory turnover ratio

2.

  

Average days in inventory

3.

  

Receivables turnover ratio

4.

  

Average collection period

5.

  

Asset turnover ratio

6.

  

Profit margin on sales

7.

  

Return on assets

8.

  

Return on shareholders' equity

9.

  

Equity multiplier

10.

  

Return on shareholders' equity (using the DuPont framework)

P 5-12 Use of ratios to compare two companies in the same industry  
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Presented below are condensed financial statements adapted from those of two actual companies competing in the pharmaceutical industry—Johnson and Johnson (J&J) and Pfizer, Inc. ($ in millions, except per share amounts).

Required:

Evaluate and compare the two companies by responding to the following questions.

     Note: Because two-year comparative statements are not provided, you should use year-end balances in place of average balances as appropriate.

1.

  

Which of the two companies appears more efficient in collecting its accounts receivable and managing its inventory?

2.

  

Which of the two firms had greater earnings relative to resources available?

3.

  

Have the two companies achieved their respective rates of return on assets with similar combinations of profit margin and turnover?

4.

  

From the perspective of a common shareholder, which of the two firms provided a greater rate of return?

5.

  

From the perspective of a common shareholder, which of the two firms appears to be using leverage more effectively to provide a return to shareholders above the rate of return on assets?

p. 289

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*This is before income from discontinued operations.

P 5-13 Creating a balance sheet from ratios; Chapters 3 and 5 
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Cadux Candy Company's income statement for the year ended December 31, 2011, reported interest expense of $2 million and income tax expense of $12 million. Current assets listed in its balance sheet include cash, accounts receivable, and inventories. Property, plant, and equipment is the company's only noncurrent asset. Financial ratios for 2011 are listed below. Profitability and turnover ratios with balance sheet items in the denominator were calculated using year-end balances rather than averages.

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p. 290

Required:

Prepare a December 31, 2011, balance sheet for the Cadux Candy Company.

P 5-14 Compare two companies in the same industry; Chapters 3 and 5 
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Presented below are condensed financial statements adapted from those of two actual companies competing as the primary players in a specialty area of the food manufacturing and distribution industry. ($ in millions, except per share amounts.)

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Required:

Evaluate and compare the two companies by responding to the following questions.

Note: Because comparative statements are not provided you should use year-end balances in place of average balances as appropriate.

1.

  

Which of the two firms had greater earnings relative to resources available?

2.

  

Have the two companies achieved their respective rates of return on assets with similar combinations of profit margin and turnover?

3.

  

From the perspective of a common shareholder, which of the two firms provided a greater rate of return?

4.

  

Which company is most highly leveraged and which has made most effective use of financial leverage?

5.

  

Of the two companies, which appears riskier in terms of its ability to pay short-term obligations?

6.

  

How efficiently are current assets managed?

7.

  

From the perspective of a creditor, which company offers the most comfortable margin of safety in terms of its ability to pay fixed interest charges?

P 5-15 Interim financial reporting (Based on Appendix 5)  
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p. 291

Branson Electronics Company is a small, publicly traded company preparing its first quarter interim report to be mailed to shareholders. The following information for the quarter has been compiled:

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   Fixed operating expenses include payments of $50,000 to an advertising firm to promote the firm through various media throughout the year. The income tax rate for the firm's level of operations in the first quarter is 30%, but management estimates the effective rate for the entire year will be 36%.

Required:

Prepare the income statement to be included in Branson's first quarter interim report.

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