chapter 4

REVENUE RECOGNITION AND STATEMENT OF EARNINGS

Charting a Course—When to Recognize Revenue

“A more adventurous and realistic look at the world and how people travel through it” is what Outpost magazine offers readers through real-life stories of journeys off the beaten track. Since its March 1996 launch, the Toronto-based publication has grown from a quarterly to six issues per year and seen its circulation climb to approximately 28,000.

What does it take to keep a magazine running smoothly? Publisher Matt Robinson says it pays to have a revenue recognition policy that makes sense.

“Advertising is our principal source of revenue,” explains Mr. Robinson. “We bill on a per-issue basis. Payment is against service rendered, so billing has to take place when the issue is published.” Since Outpost publishes every other month, the company sends out a new set of invoices every eight weeks or so.

Outpost's advertisers can then take anywhere from 30 to 90 days to pay. “We follow the standard 30–60–90 days to collect on invoices that all companies follow,” says Mr. Robinson. “We begin to place pressure on clients after 30 days, first with a phone call, then a letter, and then through other collection resources, if necessary. We also offer a two percent early payment discount to encourage clients to pay their invoices within 10 days.” Meanwhile, the magazine has to pay all its principal suppliers—the printer, landlord, and contributors.

“Circulation revenue does help mitigate cash flow issues between invoicing and payments,” says Mr. Robinson. When Outpost sells a subscription, it recognizes the entire sale as revenue right away. “Magazines are atypical in that we get people to pay up front before the service is rendered,” he points out. Subscriptions can begin and end with any issue, with each individual subscriber having his or her renewal dates. To recognize the revenue on a per-issue basis for every subscriber would be too complicated and cumbersome for a small operation like Outpost. The liability created by recognizing revenue on issues not yet published is understood.

As for newsstand sales, the company typically receives payment from distributors six months after an issue has gone out, based on the number of copies left over. The magazine is unable to plan for revenue from distributors with any kind of accuracy, despite the fact that it has already paid production and shipping costs for those magazines, says Mr. Robinson.

Outpost's own spending is focused on boosting circulation figures, and thus increasing revenues. Its website and participation in consumer shows are two areas where it markets itself. The magazine has also sponsored several speaking tours for Ian Wright, host of the travel show Pilot Guides, which airs on OLN (formerly Outdoor Life Network). “Because we're a small business, we like to keep focused on the core product,” says Mr. Robinson. “Increasing the number of subscribers is a priority.”

USER RELEVANCE

Why is it important for users to know about the recognition of revenue? First, the revenue amount is often the largest single amount on the financial statements. Total revenues need to be large enough to cover all the expenses. When users see that total revenues are greater than total expenses (when the company has a positive net earnings), they take this as a sign that the company is viable, that it has the ability to take advantage of opportunities, and that it is growing. On the other hand, companies can and do sometimes experience losses—a signal that all is not well with the company. When losses occur, it is important for users to evaluate both the size and cause of the loss. They need to observe the company over time to see how serious the problems are.

When evaluating revenue information, users also want to assess the quality of the earnings: how well management's decisions are reflected in predictable earnings. All earnings must, at some time, translate into cash. Cash is essential to a company's ultimate survival. One way to measure the quality of earnings is to compare the cash flow from operations (statement of cash flows) with the net earnings. If these two amounts are moving together (both up or both down) and if the cash flow is greater than the net earnings, we consider the earnings to be of high quality. If the two amounts do not move together and if the cash flow is less than the net earnings, we consider the earnings to be of low quality.

The second reason users need to be aware of a company's revenue recognition policies is that the revenues that are earned by companies are not all the same, as our opening story showed. Sometimes cash is received when the revenue is recognized; sometimes it precedes it or comes after it. A company can have different revenue recognition policies associated with different types of revenue. Users need to be aware of the company's revenue recognition policies so that they can make judgements about the validity of the revenue amount that is reported. As the article on the previous page shows, sometimes investors are surprised by the revenue source.

Rolling Stone magazine has found a new source of revenue. While other magazine and newspaper companies are making more of their products available on the internet usually for no cost, Rolling Stone has decided to charge people who want to see back issues of their magazine. Many newspapers allow access to their feature stories for free but charge for their other features. If you buy a paper subscription to a newspaper, you often get access to the total on-line version. Rolling Stone has gone the opposite way. If you pay for the on-line subscription, you will receive the paper version but if you pay for the paper version, you do not get access to the on-line version. Rolling Stone has repackaged an old product in a creative way and is earning revenue on it again.

As you will see later in this chapter, there are standards under IFRS for revenue recognition. Those standards can, however, be applied in various ways. Even within the same industry, companies may choose to recognize the same type of revenue in a different manner. In evaluating a company's performance, it is therefore very important to understand the impact of various revenue recognition policies on the financial statements, and therefore essential to read the disclosures about revenue recognition that accompany the financial statements.

Before we look at the revenue recognition policies in detail, it is important to first understand how cash typically flows through a company. As you saw in the opening story, cash and revenue sometimes coincide and sometimes do not.

CASH-TO-CASH CYCLE

As we have seen, corporate managers engage in three general types of activities: financing, investing, and operating. Let's focus for a moment on operating activities (the ones that generate most of the revenue).

Operating activities include all the normal, day-to-day activities of every business that almost always involve cash. These activities include the normal buying and selling of goods and/or services for the purpose of earning profits. The typical business operation involves an outflow of cash that is followed by an inflow of cash, a process commonly called the cash-to-cash cycle. Exhibit 4-1 shows the cash-to-cash cycle of a typical retail company. Each phase in the cycle is discussed in the following subsections.

Cash

The initial amount of cash in a company comes from the original investment by shareholders and from any loans that the company may have received as start-up financing. To simplify matters, let us assume that the company is being totally financed by shareholders—i.e., without any loans.

Acquisition of Inventory

Before the company acquires the inventory that it will sell to customers or will use to provide its services, it must first undertake the investing activities of acquiring property, plant, and equipment. It then hires labour and purchases the first shipments of inventory (or signs contracts to acquire them). Note that in a retail company, the costs in this initial phase may be larger than those of a service-oriented company. If you visualize even a small retail store, the amount of inventory that must be purchased to initially fill the shelves can be substantial.

EXHIBIT 4-1 CASH-TO-CASH CYCLE OF A RETAIL COMPANY

Selling Activity

The selling phase includes all activities that are designed to promote and sell the product. These may include pricing the product, advertising the product, hiring and managing a sales force, establishing retail sales outlets, contracting with agencies, signing supply agreements, and attending trade shows, among other activities. The end results of this phase are sales contracts between buyers and the seller. These may be verbal agreements, where a customer selects and pays for a product, or formal written documents. For most retail companies selling to customers, the agreement occurs when the goods are paid for in the sales outlet (the store). Some companies, however, sell to other businesses or to large enterprises such as hospitals or schools. For these sales, it is more likely that a formal contract is drawn up, specifying prices, times of delivery, and methods of payment.

Delivery of Product

Once a sales contract has been agreed upon, the product must be delivered to the customer. Depending on the type of product, this may be instantaneous (as in a grocery store), or it may take time (as with a car dealership). Some sales contracts require periodic deliveries of inventory (as with fresh produce to a restaurant).

Collection

Upon delivery of the product, collection of the sales price in cash may be immediate, as in a shoe store, or it could take place at some later date, resulting in an amount owing at the time of delivery, which is called an account receivable. Payment at a later date is the same as the seller making a loan to the buyer and accepting the risk that the buyer will not pay (this is called credit risk). The loan to the buyer may carry interest charges, but usually no interest is charged if payment is made within a short period of time that is specified (typically 30 to 60 days). If the buyer does not pay within the specified time, the seller may try to get the product back (repossession) or may try other methods to collect on the account, such as turning it over to a collection agency.

Other events could also occur that would affect the collection of cash. The goods may be returned for various reasons, resulting in no cash collection. The goods may be damaged in shipment, and the buyer may ask for a price adjustment (generally called a price allowance). There may also be an incentive built in to encourage prompt payment of cash, such as a cash discount, which means that less than the full amount will be accepted as full payment. Just as Outpost does with its advertisers, a seller may offer a 2% price discount if the account is paid within 10 days instead of the usual 30 days. These terms are sometimes stated as 2/10 net 30, which means that a 2% discount is offered if payment is made within 10 days; otherwise, the total amount is due at the end of 30 days.

In the opening story, you read about customers paying for a magazine subscription in advance. In this instance, the company has the cash before using cash to generate magazines. Collecting cash is not a concern for the company, but creating the magazine issues to satisfy the obligation to the customers is. In accepting the cash, the company is agreeing to produce future issues of the magazine and must plan its future activities to satisfy that obligation.

Warranty Service

Some goods carry a written or implied guarantee of quality. Automobiles, for example, are warranted for a certain number of years or for a certain number of kilometres. During this period, the seller is responsible, to some extent, for product replacement or repair. Because the provision of warranty work often involves additional outlays of cash for employees' time and for the purchase of repair parts, warranty service affects the ultimate amount of cash that is available at the end of the cycle. Many retail outlets today that sell products with warranties will cover the warranty for a period of time—perhaps three to six months—and will then sell additional warranty coverage to the customer. If the product needs to be repaired within the extended warranty time, the company has additional funds to offset the cost of that repair. If no repair is needed, the company earns an additional revenue amount.

Summary of the Cash-to-Cash Cycle

The net amount left in cash after this cycle is completed is then available to purchase more goods and services in the next cycle. If the cash inflows are less than the cash outflows, the amount of cash available is reduced, and the company may be unable to begin a new cycle without getting additional cash from outside the company in the form of equity or debt. If cash inflows exceed cash outflows, the company can expand its volume of activity, add another type of productive activity, or return some of the extra cash to shareholders in the form of dividends.

Note that the order of the phases in the cash-to-cash cycle may be different from one company to the next. For example, a transportation contractor such as Bombardier may do most of its selling activity early in the cycle to obtain contracts to deliver products at a future date, with much of the acquisition of raw materials and production taking place after the contract is signed. Also, in some companies, the separate phases may take place simultaneously. At Safeway, for example, the delivery of groceries to the customer and the collection of cash happen at the same time.

REVENUE RECOGNITION

Managers do not want to wait until the end of the cash-to-cash cycle to assess the performance of their company, because they must make day-to-day decisions that will ultimately affect the final cash outcome. If they wait until the end, they may not be able to make appropriate adjustments. For example, if the first few items sold result in significant uncollected accounts or require significant warranty service, they might want to rethink their policies on granting credit and providing warranties. If the cost of warranty service is too high, they might also want to purchase better quality inventory so the products last longer. Furthermore, the cash-to-cash cycle is a continuous process that is constantly beginning and ending for different transactions. There is no specific point in time at which all the cash-to-cash transactions reach an end.

To measure operating performance as accurately as possible, accountants divide normal operating activities into two groups, called revenues and expenses. Revenues are the inflows of cash or other benefits from the business's normal operating activities when these inflows result in an increase in equity that did not come from contributions from equity holders. It is important to note that revenues result from normal operating activities. There are other activities that result in increases in equity that are not from ordinary operating activities. These are not called revenues. Revenues usually involve the sale of goods, the provision of services or allowing others to use the company's assets in exchange for interest, dividends, or royalties. Expenses are the costs incurred to earn revenues. The difference between revenues and expenses, called net earnings (or net income), is one of the key measurements of performance. The expression “in the red” is related to net earnings. In the past, if a company had a negative net earnings (expenses > revenues), the net loss figure was actually written in red ink. The expression came to mean that a company had experienced a loss. Similarly, but less commonly used, the expression “in the black” meant that you had a positive net earnings.

Some companies make profits by charging higher prices, others by controlling costs. New companies in industries where there are already established players face difficult challenges. Note the article on the following page.

The need for timely information in decision-making is an argument for recognizing revenue as early as possible in the cash-to-cash cycle. The earlier in the cycle that revenue is recognized, however, the greater the number of estimates that are needed to measure the net performance. For example, if the company chooses to recognize revenue when the product is delivered to customers (a common practice for many businesses), it will have to make estimates regarding the collectibility of the receivables, the possibility of the customer returning the goods, and the costs of warranty service. To measure the return (profitability) on the sale of a product accurately, these items should be considered; otherwise, the company may be overestimating the profit on the sales of its products. To produce the most accurate measurement of net operating performance, all costs related to the earning of revenues are matched to the revenues they helped earn. In accrual accounting, this is called matching (see Chapter 2). Matching requires the simultaneous recognition of all costs that are or will be incurred (in the past, present, or future) to produce the revenue.

The question of when to recognize revenue is quite straightforward for some industries (e.g., clothing retailers like H&M). Revenue is recognized when the customer buys the goods in the store. Normally customers pay cash or use a debit or credit card, which means that the collection of cash for the sale is not an issue. While there are no warranty costs for a clothing retailer to consider, items are sometimes returned. Returns are often handled by giving the customer another article of clothing, if one is available, or the value of the returned clothing as a credit to buy a different article. Some retailers return the original cash paid. Clothing stores also usually put a time frame on returns (typically, customers have two weeks to return merchandise), which means the issue of returns is a known quantity very quickly. For other industries, the decision is not as clearly defined. For a manufacturing company such as Bombardier (a maker of trains and airplanes), contracts are signed, merchandise such as a rail car is manufactured, the merchandise is delivered, money is collected from the customer (usually some time after delivery), and warranty services are provided on the merchandise sold. When should such a company recognize revenue: when the contract is signed, when the goods are delivered, when the cash is collected, or when the warranty period expires and all obligations related to the sale have been satisfied?

The earlier in the cash-to-cash cycle the company chooses to recognize revenues, the less reliable the company's estimate of the effects of future events. On the other hand, however, the company receives more timely information. To reduce the uncertainty that is inherent in estimating future events, the company would need to recognize revenues later in the cash-to-cash cycle, when those estimates are more reliable, but the information would be less useful for making management decisions. The decision about when to recognize revenue is a very important one for managers, because it has a major impact on net earnings. Knowing about the revenue recognition policy is also important for users, so that they can assess the reliability of the information and the quality of the earnings.

There is obviously a conflict between the desire to measure performance on a timely basis (early in the cycle) and the ability to measure performance reliably (late in the cycle). Revenue recognition criteria have been developed within IFRS (IAS 18) to resolve this conflict and to produce a measure of performance that is intended to balance the need for timely information with the need for reliable information. The issue is further complicated when the company is involved in two or more lines of business that have different cash-to-cash cycles. A revenue recognition policy must be developed for each line and it is possible that they may not be the same.

Two basic criteria must be met before a revenue item can be recognized. The first is that it is probable that economic benefits will flow to the company. This condition is normally met when the activity that generated the revenue (sometimes referred to as the performance) is substantially completed—in other words, when the earnings process is substantially complete. In general, this would mean that the company has completed most of what it agreed to do and there are very few costs still to be incurred in the cash-to-cash cycle, or the remaining costs can be reasonably estimated, or both. Another way to consider this factor is to determine whether all the risks and rewards of the goods or services have been transferred to the buyer. If they have, there is very little left for the seller to do.

The second criterion is the requirement that the revenue can be reliably measured. This is often straightforward. When goods or services are sold for cash or an agreed selling price (an account receivable), the measurement is easy to determine. Sometimes, however, goods or services are sold in exchange for other products, services, or assets (other than accounts receivable). Now the measurement is more difficult. The accountant must examine the value of the goods or services sold and compare it with the value of the products, services, or assets received. In deciding which of these values to use, the accountant will look for the most reliable amount—the amount that can be most objectively determined. If the amount of revenue cannot be measured, it cannot be recognized. Within the measurement issue, there must be reasonable assurance that the amounts earned can be realized, or collected, from the buyer. If cash is given at the time of sale, this assurance is automatically satisfied. If, however, the goods or services are sold on credit, the seller must be reasonably assured that the amount owing will be collected. Companies rarely sell goods or services on credit without a credit check on the buyer. This is to provide assurance of the probable future collection of the accounts receivable. Even with this assurance, it is possible that some customers will not pay the amounts owed. Because of this possibility, companies that recognize credit sales as revenue must, in the same period, recognize an expense that measures the probable uncollectibility of the accounts receivable. This is to keep the revenues from being overstated. We call this expense “bad debt expense.” More will be said about this expense in Chapter 6.

In conclusion, if it is probable that future economic benefits will flow to the company and if the amounts earned can be reliably measured, revenues should be recognized in the financial statements. These conditions are usually met at the time of delivery of the product to the customer, so this is the point at which many companies recognize their revenues. The following sections discuss various applications of revenue recognition, including at the sale of goods to the customer and the sale of services.

Earnings Management

The criteria for revenue recognition, and the matching of expenses with revenues, make it possible for management to evaluate the company's revenue stream and establish a revenue recognition policy that best reflects the company's operating results. Sometimes management deliberately chooses how and when to recognize revenues and costs so that net earnings are higher or lower in particular accounting periods, or smoother over time. This practice is called earnings management.

It is not easy for external users of financial statements to determine if earnings management is taking place, because companies are often very complex. They are engaged in many diversified activities, and it is not possible for users to have a thorough knowledge of all their activities. Sometimes external bodies like the Ontario Securities Commission, or the Securities and Exchange Commission (SEC) in the United States, question a company's revenue recognition policy. As the following story shows, sometimes people within the organization itself identify accounting issues.

The teachers in the Langley School District called for an investigation into the accounting issues facing the school district. School districts are not-for-profit organizations. As such, they do not have the same access to funds as a profit organization does. It is therefore vital that they have well-formulated processes for managing expenditures. When those processes are not in place, the money spent can exceed the money available, and a deficit results.

Earnings management can be related to the early or late recognition of revenues and/or to the recognition of expenses before or after their related revenues have been recognized. Because it is difficult to detect, users of financial statements rely on auditors to determine whether accounting standards have been applied appropriately or not. Companies that deliberately manage their earnings may be able to affect the market's valuation of their shares, but when earnings management is discovered such companies usually pay a heavy price through shareholder lawsuits and the lowering of their share values.

In the next section, as you read through the different ways that revenue can be recognized, keep earnings management in mind. For each revenue stream, consider whether earnings management could occur. If it could, would it still meet the revenue recognition criteria?

Applications of Revenue Recognition

The revenue recognition criteria can be met at different points in the cash-to-cash cycle. The point at which different companies recognize revenues varies accordingly, as you observed in the opening story about Outpost magazine. IAS 18 provides revenue recognition criteria for specific types of transactions: the sale of goods, provision of services, and use of the company's assets by others. This section will provide more detail on each of these transactions.

Revenue Recognition for the Sale of Goods

For the sale of goods, there are five specific revenue recognition criteria¹ that must be met before revenue can be recognized:

• There has been a transfer of the risks and rewards to the buyer.
• The company no longer has managerial involvement or control over the goods sold.
• The revenue can be measured reliably.
• It is probable that economic benefits from the transaction will flow to the seller.
• The costs incurred or to be incurred with respect to the transaction can be measured reliably.

Recognition at the time of sale The most common point at which sales revenues are recognized is the time of sale and/or shipment of the goods to the customer. Once the goods have been taken by or shipped to the customer, the company has usually completed everything it has to do for the transaction. The title to the goods has been transferred, which transfers the risks and rewards to the buyer, and the company no longer has control over the goods. This meets the first two criteria listed above. At the time of sale, the amount that is earned is known and measureable. Often the customer will pay cash, which provides immediate economic benefits to the seller. If the company sells the goods on credit, the amount owed is also measurable. However, the company will have to be reasonably assured of collection of the account receivable before revenue can be recognized. Most companies will not sell on credit if they have doubts about the future collectibility of the amount. An estimate of potential uncollectibility must be made and an allowance for uncollectible accounts established. At the time of sale, the seller usually knows the costs that are related to the transaction. Thus, the last three criteria are also met.

Outpost magazine recognizes two of its revenues at the time of sale. The time of sale occurs when an issue has been printed and sent to subscribers and distributors. At this point, it has completed the earning process on that issue. It recognizes the revenue from individual subscribers and the revenue from advertisers on a per-issue basis. Prior to releasing an issue, the company can measure how much it has earned because subscribers have paid in advance and advertisers have signed a contract that specifies how much they will pay for advertisements in each issue. The only unknown at the point of sale is whether the advertisers will pay when they receive the bill from the magazine. The company would need to estimate the likelihood of uncollectibility of its advertising revenue. The issues sent to distributors pose more of a problem for Outpost. It has completed the printing of the issues but it will have to wait six months before it knows how much has been earned. It needs to wait until distributors provide information about how many issues were sold and how many issues are being returned before it can measure its earnings. Therefore, because revenue must be measureable to be recognized, Outpost cannot recognize this revenue at the time of delivery.

In annual reports, most companies state their revenue recognition policy as part of the first note, which includes a summary of the company's significant accounting policies. For example, in its 2009 financial statements, Brickworks Limited states its revenue recognition policy in Note 1 (c) to the financial statements. Brickworks Limited is an Australian company that manufactures and sells bricks, tiles, and building supplies. It also sells land and handles waste management. Part of its revenue recognition statement follows:

This is a fairly detailed statement from Brickworks. Note that it frequently refers to the transfer of the risks and rewards of ownership. Note as well the timing of the recognition—when the product is delivered to its customers. Brickworks also has revenue from interest and dividends that will be discussed later in this section. Like Outpost, Brickworks has different types of revenue and must establish different revenue recognition policies.

If a company's revenue is very homogeneous, it will need only a simple statement about revenue recognition. Maple Leaf Foods Inc., in Note 2 (d) to its 2009 financial statements, states: “The Company recognizes revenues from product sales upon transfer of title to customers. Revenue is recorded at the invoice price for each product. An estimate of sales incentives provided to customers is also recognized at the time of sale and is classified as a reduction in reported sales. Sales incentives include various rebate and promotional programs provided to the Company's customers.” Maple Leaf Foods is a Canadian-based food processing company that sells to retail, wholesale, food service, industrial, and agricultural customers. It sells meat and bakery products, as well as feed for animals. Although it has several different customers, it has a single type of revenue (sale of a product) that does not require lengthy disclosure.

Sometimes when you read the description of a company's revenue recognition policy, you will see reference to the term “F.O.B.” F.O.B. means “free on board” and is a legal term to describe the point at which title to the goods passes from the seller to the buyer. It is used by companies like Maple Leaf Foods that deliver goods in large volumes to customers. If the goods are shipped F.O.B. shipping point, the title (ownership) passes after the goods leave the seller's loading dock (the shipping point). If they were shipped F.O.B. destination, the goods would remain the property of the seller until they reached their destination: the buyer's receiving dock. The way the goods are shipped will affect the point at which revenue can be recognized. The point at which title to the goods passes is a clear indication that the seller has earned the revenue. Prior to that point, the seller is still responsible for the goods.

To illustrate revenue recognition at the time of sale, assume that Hawke Company sells 1,000 units of its product during 2011 at $30 per unit. Also assume that the costs of these units totalled $22,000 and that, at the time of sale, Hawke estimated they would cost the company an additional $500 in warranty expenses in the future. Ignoring all other operating expenses, the statement of earnings for Hawke for 2011 would appear as in Exhibit 4-2.

EXHIBIT 4-2 REVENUE RECOGNITION AT TIME OF SALE

Note that although Hawke Company may not have incurred any actual warranty expenses yet, it recognizes an expense for its estimate of what the future warranty costs might be. Recognizing the warranty expense is appropriate because the future warranty costs are directly related to the revenue. Therefore, if the company wants to recognize the revenue before it knows the actual warranty cost, it must estimate what those costs might be so that the income is not overstated. At the same time as it recognizes the warranty expense, it recognizes a liability for these future costs. When actual costs are incurred, the liability is then reduced and no further expense is recognized. In its revenue recognition note, Maple Leaf Foods said that it estimated the cost of the sales incentives and recognized them at the same time as a reduction to the revenue. This treatment is similar to Hawke's treatment of warranty costs.

In some cases, a company might receive a deposit for a product to be delivered in the future. Because it is unlikely that the revenue recognition criteria would be met by this transaction (until the product is delivered, the title has not passed and the risks and rewards of ownership have not been transferred to the buyer), the revenue from this order would not be recorded until the goods are delivered. The deposit is therefore recorded as unearned revenue, deferred revenue, or revenue received in advance (a liability account that represents an obligation either to deliver the goods or to return the deposit). For example, if Hawke Company received a $500 deposit on an order, it would make the following entry:

When the goods are delivered, the liability to provide the product is satisfied (the company has completed what it had to do in the sale and the title to the goods has passed to the buyer), and the deposit can then be recognized as a revenue item with the following entry:

Companies that require deposits or advance payments on products or services may disclose this in their footnote on revenue recognition. Note that liabilities are created for the obligation to provide the service or product in the future. Typical disclosures for this type of situation are shown here for WestJet Airlines Ltd. (2009).

Users should be aware of one other aspect of revenue recognition: sales returns. In many retail stores, customers are allowed to return merchandise. Usually a time is specified, such as 10 days or one month. When goods are returned, the company either returns the amount paid or gives a credit that allows the customer to buy new merchandise. Technically, the company should take into consideration the cost of possible returns when it recognizes revenue; otherwise, its income may be overstated. In reality, the time period in which returns are allowed is usually short, which means that the income is not materially misstated if the returns are recorded when they happen. For companies that sell to other companies (business-to-business sales), the returns can be substantial. For example, in the bookselling business, publishers often accept back from booksellers the books that have not been sold. This can result in a substantial amount of returns, depending on how well a book sells. If such companies want to recognize revenue when they ship books to a bookseller, they must estimate the amount of returns and recognize that amount when the revenue is recognized. The issue of returns has been particularly problematic for companies that sell through the Internet. Note the following example:

Recognition at the time of contract signing Even though the point of sale—or more correctly, the point at which title to the product is transferred to the buyer from the seller—is the most common method used to recognize revenues, several situations exist that require exceptions to this application of revenue recognition. Over the years, certain types of transactions have caused concern among investors and accountants because of how the companies chose to recognize revenues. One of those was in the area of retail land sales. This industry initially recognized revenues at the date of contract signing. In the case of retail land sale companies, it was the land sale agreement. The problem was that a considerable amount of uncertainty existed regarding future costs on the seller's part subsequent to contract signing, and to the collectibility of the receivables from buyers. Questions were raised as to whether any of the revenue recognition criteria were being met.

The uncertainty stemmed from industry practices. Retail land sale companies often sell land before it is developed and therefore have yet to incur the development costs. This means that the seller has not completed all the things that must be done; the seller still has continuing management involvement in the development of the property. There is also the problem of matching the future development costs to the revenues. Remember that if you want to recognize revenue before all the costs associated with the sale are incurred (note the warranty example), you must be able to estimate those future costs so that they can be recognized simultaneously with the revenue (according to the matching principle). Sales contracts typically require low down payments and sometimes include below-market interest rates to entice buyers to sign contracts. These conditions make it relatively easy for a buyer to back out of the transaction before all the cash is collected, thereby negating the sale and raising the possibility that future economic benefits may not flow to the seller.

Given that the earning process was rarely complete, and there were uncertainties with regard to future costs and the collectibility of the receivables, revenue for retail land sale companies is now only recognized at the time of contract signing if certain minimum criteria are met. These criteria require, first, that there be only minimal costs yet to be incurred (this means that the seller has completed substantially all the things that have to be done to conclude the sale), and second, that the receivables created in the transaction have a reasonable chance of being collected.

Recognition at the time of production Revenue recognition at the time of production was common in two industries: mining and long-term construction. If the product's market value and sale are both fairly certain at the time of production, as it was in certain mining operations, then the inventories produced can be valued at their net realizable value (selling price) and the resulting revenues can be recognized immediately. The reason for this practice was that the critical event in the revenue earning process for the mine was not the ore's sale, but its production. If the market for the ore was well established with fairly stable prices and there were buyers for the ore, the sale was assured as soon as the ore was produced. By recording the revenues as soon as possible, these companies had more timely information for making decisions. Although this was an acceptable practice at the time, it no longer is. The current mining market is unstable, as prices for various ores fluctuate daily. Therefore, resource companies now delay the recognition of the revenue until the ore is actually delivered. Many companies manage the risk of changing prices by purchasing forward contracts to sell their ore at a fixed price. A forward contract is an agreement between a buyer and a seller that establishes a fixed selling price.

The following example presents the revenue recognition method of the international mining company Barrick Gold Corporation, which operates gold and copper mines:

Note that for Barrick Gold Corporation, the earning process is complete when title to the gold has passed. At this point, the sale's final amount is certain. Because it uses forward or option contracts, the amount earned is known for certain. A forward or option contract stipulates the amount that will be received for the gold in the future.

The other industry that recognizes revenue at the time of production is the long-term construction industry, which has a long production period. In this industry, revenue is recognized using the percentage of completion method, which recognizes a portion of a project's revenues and expenses during the construction period based on the percentage of completion. The basis for determining the percentage completed is usually the costs incurred relative to the estimated total costs.

As an example, suppose that Solid Construction Company agrees to construct a building for $300 million. It will take three years to build, and the company expects to incur costs of $75 million, $105 million, and $30 million in 2011, 2012, and 2013, respectively. The total expected cost is $210 million and, therefore, the profit on the project is expected to be $90 million. Assuming that all goes according to plan, Exhibit 4-3 shows how Solid Construction would recognize the revenues and expenses (and related profits) during the three years with the percentage of completion method.

EXHIBIT 4-3 REVENUE RECOGNITION WITH THE PERCENTAGE OF COMPLETION METHOD (amounts in millions)

How well does the percentage of completion method meet the revenue recognition criteria? The total revenue can be measured reliably and, because of the construction contract, it is probable that the economic benefits will flow to the builder. For many long-term construction contracts, the buyer is often billed periodically during the construction process. The periodic billing and collection provide the seller with the ability to estimate collectability. The costs incurred to date are known and can be recognized when the revenue is recognized. It is also possible to reliably measure the cost to complete the contract and the stage of the contract. Has the builder transferred the risks and rewards of ownership to the buyer? It is assumed that the transfer of the risks and rewards of ownership are transferred as the contract proceeds through the building phases. This is not the same as the title but is accepted as a sufficient basis for recognizing revenue.

Instead of waiting until all the contract work has been completed (which can take several years), this method allows the company to measure how much work has been completed so far and then recognize as revenue the same percentage of the total contract price. The expenses for the period and the percentage of revenue earned are recognized each period, which provides timely information to users. The total revenue from the contract is known before the work begins. The company also has an estimate of the total costs that it expects to incur. As actual costs are incurred and some of the work is completed, we can calculate how much of the contract is finished and, therefore, how much revenue has been earned. We do that using the formulae in Exhibit 4-3.

The disclosure below for Bombardier Inc. (used as an example earlier in this chapter) for the fiscal year ending January 31, 2010, illustrates the percentage of completion method of revenue recognition.

In some cases, it may not be possible to measure how much of the project is completed, which would make it difficult to measure the revenue earned. There could also be a question about the future collectability on the contract, although it is doubtful that a company would continue work on a project if it was concerned about the future payment for its work. If it is not possible to reliably estimate future costs and revenues, revenue can only be recognized at an amount equal to the construction costs already incurred, and assuming also that the recognized revenue will be collectible.

With the percentage of completion method, if an overall loss is projected on the project, IFRS requires that the loss be recognized as soon as it is identified. For example, if, at the end of 2012, the total estimated costs to complete the Solid Construction contract were $315 million (instead of the original $210 million), an overall loss of $15 million would be indicated for the contract. At the end of 2012, Solid Construction would have to recognize a loss of $48 million (the overall loss of $15 million plus the $33 million in profit recognized in 2011). This loss would offset the $33 million profit reported in 2011 and would result in a net loss at this point of $15 million on the contract. If the actual costs equalled the new estimated costs in 2013, no additional profit or loss would be recorded in 2013, as the overall loss on the contract would already have been recognized. The details for an expected loss on a long-term contract do not need to be learned until you take an intermediate accounting course. For now, however, it is important that you understand that contract losses can occur and that the total potential loss is recognized in the year that the loss is determined. Note that Bombardier has a statement about how it recognizes expected contract losses.

Recognition at the time of collection Except for cash sales, revenue recognition criteria are almost always met before cash is collected. Therefore, for reporting purposes, the collectibility of cash rarely delays the recognition of revenue. Magazines such as Outpost have one of those rare circumstances. When Outpost sends magazines to a distributor for sale on newsstands, it does not know how much it has earned until it receives the money from the distributor six months later. It has no choice but to delay the recognition of revenue.

There are other circumstances under which the collection of receivables is so uncertain that accounting standards would require that revenue recognition be postponed until cash is actually collected. Some companies allow their customers to pay for their merchandise through instalments over an extended period of time. Many companies that sell merchandise this way have learned about the probability of collecting all the amounts owed by their customers. These companies will recognize revenue at the time of the original sale and recognize the probability of uncollectibility at the same time. However, there are rare situations where it is not possible to estimate the probability of collection. In these rare cases, the company would need to delay the recognition of revenue until the actual cash is received.

Revenue Recognition for Delivery of Services

Companies that earn revenue from the delivery of services are a growing sector of the economy. The revenue recognized by WestJet for passenger flights is service revenue. Bombardier, as well, described how it accounts for maintenance and long-term service contracts. The criteria for the recognition of service revenue are very similar to the criteria for the sale of goods²:

• The amount of revenue can be measured reliably.
• It is probable that economic benefits from the service will flow to the provider.
• The stage of completion of the service can be measured reliably.
• The costs incurred or to be incurred with respect to the transaction can be measured reliably.

Revenue from the provision of services is normally recognized in the period when the service is completed. If the service takes a long time to complete, the percentage of completion method is used when the costs and the probable revenue can be measured reliably. Financial institutions are one of the largest providers of services. The Toronto-Dominion Bank, one of Canada's major banks, describes its revenue recognition policy as follows:

Revenue from the Use by Others of a Company's Assets

Companies can also earn revenue by allowing others to use their assets. The revenue is in the form of interest, dividends, or royalties. The recognition of the revenue from these sources follows the basic revenue recognition criteria plus additional specifications depending on the type of revenue.

Interest revenue is recognized after the issuance of the interest-bearing asset and is proportional to the time that has passed. For example, if a company accepts a $5,000, 3-month, 5% interest-bearing note receivable from a customer on February 1, 2011, interest will be earned on March 1, April 1, and May1, and would be calculated as follows for each month: $5,000 × 0.05 × 1/12 = $20.83.

The journal entries for this note receivable would be as follows:

When a company owns shares (has an investment) in another company, it may receive dividends from the other company. When dividends are declared by the board of directors of the other company, the company is legally obligated to distribute the dividends to shareholders in proportion to the number of shares owned. For example, assume that Hawke Company buys 500 shares in Axle Corporation. On June 1, 2011, the board of directors of Axle Corporation declared a dividend of $0.07 per share payable to shareholders on June 21, 2011. Hawke Company would record the following:

If a company owns a licence, copyright, patent, or other intangible asset, it could allow other companies to use the rights associated with the asset in return for a royalty. Royalty revenue is recognized on the accrual basis according to the contractual agreement that outlines the amount and timing of the payments. For example, assume that on September 24, 2011, Hawke Company purchased 10 airport taxi licences from the city for $5,000 each. Hawke does not own taxis but intends to resell the rights to individual taxi owners for $300 a month, payable monthly. On October 1, Hawke Company drew up a contract with Jonathan Wittly for the use of one taxi licence for six months. Hawke would record the following transactions:

Companies often earn these types of revenue in addition to selling goods or performing services. As the following note shows, Brickworks Limited, the company you met earlier in the chapter and that sells bricks, tiles, and other building products, also has the kind of revenue described above:

Revenue Recognized from Multiple Lines of Business

In businesses that have multiple lines of business or that sell products in either standard or customized models, the revenue recognition criteria may be met at different points for different products. The disclosures that follow for Finning International Inc. illustrate this point. Finning International is the largest Caterpillar equipment dealer in the world. Caterpillar equipment includes large construction and mining equipment like large earth movers used in highway construction.

Ethics in Accounting

ethics in accounting

The choice of a revenue recognition policy is one of the critical policy decisions for a company. Current and future profitability measures will be affected by when revenue is recognized. Companies must choose a revenue recognition policy that is appropriate for their revenue streams and must disclose what that policy is so that users can make informed decisions.

STATEMENT OF EARNINGS FORMAT

One of the most fundamental objectives of financial reporting is to ensure that financial statements provide information that is useful to the users. To be useful, the information should enable investors, creditors, and other users to understand the enterprise's performance and financial position, and help them assess the amount, timing, and certainty of future net cash flows to the enterprise.

As you learned in Chapter 1, the purpose of the statement of earnings is to provide information about the company's performance. The statement summarizes all the revenues and expenses to show the net earnings or net income. The information is primarily historical. The revenues are the historical amounts received or receivable from the sale of goods and services, and the expenses are based on the amounts actually paid or payable for the goods and services that were used to produce the revenues. Some of the expenses may represent very old costs—for example, the depreciation of very old assets such as buildings.

For the statement of earnings to provide information about future cash flows, the connection between the amounts presented in the statement and those future cash flows must be understood. As you learned in this chapter, accrual-basis accounting requires that revenues and expenses be recorded at amounts that are ultimately expected to be received or paid in cash. For example, to estimate the actual amount of cash that will be collected from sales, the company estimates the amount of sales that will not be collected (bad debts) and deducts that amount from the sales. On the expense side, estimates are made for some expenses where amounts are not yet paid, such as for warranties or taxes. In both cases, the figures reflect management's estimates about future cash flows. Thus, the statement of earnings provides information to readers about management's assessment of the ultimate cash flows that will result from the period's operations. This means that the statement of earnings, prepared according to IFRS on an accrual basis, actually provides more information about future cash flows than a statement of earnings prepared on a cash basis, which only reflects the cash flows that have already occurred.

A second aspect of providing information about future cash flows is the statement's forecasting ability. If trends in the revenues and expenses over several time periods are examined, the revenues and expenses that will occur in the future may be predicted (assuming that trends in the past continue into the future). An understanding of how revenues and expenses are related to cash flows will allow a reasonable prediction of the amount of cash flows that will result in future periods.

The ability to predict future revenues and expenses depends on the type of item being considered, the industry in which the company operates, and the company's history. If the business is in a fairly stable product line, the sales revenues and cost of goods sold figures may be reasonably predictable. However, this type of forecasting is much more difficult for new businesses and new products.

Some other types of items on the statement of earnings are not very predictable. Sales of capital assets, for example, tend to be more sporadic than normal sales of goods or services. Some items may occur only once and cannot, therefore, be projected into the future. For example, the closing of a plant or the sale of a business unit is an event that has implications for the statement of earnings in the current period, but will likely not be repeated in the future.

To enable readers of the statement of earnings to make the best estimates or projections of future results, the continuing items should be separated from any non-continuing items. For this reason, the format of the statement is designed to highlight these differences.

In general terms, there are two approaches to presenting information on a statement of earnings: the multi-step format and the single-step format. We will illustrate and discuss the multi-step format first.

Exhibit 4-4 provides an overview of the major sections of a typical statement of earnings presented in the multi-step format.

EXHIBIT 4-4 MULTI-STEP STATEMENT OF EARNINGS FORMAT

The sections that follow discuss each of the major components.

Earnings from Operations

This section provides information about the revenues and expenses that result from selling goods and services. The operations that are reported are the company's normal operating activities that are expected to continue in the future. Later in the statement, there are sections for items that are not part of regular activities, including the results of any operations that management has decided to discontinue.

A distinguishing feature of many multi-step statements of earnings is that the statement starts with sales less the cost of the goods sold (or cost of sales), to arrive at a gross profit or gross margin amount. If a company's major source of revenue is selling goods, it must make enough profit or margin from the sales of its goods to cover all the other costs of operating the business. By examining the gross margin, users can assess the profitability of the company's products. You can also calculate a gross margin percentage, which is the gross margin divided by the sales. You can then use this percentage to evaluate a company's performance over time (by noting whether this percentage has been increasing, decreasing, or remaining stable) and to compare it with other companies in the same industry. The gross margin can therefore be a very informative and useful figure.

Following this, other normal operating revenues (if any) will be added, and all the usual operating expenses will be deducted, to show the amount of income that was generated from regular business operations that will continue in the future. For predictive purposes, this is usually a key figure on the statement of earnings.

Earnings from Non-Operating Sources

This section of the statement of earnings reports the results of transactions that are not part of the company's core operations. The typical types of items found here are interest income and expense, gains or losses on disposals of capital assets (such as property, plant, and equipment), and other events or transactions that are not considered part of the company's core business operations. IFRS guidelines do not strictly specify what should be included in each section of a multi-step statement.

Earnings from Unusual or Infrequent Events

Sometimes unusual or infrequent events occur that the company wants to segregate from the rest of its results so that statement readers can better understand the nature of the events and assess their continuing or noncontinuing status. For example, losses associated with a labour dispute or costs related to restructuring the organization might be reported here. Rather than being reported in a section by themselves, however, these types of items are often reported with the other non-operating items, discussed above.

Corporate Income Taxes

After the statement sections that have been discussed so far, there is a line item for corporate income tax expense, which is calculated on the net of all the items listed above. Sometimes the term provision for income taxes is used instead of income tax expense. Taxes are calculated based on the aggregate (total) income to this point.

The tax expense listed on a company's statement of earnings may not be the actual taxes that will be paid to the Canada Revenue Agency. The rules to calculate the taxes owed to the government are specified in the Income Tax Act and regulations. Although many of these rules parallel the accounting guidelines, there are some tax regulations that differ significantly from IFRS. When the amount of income tax expense for the period differs from the amount of tax that must be paid in the current period, the difference is shown as deferred income tax. This means that additional taxes will likely be paid in future years, as some of the income that was recognized currently, under accounting principles, becomes taxable in the future, based on the rules in the Income Tax Act. More will be said about these dual income tax calculations in future chapters.

Discontinued Operations

An additional item may appear after the calculation of income tax expense: discontinued operations. When a company has decided to discontinue a significant segment of its operations, it is important to segregate the results of the discontinuance from the ongoing operations. This item, therefore, appears below all the other items on the statement of earnings, including the income tax. This enables readers to focus on the earnings before the discontinued operations (frequently called earnings from continuing operations) as a key figure for predicting future income.

Because it appears after the calculation of income taxes, the tax effects of discontinued operations must be reported along with the items themselves. The company must pay taxes on these items, just as it does on the items in the upper part of the statement of earnings; so discontinued operations are reported on what is known as a net-of-tax basis. This means that the tax effect of each such item is subtracted from the original amount to produce a net, after-tax amount. If, for example, discontinued operations result in a gain of $1,000 before taxes and the tax on this is $400, the net-of-tax amount would be a $600 gain (i.e., the $1,000 gain minus the $400 tax expense related to it). Losses from discontinued operations are handled in the same way. For example, if discontinued operations result in a loss of $1,000 before taxes, which saves the company $400 in taxes (due to the deductibility of the loss), the net-of-tax amount would be a $600 loss (i.e., the $1,000 loss minus the $400 tax saving arising from it).

Discontinued operations are significant segments of the company that management has decided to eliminate. There are specific criteria for deciding what constitutes a discontinued operation; however, the basic idea is that this category involves dispositions where the business unit or segment can be clearly distinguished, both operationally and for financial reporting purposes, from the rest of the enterprise.

Once management has discontinued a segment of the company or a separately identifiable portion of its business, there are two types of results that must be reported in the discontinued operations section of the statement of earnings:

• The income earned by operating the business segment since the decision to discontinue it must be reported separately from other (continuing) income. Since the company has exited from this portion of its operations, it is important to show users what effect the discontinued business segment had on income.
• The gain or loss on the closure and disposal of the discontinued business segment must also be reported in the discontinued operations section of the statement of earnings.

Variations in Statement of Earnings Formats

An alternative to the multi-step format of the statement of earnings illustrated thus far is the single-step format. Exhibit 4-5 shows this approach.

Note that this method of presenting the statement of earnings contains the same data as the multi-step format shown earlier; the differences relate to how the data are organized in the statement. Although there are many variations in practice, the general idea of the single-step format is that all the revenues and gains (other than any related to discontinued operations) are listed together. Then, all the expenses and losses (other than any related to discontinued operations) are listed. As a result, there are fewer subsections and subtotals in a single-step statement, than in a multi-step statement.

To ensure that you grasp the difference between the multi-step and single-step approaches to the statement of earnings, take a few minutes to compare Exhibits 4-4 and 4-5. Notice that although they are organized quite differently, the same line items appear in each statement of earnings format. You should also note that, regardless of whether you use the multi-step or single-step format, discontinued operations have to be segregated in the bottom portion of the statement and shown on a net-of-tax basis. Remember that the discontinued operations will not form part of the earnings in the future, so it is important to allow users to see what will continue into the future and what will not.

EXHIBIT 4-5 SINGLE-STEP STATEMENT OF EARNINGS FORMAT

It should be noted that Exhibits 4-4 and 4-5 illustrate “pure” forms of multi-step and single-step statements of earnings. In actual practice, companies often use hybrid forms of these approaches, combining elements of both the multi-step and single-step formats in their statement of earnings. The statement of earnings for WestJet Airlines for 2009, which is shown in Exhibit 4-6, provides a good example of a hybrid form of presentation that includes elements of both the multi-step and single-step formats. It has revenues and expenses segregated (single-step characteristic) and then it has a segment that includes non-operating items (multi-step characteristic).

It should also be noted that published financial statements are often very condensed, with several items combined and presented as one line item. A consequence of this practice is that information on individual revenues and expenses is often unavailable. In particular, many companies do not disclose their cost of goods sold. Instead, they combine the cost of goods sold amount with other operating expenses and report the combined figure as a single amount. (An example of this can be seen in the income statement for H&M, in Appendix A. H&M combines its cost of goods sold with some of its salaries and depreciation, and reports these items as a single amount with reference to Notes 6 and 8.) The usual reason for doing this is that, for competitive reasons, companies do not wish to reveal their cost of goods sold. Unfortunately, when the cost of goods sold is not disclosed, it is not possible to calculate a gross profit figure; as a result, the statement of earnings is less informative and useful to readers.

EXHIBIT 4-6  WESTJET AIRLINES LTD. 2009 ANNUAL REPORT

Examples of Actual Statements of Earnings

Exhibit 4-7, which shows the consolidated income statement for Michelin Group, provides an example of the multi-step income statement format. Michelin is an international company with its headquarters in France. Its main product line is the manufacture and sale of tires. Notice that its income statement begins with sales minus cost of sales, to give a subtotal called gross income. This represents the profit that was earned on the company's sales. Then, the company's operating expenses (i.e., its sales and marketing, research and development, general and administrative, and other expenses) and non-recurring profits and expenses related to its operations are shown, resulting in a subtotal for operating income. The statement then includes non-operating items, including cost of debt (interest expense), other financial income and expenses, and its share of profit/losses from associates (companies in which it is holding a block of shares), which are added or deducted to give a subtotal for income before taxes. Finally, the income taxes are deducted, giving the net income for the year.

EXHIBIT 4-7  EXAMPLE OF A MULTI-STEP INCOME STATEMENT; MICHELIN GROUP 2009 ANNUAL REPORT

In Exhibit 4-8, the consolidated statements of earnings and statements of comprehensive income for Suncor Energy Inc. provide an example of a statement of earnings prepared using the single-step format. Suncor is a major North American energy producer focused on the oil sands of northern Alberta. Notice that all the company's revenues are listed together, totalling $25,480 million for the year ended December 31, 2009. Then all its expenses (except income taxes) are listed, totalling $24,191 million, resulting in earnings before taxes of $1,289 million for 2009. After corporate taxes totalling $143 million (of which $725 million will likely result in tax savings in the future), Suncor Energy shows net earnings for the year of $1,146 million.

Earnings Per Share

IFRS stipulates that earnings per share figures must be reported, either in the statement of earnings itself or in a note accompanying the financial statements. The earnings per share figures express the amount of income earned during the period in relation to the number of common shares held by the owners. Although this can be a complex calculation in some situations, in essence it is a simple one that consists of dividing the earnings by the number of common shares outstanding during the period. If the number of common shares outstanding changed during the year, a weighted average number of shares must be used. Calculating a weighted average means determining each increase or decrease in the number of shares outstanding during the year and calculating an average based on the length of time each level of shares remained outstanding. For example, if a company started the year with 100,000 shares and on July 1, issued an additional 20,000 shares, the weighted average number of shares would be:

EXHIBIT 4-8  EXAMPLE OF A SINGLE-STEP STATEMENT OF EARNINGS; SUNCOR ENERGY INC. 2009 ANNUAL

Look at the disclosure of earnings per share in Exhibit 4-8 for Suncor Energy. The basic earnings per share figure was $0.96 for 2009 (versus $2.29 for 2008 and $3.23 for 2007). Note that another earnings per share amount is also reported, called diluted earnings per share. The diluted earnings per share figure is usually lower than the basic earnings per share; for Suncor, it was $0.95 for 2009 (versus $2.26 for 2008 and $3.17 for 2007). The inclusion of the diluted earnings per share figure is a signal to users that the company has some financial instruments such as convertible debt (the company will allow the debt holder to turn it in and receive shares in exchange), or some obligations such as stock options given to its employees, that could result in more common shares being issued. Since the earnings per share amount is calculated by dividing the earnings by the number of shares outstanding, if more shares are issued, then the amount earned per share could decline. The diluted earnings per share amount shows how much the earnings per share would have declined if new shares had been issued as a result of existing financial instruments and obligations.

In addition, when companies have discontinued operations, they must report earnings per share amounts based on the income both before and after such items. This means that, in an extreme case in which a company had financial instruments or obligations that could result in more common shares being issued, as well as discontinued operations, the company would have to report four earnings per share amounts: both basic and diluted earnings per share, and calculated for both on the earnings before discontinuing operations and on the net earnings. Chapter 12 discusses earnings per share calculations in more detail.

Comprehensive Income

The Accounting Standards Board and the IFRS require companies to report comprehensive income, as well as net earnings, in their financial statements. Comprehensive income is defined as the total change in the shareholders' equity (or net assets) of the enterprise from non-owner sources. It includes all the changes in shareholders' equity during a period, not including investments by owners or distributions to owners. Net earnings is, therefore, part of comprehensive income because it causes a change in retained earnings, which is part of shareholders' equity.

Besides net earnings, there are other items that cause changes in shareholders' equity. For example, some gains and losses (such as certain gains or losses arising from the translation of foreign currencies, unrealized gains or losses arising from changes in the fair values of certain types of financial investments, and unrealized gains and losses from revaluations of long-term assets to market value) are not included in the determination of net earnings but are included in comprehensive income. Comprehensive income is therefore broader than net earnings. It includes net earnings plus a few other specified items.

Some of the concepts and procedures related to this issue are very complex. At this introductory level, you should focus on the basic concept that companies are required to present certain gains and losses outside net income, in a category referred to as other comprehensive income, which will then be combined with the net earnings to give the comprehensive income or loss. These other elements of the comprehensive income may be presented on the statement of earnings, immediately below the net income, or in a separate statement that begins with the net earnings. In either case, the final total is the comprehensive income for the period. In Exhibit 4-8, Suncor presents a statement entitled statement of comprehensive income just below its statement of earnings.

The concept of comprehensive income is based on an all-inclusive approach to earnings measurement. This means that all transactions affecting the net change in shareholders' equity during a period are to be included when determining income, except contributions (or investments) by the owners and distributions (or dividends) to them. To illustrate the reason for introducing the concept of comprehensive income, we will now see a simplified example of the distinction between net income and other comprehensive income.

Assume that a company buys shares in another company as a long-term investment. If the market value of this investment increases during the period, but the investment is still held, the increase in value can be reported in the net earnings, or the company could elect to include the gain in other comprehensive income. Because the gain is not considered realized until the investment is sold, the company may decide that it is better to include the gain in other comprehensive income so that there are no fluctuations in net earnings when the investment is revalued to market every year. (Bear in mind that, until the investment is sold, an unrealized gain is not “locked in.” If the market value decreases before the investment is sold, the unrealized gain could be reduced or eliminated, or become a loss.) Later, when the investment is sold and the gains/losses are realized, the total change in value will be recognized as a gain/loss and transferred to net earnings.

Companies have to present comprehensive income and its components in a financial statement displayed with the same prominence as the rest of the financial statements. This statement must show net earnings, each component of other comprehensive income (on a net-of-tax basis), and the total comprehensive income. Note again that net earnings, as traditionally defined, is a component of comprehensive income (i.e., net earnings + other comprehensive income = total comprehensive income). Companies can decide to include other comprehensive income at the bottom of the statement of earnings (it is often called the statement of earnings and other comprehensive income) or they can prepare a separate statement of comprehensive income as Suncor does.

Exhibit 4-9 presents Finning International Inc.'s statement of comprehensive income from its 2009 annual financial statements.

As stated earlier, Finning International is a company that sells and services large construction equipment that carry the CAT brand. Note that the statement starts with net income. The first line under the net income states that all items are listed net of income tax. The items included are currency translation adjustments, unrealized gains on net investment hedges, tax recovery (expense) on net investment hedges, unrealized gains (losses) on cash flow hedges, realized losses on cash flow hedges, reclassified to earnings, and tax recovery (expense) on cash flow hedges. It is not important that you understand what all of these items mean. You should know, however, that there are some items that are not included in net earnings and retained earnings but are included in shareholders' equity and that might in the future be transferred to net earnings.

On the balance sheet, accumulated other comprehensive income would be shown, along with (but separate from) retained earnings. The shareholders' equity section of Finning International is presented in Exhibit 4-10 to illustrate where it appears on the balance sheet.

EXHIBIT 4-9  FINNING INTERNATIONAL INC. 2009 ANNUAL REPORT

Rather than presenting the details on the balance sheet itself, most companies will summarize the changes in their shareholders' equity accounts in a separate statement, and then present only the final amounts on the balance sheet. The statement of changes in equity will be discussed in more detail in Chapter 11.

PERFORMANCE MEASUREMENT

Now that you have a good idea about the various ways that revenue can be recognized and a better understanding of the components of the statement of earnings, let's use that information to have a closer look at how we can measure performance. After making an investment, investors want to know how well their investment is performing. To put this in a simple context, suppose an investment is made in a savings account at a bank. The money is put in the bank so that it can earn something and it is safe. Periodically, the bank provides information that details any new deposits or withdrawals and any interest earned on the savings. The interest earned can then be compared with the balance in the account to indicate the investment's performance. The comparison of the interest earned to the balance in the account is called a ratio. Ratios can help us assess performance.

The Return on Investment (ROI) Ratio as a Measure of Performance

A common measure of business performance is a ratio called the return on investment (ROI), which is generally calculated as follows (in Chapter 12 we will discuss several other ratios that also calculate returns):

EXHIBIT 4-10  SHAREHOLDERS' EQUITY SECTION OF A BALANCE SHEET—FINNING INTERNATIONAL INC. 2009 ANNUAL REPORT

In the case of the bank account, the numerator is the interest earned during the period, and the denominator is the average amount invested over the period. By averaging the denominator, additional deposits or withdrawals made during the period are taken into account. A simple average of the beginning balance and the ending balance in the investment is often used; however, more sophisticated averaging methods may be more appropriate. Suppose the average investment in a bank account was $1,000, and the return was $50. The ROI from the investment would be calculated as follows:

Based on this return, two questions might be asked: (1) Is this a good return on investment? And (2) how confident is the investor that this really is the return? To answer the first question, the return on this investment should be compared with the returns that could have been earned on alternative investments, or with the returns that similar investors are earning. If the next best alternative of similar risk would have returned only 4%, the bank account was a good investment. If, however, investors are earning 6.5% for similar investments, it would seem that this was not the best investment.

To answer the second question, the investors must assure themselves that their $1,000 investment plus their $50 return is really worth $1,050 today. Ultimately, the only way to be sure that the investment is worth $1,050 is to sell the investment—that is, to withdraw the $1,050 from the bank. If the investors do not sell the investment, there is still some chance that the bank will not have the money to repay them; the bank might, for example, file for bankruptcy. In the late 1980s and early 1990s, this was not an inconceivable event, as several small Canadian banks went out of business. More recently, several banks in the United States have gone out of business. In Canadian banks that are insured by the Canada Deposit Insurance Corporation (CDIC), small accounts (those up to $100,000) are insured so that, even in the event of a bank collapse, the investor would still be repaid by the CDIC. A bank account of this type is about the safest investment you can make. An uninsured account would not give you the same comfort level regarding the possible failure of the banking institution.

Now suppose that instead of investing in a savings account, an investment is made in a house. Assume that the house is bought for investment purposes for $250,000. The buyer is hoping the property value will rise. Assume also that there are no further cash outlays or inflows during the year from this investment. To assess the return on the investment, the investment's value at the end of the period must be determined. This value could be estimated by getting the house appraised by a real estate agent, or by comparing the house with the selling prices of similar houses in the area that have recently sold. In either case, the value will be an estimate. Confidence in these estimates will surely be lower than the confidence in the return earned from the investment in the savings account at the bank. In fact, the only certain way to determine the return on the house would be to sell it. If the investor does not want to sell the property, however, the only alternative would be to use an estimate of the selling price to measure performance. If the investor estimates the selling price to be $270,000, the ROI will be calculated as follows:

Measuring the performance of a business is much like estimating the return on the investment in a house. The business makes investments in capital assets (property, plant, and equipment), inventory, accounts receivable, and other assets, and it periodically measures the performance of these investments. However, it does not want to sell its investment in these assets at the end of every accounting period simply to determine the proper ROI. It must, therefore, estimate any changes in the value of its assets and liabilities that may have occurred during the accounting period, and report these as net earnings. We then use that net earnings amount to calculate two more specific kinds of ROI that you will see in greater detail later in the book. The first is a return on assets (ROA). This ratio measures the amount of income earned per $1 of assets. It attempts to provide the user with information about how effectively the assets are being used to generate earnings. The second ratio is the return on equity (ROE). This ratio measures the amount of income earned per $1 invested in the company's shares. It provides users with information about the amount of return being earned by shareholders. They can compare this ROE with investments of other types and risks to determine whether investing in this company is still a good idea.

Some of the changes in value (returns) are easy to measure, such as the interest earned on a savings account. Other changes, such as the change in the value of property, plant, and equipment, are not as easily measured, as the example concerning the investment in a house demonstrates. Because accounting data should be reliable as well as relevant (as we discussed in Chapter 1), accountants have established concepts and guidelines for recognizing the changes in value of assets and liabilities. This ensures that the measurement of performance that is most commonly used (net earnings) reliably measures the effects of the transactions that took place during the period.

Net Earnings as a Measure of Performance

The statement of earnings attempts to measure the return to the shareholders on their investment in the company; that is, it measures changes in shareholders' wealth in the company. The accounting value of this shareholders' wealth is measured by the value of shareholders' equity accounts. Remember that these accounts include common shares, retained earnings, and accumulated other comprehensive income.

Shareholders' equity accounts are typically affected by three general types of transactions: shareholder investment activities, the declaration of dividends, and transactions that result in profits or losses. Shareholders may invest more money in the company by buying, for example, new shares when they are issued. This does not directly affect their return on the investment, but does affect the amount of investment they have in the company. Second, shareholders may receive a dividend (via a declaration by the board of directors) that reduces their wealth in the company by reducing the company's total assets. This also does not directly affect the return on investment, but again affects the amount of the investment. Finally, transactions that result in profits or losses will affect shareholders' wealth through their effects on retained earnings. It is this last set of transactions and their impact on value that are measured by the statement of earnings.

Because the company does not want to sell its investments at the end of each period to determine its performance, the net earnings amount is used as part of several ratios that inform users about how their investment is doing. Now that you have a better idea of the various ways that revenue can be determined, you can better assess the underlying strength of the net earnings amount. You also understand the value of reading the notes to the financial statements to learn about the company's revenue recognition policy.

SUMMARY

In this chapter, we first discussed the importance of revenue to a company's overall health, which led to an explanation of why we have established revenue recognition criteria. We then explained the cash-to-cash cycle and its importance in understanding a company's performance. Tied to the cash-to-cash cycle are the concepts underlying the recognition of revenue. We introduced the concept of earnings management to increase your awareness of how the management of a company can set revenue and expense recognition policies to make its net earnings higher or lower in particular accounting periods, or smoother over time. We looked at revenue recognition for the sale of goods, the rendering of services, and the receipt of revenues from allowing others to use the company's assets in return for interest, royalties, and dividends. In the sale of goods discussion, we illustrated revenue recognition at the time of sale, at contract signing, at the time of production, and at the time of collection. We explored these concepts to improve your understanding of net earnings as a measure of business performance. Companies use different revenue recognition criteria according to the type of revenue they are generating. When assessing a company's performance, it is important to understand the type of revenue the company is generating and the revenue recognition policy it has established. If you know these two things, you will be better able to understand its cash-to-cash cycle. We then built on your previous understanding of the statement of earnings. We showed you some of the complexities of the statement of earnings, such as earnings from operations, non-operating earnings, unusual or infrequent items, income taxes, discontinued operations, and earnings per share. We introduced a new statement, the statement of comprehensive income. As we progress through the text, you will have some of these items explained more fully. We then concluded the chapter with a brief look at some measures of performance, or returns on investment. These measures enable users to better assess how their investments are doing.

While net earnings is a useful measure of performance, it is not the only measure in which users of financial statements should be interested. In the next chapter, the cash flow statement is considered. We had a brief look at this statement in Chapters 1 and 2. Chapter 5 will explore it in more detail by showing how the statement is created and how to interpret its information. We will also discuss the implications for a company's health of some matters that are not shown on the statement of earnings.

Additional Practice Problems

ABBREVIATIONS USED

F.O.B.	Free on board
ROA	Return on assets
ROE	Return on equity
ROI	Return on investment

SYNONYMS

Gross margin Gross profit

Net earnings Net income

Statement of earnings Income statement

Tax expense Provision for taxes Tax provision

GLOSSARY

Account receivable An amount owing as a result of the sale of a product or service.

Accumulated other comprehensive income A component of shareholders' equity representing the cumulative amount of unrealized increases and decreases in the values of the net assets of the entity. Once realized, these gains/losses are transferred to retained earnings.

Cash discount A reduction in the amount that has to be paid on an account payable or receivable if payment is made within a specified time limit.

Cash-to-cash cycle A company's operating cycle: its operating activities beginning with the initial outlays of cash to buy a product or to provide a service and ending with the replacement of cash through collections from customers.

Comprehensive income The total change in the shareholders' equity (net assets) of the entity from non-owner sources. Includes net income as well as other components, which generally represent unrealized gains and losses.

Deferred income tax An asset or liability representing tax on the difference between the accounting balance of assets/liabilities at a given point in time and the tax balance of the same assets/liabilities. These differences arise when the company uses one method for accounting purposes and a different method for tax purposes. This concept is discussed in more detail in Chapter 8.

Diluted earnings per share An earnings per share calculation that shows what the company's basic earnings per share would have been reduced to if financial instruments such as convertible debt or obligations such as employee stock options had caused more common shares to be issued.

Discontinued operations Business operations that have been (or are being) phased out or sold and will, therefore, not continue in the future. They are reported separately on the statement of earnings.

Earnings management The deliberate choice of revenue and expense recognition methods that will increase or decrease net income in particular accounting periods or smooth them over time.

Earnings per share A calculation in which income or earnings are divided by the average number of common shares outstanding during the period.

Expenses The costs incurred to earn revenues.

Gross margin Sales minus cost of goods sold. Synonym for gross profit.

Gross profit Synonym for gross margin.

Income tax expense The expense for income taxes. A synonym for provision of taxes.

Matching principle The concept that requires all expenses related to the production of revenues to be recorded during the same time period as the related revenues. The expenses are said to be matched with the revenues.

Measurement The process of determining an appropriate amount or value for some attribute of the item being measured.

Multi-step statement of earnings A statement of earnings in which revenues and expenses from different sources are shown in separate sections.

Net earnings The difference between revenues and expenses. Synonym for net income.

Net income Synonym for net earnings.

Net-of-tax basis The presentation of a gain or loss with the related income tax deducted from it, to show the remaining amount after tax.

Operating activities Activities involving the cash effects of the normal operations of a business, such as the buying and selling of goods and services.

Other comprehensive income Changes in net asset values representing unrealized gains and losses, which are not included in net earnings but are included in comprehensive income.

Percentage of completion method A method of revenue recognition used in the construction industry in which a percentage of the profits that are expected to be realized from a given project is recognized in a given period, based on the percentage of the project's completion. The percentage completed is typically measured as the fraction of costs incurred to date relative to the total estimated costs to complete the project.

Performance The work associated with the generation of revenue. Used in a similar way to the term “earned.”

Price allowance An adjustment made to the selling price of a good or service to satisfy a customer, typically for some defect in the good or service provided.

Provision for income taxes The expense for income tax. A synonym for income tax expense.

Recognition Recording an event in the accounting system and/or reporting an item in a financial statement, including both the description and the amount.

Return on investment (ROI) A measure of an investment's performance, calculated as the ratio of the return from the investment to the average amount invested.

Revenue recognition criteria Criteria developed that specify the conditions under which revenue should be recognized.

Revenues The inflows of cash or other assets from the normal operating activities of a business, which mainly involve the sale of goods, provision of services, or allowing others to use the company's assets.

Single-step statement of earnings A statement of earnings in which all revenues are listed in one section and all expenses (except income tax, perhaps) are listed in a second section.

Statement of comprehensive income A statement showing net income plus other components of other comprehensive income, combined to produce the total comprehensive income.

Self-Assessment Quiz

ASSIGNMENT MATERIAL

Assessing Your Recall

4-1 Draw a diagram of a typical cash-to-cash cycle of a retail company and briefly explain the cycle's various components.

4-2 List the two basic revenue recognition criteria that exist under IFRS.

4-3 What are the three types of revenue that are typical of many companies?

4-4 Describe the five criteria for revenue recognition from the sale of goods.

4-5 Explain the meaning of “performance has been achieved.”

4-6 What is the most common point at which revenue is recognized for the sale of goods? How does this point meet the five criteria for revenue recognition?

4-7 Describe the revenue recognition method that is recommended for long-term construction contracts. What information do you need to know in order to apply this method?

4-8 Describe how revenue is recognized for mining companies that extract ore.

4-9 Explain the meaning of the matching principle.

4-10 Describe the accounting treatment for a deposit made by a customer for the future delivery of inventory. Using the revenue recognition criteria, explain the rationale for this treatment.

4-11 Identify and briefly describe the major sections of a multi-step statement of earnings.

4-12 How does the single-step statement of earnings differ from the multi-step statement of earnings? Do they produce different net income? Explain.

4-13 What two types of disclosures are made in the statement of earnings with regard to discontinued operations? Why are these items segregated to the bottom of the statement of earnings?

4-14 What kind of items are included on the statement of comprehensive income? Explain where these items are included in shareholders' equity.

4-15 Explain how ROI measures performance.

Applying Your Knowledge

4-16 (Revenue recognition criteria)

In the opening story to this chapter, the owner of Outpost magazine explained how the company recognizes revenue. Using the revenue recognition criteria described in this chapter, explain the appropriateness of Outpost's revenue recognition policies for revenue from advertisers and revenue from subscribers.

4-17 (Revenue recognition and statement of earnings)

Vanessa Simon and Juan Cassetto started a landscaping company as a way of earning money for the summer. They purchased two lawn mowers for $250 each, a leaf blower for $59, and various smaller items, such as rakes, a shovel, canvas, clippers, and pails, which cost them $63. Vanessa rented her father's van for $100 per month. They began work in May and worked through to the middle of September. They had several regular customers who paid them for managing their yards either once or twice a week. These customers paid them at the end of each week. They did the landscaping for three malls, watering and planting flowers and trimming hedges. They left an invoice with the mall manager every two weeks and received a cheque for the work the following week. They set up a separate bank account for their company and deposited money when they were paid. On September 15, they tallied up what they had earned over the summer. They had deposited $14,350 in the bank account, which represented the amount received from customers. One customer still owed them $150 for work and has promised to pay them on September 20. The final cheque from the mall manager for $136 had not arrived yet. In addition to the original amount spent at the beginning of summer, they paid for the following items: $100 per month for their two cell phones, $450 for gas and $39 for an oil change for the van, $20 for sunscreen, $250 for gas and oil for the lawn mowers, and $600 to rent a trailer to carry their equipment. Vanessa still owes her father for renting the van for the half month in September.

Required:

Prepare as much of the income statement for Simon and Cassetto as you can, showing the proper amount of revenue and any expenses that should be included. Show all calculations. Using the revenue recognition criteria, justify the revenue recognition method you selected. Do you have a cost of goods sold? Why or why not? What other expenses do you think they would probably have?

4-18 (Revenue recognition and statement of earnings)

Dimitri Chekhov owns a medium-sized Russian restaurant called The Steppes. Most of his business is from customers who enjoy in-restaurant lunches and dinners and pay before they leave. He also provides catered food for functions outside of the restaurant. Because he needs to prepare the food in large quantities and transport it to the venue, he requires these customers to make a 40% deposit at the time of booking the event. The remaining 60% is due on the day of the function.

During 2011, the restaurant took in $736,432 from restaurant and catered sales. At year end, December 31, 2011, the catered sales amount included $12,678 for a convention scheduled for January 12, 2012. Dimitri paid $198,108 for food supplies during the year and $248,572 for wages for the chefs and other restaurant staff. The restaurant owed $6,161 in wages to its staff at year end, which will be paid on January 4, 2012, as part of the normal bi-weekly pay schedule.

Required:

Prepare as much of the income statement for The Steppes as you can, showing the amount of sales and any other amounts that should be included. Show all calculations. Using the revenue recognition criteria, justify the revenue recognition method you selected. Do you have a cost of goods sold? Why or why not? What other expenses do you think the restaurant probably has?

4-19 (Revenue recognition and statement of earnings)

The Warm as Toast Company installs furnaces and fireplaces in homes and businesses. Each furnace and fireplace carries a four-year warranty. During 2011, the company had sales of $835,000. Customers paid half of the sales price when they arranged for an installation and the other half when the furnace or fireplace was installed. At year end, $76,000 of the sales amount represented amounts paid for furnaces or fireplaces that were not yet installed and for which the second half of the payment had not yet been received. The cost associated with the sales was $407,000 for the furnaces and fireplaces that had been installed that year. An additional cost of $198,000 was incurred for the labour associated with the installation. The accountant estimated that total future warranty costs associated with the installed items would likely be $46,000 over the next five years.

Required:

Prepare as much of the income statement for The Warm as Toast Company for 2011 as you can, showing the proper amount of sales, cost of goods sold, gross profit, and any other amounts that can be included. Show all calculations. What other expenses do you think the company would probably have?

4-20 (Revenue recognition on long-term contract)

Allied Construction Company has signed a three-year contract to construct an apartment complex for $64 million. The expected costs for each year follow (in millions):

The apartment complex will be completed in 2013.

Required:

Calculate the total revenue, expense, and profit for each year using the percentage of completion method.

4-21 (Revenue recognition on long-term contract)

Atlantic Ferries arranged for Columbus Shipbuilders to build three new ferries for its Nova Scotia to Prince Edward Island run. Atlantic agreed to pay $22.5 million for the ferries ($7.5 million each). The contract was signed on June 30, 2011, with a delivery date of September 30, 2013. Atlantic agreed to pay the $22.5 million as follows:

$4 million at the signing of the contract

$9.5 million on December 31, 2012

$9 million on September 30, 2012 (at completion)

The following costs were incurred by Columbus Shipbuilders (in millions):

Required:

1. Calculate the revenue, expense, and profit (ignoring interest) that Columbus Shipbuilders should report for each of the three years, using the percentage of completion method.
2. What should Columbus Shipbuilders do if, in 2010, it determines that it will cost more than $22.5 million to complete the three ferries?

4-22 Revenue recognition on a layaway sale)

Enchanted Brides sells complete bridal ensembles. The most expensive part of the ensemble is the wedding gown. Recognizing that some of its customers may not have enough immediate funds to purchase one of its gowns, the store provides a layaway plan. The customer selects a gown and the store agrees to hold the gown until it is paid for. The store sets up a monthly payment schedule for the customer, extending the payment time over six months to a year. The store charges an additional $35 for storage fees and $100 in possible default charges. If all payments are made on schedule, the default charge reduces the final payment. If the customer defaults, the $100 is not refunded.

Required:

Using the revenue recognition criteria, explain how the store should account for the monthly payments from the customer. Should the $35 storage fee be treated as revenue? Why or why not? Should the $100 default charge be treated as revenue? Why or why not? When should the store recognize the original cost of the wedding gown?

4-23 (Revenue recognition on gift cards)

The Carrot Top is a trendy clothing store that is very popular with young teens. Because it is difficult to select clothes that young people might wear, the store offers gift cards to parents, friends, and relatives. The cards are very popular, particularly for birthdays. When a card is purchased, the cashier identifies the purchase as a gift card and activates the card so that it can be used within 24 hours. There is no time limit on when the card must be used.

Required:

Using the revenue recognition criteria, explain how the store should account for the purchase of a gift card. Discuss how the store could account for gift cards that are not used. Is there a time when the store could assume that the card will not be used?

4-24 (Revenue recognition on long-term contract)

Concord Construction Inc. agreed to build a new science building on the Northern University campus. Both parties signed the contract on October 31, 2011, for $60 million, which is to be paid as follows:

$5 million at the signing of the contract

$15 million on December 31, 2011

$30 million on December 31, 2012

$10 million at completion, on August 15, 2013

The following costs were incurred by Concord Construction (in millions):

Required:

1. Calculate the revenue, expenses, and profit (ignoring interest) that Concord Construction should report for each of the three years, using the percentage of completion method.
2. Explain how this method appropriately allows Concord Construction to show the company's performance under the contract.

4-25 (Revenue recognition on long-term contract)

Cougar Builders Ltd. takes on both short- and long-term contracts. For short-term contracts (nine months or less), it recognizes expenses as they are incurred and revenue when the contract is complete, unless the contract is not complete by year end. When the contract spans two accounting periods, it uses the percentage of completion method for that contract. For long-term contracts (over nine months), it uses the percentage of completion method. It recently agreed to do two contracts. On June 30, 2011, the company agreed to a six-month contract to replace the bricks on the outside of an apartment building. The contract was for $650,000 and the company expected to incur costs of $480,000. The contract was completed by December 20, 2011, and had actual costs of $510,000.

The second contract was for the construction of a new apartment complex for $5,620,000. The contract was signed on August 1, 2011, and was expected to be finished by September 30, 2012. The expected costs for the contract are as follows:

Cougar Builders closes its books every December 31.

Required:

1. For each of the two contracts, determine the revenue, expense, and profit (loss) as at December 31, 2011.
2. Explain why the accounting method chosen for the two types of contracts is appropriate for Cougar Builders.

4-26 (Revenue recognition on long-term contract)

On June 21, 2011, Three Rivers Concrete Company signed a contract with Premier Power Incorporated to construct a dam over a river in northern British Columbia. The contract price was $42 million, and it was estimated that the project would cost Three Rivers Concrete $27 million to complete over a three-year period. On June 21, 2011, Premier Power paid Three Rivers Concrete $1.2 million as a default deposit. In the event that Premier Power backed out of the contract, Three Rivers Concrete could keep this deposit. Otherwise, the default deposit would apply as the final payment on the contract (assume, for accounting purposes, that this is treated as a deposit until contract completion). The other contractual payments are as follows:

Estimated construction costs were as follows:

The contract was completed on September 30, 2013. Solid Concrete closes its books on December 31 each year.

Required:

Calculate the revenue, expense, and profit to be recognized in each year, using the percentage of completion method.

4-27 (Revenue recognition decision)

After graduating with a degree in computer systems and design, Terry Park set up a business to design and produce computer games for arcades. Terry hired two other designers because of the anticipated volume of business. One designer, Kim, is paid an hourly wage. The second, Sandy, is paid 50% of the revenue received by Terry on the games designed or redesigned by Sandy. Terry rents an office where they all work and provides all the necessary equipment, supplies, and other items. Terry is not paid a wage but keeps all of the profits earned.

Terry realized there were two kinds of business: speculative design and custom design. For the speculative designs, Terry or one of the designers would think of a new game and design, program, and test it. Terry would then try to sell it to a distribution company, for either a fixed price or a percentage (which ranges from 10% to 25%) of the total revenues earned by the game. To date, Terry has sold three of the four games produced. He is currently negotiating the sale of the fourth game.

For the custom design business, Terry would receive an order from a distribution company for either the design of a new game or the redesign of an existing game (which occurs frequently because games have a useful life of only six months as players quickly get bored with them). Terry negotiates either a fixed fee payable upon completion, or an hourly rate based on the estimated length of time it should take to redesign the game. Terry sets the hourly rate based on the perceived difficulty of the project, but the rate is always at least triple the amount paid to Kim. For the hourly rate contracts, Terry submits monthly invoices showing the number of hours worked on the project.

Required:

1. Describe Terry's cash-to-cash cycle.
2. What revenue recognition options are open to Terry? Which one(s) would you recommend and why?
3. Using your recommended revenue recognition policy, how would you account for all of the costs incurred by Terry?

4-28 (Revenue recognition decision)

Juan Hernadez had seen many signs advertising house painters during the previous summers. Between his third and fourth year of university, he decided that he would start a painting business so that he could earn enough money to pay his tuition in the fall. He talked with a fellow student who ran a business like this the previous summer and knew the rates that he could charge. He made the following decisions: When he had a customer sign a contract for the inside or outside painting of a house, he would ask for a 20% down payment. The remainder of the contract price would be required when the job was completed. He made a deal with a local paint supplier for a discount on paint and other supplies. He assumed that most of the brushes and other painting supplies would be worth very little by summer's end, but he would sell off other supplies, such as ladders, when summer ended. If he needed a piece of equipment to do a job that he would likely not need again, he would rent it. His parents provided him with $500 in start-up money that needed to be repaid when he closed his business.

Required:

1. Describe Juan's cash-to-cash cycle.
2. What revenue recognition options are open to him? Which one would you recommend and why?
3. Using your recommended revenue recognition policy, how would Juan account for all the costs for his various contracts?
4. How should he account for the original loan that he received from his parents?

4-29 (Revenue recognition decision)

Sonya's Christmas Tree Company began operations on April 1, 2011, when she bought a parcel of land on which she intended to grow Christmas trees. The normal growth time for a Christmas tree is approximately six years, so she divided her land into seven plots. In 2011, she planted the first plot with trees and watered, cultivated, and fertilized her trees all summer. In 2012, she planted her second plot with trees and watered, cultivated, and fertilized both planted plots. She continued with her plantings and cultivation every year through 2017, when she planted the last plot. On November 1, 2017, she harvested the first plot of trees that she had planted in 2011. In 2018, she replanted the first plot.

Required:

1. Describe Sonya's cash-to-cash cycle.
2. What revenue recognition options are open to her? Which one would you recommend and why?
3. Using your recommended revenue recognition policy, how would Sonya account for all her costs for growing the trees?

4-30 (Revenue recognition decision)

Sparkling Cleaners operated six outlets in the city. At each outlet, customers could drop off clothes to be either dry cleaned or laundered. Clothes were normally ready for pickup within one to three days, and customers paid with cash, debit, or credit when they picked them up. Sparkling Cleaners had a central facility at which the clothing was cleaned. The company also had large contracts with hospitals and hotels. Under these contracts, laundry was picked up daily, cleaned, and returned the following day, and the customer was sent a weekly invoice for the laundry cleaned that week. Payment was due before the next invoice was sent out. Whenever a payment had not yet been received by the time that the next invoice needed to be sent, the unpaid amount was added to the new invoice.

Required:

1. Describe Sparkling Cleaners' cash-to-cash cycle. To do this, you will need to determine the types of expenditures that the company will likely incur in the operation of its business, as well as outline when the company receives cash in return for its services.
2. What revenue recognition options are open to the company with respect to its two types of customers? Which one would you recommend for each type of customer and why?

4-31 (Revenue recognition decision)

Carolina Dubasov enjoyed working with wood. She had a workshop set up in her backyard where she built articles of furniture, including tables, chairs, chests of drawers, end tables, and desks. She called her workshop C's Den of Wood. Every Saturday, she opened her workshop to the public and sold items of furniture that she had completed. Customers paid with cash or credit card. Sometimes customers asked her to make specific articles such as a table and six chairs or a bedroom suite. For these customers, she would draw up the plans. When the customer agreed to the design and the wood, she drew up a contract and asked for a 30% down payment. When the furniture was 60% completed, she showed it to the customer and collected another 30%. She collected the final 40% of the contract price when the furniture was completed.

Required:

1. Describe Carolina's cash-to-cash cycle.
2. What revenue recognition options are open to Carolina? Which one(s) would you recommend and why?
3. Using your recommended revenue recognition policy, how would you account for all the costs incurred by Carolina?
4. If a customer had signed a contract for a roll-top desk, paid the 30% down payment, and then decided he did not want the desk, should Carolina return the 30% down payment? Why or why not? How can she protect her business from this possibility?

4-32 (Statement of earnings presentation)

The following information is for Rooftop Ltd. for the year ended December 31, 2011:

Cost of goods sold	$175,000
Dividends declared	4,900
Dividend revenue	2,100
Gain on expropriation of land	5,600
Gain on sale of land	5,880
Interest expense	7,000
Loss from earthquake damage	13,300
Loss from flood damage	11,620
Income from operations of the company's Wholesale Division, which was closed (discontinued) during the year	2,800
Loss on sale of the Wholesale Division	44,800
Operating expenses	63,000
Sales revenue	287,000

The income tax rate is 40%. The company had 10,000 common shares outstanding throughout the entire year, and is located in a part of Ontario where earthquakes have rarely occurred before but floods have been known to happen in the past.

Required:

Prepare a statement of earnings, in single-step format, based on the information. (Note: Expropriation is a process by which governments can take over private property for public purposes. When property is expropriated, the owner has no choice but to sell it to the government.)

4-33 (Calculate ROI)

Calculate the ROI for the following independent investments:

1. Maria Chevas bought a GIC (guaranteed investment certificate) on June 1 for $3,000. The certificate reached maturity on December 1 (it was a six-month certificate). On December 1, she cashed in the certificate and received her original $3,000 back plus $37 in interest.
2. On January 2, Jim Wilson bought 10 shares of a pharmaceutical company for $12.00 a share. At year end, he received a dividend of $0.30 per share. At that time, the shares were trading for $12.50 per share.
3. Susan Blanchard bought a 25% interest in an outdoor adventure partnership for $15,000. During the year, the partnership earned net income of $50,000.
4. The Free-flow Plumbing Company had $250,000 in net assets (shareholders' equity) at the beginning of the year, and $280,000 at the end. During the year, it earned net income of $60,000.
5. Anastasia Kostovia bought a condo in Ottawa for $125,000. One year later, a real estate agent suggested that she could sell the condo for $130,000.

4-34 (Calculate ROI)

Calculate the ROI for the following independent investments:

1. The Cordova family bought a home in Calgary for $320,000. Two years later, a real estate agent told them that they could probably sell their home for $390,000.
2. Melrose Motor Company bought an investment in a supply company for $110,000. During the year, it received $4,000 in dividends.
3. Jack Valaas bought 5,000 shares in his sister's retail company for $20,000. The company earned net income of $72,000, which resulted in earnings per share of $3.75.
4. Margot Chan bought 10 shares in Transit Airlines for $6.60 per share. One year later, she had not received a dividend but the shares were selling at $8.10 per share.
5. Downing Disposal Company had $1,340,000 in assets at the beginning of the year and $1,150,000 at the end of the year. During the year, it earned net income of $120,000. (Assume that no new shares were issued during the year and no dividends were declared.)

User Perspective Problems

4-35 (Revenue recognition and earnings)

Financial analysts frequently refer to the quality of a company's earnings. By quality, they mean that the earnings are showing growth and are good predictors of future earnings. If you were looking for evidence of a company's quality of earnings, what would you look for on the financial statements?

4-36 (Changing revenue recognition policy to affect earnings)

Suppose that a company is currently private (its shares do not trade on a public stock exchange) but it is considering going public (issuing shares on a public stock exchange). Discuss the incentives that the company might have to misstate its income statement via its revenue recognition policies. If a company decided to change its revenue recognition policy to enhance its earnings, would the investors realize what it was doing? Where would a new investor look for information about the changes?

4-37 (Revenue recognition)

Suppose that a company has short- and long-term construction contracts. Explain how using the percentage of completion method for revenue recognition could meet the accounting requirements for both types of contracts.

4-38 (Revenue recognition)

Suppose that your company sells appliances to customers under sales contracts that require them to pay for the appliance in monthly payments over one year. Describe a revenue recognition policy that would be appropriate for this type of sale. How should the company account for the fact that some customers might not make the payments as required?

4-39 (Short-term borrowing)

Suppose that a company would like to increase a short-term loan outstanding that it has with a local financial institution. The institution currently requires monthly payments on the loan. Would the financial institution be interested in receiving periodic financial statements from the company? Why? If it did receive financial statements, what items would it find of most interest?

4-40 (Revenue recognition policy and management performance measurement)

Suppose that you are the sales manager of a company with an incentive plan that provides bonuses based on meeting sales targets. Explain how meeting your sales target is affected by the company's revenue recognition policies.

4-41 (Revenue recognition policy and sales targets)

Suppose that you are the vice-president in charge of marketing and sales in a large company. You want to boost sales, so you have developed an incentive plan that will provide a bonus to the salespeople based on the revenue they generate. At what point would you recommend that the company count a sale: when the salesperson generates a purchase order, when the company ships the goods, or when the company receives payment for the goods? Explain.

4-42 (Revenue recognition policy for accounting and tax purposes)

The guidelines for revenue recognition for accounting are not always the same as the rules for revenue recognition for tax purposes. Describe some incentives a company might have for setting its revenue recognition policy for accounting. Describe some incentives that the government might have for setting the rules for revenue recognition for tax purposes.

4-43 (Revenue recognition policy and return policies)

In the toy manufacturing industry, it is common to allow customers (retail stores) to return unsold toys within a specified period of time. Suppose that a toy manufacturer's year end is December 31 and that the majority of its products are shipped to customers during the last quarter of the year (October to December) in anticipation of the holiday season. Is it appropriate for the company to recognize revenue upon shipment of the product? Refer to revenue recognition criteria to support your answer.

4-44 (Revenue recognition policy and modes of shipping goods)

Suppose that an exporter in Vancouver sells goods to a customer in Australia. The goods are shipped by cargo vessel. For goods that are in transit at year end, what recognition should the Vancouver exporter make in its financial statements? Support your answer based on revenue recognition criteria.

4-45 (Revenue recognition for car leases)

Suppose that you are the owner of a car dealership that sells and leases cars. When customers lease a vehicle, they are required to sign a three- or five-year lease. A lease is a contract whereby the customer agrees to make monthly payments for the duration of the lease period. There are penalties if the customer decides to return the vehicle before the end of the lease. During the lease, the customer is required to keep the vehicle in good condition with respect to mechanical operations and appearance. When the customer returns the vehicle at the end of the lease, it is inspected for damage. The customer is often expected to pay for mechanical work or repainting that is required. Using revenue recognition criteria, explain when you would recognize the revenue from the monthly lease payments. How is your decision affected by your awareness that the customers pay a penalty if they return the vehicle early and that they pay for any damages at the end of the lease term?

4-46 (Advertising revenue recognition)

Suppose the sports channel on television sells $10 million in advertising slots to be aired during the games that it broadcasts during the World Cup. Suppose also that these slots are contracted out during the month of October with a down payment of $2 million. The ads will be aired in June and July of the following year. If the sports channel's fiscal year end is December 31, how should it recognize this revenue in its financial statements?

4-47 (Revenue recognition for gift certificates)

Suppose that The GAP (a clothing retailer) sells gift certificates for merchandise. During the Christmas holiday period, it issues $500,000 in gift certificates. If the company's fiscal year end is December 31, how should it recognize the issuance of these gift certificates in its financial statements at year end? Explain your answer in relation to the revenue recognition criteria.

4-48 (Revenue recognition on software sales)

Suppose that Solution Software Company produces inventory tracking software that it sells to retail companies such as Canadian Tire. The software keeps track of what inventory is on hand and where it is located. It automatically adjusts the information when items are sold and alerts the company when new inventory needs to be ordered. The software package sells for $100,000 and the company agrees to customize it to the buyer's operations, which can take several months. If the fiscal year end is September 30 and the company sells 10 software units in August, how should it recognize these sales in the financial statements at year end? Use the revenue recognition criteria to support your answer.

4-49 (Revenue and expenses associated with obsolete inventory)

Suppose that you are the auditor of Nichol's Department Store and, during your audit of the company's inventory, you observe a significant amount of inventory that appears to be extremely old. How would you recommend that the company deal with this inventory, and how will it affect the revenues and expenses recognized during the period? Explain the incentives that management might have for keeping the inventory in its warehouse.

Financial Analysis Assignments

Reading and Interpreting Published Financial Statements

4-50 (Revenue recognition for multiple products)

Brickworks Limited is an Australian company whose main activity is to manufacture clay and concrete bricks, tiles, and terracotta shingles that it sells for residential and industrial construction. Its other operations include timber products sales, land sales, and waste management services.

Required:

Using the revenue recognition criteria, describe how Brickworks should recognize revenue for its brick sales, its land sales, and its waste management services. You might find it useful to find out more about the company by going to its website at www.brickworks.com.au

4-51 (Catalogue production, revenue recognition, and matching)

Marks and Spencer (M&S) is a British company that sells clothing, home and furniture items, home electronics, food, and other items from retail stores and over the Internet. The cost of Internet shopping site development and maintenance is fairly substantial for a company such as M&S. Considering that these costs occur before any revenue can be generated from the sale of items through the Internet site, discuss how they could be recorded in the accounting system so that they can be matched with the revenue that is eventually generated.

4-52 (Apply revenue recognition criteria)

Qantas Airways Limited is the major airline company in Australia. The company's statement of financial position (balance sheet) as at June 30, 2009, is presented below in Exhibit 4-11. In Note 1(G) to the financial statements, Qantas describes its passenger, freight, and tours and travel revenue policy:

Required:

1. Referring to the balance sheet, what was the value of the transportation that Qantas was committed to provide at year end in 2009 and 2008?
2. Referring to the revenue recognition criteria, explain why Qantas's revenue recognition policy is appropriate.
3. Qantas passengers can earn frequent flyer miles each time they fly with Qantas. When passengers have earned enough frequent flyer miles, they can travel free on Qantas. How should Qantas account for these free trips?

   EXHIBIT 4-11  QANTAS AIRWAYS LIMITED 2009 ANNUAL REPORT

   

4-53 (Apply revenue recognition criteria)

According to Note 2(e) to its 2009 financial statements, the revenue policy of Catalyst Paper Corporation, a leading North American newsprint and specialty paper products manufacturer, is as follows:

Revenue Recognition

The Company recognizes revenues upon shipment when persuasive evidence of an arrangement exists, prices are fixed or determinable, title of ownership has transferred to the customer and collection is reasonably assured. Sales are reported net of discounts, allowances and rebates.

Required:

1. Describe Catalyst Paper's revenue recognition policy and explain how it satisfies the revenue recognition criteria.
2. Explain what the term “F.O.B. shipping point” means. After reading the revenue recognition criteria stated by Catalyst Paper, do you think that it ships its products F.O.B. shipping point? Explain your reasoning.

4-54 (Apply revenue recognition criteria)

The revenue recognition policy of Imperial Metals Corporation, a Canadian gold and copper mining company, is as follows, from Note 1 to its 2009 financial statements:

Required:

1. Describe Imperial Metals' revenue recognition method. Explain why this method conforms with the IFRS criteria for revenue recognition. Include consideration of the treatment of estimated revenues and settlement adjustments (adjustments caused by changes in metal prices and changes in quantities arising from final weight and assay calculations).
2. What alternative revenue recognition policies and recording could Imperial Metals use that would also conform with IFRS?

Financial Analysis Assignments

4-55 (Statement of earnings items)

High Liner Foods Inc. processes and markets seafood products throughout Canada, the United States, and Mexico under the High Liner and Fisher Boy brands. It also produces private label products and supplies restaurants and institutions. Using High Liner Foods' consolidated statements of income for 2009, which appear in Exhibit 4-12, answer the following questions:

1. Has High Liner Foods used a single-step or a multi-step income statement? What aspects of the statement influenced your answer?
2. Calculate High Liner Foods' gross profit rate (gross profit divided by net sales) for 2009 and 2008. Did the company's gross profit, as a percentage of its revenue, increase or decrease?
3. Calculate High Liner Foods' net profit rate (net earnings divided by net sales) for 2009 and 2008. Did the company's net profit, as a percentage of its revenue, increase or decrease?
4. High Liner Foods reports both “basic” and “diluted” earnings per share (EPS). Briefly explain the difference between these two terms and why the figures for diluted EPS are lower than those for basic EPS.

   EXHIBIT 4-12  HIGH LINER FOODS INCORPORATED 2009 ANNUAL REPORT

   

4-56 (Income statement items)

Gildan Activewear Inc. is a marketer and manufacturer of quality T-shirts, sport shirts, and fleeces. It sells the apparel to wholesale distributors as undecorated shirts, which are subsequently decorated with designs and logos.

Using Gildan Activewear's consolidated statements of earnings and comprehensive income, which appear in Exhibit 4-13, answer the questions below:

1. Has Gildan Activewear used a single-step or a multi-step income statement? What aspects of the statement influenced your answer?
2. Calculate Gildan Activewear's gross profit rate (gross profit divided by net sales) for 2009, 2008, and 2007. Did the company's gross profit, as a percentage of its revenue, increase or decrease?
3. Calculate Gildan Activewear's net profit rate (net earnings divided by net sales) for 2009, 2008, and 2007. Did the company's net profit, as a percentage of its revenue, increase or decrease?
4. Gildan Activewear reported both “basic” and “diluted” earnings per share (EPS). Briefly explain the difference between these two terms and why each of these amounts may be important to users.

EXHIBIT 4-13  GILDAN ACTIVEWEAR INC. 2009 ANNUAL REPORT

4-57 (Income statement items)

As its name suggests, West Fraser Timber Co. Ltd. is a Canadian forest products company that produces lumber, wood chips, fibreboard, plywood, pulp, linerboard, kraft paper, and newsprint. Using West Fraser Timber's consolidated statements of earnings and comprehensive income, which appear in Exhibit 4-14, answer the questions below:

1. Has West Fraser Timber presented a single-step or a multi-step income statement? What aspects of the statement influenced your answer?
2. Calculate West Fraser Timber's gross profit rate (gross margin divided by revenue) for 2009 and 2008. Did the company's gross margin, as a percentage of its revenue, increase or decrease?

   EXHIBIT 4-14  WEST FRASER TIMBER CO. LTD. 2009 ANNUAL REPORT

   

3. Calculate the company's net profit rate (net earnings divided by revenue) for 2009 and 2008. Did the company's net profit, as a percentage of its revenue, increase or decrease?
4. West Fraser Timber has included other comprehensive income at the bottom of its statement of earnings. What is other comprehensive income? What item is included by West Fraser Timber under other comprehensive income?

BEYOND THE BOOK

4-58 (Revenue recognition policies used)

Using an electronic database, select a company in the oil and gas industry. Then use the information on its financial statements and in the notes to the financial statements to answer the following questions:

1. Describe the types of revenue that the company generates.
2. Describe the policies that the company uses for revenue recognition for its various revenues. Using the revenue recognition criteria, explain why the company's policies are suitable for the revenues it generates.

4-59 (Financial statement disclosures)

Find the annual report of a Canadian company that is listed on a Canadian stock exchange, and answer the following questions:

1. Does the company prepare a single-step or multi-step income statement (statement of earnings)? Briefly explain your answer.
2. Does the company have any discontinued operations? If so, search through the information provided with the financial statements and explain why this item was classified in this way.
3. Has the company reported diluted earnings per share? If so, how do the amounts reported for diluted EPS compare to the amounts reported for basic EPS?

Case Primer

Cases

4-60 Quebec Supercheese Company (QSC)

Quebec Supercheese Company (QSC) produces many varieties of cheese that are sold in every province in Canada, mainly through large grocery stores and specialty cheese shops. The cheese is produced at its factory in Montreal and shipped across Canada using commercial refrigerated trucks that pick up the cheese at the factory loading dock. All cheese is shipped F.O.B. shipping point, meaning that the purchasers pay for the trucking and assume responsibility for the cheese as soon as the trucks pick it up at the factory. In accordance with IFRS, QSC recognizes the sale as soon as the trucks load the cheese, as the purchasers have title and responsibility for the cheese at this point.

QSC is not happy with these arrangements because it has received many complaints from purchasers about spoilage. Even though the purchasers and their truckers have full responsibility for this spoilage, many disputes have occurred because the truckers insist the cheese is spoiled when they pick it up. QSC is considering setting up its own fleet of trucks to deliver its cheese across Canada. It estimates that the additional freight costs can be regained through the higher prices it would charge for including shipping in the price (F.O.B. destination).

If the company makes the deliveries, the title to the cheese will not transfer until the cheese is delivered. QSC's president was not happy when she learned that sales would be recognized and recorded only upon delivery to the customer, since she knew that an average of five days' sales are in transit at all times because of the distances involved. One day's sales total approximately $100,000 on average. The effect of this change would be an apparent drop in sales of $500,000 and a $50,000 decrease in net income in the year of the change.

Required:

1. Advise the president about revenue recognition guidelines.
2. Do you see a solution that could change the shipping method while avoiding the resulting effect on the income statement?

4-61 Windsor Contracting Ltd.

Windsor Contracting Ltd. has been delaying the recognition of revenue until its contracts are complete. In the past, the company has focused on performing small renovation and home improvement jobs that typically lasted from two weeks to three months. The company has a very good reputation for quality work and fair pricing. Due in large part to its strong reputation, the company has begun to expand its operations to include larger contracts that may take up to two years to complete. Dan Fielding, the president, is thrilled with the company's success but is a little concerned about accepting these larger contracts. He contacts you, John Philpot, a local accountant, to obtain some advice on the accounting for these larger long-term contracts.

“John,” Dan says to you, “I'm concerned about accepting these long-term contracts. If I can't recognize any of the revenue associated with these jobs until they're completed, my income statement is going to look very poor for the years when the contracts are in progress but not completed. I'll need financing to undertake these large jobs and the bank needs a yearly income statement to support my line of credit. What do you suggest?”

Required:

As John Philpot, write a memo to Dan Fielding, addressing his concerns. Your memo should focus on a discussion of the percentage of completion method of accounting for revenue recognition and how this method would meet the needs of Windsor Contracting. The memo should also include a discussion of any estimates that Windsor will have to make to apply this method of revenue recognition.

4-62 Mountainside Appliances

Danielle Madison owns a store called Mountainside Appliances that sells several different brands of refrigerators, stoves, dish washers, washers, and dryers. Each of the appliances comes with a factory warranty on parts and labour that is usually one to three years. For an additional charge, Danielle offers customers more extended warranties. These extended warranties come into effect after the manufacturers' warranties end.

Required:

Using IFRS guidelines for revenue recognition, discuss how Danielle should account for the revenue from the extended warranties.

4-63 Furniture Land Inc.

Furniture Land Inc. is a producer and retailer of high-end custom-designed furniture. The company produces only to special order and requires a one-third down payment before any work begins. The customer is then required to pay one-third at the time of delivery and the balance within 30 days after delivery.

It is now February 1, 2011, and Furniture Land has just accepted $3,000 as a down payment from H. Gooding, a wealthy stockbroker. As per the contract, Furniture Land is to deliver the custom furniture to Gooding's residence by June 15, 2011. Gooding is an excellent customer and has always abided by the contract terms in the past. If Furniture Land cannot make the delivery by June 15, the contract terms state that Gooding has the option of cancelling the sale and receiving a full reimbursement of any down payment.

Required:

As Furniture Land's accountant, describe what revenue recognition policy the company should be using. Prepare all journal entries related to the sale in a manner that supports the revenue recognition policy you chose.

Critical Thinking Questions

4-64 (Revenue recognition decision-making)

Alliance Atlantis Communications Inc. is a fully integrated supplier of entertainment products to the television and motion picture production industries. One of its products is television series that it sells to TV networks. Often these series involve the development of an idea and production of a pilot show. This is followed by attempts to market the show to television stations. If the series is sold, weekly shows are produced for later airing by participating stations.

Required:

Discuss the revenue generation process of this kind of television series, emphasizing the critical points in the revenue recognition process and pointing out the similarities and differences between the revenue process for Alliance Atlantis and for a company that manufactures television sets.